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I love the idea of purchasing a rental property. I have toyed with the idea before and my spouse likes the idea as well. When I bought my first house back in '93, I rented for the next 3 years so I do have some experience with being a landlord.

Here lies one of the issues. I'm using a lot of assumptions with this scenerio as well.

Let's say I want to buy a rental property such as this one.

http://tinyurl.com/jfkq

I hope that link works. I'll try to remember and preview it to make sure.

If this house was purchased at asking price and I wanted to put a 20% down payment on it, I would need to save up $9,400. That's not figuring in any closing costs, but it's also not figuring in that I would offer less than this to buy the house.

For me to save up that downpayment, I would have to divert my current contributions to IRA's and 457 plan to another, taxable type account. I'm thinking I could go with saving $400 a month at this day in time towards this goal. That amount should increase slightly over the next year to two years.

Let's say I saved $400 a month for 12 months and then $450 a month for 12 months. That would give me $10,200, not figuring in any interest.

That would put me pretty close to the 20% downpayment and the amount needed for closing costs. There's a good chance, IMHO, that interest rates may be higher in 2 years so let's raise the estimated monthly payment for a mortgage in 2 years to an 8% rate which works out a $276/month and that's not figuring in insurance or taxes.

If this property, and this is just an example and not a real one I'm considering to buy, could rent immediately for $350/month, I should be cash positive by a little bit.

Now, I would have to keep up my savings into a taxable account for another year or so to get another $5400 saved to have as an emergency fund for this house.

Now, this is just a plan that I've thought about while typing this post. I'm guessing on the rent, but I'm thinking it may be conservative at $350/month and could possibly go to $400-450/month.

Looking at this "plan", I would have to curtail my investments into equities for the next 3 years or possibly longer. However, I would gain another house out of the deal with the possible rental income that should more than cover a mortgage.

Currently, with my savings they are relatively painless. I no longer buy individual stocks, even though I still own quite a few of them. I have money going into both the S&P 500 index fund and the Vanguard Total Stock Market Index fund. No stress, no phone calls for broken pipes etc. The only concern is what if the market tanks for the next 20 years, while housing prices keep rising for the next 20 years. That's the unknown factor.

Now, I've posted before about my possible pensions. In less than 15 years, I am eligible for an early retirment. I think a conservative figure is a pension of about $1k/month and the supplement of about $800/month. This would give me a bit over 21K a year, which if my house was paid off and the kids were grown, would be liveable, although we'd have to scrimp a little bit.

Now, let's say I only bought this one rental property and let's say in 15 years I was making $100 gross a month on the rents. That's a little bit more gravy, even though my rough guess is that in 15 years, rents would go up much more than $100/month.

I would also have my stock investments that I could tap into if necessary. I would also have my Navy pension that would kick in 10 years from my retirement from the Police. Knowing this could allow me to withdraw more from my stock accounts as when that pension kicks in it should be another 1K a month.

Like I said, this is something to think about. If I survive the next 3 years and purchase one rental property and build up an e-fund for it, then I could look at getting another one and then 3 years later another one.

I really want to FIRE in less than 15 years from the police department as I'll be 50 by then and that's getting old to be a cop. Too many young'uns now that can outrun me, much less in another 15 years.

I am not against working some sort of PT job if necessary to cover the bills, but I don't want to have to work FT.

I have not discussed how much I'll have in equities as that's another unknown factor. $400/month is $4800/year. Figure over the next 15 years I slowly increase savings each year, plus figure I'm making something on the stocks I own.

If I could maintain positive cash flows of $100 each, that's $300 more each month on the rental property. If rents go up by more than $100/month on the properties and/or I pay the mortgage off, the gross for me would be much more.

Wow, this post rambles quite a bit and I don't know if anyone will read the whole thing, but I'll be curious as to any comments. No one can answer for me, but if I stick with stocks and the market doesn't completely tank, I'm Firing at age 50. If I buy rental property I am still Firing at age 50. The big question is, does anyone who is smarter than I, all of you, think I'll make more money by buying some rental properties than I would if I stuck with stocks?



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Good ole' Mazske:The big question is, does anyone who is smarter than I, all of you, think I'll make more money by buying some rental properties than I would if I stuck with stocks?

