Stewart Hsu

The real estate world is full of different types of investments. Similar to the fields of medicine or law, where you can specialize in pediatrics, dermatology, oncology, etc. or criminal, civil, corporate, etc. real estate has many areas of specialization as well — single family homes, multi-family residential, pre-construction, foreclosure, fixer-upper, office, retail, industrial, land development, condo conversions, etc. For the sake of simplicty and also to help make this post applicable to the largest number of readers out there (and also because I personally have the most experience here), I’m going to focus on analyzing single family residential property. It’s a great place to start.

A single family home (SFH) property could be a house, townhouse, or condo. You, as the investor, are most likely buying the SFH with the hopes that buying in the right market, over time, you will see appreciation in the value of the SFH. If you buy a new SFH with a 20% down-payment, chance are the property is going to be negative cash flow, which means that your rental income will not cover all of the operating expenses associated with owning the property. More on this below. One “sliding factor” is, the older the SFH you buy, the closer to breakeven you’re likely to be, however the trade-off is that your annual maintenance expenses will likely be higher. Also, depending on where you are buying your SFH investment, the location will impact if your rents will be enough to cover all of the expenses. You, as the investor, must self-assess your own risk tolerance to make the choices that are right for you.

Looking down the road, at some point x-years in the future, if you’re in the United States, you’ll likely want to take advantage of IRS 1031 Exchange provision in order avoid paying any capital gain tax. [I will write an article on 1031 Exchanges as they are a critical “tool” you’ll want in your toolbelt as a real estate investor.] Note, as of this writing, there is no limit to the number of 1031 Exchanges you can do (nor does the author have any reason to believe this will change in the future). So one strategy, is that over time, you keep exchanging your property so that you *never* pay capital gains tax. Consider it a gift from “Uncle Sam”, take advantage of it.

All real estate analysis can be separated into one of two types:
1) Quantitative
2) Qualitative

In the first “Quantitative” bucket you’ll want to figure out the income and expenses and determine your net (positive or negative) cash flow for the given property. You’ll also want to research market trend data; markets meaning both a) property values and b) population/job growth. Generally, in most cases you want to be buying in markets where people are moving to; in other words we want to ensure there will continue to be demand for homes in the area you decide to invest.

The “Qualitative” analysis (though sometimes overlooked) is as important as the Quantitative and should always be considered. Some questions to ask and find answers to would be:

* What’s the neighborhood like?
* What would a typical renter be like in this area?
* Where would my tenants go to work?
* Where are the closest schools?
* Where is the closest grocery store?
* How far is the highway?

You want to imagine what life would be like if you lived at the property and paint yourself a more complete picture of the area. Chances are things that would be important to you, will also be important to your renters.

On the quantitative side, let’s drill into the specifics.

1. INCOME
For a SFH, your primary source of income is going to be the rent received from your tenant/renter. If it’s a furnished home, you would likely charge more rent than an unfurnished home.

You may also collect late fees occassionally when applicable. Ensure it’s clear in your lease agreement the conditions when late fees apply. As a tip, if local laws permit, it’s smart to include accumulating *daily* late penalties, that way the pressure remains on the tenant to pay the rent as soon as possible. This is a mistake I’ve made in the past. My friend Steve likes to say “Smart people learn from their own mistakes, really smart people learn from other peoples mistakes.” Learn from mine.

To briefly mention, for other types of property more sources of income are possible. For example on a multi-family apartments, you may have laundry facilities, vending machines, payphones which would also increase your monthly income.

One word of advice before we move off the topic of rents. In your forecast/budget, it’s wise to include a vacancy factor. Sooner or later your tenant will move out, and it’s prudent to factor this into your forecast. After a tenant moves out, it may take you (or your property manager) a few days to get it cleaned up and ready for the next renter. Then it’ll take some time to have it advertised, to have it shown, to process tenant applications, and then to finally move-in your new happy renter. Before you know it, a few weeks have passed. As a guideline, it’s generally safe to plan for an annual vacancy of 8.3% which is the equivalent of one month vacant per year. You can tweak the percentage based on your own experience. The ideas is that it’s better to include a vacancy and be pleasantly surprised you didn’t have any downtime than to not plan for any vacancies and be frustrated that your results were not as good as you were expecting.

2. EXPENSES
This list is a bit longer, but these 8 expenses pretty much cover all the expenses you need to be concerned with for your SFH investment.

a) Mortgage Payment (also known as Debt Service)
b) Property Management Fee
c) Property Taxes
d) Insurance
e) HOA (Home Owners Association) dues
f) Maintenance
g) Home Warranty
h) Utilities (depends on the area)

Mortgage Payment. Your mortgage bill will depend on the type of loan you take out and how much you borrow. Consult your loan agent for the different options and rates. I’m partial to loans that have a fixed interest rate period, specifically for a minimum of 5 years. How long you want it fixed for will depend on your overall strategy for your real estate. The key question being how long do you intend to hold the real estate? If you’re doing a rehab and want to sell it within a year, then you’ll want to get a loan that has a shorter fixed interest rate period, not a 30-year fixed mortgage. If you’re not sure how long you want to hold it for, then getting a 5 or 7 year fixed interest rate loan is probably safe. It seems to be getting more rare that people hold a piece of real estate over 10 years. Also, if you’ve done your research, 5 to 7 years should be enough time for your property to appreciate and you’ll want to 1031 those gains into more property in the next growing market.

