The Beginner’s Guide to Buying Rental Properties (A Case Study)

Rental PropertyOne of the primary objectives of my real estate business is to acquire income-producing rental properties that ROCK.

What makes a rental property “rock” you might ask?

It doesn't necessarily need to pump millions into my bank account each month, and it doesn't need to be a “no money down” deal either (although either of these things would certainly sweeten the pot).

To put it simply, a great rental property is one that makes every one of my invested dollars work hard. I want every penny to work overtime, producing as much revenue as possible while simultaneously paying off any debt associated with the property. When you buy properties with this goal in mind, there is basically no limit (mathematically speaking) to how far you can grow your net worth and personal income.

The Problem

When I first got started as an investor, I spent a lot of time trying to find these types of properties. I remember spending hours upon hours scanning my local MLS listings, desperately trying to find a deal that would make financial sense.

After running the numbers on dozens of properties, I was shocked at how difficult it was to find just one single property that would justify my investment.

A great rental property is one that makes every one of my invested dollars work hard. Click to Tweet

At the time, it was 2005 and housing prices were through the roof – which made this a very difficult task (especially when I limited myself to ONLY the properties that were “listed”, with a realtor sign in the front yard). Needless to say, it was an extremely discouraging time in my journey.

I eventually realized I was dealing with two fundamental problems:

  1. I didn't have an effective way to find motivated sellers and get them calling me. I was relying ONLY on unmotivated sellers who were holding out for top dollar. This was a losing strategy that wasn't going to cut it.
  2. I didn't have an effective way to analyze properties or determine their potential profitability. I needed a basic, but highly reliable method so I could calculate exactly what I was getting into.

After a lot of research and learning, I was able to find some very effective ways to solve BOTH of these problems.

Both issues are equally important to deal with but for obvious reasons, problem #2 cannot be addressed until problem #1 has been dealt with. In other words, you can't start working on your analysis until you have something to analyze. This may seem obvious, but it's important to reiterate this so you can prioritize correctly and deal with first things first.

The Reason For This Case Study

The purpose of this guide is to show you exactly how I handle Problem #2 (above). If you haven't figured out how to find motivated sellers yet, go and read this or this first and THEN come back to this case study.

I often find myself evaluating rental properties and consulting with other investors on how to find, evaluate and buy their own deals – so the purpose of this blog post is to explain exactly how I do this. This article is intended to provide a brief education, where I will show you the entire process that I go through when buying a rental property, which includes some of the following steps:

If you're reading this, you may very well fall into one of these categories:

  • You don't know how to find a legitimate, profitable rental property.
  • You understand the theory, but have never actually purchased a rental property before.
  • You don't understand how to analyze and evaluate a rental property the right way.
  • You need a better understanding of how the entire process works, from start to finish.
  • You don't have a proper set of expectations about what a rental property should produce, and why investors buy them in the first place.

This blog post is intended to show you exactly what steps I go through, what my expectations are, and how I ensure my (or my client's) return on investment is something they can be proud of.

I'm a pretty big fan of “on-the-job training”, so I figured the most practical way to show you this process would be to use a real life example I dealt with just a few short years ago.

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First Contact with the Seller

In early December, I received a voicemail in response to one of my direct mail campaigns (I had used Template #3 for this particular mail campaign, and I pulled my list using the same process I describe in this blog post).

This mailing was actually sent out the previous summer (over a year earlier) – this guy had simply held onto my postcard and called me about 16 months later (gotta love the residual benefits of direct mail).

This was his first voicemail to me:

(note: caller's name and address have been removed from this recording for privacy)

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Quick Property Evaluation

Once I got this message and learned the basic details about this property (i.e. – the owner's full name and property address – which were edited out of the above audio clip), I went to work.

I was fortunate in some respects, because I was very familiar with this neighborhood. I had sold a similar house a few blocks away for $88,900 in late-2009 (by which time, the market had already taken a dive), so I had some perspective on what a house like this would legitimately be worth.

Before I called the prospect back, I went through my quick property research process and learned most of the pertinent details about this property. It was a single-family home with 2 bedrooms & 1 bathroom. According to the seller, it generated approximately $750 per month in rent. Using AgentPro247, I learned that the seller had purchased this property eight years earlier for $55,000 – which gave me some perspective on where he was coming from.

Armed with this basic information, I called the prospect back.