I think that the downside of diversifying your stocks holdings with real estate is essentially nil and the payoff is potentially large. The diversification benefit provided by real estate is substantial when compared to stocks. If the market has a dismal 20 years you will at least have real estate batting for you. If the market takes off real estate will likely not do as well, but it won't hurt your overall return too much compared to the piece of mind it will bring. Even if the market is 20X higher 20 years from now there are bound to be times when it drops in half over the course of a year. You will be a lot happier with a real estate investment at that point.

Maybe you could buy your first place and then use the income from that towards more real estate and keep saving for stocks also. There are lots of possibilities...

st
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The big question is, does anyone who is smarter than I, all of you, think I'll make more money by buying some rental properties than I would if I stuck with stocks?

I don't know that I'm any smarter than you, but in my "Funding Future Needs" post I discovered that I can get where I want to be in 20 years by buying rental properties, but I can't get there in the stock market. So my answer would be yes, you'll do better with rental properties, if you can manage to get them paid off before retiring OR if you can accumulate enough of them to live off the income while still paying a mortgage on them.

BTW, I figured out that based on our current rate of investment and a 3% increase in DH's salary for the next 20 years allowing us to increase that rate of investment, and an 8% return, we will have $814,544 in 20 years. Not enough to retire on.

If we buy 5 rental properties over the next 8 years (as we save up the down payments), we'll be able to not only stop working and live off the rental income in 20 years, but we'll also have an additional 300,000+ stashed away in stock/bond investments.

Now that I've figured out my current budget, my future needs, and how I'm going to get there, I really need to let all of you take it from here so I can get some paying work done.

I really, really, like the new board. Writing this stuff down has helped me figure out a lot of things that I only had vague notions of before. Glad I stuck around - thanks mazske and FMO. :)

SS
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I second the responses from SoftSimp and SloanT. They represent good common sense. Of course, I would feel that way because their sentiments are aligned so closely with mine.


mazske writes:

If this property, and this is just an example and not a real one I'm considering to buy, could rent immediately for $350/month, I should be cash positive by a little bit.

Maybe. Maybe not. You still need to analyze your expenses. This would include property taxes, insurance, maintenance, repairs, etc.


The only concern is what if the market tanks for the next 20 years, while housing prices keep rising for the next 20 years. That's the unknown factor.

Yes. You have hit on it. I don't like to be concentrated in equities during the accumulation phase because the possible range of outcomes is so large. If you want to make a plan and have some assurance that it will actually succeed, you can't be too concentrated in equities.


Now, let's say I only bought this one rental property and let's say in 15 years I was making $100 gross a month on the rents. That's a little bit more gravy, even though my rough guess is that in 15 years, rents would go up much more than $100/month.

Consider this. If you can rent the property for $400 and assuming your non-mortgage expenses are not too much more than 2.3%, and you apply all excess cash flows to reducing the mortgage, it is possible that you could own the house free-and-clear in just 17 years. At a 3% increase in rents per year, your net operating income (gross rents less expenses) would be about $5,720/year or about $475/month.. Consider how you might have done if you invested (even on a tax-deferred basis) in the stock market: A single $9400 earning a compound annual return of 10% (some think this is unlikely) would grow to about $47.5K. A 4% withdrawal rate on this sum would yield $1900/year (before-tax) or about $158/month. Not only would the house be throwing off 3 times as much income but at only 4% appreciation the value of the house would be in excess of $90K. It's not even close.

Consider what your downside is in the stock market. Historically speaking over a 17 year period, the stock market is quite capable of returning less than 2%, meaning under the worst case, your original 9400 grows to only about $13K, probably not even keeping up with inflation.

Even if your rents and property value decline by 20% immediately after purchase. (This would be totally without precedent for your area) You might have a small negative for a few years but after 17 years you would still have substantial equity of over $40K and a positive cash flow.

Keep in mind that this is a very average property. With work you can do much better.

Regards,
FMO



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Two questions:

1. If I can do this well by renting, then why would I ever sell my house to someone else who would take that profit opportunity away from me?

2. If rents are high enough to justify cash flows like this, why would your high-quality renter continue to rent?

This is my natural skepticism saying that if a deal looks too good to be true, it must be. But I'm trying to keep an open mind.

thanks,
dan
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Here is something I don't understand, and granted I've only been investing for about 6 months. If buying property and renting it provides better returns than the stock market, why don't more people do it?
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galagan writes:

If I can do this well by renting, then why would I ever sell my house to someone else who would take that profit opportunity away from me?