Property Management. For SFH homes this fee typically ranges from 9% to 12% of collected rents. Make sure it’s based on the collected rents, not the projected rents; part of the incentive for the property manager is that they *only* get paid when they collect the rent.

If you decide to self-manage, you can save on this fee, but my advice would be to hire an experienced property manager. This is for two reasons a) if you self-manage all your properties, you will be limited in terms of how much property you can own and b) the reason to own real estate is not to buy yourself into a job, but to create more time and freedom for yourself [link to Why Invest]. [Reminder for myself: write post on How to Build a Strong Team].

Property Taxes. This will vary depending on the state/county/school district where the property is located. You can ask your real estate agent who’s assisting you with the purchase to estimate this. Also, each county has a tax assessor/collector you can contact to figure this out. You could do a Google search on “[county name] tax collector [or assessor]”.

Insurance. There are two bascially two types of insurance policies to obtain depending if your SFH has an HOA or not. If you own a stand alone single family home, you’ll want to get insurance for the entire structure. If you’re buying a SFH that has a HOA, then chances are the HOA already includes insurance on the structure, so your policy may just need to include from “the studs in”, which means in the event the building needs to be rebuilt, the HOA policy would include rebuilding the structure, and your insurance policy would need to cover putting in the dry wall, painting, flooring, cabinets, etc. This policy is called a “landlord policy”; insurance agents familar with rental property will know this term. Both policies should include some liability coverage as well.

One key tip. Your insurance should not include insuring the renter’s belongings. You want to be explicit in your lease that you as the landlord recommend the renter getting adequate insurance for their own contents.

Ask your real estate agent or lender for reputable insurance agents in the area. Better yet, if you know of other investors whom have purchased in the same area, ask for their contacts. This applies not just to insurance contacts, but all of their contacts — good agents, builders, lenders, etc.

HOA (Home Owners Association) dues. If you buy a condo or townhouse, it’s very likely there will be some shared common spaces. The maintenance and upkeep of these areas is covered by the monthly HOA dues. Some stand alone single family homes if they’re part of a community may have a quarterly HOA due as well, though it’s typically relatively low depending on the extent of the common areas (e.g. park, pool, walking paths etc.). In my own experience, most stand-alone SFH do not have an HOA fee.

Maintenance. This will vary depending on the age of the home, but it’s another one of those things where it’s better to plan on something and be pleasantly surprised, than to not factor in and be frustrated about. Maintenance expenses could include things like plumbing, fixing an appliance, mowing the lawn, painting, etc. A rough guideline would be to set aside 5%-10% of rents for maintenance.

Home Warranty. Something that you might want to consider purchasing, especially if it’s an older home with older appliances, is a Home Warranty policy. I’ve got one on a 2-bedroom condo I have in Sacramento, which costs me $380/year and it covers replacing my hot water boiler, A/C and heating units, washer/dryer, stove, fridgerator, etc. in the event any of these breaks down. If your tenant contacts you and informs you something’s not working, you call the Home Warranty company, they send someone out (you typically pay a per visit fee), and if they can’t fix it, they’ll replace it. It’s a pretty good deal. You can look at it as another level of insurance.

Utilities. This would be primarily water, sewer and/or gas. In most cases, based on my own experience, the tenant always pays for their own phone, electricity and cable. However, the tenant may also pay for their own water, sewer, gas and/or trash. Find out what’s competitive for the market your looking to provide rental housing. It’s not uncommon if there is an HOA, for the HOA dues to cover some of these utilities; ask your HOA for the breakdown.

If you’ve made it this far, congratulations! I know this can be a bit dry at times, but it’s important to know what to watch out for and what to ask your team about. I will publish another blog entry on How to Research Market Trends as it is well worth covering; for now, ask your team how do they do it, and try to gather as much evidence that supports the area where you’re interested in buying is well position for population growth in the years to come.

One last idea on the Qualitative Analysis side. See how far is the closest Wal-Mart, Home Depot, Walgreens drugstore and McDonalds. I believe all of these companies have “store locators” on their websites. Each of these companies have full time departments, with budgets that likely exceed millions of dollars per year, dedicated to figuring out which areas are most likely to have the greatest population growth. Also, Yahoo Maps has a “Smart View” option that allows you to see where is the closest shopping, banks, recreation, etc. and what they are. One strategy might simply be to invest whereever they are building a Home Depot (or where one was recently built).

My intention for this blog entry is to help the beginning real estate investor become familar with some key analysis concepts, as well as to provide a review for the more experienced investor. I included specific details on the income and expense line items so that you can be confident when making your first few real estate investments you know what you should be aware of. I will be including a free Excel spreadsheet download that details these income/expense line items to help you perform your quantitative analysis; if you cannot wait, fill out the Contact form, and I’d be glad to e-mail you one directly.

One concluding thought: don’t become a victim of “analysis paralysis”. Meaning all you end up doing is analysis and by the time you’re done analyzing the deal, the opportunity has already come and gone. One common trait that ALL successful people have in common is that they take action. I agree it’s important to do your homework and consider the available facts, but if you never take action, you’ll never see any results. I know you want more results in your life otherwise you wouldn’t be reading this now. I want you to be successful, and in order to do so, you need to take action.

“I would rather have a good plan today than a perfect plan two weeks from now.”
General George S. Patton

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