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Author: FoolMeOnce Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 5069  
Subject: A Strategy for Retiring Early Date: 8/7/2003 6:45 PM
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For those that are inclined to favor or consider real estate as a vehicle for building net worth, I offer the following.

I'm currently looking at a duplex about 3 miles from where I live. It is an older building but has been very well maintained. I have known the owner for years. The asking price is $140K but I think it can be had for $135K. Each side rents for $600/month. I am in the process of evaluating the place now. I am using the following assumptions which I believe to be reasonable for my area and situation.

Inflation (Rents and Expenses): 3%
Appreciation: 4%
Federal Income Tax: 25%
State Income Tax: 5.75%
30 Year Fixed-Rate Note @ 7.25%
Property Taxes: .75%/Annum
Insurance: .5%/Annum
Maint./Repairs/Reserve: 1.25%/Annum
Improvement Ratio: 80%
Purchase Costs: 3%
Sale Costs: 7%
Capital Gain Rate: 15%
Vacancy: 5%
Down Payment: 20%
Depreciation Recapture: 25%

My 10 year proforma shows a projected after-tax internal rate of return of about 14.75%. I can live with that.

Another analysis I like to perform is to see how long, using the above assumptions, it would take for the property to pay for itself. I allocate all after-tax cash flows to the note to accelerate the date at which the property would be owned free-and-clear and generating income to be used for living expenses. It turns out the property would be owned free-and-clear after only 16 years. In the 17th year, the net operating income (gross rents less vacancies and expenses) would exceed $16,500/Annum. The duplex itself is now worth over a quarter million dollars.

By comparison let's assume that the amount of the down payment ($27K) could be invested in the stock market for a compounded total return of 10%/Annum. After 16 years the stocks would be worth about $124K. Withdrawing at a rate of 4% would yield about $5000/Annum. The duplex in all likelihood will throw off more than 3 times as much income to a prospective early retiree. Just how bad would my assumptions have to be for the duplex to become an inferior approach? Imagine what owning just 2 or 3 buildings such as this would do for your early retirement aspirations.

This is just an example to get you thinking about the possibilities and about different ways of looking at small income properties and how they might fit in with your plans. Every location is different. I am fortunate to live in a rural area with low taxes, but with a very strong rental market and dependable appreciation.


Standard caveats:

> The expenses and all assumptions are for my area. Your mileage may vary.

> Yes, investing in an index fund requires less effort than owning and managing real estate. You may also achieve results commensurate with the effort required.



Also, those of you in the Roanoke, VA area might be interested in the following auction:
http://www.woltz.com/469/home.cfm

Regards,
FMO
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Author: mazske Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 182 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/7/2003 8:38 PM
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Great post, FMO.

I really like the idea of owning rental property as I did rent one house I owned a few years ago and didn't have any major problems.

However, the problem I would have in the above scenerio would be coming up with a 20% downpayment. The majority of my money is in IRA's and a 457 plan and it's untouchable to me. I do have a little bit in a taxable account that I could use for investment purchases, but not enough for a property like this.

I see houses for sale in my area in the range of 50-60K. I don't know rental prices and this is where I need to do my homework, but I'm guessing something like this would rent for $400/month.

If that guess was true, would a 2 minute thought on this lead you to say this would work or would you say stay away from houses that can be bought for 50K.

I would still have to come up with the downpayment though and there lies the main problem. That initial downpayment and then enough in the bank to cover any emergency repairs that may crop up.

I think you said something in another post about 0% down deals. Are these possible to get for investment properties and are they worthwhile, or do you think it's better for someone to save up a downpayment.

A few years ago, I discussed with my wife the idea of slowing down my investments into equities and saving for a downpayment on a rental property. She liked that idea as a rental property is here and she can see it versus a stock is not and it may be worth $100 today and $2 tomorrow. Property values may drop, but usually not as dramatic as a stock could.

Thanks for any comments you may have.

mazske

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Author: bengebreth One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 188 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/7/2003 11:32 PM
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FMO, if it's not too much trouble, could you post the equation that you use to compute return 't' years in the future given the numbers you are using.

Thanks, Ben

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Author: brewer12345 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 192 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/8/2003 9:31 AM
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I'm curious: how are you financing this property? Do you finance with a "second home" mortgage, or is this a loan specifically intended for investors?

I have given a lot of thought to a real estate investment, and I am very interested, but I have two things holding me back:

1. RE prices in my area are out of whack with what rents can cover. If its not in my area, I can't manage it myself and there go the profits.

2. If you have a deadbeat tenant, getting them out is a nightmare. I could carry the building for a while, but it would really kill the returns.

The first I can deal with: wait for an opportunity in pricing. The second I would be interested in hearing your take on.

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Author: SoftSimp Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/8/2003 9:59 AM
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1. RE prices in my area are out of whack with what rents can cover. If its not in my area, I can't manage it myself and there go the profits.