I'm not sure I understand your question. My assertion is that you do better by owning, not renting. Perhaps you could elaborate.


If rents are high enough to justify cash flows like this, why would your high-quality renter continue to rent?

Every market is different. My tenants are what I call renters of circumstance. They can afford to buy a house (and some own houses) but like the lifestyle that a single family home provides. They are in my area for 2-3 years working on a contract or some such thing and need a place temporarily. I fill their need. Many renter have difficulty living below their means. They just can't seem to get their act together to afford a house. I have a tenant like this right now. I suspect they will continue to make me wealthy for as long as I allow them to stay.

Regards,
FMO

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WXFranklin:

Here is something I don't understand, and granted I've only been investing for about 6 months. If buying property and renting it provides better returns than the stock market, why don't more people do it?

Good question. Many people are too ignorant, lazy or fearful. They will not educate themselves to the extent required to see through the myths. They have all heard the horror stories about bad tenants without stopping to think about how the situation usually came about (usually the landlord screwed up by not properly qualifiying the tenant) It's easier to blame the house or the tenant for their own mistakes.

It has been said that one does not acquire real estate without also acquiring a little math. Many people are math-phobic. Ask yourself; if real estate was such a terrible investment, why would I be here singing its praises? Why would I own property? I have nothing to gain. If you buy ahouse whereever you live it affects me not one bit. I enjoy real estate, am convinced of its advantages and I enjoy helping other people enjoy the success that I have had.

Regards,
FMO
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If I can do this well by renting, then why would I ever sell my house to someone else who would take that profit opportunity away from me?

I'm not sure I understand your question. My assertion is that you do better by owning, not renting. Perhaps you could elaborate.


Sorry, my question wasn't clear. Let me try again.

If I've decided I don't want to live in my home, and I have a choice between renting it out to someone myself, or selling it to you so you can rent it out, then why would I ever sell it to you and give up that profit opportunity?

Put another way: why would anyone be willing to sell at a price that would make it extremely attractive to a potential landlord? Why wouldn't they run the math and try to price it at a level near the margin of what a potential landlord would accept?

I think you may have answered the question by responding to a later post.

thanks,
dan
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galagan writes:

If I've decided I don't want to live in my home, and I have a choice between renting it out to someone myself, or selling it to you so you can rent it out, then why would I ever sell it to you and give up that profit opportunity?

Because you need the equity in your current house to afford the down payment on your next one, or

Because you want to relocate a considerable distance away and don't want to manage it from long distance, or

Because you want to retire to Del Boca Vista and have decided that carrying a note on the sale of the house will generate hassle-free incme at your advanced age, or

Because you know next to nothing about owning and managing investment real estate and don't want to learn, or

any of a hundreds of other reasons.


Put another way: why would anyone be willing to sell at a price that would make it extremely attractive to a potential landlord?

People do this all the time. It has been said that there are no bad houses, only bad ownerships, and this is very true. Maybe the owners are getting divorced and the a quick sale of the house is the only thing standing in the way of them going their separate ways. Maybe they have run into financial difficulties and are happy to give-away their equity to preserve their credit. The reasons are numerous and varied as people themselves. I've got people willing to pay me more in rent than there mortgage payment would be if they purchased. Why? They like the lifestyle that a single family home represents but are only going to be around a couple of years. We both win.

I bought a house once with owner financing provided at 12.5 %. This is when market interest rates were around 18%. Within a year, the previous owner discounted the loan to me by 20% to get his cash. I didn't ask why he needed the cash. I didn't ask why he was willing to give away 20% of the note value. I didn't care. I certainly didn't sit around convincing myself that I could not make money because his behavior didn't make sense. I simply bought the note and made $7500 for virtually no work.


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Put another way: why would anyone be willing to sell at a price that would make it extremely attractive to a potential landlord? Why wouldn't they run the math and try to price it at a level near the margin of what a potential landlord would accept?

I can't answer for everyone, but the folks who sold me their double needed to get out from under the payments. Desperately.

1. They had thought they sold the house to someone who, apparently, couldn't actually qualify for financing.

2. Based on their belief that their house was sold, they moved out of state.

3. The sale fell through. They found themselves responsible for 2 mortgages, two water bills, etc. and taxes were due in a couple months (another $1000).

