How to Invest in Residential Real Estate (Part Two)

In part one, Dollabuzz showed you the key risks when it comes to investing in real estate. We also showed you how to vaule a property to so you can make money investing in real estate. In part two, we cover the importance of location.

Welcome back, Dollabuzz readers. Glad you’re here! If you read Part One of this series, you should have a pretty good idea of how to value a property. The next step is to locate the right property. “How to Invest in Residential Real Estate (Part Two)” covers selecting the location, location, location of your investment.

The location of your real estate is critical when investing in (RRE). Location determines the type of tenant you attract and the value of your investment. In this post, we discuss how “smart money,” the local job market, and affordability is determined based on the location of your investment.

Today We Cover The Keys To Location Which Are:
  • Following the smart money
  • The local job market and,
  • Affordability and profitabilty

Follow the Smart Money

My business partner and I wanted a house in Downtown Lansing because we believe this area has upside potential. Dollabuzz is not the only one who thinks this. “Smart money” was planning to invest hundreds of millions in Lansing. At Dollabuzz, we follow the smart money and realized developers planned to invest in hotels, apartments, retail, and restaurants right in that same area.

It’s hard to go wrong if you follow the smart money

According to the Gilespie Group website, “ongoing revitalization projects, delicious cuisine, and diverse nightlife make Lansing the perfect setting.” This sounds like a Dollabuzz upside, and we had to get in on this action.

Look at the Job Market

As we noted, the smart money was investing in Lansing. In addition, Downtown Lansing is home to Lansing Community College, Davenport University, and Cooley Law School. Furthermore, the State of Michigan offices, Sparrow Health System, and Accident Fund are located in Downtown Lansing. These learning institutions and well-paying jobs are perfect for attracting our ideal tenant. But wait… who is the ideal Dollabuzz tenant?

Our ideal tenants are younger professionals, and the location has to match.

For Dollabuzz, our ideal tenants are young professionals. Nothing against college kids or families – we would rent to them as well. In fact, it’s against the law to discriminate against tenants. But every business has their target customer, and our target is the young professional. Downtown Lansing has the jobs, educational opportunities, and nightlife that young professionals tend to be looking for.

A vibrant downtown enhances a property’s location.

Affordability and Profitability

Many investors look to invest in East Lansing, since it’s objectively a very desirable place to live. However, the cost to rent in East Lansing is expensive. A quick internet search shows the average rent for a two-bedroom apartment in East Lansing is $956. By the same token, the median home price in East Lansing is $200,000. For us, investing in East Lansing just wouldn’t be profitable.

Downtown Lansing was our target location. However, we discovered quickly that there was a shortage of nice and affordable houses for sale. As a result, we struggled to find a viable investment property in Downtown Lansing. So now what? Give up? I don’t think so!

Invest Near Downtown

The trend for young professionals is to live near the city, their job, and the local nightlife. The logical conclusion is to find a house that would attract our ideal tenant. However, as we just discussed for East Lansing and Downtown Lansing, those options were not available to us. At this point, we determined that our solution was to look just outside of Downtown Lansing.

We located a house within walking distance of Downtown Lansing and a five-minute drive from East Lansing.  Prior to investing, we drove around the area numerous time to get a feel for the neighborhood. We noticed a few people walking toward Downtown Lansing carrying their laptops, which indicated they were heading towards either work or school. With a walkability score of 56, this area is the second-most walkable zip code in Lansing and appeared to offer solid investment potential.

Looks Can Be Deceiving: “Look Real Close Cuz Strobelights Lie”

Dollabuzz: Look for hidden gems in a prime location.

So we found our house. Yeah, she looked rough – no doubt about it. However, we saw the potential this property offered. The open floor plan, good-sized kitchen, deck(!), and detached garage provided a solid investment foundation. New siding, vinyl flooring, and fresh paint are relatively simple and inexpensive cosmetic fixes. The key to this investment property is its location and the tenants it would attract.

A good-size deck offers plenty of potential, especially to our target demographic. Backyard BBQ, anyone?
BEFORE: An open floor plan along with a deck enhance a property’s location.
AFTER: Peel-and-stick vinyl and fresh paint are easy ways to make a kitchen feel bigger.
New siding and fresh stain are easy cosmetic fixes that will help your property Dollabuzz.

Prior and Current Tenants

The first tenants we had were a young couple. She was going to grad school at Michigan State University and he worked 10 miles away. They wanted a nice house close to East Lansing and the highway. This house fit their needs perfectly! Now, our current tenants wanted to live near Downtown Lansing because there’s plenty to do and the house is near Lansing Community College. In my opinion, it appears we struck location gold – and that’s how you Dollabuzz!