2. If you have a deadbeat tenant, getting them out is a nightmare. I could carry the building for a while, but it would really kill the returns.


You've hit on the two biggest obstacles to making money as a landlord.

First, you can NOT pay too much for a property. Like stock, if you buy too high you really cut into your returns. You have to be willing to search long and hard for a seller who is willing to work with you. They're few and far between, but there ARE good deals out there, even now. Some people are into pre-foreclosure sales and the like, but I'm not knowledgeable enough to be able to do this without considerable risk. And I've heard that the after-forclosure deals really aren't all that great.

Second, you have to screen your tenants thoroughly. I think that this is really THE most important thing you can do. Generally, someone who has been a deadbeat in the past is likely to be so again in the future. It's not so much about earning power as it is about attitude - some people just aren't bothered by having bad credit or judgments against them.

Someone with an attitude like that is also not likely to take good care of your property, thereby reducing the value of your investment (in addition to costing you money in terms of lost rent and eviction proceedings).

I protect myself by running tenant credit checks, checking references, etc. I also have a 7 page lease. When I rent a unit, I sit down with the tenant and go over the lease item by item to make sure that not only do they know what the "rules" are, but that they understand them.

Two things I stress are: if there's something wrong, I need to know immediately (like a leaky roof or pipe), and I expect the rent on or before the due date. I explain that I use the rent to pay the mortgage - if they don't pay the rent on time, then I can't pay the mortgage on time, in which case we'll BOTH lose the house. Explaining it in this fashion really seems to make it sink in.

In the years that I've been a landlord (since 1999), only one tenant has ever been late. She was only late one time, she called me a week in advance to let me know she would be late and why (her boyfriend had been killed in a boating accident). She paid $500 of her $600 rent on time and the other $100 within a week. I did NOT charge her a late fee nor do I count that as a late payment (in case she ever needs me as a reference). I think that under the circumstances she handled it very well - and this is a tenant who didn't have stellar credit (I originally rented the place to her boyfriend because her credit was bad), but she thoroughly understood that I need the rent to pay the mortgage. Her rent has never been late since.

You may want to take a look at the "Real Estate Investing" board (http://boards.fool.com/messages.asp?mid=19352652&bid=113590). If you view the board in Rec order, you'll see a bunch of posts by Jiml8. He's quite knowledgeable and worth reading.

SS

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Author: SoftSimp Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 201 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/8/2003 11:57 AM
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FMO, if it's not too much trouble, could you post the equation that you use to compute return 't' years in the future given the numbers you are using.

I'd be interested in this, too.

Ben,

I'm not FMO, but I may be able to give you a decent "ballparking" tool. On average, taking the typical expenses into account, a property with a 1:100 ratio between purchase price and monthly rental income will break even from the outset (no income, but also no loss). For instance, a property that costs $100,000 should generate about $1,000 per month gross if breaking even is your goal. Typically, your income rises each year because rents increase, but your mortgage remains fixed. So almost any property will give you a positive cashflow sooner or later, even if it starts out negative.

Things like interest rates, downpayment amounts, tax rates, etc. will impact this ratio one way or another, so you will really need to analyze each property individually. This ratio is basically helpful when deciding which properties are worth further study.

Now, not everyone's goal is to make money, or even to break even, in the first few years. In the example that FMO gave where a property will cost $135,000 and earn $600, it's not even close to breaking even - HOWEVER - he figured that his IRR would be 14.75% within 10 years and he's comfortable with that. So it really depends on what your goals are.

For me, the goal is always to AT LEAST break even from the start, and preferably to come out ahead, with a 20% downpayment. The ratio on the property I currently have started out at about .7:1, or 1:1.4, so it was putting a monthly income in my pocket from the start. Based on my initial investment, my before tax ROE was only .02% in the first year, due to my fix up costs (which the income from the property paid for) - but at least it was positive! The second year, my before tax ROE was over 18%. Last year it was about 21%. These figures don't take tax benefits or appreciation into account. Using those would make these figures much higher.

But - I got very lucky in getting the price I got on that house. A typical house like it in the same area would have sold for $85,000-$105,000 at the time. I bought it for $68,500, because I found someone who just wanted to sell it and be done with it, and I was able to show them I was a serious buyer and would be able to close the deal.

If you look at houses just one city over, the typical selling price for a house generating the same gross income was between $140,000 and $175,000. While I couldn't resist looking at those houses (they're newer and "cuter"), I couldn't justify buying one for my purposes. However, if I were buying it as a retirement vehicle and wasn't concerned about coming out of pocket for the first few years, I would consider one of them. And if I intended to live in half the house, they would be my first choice. So it really depends on what your goals are.

We would not be able to afford to buy a house that was costing us money every month, so if they don't at least break even, we can't afford them.

This isn't exactly what you were looking for, but I hope it helps.