4. They hired a real estate agent (while remaining out of state) and put the house on the market at a sell-it-quick $80K (that type of house generally sold for $85K to $105K at the time).

5. The following week the price dropped to $75K.

6. I pounced, smelling a deal. I saw it, made an offer, and it got accepted.

Apparently the offer was high enough to allow them to pay off what they owed on the property, which was all they wanted at that point.

Many buyers would have asked the sellers to clean up the house, maybe paint it, etc. I requested none of that - I simply made an offer, as is, to take it off their hands. Mind you, this house needed some work (fortunately, the kind of work that I'm good at) and there was a lot of clean-up to be done. It looked like they had moved in a hurry.

It may not have been the wisest move on their part, but the deal accomplished what they needed. That's the key - every seller needs *something* out of the sale, and that "something" is not necessarily the highest price possible. If you can find out what that "something" is and make it happen, you can get a good deal. In their case, all they wanted was a guaranteed sale that would allow them to pay it off and get on with their relocated lives.

I've run across two sellers like this. Unfortunately, on the second one, another buyer made a better offer than I did (although mine was higher). The other offer didn't require an inspection - and the seller didn't want to risk the sale falling through due to something that turned up on the inspection. What really stinks about that deal is it was even BETTER than my current property (it was a duplex in better shape than my rental that I could have owned for $64,000) and I knew that the inspection wouldn't turn up anything I couldn't deal with. I just didn't trust my own inspecting skills sufficiently at that point in time to make the offer without a safety net. If I had that same deal in front of me today, I'd jump on it. I'm still kicking myself. :(

You do get better at this sort of thing, with practice.

SS
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Put another way: why would anyone be willing to sell at a price that would make it extremely attractive to a potential landlord? Why wouldn't they run the math and try to price it at a level near the margin of what a potential landlord would accept?

Never mind the seller or taking into consideration the potential landlord what about the buyers who don't care about ROI but are looking for the perfect house to raise junior and geraniums? There are far more of these in the market and the price will be set by them.

Hyperborea
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Never mind the seller or taking into consideration the potential landlord what about the buyers who don't care about ROI but are looking for the perfect house to raise junior and geraniums? There are far more of these in the market and the price will be set by them.

Unless, of course, they don't want the house in question, for whatever reason (dirt, school system, cracks in walls, no curb appeal), in which case the price will be set by the first person to make an offer that is acceptable to the seller.

SS
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Never mind the seller or taking into consideration the potential landlord what about the buyers who don't care about ROI but are looking for the perfect house to raise junior and geraniums? There are far more of these in the market and the price will be set by them.
----------

Unless, of course, they don't want the house in question, for whatever reason (dirt, school system, cracks in walls, no curb appeal), in which case the price will be set by the first person to make an offer that is acceptable to the seller.


That is definitely a possibility but then you also have home buyers who don't want to be landlords doing the same thing. I did it and got a place at good discount because it smelled, no more reeked, of cat. Even though I got it for a good bit less than the market price even after the remodelling (done myself) there is no way that it would cash flow right now or likely for years but that's the local market.

The biggest problem with real estate investing in directly owned rental properties is that it is incredibly location dependent. While, FMO may live in landlord nirvana - properties with good rental income versus property cost andhigh flowthrough of short term high quality renters - most of us don't.

It is also very highly dependent on your personal and career paths as well. Are you a hard working long hours professional? So when are you going to find the time to be able to make repairs or sometimes even arrange to meet with the hired handyman? If you're a hourly blue collar or a 9to5 government employee (which IIRC FMO is) then that makes things much easier.

Are you planning to retire and move in less than 20 years? Are you planning or likely to move in that timeframe for career (or spouse's career)? Now you compound your risk of being in a stagnant or declining period of a market. Oh you'll hold after you move? Now take a chunk of your cash flow out for the property management company and another chunck out for inefficiency and possibly lining of their and their "friend" the handyman's pockets.

There is a certain class of people for whom owning rental real estate makes sense and FMO may be one of them. There are probably a lot more people for whom it doesn't make sense. It's likely to be people in the second category who don't realize it that provide many of the bargains for people in the first category.

Hyperborea
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Let's say I want to buy a rental property such as this one.

http://tinyurl.com/jfkq

.....
Now, this is just a plan that I've thought about while typing this post. I'm guessing on the rent, but I'm thinking it may be conservative at $350/month and could possibly go to $400-450/month.



