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Rental Property and 400% ROI – Part 2

by Matt Jones, CPA
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This is the second of a 3-part series on my real estate experience. Start with Part 1.

Brian called with a property he wanted to sell. He explained that he bought and totally renovated this duplex, originally in very poor condition: the duplex received a new roof, electrical rewiring, new bathrooms and carpeting, a crew removed the piles of trash from inside and the front porch was rebuilt. 

Brian also paid back taxes on the property. Now, he wanted to sell this property quickly to put the money to work on another project. Sometimes Brian would keep a property like this to rent, but the returns weren’t high enough for him. 

The renovation was a bigger project than I could accomplish on my own. Brian and his team managed to complete it in a matter of months.

You see, Brian is a professional – regularly renovating properties to outfit as rentals. This is what differentiates him from me. I wanted one good rental. Brian has flipped nearly one hundred properties. 

Brian had a full-time crew working for him and could make more money renovating properties than he could managing rentals. In a way, I was doing Brian a favor by letting him cash out easily. He was certainly doing me a favor providing a turnkey property.

Also, this fit the rule I’d set for myself to be the “first or last” to look at a property, in this case I was the first. I prepared my spreadsheets to estimate what I could expect under best, worst and most likely circumstances.

Using conservative assumptions, I found that the property provided a high “cap rate” (~13%) and a positive cash flow. Finally, a property had passed my financial tests. See below.

My calculations from 2015

Loans

I researched different lending options and decided on a credit union based on their lower fees. Also, some traditional lenders would not consider loans on multifamily homes. 

The purchase price of the home was ~$80,000 with appraisal, inspection, and other closing costs. In part 1, I mentioned that I didn’t have a pile of money for a large down payment. Since I planned on living in the house (and met the other requirements) I was eligible for a Federal Housing Administration (FHA) loan

The FHA loan allowed me to put down less than 5% of the purchase price. However, the low down payment added additional fees to the purchase and ongoing costs like a higher interest rate and private mortgage insurance (PMI). 

Why would I, of all people, accept these additional fees? A valid question. If I were buying a primary residence for my family, I would make a ~20% down payment to avoid PMI and higher interest rates because they can cost tens or even hundreds of thousands of dollars over the life of a loan. 

However, this was a business opportunity and those were business expenses. I knew from my years preparing tax returns that these fees might not be deductible on a personal basis, but for a business they are expenses

“Begin with the end in mind”

– Stephen Covey

I also knew I could sell the property or refinance the loan to eliminate the fees. If you are buying a home for yourself, think twice about why you are buying. Save for a down payment to avoid PMI and high interest rates. Tax law changes reduce the ability to deduct these expenses on personal tax returns. 

Finding good tenants

Many real estate investors will tell you that the most important thing is to buy the property for a good price. As you may have heard, “You make your money when you buy, not when you sell.” Meaning that if you pay too much when you buy, you’re beginning at a significant disadvantage. 

But, the second most important thing in real estate is finding good tenants. From what I read, it was important to conduct a credit check and background check on potential tenants. I found a service called MySmartMove that allowed for background checks that applicants pay for themselves. My cousin, a real estate agent and owner of rental properties, recommended against individual showings with applicants. Instead, he suggested scheduling open houses. 

I hosted an open house and exactly one couple showed up – Jake and Connie. They chose to pay the additional $25 per month to have pets, but weren’t interested in the $25 per month premium to live upstairs. The couple also paid for their background check and passed with flying colors. They were excited to be the first to live in the home after renovations. Jake and Connie signed a 12-month lease at $725 per month and moved in soon after with their dog and cat. 

The final step was to purchase two ovens, two refrigerators and a washer and dryer. This cost less than $1,500 and was written off for tax purposes. I hired a moving company and began my two-year adventure living in the upstairs unit as a landlord.

That’s how I bought and rented my first investment property. In the 3rd and final part of this series, I share what happened when I was approached to sell, the finances of the sale, and why I haven’t directly bought real estate again since.

Thanks,

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