After roughly 4 minutes on the phone with the property owner, I asked him (point-blank) if he would sell his property for $30,000 – $40,000.

He replied very quickly with, “Yes, I would consider that.”

Later in the week, I called the seller back and told them that our offer would likely be for $25,000He said that he would think about it.

A few days later (after hearing nothing from him), I called him again to see what he was thinking. He said that he was hoping for something more in the $30K – $40K like I initially stated (*kicking self*). I realized pretty quickly I should have suggested an even lower number to begin with. Setting his expectation in the $30K – $40K range right out of the gate probably wasn't smart (it's generally easier to start low and negotiate up, than to start high and negotiate down). Lesson learned.

Eventually (after a few more discussions) we settled verbally on a price of $27,500 cash, with all closing costs paid by the buyer. In other words, the buyer (aka – me) would have to cough up another couple thousand dollars in order to close the deal (this includes things like title insurance, closing fees, property insurance, pro-rated property taxes, etc).

Show Me The Money

Now, most people don't have $27,500 sitting in their checking account at any given time and at the time, I was no exception. Luckily, I knew some other investors who did.

I called one of my cash buyers and gave them a quick overview of the deal. They were very interested in finding out more. Like most people, they were stuck with Problem #1 (above). They had plenty of money to invest, but they didn't know how to find good deals. These are excellent people to have on your buyers list because in their minds, any property at 70% or less of market value is an AMAZING deal that will get them very excited.

Luckily, I had mastered the art of finding cheap real estate in my area (FAR below 70% of market value) so when I told them about this property, I had their attention very quickly. I gave them a general overview of the property (“a 2 bedroom, 1 bathroom house on the southeast side of town, a 1.5 stall garage close to the local public school, etc.”). I also prepared a Rental Property Analysis to show them exactly what kind of ROI they could expect from this property as a rental unit (more details on that below).

After seeing my property prospectus report, my buyers said they were ready to go with cash in hand, contingent on an acceptable home inspection and verification of all of all my assumptions.

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Running The Numbers

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One of the most important things you MUST do as you're evaluating a new property are your projections.

“Projections” are basically just a series of highly informed guesses about how profitable a property may (or may not) be in the future. In order to figure this out, you'll have to do a little bit of homework and develop a thorough understanding of what the income and expenses are likely to be from this property in the future.

It's not difficult, but as with any real estate transaction, there are a number of things you need to pay close attention to. As you research a property and learn more about what you're getting into – certain things matter greatly, and other things matter very little. My hope is that as we're walking through this process, I can give you a good idea on what to look out for.

Many, MANY of the deals you'll see on a regular basis won't have positive cash flow (in fact, that's almost exclusively what I saw in my first year as a real estate investor) – and there are a lot of things that can sabotage the profitability of a rental property. Things like:

  • Paying too high a price for the property
  • Excessive Property Taxes
  • Excessive Interest Expense
  • Insurance Costs
  • Maintenance, Utilities and Upkeep
  • Unforeseen Disasters
  • Home Owner's Association (HOA) Fees

If a deal doesn't cash flow, don't buy it. PERIOD. This is why it's crucial for you to nail down your projections and get an accurate depiction of its profitability – because frankly, your “GO” or “NO GO” decision usually boils down to the answers you get after going through these motions.

Dealing With Imperfections

Are your projections going to be perfect? Not likely. We aren't fortune tellers after all, so it's impossible to know EXACTLY how things will pan out in the coming months and years.

Projections rarely come to fruition exactly as we plan, but when they're done correctly, using realistic data and assumptions, they will almost always set you up with reasonably accurate expectations that won't lead you astray. The numbers may turn out better or worse than you estimated, but they should at least come out somewhat similar to what you had originally predicted.

Challenge Your Assumptions

  • So you think rent will be $750 per month? Says who?? Is this a reliable and unbiased source of information?
  • You think the vacancy rate will be 10%? What makes you think so? Do you have any actual experience or market data to back this up?
  • What kinds of maintenance and repairs will you have to take care of? How certain are you about what the costs will be?
  • What if one or more of your assumptions turns out to be wrong? Does the property still perform to an acceptable standard?

In order to come up with your “best possible guess” at what the future is going to look like, you need to be armed with the right information. Your inputs will literally determine everything here, so remember the theory of “garbage in, garbage out”. If you start with bad information (or if you just guess at the numbers without really getting them from a credible source), you're not going to have a very reliable number in the end.