That house looks almost exactly like the first house I bought and it's about the same price! I sold my house and took back a second and was glad I did because the neighborhood proceeded to take a dive. They built an "adult motel" on the next block a year later. (although it's now 20 years later and the motel is a Motel 6 or a Super 8.) Just something else to consider.

You can probably find rents on line too.

Vickifool
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mazske writes:

I love the idea of purchasing a rental property. I have toyed with the idea before and my spouse likes the idea as well. When I bought my first house back in '93, I rented for the next 3 years so I do have some experience with being a landlord.

Just for kicks I did a little searching in your area for small multiple unit properties. It appears there are an abundance of 2-6 units properties available. I am jealous. In my area it is either single family homes or large apartment complexes. I was attracted to this listing for a triplex:

http://tinyurl.com/jhyl

Why? Because it is different. There are a number of interesting characteristics about this listing that would make me interested in checking it out. The property may be a total dog, but there is no way to tell without doing the required due diligence.

The first thing I note is that the building appears to be be brick (translation: little exterior maintenance expense).

The second thing I note is that the building has a lot of square footage for the price at 2,920 SF for $124.5K. This is only about $42/SF. I doubt a brick building can be reproduced for anywhere near that price including the price of the land.

Thirdly, the interior floor plan is very eclectic. Many times this spells opportunity for someone with vision. Note the disparity in the sizes of the units. One is 425 SF, the other 2 are 1280 SF. One of the units has 6 bedrooms? Note that there are three units but there are 4 bathrooms. The property is served by a septic system but the area around it appears built-up. This means that central sewer might be available. You might be starting to figure out where I am going with this.

If the zoning allows, this building might be convertible to 4-5 units without too much expense. It already has 4 baths and 10 bedrooms. It has sufficient square footage. Five 2 Br units at $350/month would yield monthly gross rents of $1750. With a 20% down payment the mortgage on a place like this would be less than $750/month. The cash flow would support a fair alteration budget.

Income properties are valued by the cash flow they produce. By adding more units, you not only increase your cash flow but you instantly increase the value of the building. If this conversion would fly, but I didn't have the downpayment, I wouldn't let that stop me. Take in a partner. Try to option the property and sell it to another investor. The possibilities are endless.

Regards,
FMo










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The big question is, does anyone who is smarter than I, all of you, think I'll make more money by buying some rental properties than I would if I stuck with stocks?

Yes. The key concepts regarding the benefits of diversification are non-correlated risks and, um, I don't know what it's called, but "non-additive compounding" would work.

First, your rental IRR will not be perfectly correlated with your stock portfolio IRR. Even were you to encounter the incredibly unlikely hypothetical extreme event of a renter using the exact same stocks you own to fund his rent, their prices cratering, and their dividends being cut, he would probably preferentially cut down on his discretionary spending before moving; and even if that wasn't enough, then you could (eventually) replace him with someone who has a job. In fact, I would expect rentals and stocks to be nearly inversely correlated, for two reasons. For one, most people pay their housing costs out of their wages -- if they don't own their residence outright, then it probably means that they can't afford to retire, since most people will eliminate the monthly cost if they can -- and business owners, employees, suppliers, and customers all compete for pieces of the potential revenue pie. For another, at this point in time, I think that stocks taken as a whole -- literally, such as a total market index fund -- are priced to a low enough dividend yield that they are clearly expected to depend more on price appreciation for their total return than a nice little rental would; so, your stock portfolio would probably take more of an IRR hit from price depression caused by rising interest rates (implying a shift in the time value of money) than your rental would.

Second, compounding is not additive. For example, $10,000 compounded at 10% for two years in a row is $12,100, but compounded at 0% one year and then 20% the next (or vice-versa) is only $12,000. Let's say that was the only difference in forty years, and for the next 38, they both compounded at 10% each year; just from that little $100 difference in the first two years, the first example would end up at about $452,593, while the second would end up at about $448,852. That's still not a huge percentage difference, but of course, there would actually be many more chances in 38 years for the more variable return to fall behind.

So, adding rental property (or, presumably, residential REITs) to your all-stock portfolio would be expected to smooth out your returns; and, all else being equal (and even sometimes when they're not), lower variance means faster compounding.

¤ Daniel ¤
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