Listen Money Matters and Roofstock.com

At Dollabuzz, we’re always on the lookout for interesting and informative books, blogs, and whatever else we think will help our readers get their money right. A few months ago, I came across Listen Money Matters. I liked what I read and subscribed to their emails. A few weeks ago, I received an email blog about investing in residential real estate through Roofstock.com. Strangely enough, I’d never heard of Roofstock, but I was intrigued.

RAISE THE ROOF!

What I like about Roofstock is the ability to invest in RRE in a different part of the country. Roofstock does A LOT of the work for you and makes investing in RRE as simple as possible. Consequently, I was very excited to learn about Roofstock. I’ve been trying to figure out how to invest in RRE in another part of the county, and Roofstock will allow me to do just that.

If you want to learn more, I strongly encourage you to read Andrew Fiebert’s review of Roofstock.com over at Listen Money Matters, which discusses his experience investing through Roofstock. It’s truly a great read. I read it twice and will use Roofstock if I have trouble finding a good property on my own from now on.

Be on the lookout for Part Three! See you then.

How to Invest in Residential Real Estate (Part One)

Investing in residential real estate is risky but can be very lucrative. Dollabuzz shows you a few key risks and how to value a property so you can make money by investing in residential real estate.

Two story house that is well maintained and rented for a profit
Investing in residential real estate is risky but can be very profitable.
Dollabuzz will get you ready to invest in residential real estate.

How to invest in residential real estate (RRE) is one of the more common questions we’re asked here at Dollabuzz. It seems like 2008 was yesterday and investing in RRE was “risky” – but, in reality, it was a great time to buy. Today though, with a healthy housing market where demand exceeds supply, RRE is once again the “in” investment.

Image result for fire
If you’re looking for how to invest in residential real estate, now’s the time. The housing market is once again on fire!
What We Cover Today
  • Top 3 risks of investing in residential real estate
  • Financing your investment and,
  • How to value a property

The overall housing market is hot, which makes investing in RRE more appealing but also riskier. Since the supply of homes is tight, it can be challenging to find great deals – but that doesn’t mean deals aren’t out there.

It might sound counterintuitive, but rising prices is a good thing. That’s because as RRE becomes more expensive, people are forced to rent while they save money for a house.

This is part one of a three-part series on how I invested in RRE – specifically, the rental house we bought in the spring of 2016. Part one will cover the risks associated with RRE, financing your purchase, and how to value a property. “How To Invest In Residential Real Estate (Part Two)” will discuss the importance of location, and part three will focus on finding your house and how to attract quality tenants.

What Are the Top 3 Risks of Investing in Residential Real Estate?

Before we get too far along, let’s cover a few risks associated with investing in RRE. We can’t cover all the risks associated with investing in RRE in one post, but here are a few of the top risks:

Risk #1: No Liquidity

The biggest risk when investing in residential real estate is lack of liquidity. In other words, your money is “tied up” and you can’t get it out quickly.

The biggest risk when investing in RRE is the lack of liquidity. You can’t sell a house at the click of a button like you can with a stock. According to Murphy’s Law, you will need to sell at the worst possible time and the process will take twice as long. Tied-up money is a risk that can really kill your Dollabuzz.

Risk #2: Bad Tenants

Nothing will kill your Dollabuzz faster than bad tenants. Concerns over deadbeats not paying their rent or trashing the place is the number-one reason I hear about why NOT to invest in RRE. This is why location is so important to you. A good location will help attract good tenants, and good tenants are critical to investing in RRE. Part Two will show you how to find (and keep!) those perfect tenants.

Risk #3: Investing in RRE Costs More Than You Think

A “fixer-upper” ALWAYS costs more than you think it will

A good rule of thumb when estimating the cost of a fixer-upper is that it will cost twice as much and take twice as long as you think it will. Even if you have an inspection, things always pop up. For example, our inspector didn’t notice that some of the pipes in the basement had been removed. As you’re about to see, our inability to keep costs down impacted our Dollabuzz.

Financing Your Investment

Traditional Financing Requires 20% Down

To finance RRE as an investment, you need to put down 20% of the purchase price. This is a very common way that investors purchase RRE, and why not? You only put up 20% while the bank finances the remaining 80%. In addition to requiring lower upfront cash, interest is tax-deductible, so let the bank finance the majority of the purchase.

However, some people will say that borrowing money for RRE is too risky. “Risky for who, exactly?” is my question. If you don’t pay, the bank is on the hook for the remaining balance.

All-Cash Purchase Is Riskier but Simpler

All cash in is much more risky than financing.

For this purchase, we went all-cash for one reason: Simplicity. Since we paid in all cash, no banks were involved, which means a lot less paperwork. No tax returns, pay stubs, or appraisals.