SS

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Author: FoolMeOnce Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 202 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/8/2003 12:03 PM
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SoftSimp writes:

In the example that FMO gave where a property will cost $135,000 and earn $600, it's not even close to breaking even

The property is a duplex. Each side rents for $600. It has cash flow from the beginning. it would be very difficult where I am to get a 100:1 ratio. I am usually satisfied with 120-125:1 for a single family home. I expect better ratios for multiples.

Regards,
FMO

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Author: FoolMeOnce Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 203 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/8/2003 12:04 PM
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bengebreth writes:

FMO, if it's not too much trouble, could you post the equation that you use to compute return “t” years in the future given the numbers you are posting.

Due to the large number of variables involved, there is no single equation that can be used. I use a proforma spreadsheet that I designed specifically to evaluate investments, subject to assumptions that I deem important. If you are interested, I can email it to you.

Regards,
FMO


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Author: FoolMeOnce Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 204 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/8/2003 12:05 PM
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mazske writes:

I see houses for sale in my area in the range of 50-60K. I don't know rental prices and this is where I need to do my homework, but I guessing something like this would rent for $400/month.

A rule of thumb that I use is to try to keep the price of a property purchased with a 20% down payment to 120-130 times the monthly rent. In some areas this is not difficult to do. In others it is very difficult. It is just a rule of thumb though. Each property should be evaluated on its own merits.

I think you said something in another post about 0% down deals. Are these possible to get for investment properties and are they worthwhile, or do you think its better for someone to save up a down payment?

I think it's better to save up a down payment. “Nothing-down” deals have been popularized by various gurus appealing to the naïve and under-capitalized. The ability to leverage your real estate investments is a good thing, but like all good things, it can be taken to excess. In many areas, a nothing down transaction means poor, nonexistent or negative cash flows. It also means that you will be relying much more on appreciation than cash flow to provide your investment return. This has the effect of making the purchase more speculative. In the short term, appreciation is unpredictable. If rents decline, or your personal situation affects your ability to handle the negative cash flows, the whole enterprise may go belly-up. I think it far preferable for anyone contemplating real estate investing to exercise the discipline of saving for a down payment and accumulating an emergency fund to handle the unexpected. This is just good risk management.

Since owner-occupied dwellings are easier to finance with less down, an easy way to get started is to purchase a house to live in and then some time later purchase a new personal dwelling and convert the old to as rental.



Regards,
FMO





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Author: SoftSimp Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 206 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/8/2003 12:09 PM
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The ratio on the property I currently have started out at about .7:1, or 1:1.4,

Oops. I dropped some zeros. I also stated the initial ratio backwards. Hopefully my example explained it better than I did! I meant that you're looking for a 100:1 ratio between purchase price and monthly rental income to break even. The ratio on mine was 70:1 or 100:1.4. Basically, the lower the ratio, the better.

Sorry about that. Hope I haven't gotten anyone's head spinning.

SS

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Author: FoolMeOnce Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 255 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/9/2003 8:55 AM
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brewer12345 writes:

I'm curious: how are you financing this property? Do you finance with a "second home" mortgage, or is this a loan specifically intended for investors?

It is not difficult to finance even investment properties with 20% down. I could simply go to a local savings and loan that I have dealt with in the past.


RE prices in my area are out of whack with what rents can cover. If its not in my area, I can't manage it myself and there go the profits.

Yes, this can be a problem, especially with single family homes which are valued primarily by owner-occupants and not by the amount of income they can produce. I think the best solution in such areas is to look more at multiple units whose appeal is primarily to investors, and which are valued by the amount of income they can produce.


If you have a deadbeat tenant, getting them out is a nightmare. I could carry the building for a while, but it would really kill the returns.

Tenant qualification is very important. In 25 years of owning and managing real estate, I have not once had to evict a tenant. If deadbeats are a concern due to the types of properties or areas in which you would be investing, you should take that into account when you formulate your offer to maximize the probability of obtaining a return you can live with. This is why properties in bad areas can be very lucrative for a good manager. The market recognizes that bad tenants affect returns and the prices are discounted accordingly. Even in the best areas, getting a bad tenant is a possibility. Each investor has to weigh that risk and act accordingly.

Regards,
FMO



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Author: nmckay Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 383 of 5069
Subject: Re: A Strategy for Retiring Early Date: 8/14/2003 2:01 PM
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Also, some states allow for faster evictions. New York is 3 months and I've been told that Arizona is two weeks. You should probably know what it is in your area.

nmckay

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Author: Stetson20 Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 621 of 5069
Subject: Re: A Strategy for Retiring Early Date: 9/3/2003 12:47 AM
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Your post dated 8/7/03

For those that are inclined to favor or consider real estate as a vehicle for building net worth, I offer the following.

I'm currently looking at a duplex about 3 miles from where I live.

.... edited for space .....

Maint./Repairs/Reserve: 1.25%/Annum
Improvement Ratio: 80%
Purchase Costs: 3%
Sale Costs: 7%


Could you expound on this term?

Thanks!

Stetson20

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