The Decision to Buy Real Estate
The housing crisis of 2008 impacted a great amount of people both directly and indirectly. If you lost your home to foreclosure or had to sell through a short sale, you may just now be financially recovering. Or maybe it was your parents who experienced the crisis and you never want to go through anything like that yourself.
There is always a chance something like that could happen again. Enter student debt, geo-political uncertainty, Brexit, North Korea, whatever the next “something” is, it could happen. As far as the reason for the 2008 “subprime” mortgage crisis, individuals are now vetted to a much higher standard prior to qualifying for a loan. "Stated income” does not exist anymore. Lending institutions are held to a much higher caliber when allowing investors and individuals to obtain leverage.
Investing in real estate comes with a great deal of risk. It is crucial to weigh out this risk and make sure you are both financially and emotionally ready to take on this challenge.
The Down Payment
When you decide to buy your first home, you are able to put as little as 3% down with a conventional loan based off of the purchase price. Financial institutions do this based off the assumption that you need a place to live and will be more likely to pay the monthly mortgage payments.
$200,000 purchase price and 3% down = $6,000 down payment. A big chunk of change, but with some intentional saving and discipline, you can save that money.
It is tough to qualify to buy your first home. Be prepared to offer up information such as two years of income tax returns, your most recent pay stubs, what that deposit was in June of 2018, and what your mom's favorite color of flower is. Banks want to make sure whoever they are loaning to are theoretically going to be able to repay them. This ensures that only people who are financially "qualified" can buy a home. Thus, strengthening your position as a home owner.
For an investment property, financial institutions will require 20% to 25% down payment. Wow! That’s a lot of money. The median price of a home at the beginning of 2019 in the United states was hovering right around $200,000. That would be a $40,000 to $50,000 down payment, not including closing costs of the purchase.
Hopefully you have saved those savings bonds your grandma gave you for your thirteenth birthday!
So, you've saved up the 3% if you're buying a personal home or 20-25% if you're investing. That is amazing, congrats! Don't forget about the closing costs though. Huh? Yeah, the closing costs. Those costs that pay for all the fees/pre payments to obtain the loan and home.
You will have fees from the title company and lending institution to consummate the deal. These fees will range from closing fees, recording fees, loan origination fees, appraisal fee, and others. In addition to all of these fees, you should also expect some pre payments to be charged. These will include pre-paid interest on your loan, pre-paid insurance (12 months) as well as escrowing 3-4 months of insurance and property taxes. The good thing is, these pre-paid expenses will be applied to future amounts due. It just sucks you have to pay these up front.
Closing costs are going to range anywhere from 1.5-3% of the loan amount depending on your loan costs and negotiated closing costs. That means, on top of your down payment of $40,000 to $50,000 on your investment, you will owe an additional $2,400 to $4,800 in closing costs. To get those figures, I took the purchase price of $200,000 less the down payment of $40,000 to get you a loan amount of $160,000. The closing costs estimate will be based off your loan amount ($160,000*.015=$2,400 and $160,000*.03=$4,800).
Operating The Property
The financial burden does not stop with the down payment and closing costs. Make sure that your 25% down payment was not all the money you had in the bank. Maintaining and operating the property costs money. Some costs though, could surpass the cash flow your property produces and require you to dip into your bank account.
Let’s say your new asset gets a plumbing leak. Although it is quite simple to get a plumber over there to fix the leak, you may also have to get a water extractor out, and possibly a handyman to replace some flooring. Maintenance issue resolved, but now come the bills. Due in 30 days. That plumbing leak could end up costing a couple thousand dollars.
A good rule of thumb is to have 1% of the value of the home in the bank for unexpected repair and maintenance. So, if you bought a home for $200,000, having $2,000 in the bank at all times for repair and maintenance is a must. If you bought a $600,000 4-plex, bump that up to $6,000 in the bank. The higher price point you go, the more issues or more expensive issues could pop up.
Investing in real estate is again, risky. There are ways to mitigate these risks, but sometimes, shit happens. You need to be financially prepared for these mishaps and ready to pay for their repairs. It is going to suck and will be upsetting, which is why you also need to be emotionally prepared to invest in real estate.
We have already discussed how investment properties take a big chunk out of your bank account, however the emotional burden may be something even less desired.
I will never forget the first 4-plex I bought and the stress I put on myself. The "what-ifs" that ran rampant in my mind. You can drive yourself crazy thinking of all the possibilities of what could happen.
"What if there is a sewer back up?!"
"What if my tenant pours cement down the drains because I charged them a late fee?!"
"What if I can't get the place rented?!"
In reality, most of the scenarios will never happen, however it is important to understand the possibility of them happening.
You will now need to ensure the property operates properly. You will need to keep it occupied, maintain the furnace, sprinklers, A/C, and be willing to fix maintenance issues that pop up. Your Saturdays and Sundays could and may be impacted. Leaks don't just happen on Tuesdays between 8AM-5PM.
It is not fun to see your unit completely trashed after a tenant moves out. You start scrambling about what all you have to do because your new renter moves in, in 4 days. You work a full-time job and now on top of that have to schedule and follow up on all this work. Those next 4 days will be taxing.
Maintenance issues are not the only issues you will come across that may affect you emotionally.
Vacancy is at an all-time low right now. Development companies are hastily working on fixing that. A substantial amount of building is going on to accommodate the rental market, including a multitude of rental units. If supply inflates, potentially beyond the current demand, prices can be impacted. Vacancies can jump and individual investors will feel the effects.
If supply does surpass demand, filling units will become your number one job. You will have to show the property more, renters will be more selective and you will have to overcome any personal self-doubt and uncertainty. No more of the "take it or leave it" mentality. It is a numbers game. If you are not ready for that challenge and run at the first hiccup, this investing game is not for you.
There is a reason when you look at all pro formas there is a section at the top that considers vacancy, usually at 5%. When you turn a unit over and it takes 4 days, those are 4 days of vacancy and lost rent. If you are unable to get the unit rented for 1/2 of the month, that is 15 days of lost rent. You invested in real estate to have another individual pay your mortgage. You won't be able to pay 2 mortgages for too long. Vacancy is both financially and mentally taxing.
The Decision to Invest in Real Estate
The real estate investing world is sexy right now. Bitcoin was sexy, jumping from $3,000/coin to $20,000/coin. Bitcoin is now back down to $9,000/coin. The folks who bought in at $3,000 and sold at $20,000 made a great big chunk of change. The folks who bought at $20,000 and rode the plunge to $9,000 may be feeling the pain.
Don't invest in real estate because it is sexy and the hot thing to do right now. Invest in it because you are ready to work and would prefer control over your assets. You have studied and put together a team of individuals who are able to help you. Possibly a mentor, a lawyer, an accountant, and a team of maintenance vendors. Be prepared both financially and emotionally for the journey of real estate, if that is what you decide to do.