However, all-cash is much riskier. Instead of 20% down, we are 100% down, which ties back to risk number one: lack of liquidity. The only way we can get this money out is to sell the house or wait for the tenants to pay us back each month.

How to Value a Property

Assist to the Wu Tang Clan for helping me out on this one. How do you make a blog about investing in RRE not boring? Why are you asking me? You’re the one writing this post! Talk about CREAM. Cash money. Dolla dolla bills. Investments are valued on how much free cash flow is generated. To quote my man Mike Soo, who’s a real savvy investor, “I love me some free cash flow!” PREACH, Mike!!

Dollabuzz preaches that real estate investing is all about the free cash flow.

There are many ways to value RRE. At Dollabuzz, we focus on the cash flow, yo. Investing in RRE is essentially purchasing the future cash flows generated. The two methods Dollabuzz likes to use are the discounted cash flow analysis (DCF) and the cap rate (CR). Dollabuzz uses those two methods to ensure as much accuracy as possible. What in the world is DCF? Don’t worry, loyal reader – we got you.

DCF: The Value Today of Future Cash Money

It’s all about the cash flow, yo.

This is where things can get confusing, but hang with me and it will make sense. The DCF method simply determines the present value of an investment based on future net cash flows given a discount rate (DR). The projection of future net cash flows requires you to estimate future rental income and operating expenses.

Operating expenses keep the property operating and include property taxes, insurance, utilities, etc. The difference between your rental income and operating expenses is your net cash flow from operations.

Please note: Principal and interest payments are NOT operating expenses.

But What’s “Discount Rate”? My Head Is Buzzin

As we previously noted, DCF requires a DR. The DR is the rate of return you require given the rate of return you could earn in a similar investment at the same level of risk. The DR combined with the projection of all future net cash flows from operations gives you the present value of those cash flows, which is the net present value of the property. For this investment, our goal was a 15% DR. Let’s see how we did.

How Did We Do?

I’ll spare you the details here, but the current projected DR using the DCF is 11.5%, which is 28% below our target return of 15%. Wow that’s a pretty big miss. Waaaaay off. What happened? Risk number three killed our Dollabuzz hard. It cost us a lot more to make the house nice.

But the silver lining: This will allow us to attract quality tenants in the future. Yes, we missed our target return, but not having a nice house would cost us more in the long run. If you have a nice house, tenants are far more likely to treat it nice. Have a dump, and it will be treated as such.

The Biggest Drawback to DCF

DCF relies on future assumptions, which is its biggest drawback. However, I really like the DCF method because it puts a current value on net future cash flows. In other words, the DCF provides a current value (net present value) of future cash flows, which is used to determine what a property is worth. Knowing what a property is worth from a free cash flow perspective allows you to determine what to pay for a property.

Dollabuzz Note: The DCF method requires the use of a net present value calculator. This calculator is very useful and easy to use, and for my readers’ sake we’ll skip the “how to use it” discussion and simply refer to the calculator.

Cap Rate: What Is Cap Rate?

Can It All Be So Simple?

The Cap Rate (CR) method is much simpler than the DCF method, but it may not be as accurate over a long period. However, this is a popular way to measure the value of a potential property versus a similar property.

CR data for a particular location is easy to calculate, or it can be provided by a real estate agent. Compare the CR for the property you want to purchase versus others in the area to determine whether you’re getting a good deal or someone is trying to play with your money.

How to Use Cap Rate

Simply calculate your annual net free cash flow and divide that amount by the value of the property. For example, cash all-in cost us $45,000, and that’s roughly its market value. Our annual net cash flow is $6,200, which is a 13.7% CR and below our target return of 15% but above our DCF return of 11.5%.

Dollabuzz Your RRE Investment

DCF is a measure of the investment’s performance over a time period, while the CR is a measure at a point in time. Since the DCF measures an investment performance over a longer period of time based on operating cash flows, it is an excellent valuation tool, which is why I prefer this method.

Related image
Dollabuzz will show you how to invest in RRE

Location, Location, Location

Now that you have the first step toward understanding how to invest in residential real estate – which is how to value RRE – spend some time experimenting with the DCF calculator, which will allow you to value a property under various assumptions. The next step is to find the right property, and that requires finding the right location. Part two of this series will show you how to find the right location.

The Geeky Nerd Numbers You Need to Know When Investing in Residential Real Estate

Knowing the “numbers” is key to investing in RRE. In this post, I can’t possibly cover every metric used to invest in RRE. I respect my readers too much, because don’t nobody got time for that.

However, after we purchased the house, I came across an excellent resource: a book titled What Every Real Estate Investor Needs to Know About Cash Flow… and 36 Other Key Financial Measures. The author is Frank Gallinelli, and he does an excellent job of explaining how to value a property. This book is a MUST for investors. To order the book on Amazon, click here.

See you in Part Two!