The last thing we want is to invest our life savings into a property that loses money hand-over-fist.

logo_1One of the best rental property evaluation tools I've ever found is called the PropertyREI Rental Property Calculator. It's an easy-to-use excel spreadsheet that allows you to plug-in a few basic inputs, and (assuming your numbers are reasonably accurate) will show you some very clear results that will help you determine if/when you're looking at a worthwhile real estate investment.

In the example below, I'll show you how I used this calculator to go through the motions of plugging in the numbers so I could understand whether I was looking at a solid deal for an investor to pursue.

(Note: If you want to get a copy of this calculator for yourself, be sure to use Promo Code: RETIPSTER1 at checkout for an instant 10% discount).

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Step 1: Determine Your Rent Revenue

It all starts with having a solid understanding of the revenue your property is likely to generate every month. We're talking gross income – before any/all expenses.

Now – in my first conversation with this seller, he told me that he was generating $750 per month in revenue from this house.

Can we trust him? There are a couple of ways to find out.

I started by asking him to send me Schedule E of his past two years of tax returns (a Schedule E is basically an income statement, showing the amount of revenue and expenses he reported to the IRS for this particular rental property). After reviewing his information, it turned out that he did make approximately $750/mo  for the past two years.

I also ran the numbers on Rentometer – which gave me a quick look at what similar properties were renting for in the immediate vicinity. I found that $750 was a little on the high-end for the area, but not a completely unreasonable expectation.

rentometer screen shot

I also gave my property manager a call to see if he thought this was a realistic expectation given the property and neighborhood. He expressed some hesitancy and mentioned that in his opinion, a more realistic number (in THIS neighborhood, for THIS kind of house) would be around $700.

In the end, since I had proof that $750 was attainable based on the seller's tax returns (and since the property was being sold with the same tenant who had been paying that amount for the past 2 years), I decided to use this number in my calculation… but I would likely re-run the numbers again later with this $700 number, just to make sure the deal still produced adequate cash flow.

Rental Analysis Step 1

I also assumed the property would have no other sources of income (i.e. – no vending machines or coin laundry), a vacancy rate of 10% (i.e. – the property will be vacant and/or between tenants for 5 weeks out of the year… a pretty conservative estimate in this market) with the plan for increasing rent revenue each year by 3% on average.

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Step 2: Purchase Price and Financing

Depending on whether the property is being purchased with some form of financing, or whether it's being purchased outright as an all cash deal – the financing picture will usually have a big effect on the outcome of your calculation.

In my example, the property was being purchased with cash – which greatly simplified this portion of the calculator.

Rental Analysis Step 2

Why was this property being purchased with cash instead of financing? A few reasons…

  • The property was relatively inexpensive.
  • The investor had the cash available.
  • The investor was more concerned about generating more cash flow than about making their cash work harder for them (which we'll get to in a minute).

Rental Analysis Step 3

For this deal, the closing costs came out to approximately $1,500 (which is actually closer to 5.5% – but not a huge variation from the 5% shown above) and the deferred maintenance costs we planned for were $2,500 (the furnace was in rough shape. It was apparent the previous owners had no idea how to replace furnace filters, so we assumed it would need to be replaced shortly after closing).

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Step 3: Factoring in All Expenses

Understanding a property's expenses can be a painful dose of reality.

These are the items that most sellers tend to downplay (or just fail to mention altogether)… but these numbers are CRUCIAL to understand.

These numbers are very real and will play a major role in the profitability (or lack thereof) of your rental property. You’ll have to do your homework in this section, and it’s important that you do this part of the process well because if you use the wrong numbers, you'll only be fooling yourself and hurting your (or your buyer's) future.

Rental Analysis Step 4

Property Taxes: Property taxes have always been a depressing subject for me. Why? Because regardless of whether you purchase a property with financing or you buy it free and clear, you will always have to pay property taxes. Since this expense is permanently attached to the property, it’s important that you find the correct number and factor it into your calculation. I found this number by checking the seller's Schedule E and by checking the City Treasurer's website for the total annual property taxes over the past two years. In the previous year, this property owner paid $1,464 in property taxes, so that was the number I used here.

Insurance: This one is pretty easy. You can call any property insurance agent (I recommend trying at least a couple to compare prices) and they will be more than happy to tell you what the annual cost will be. I called my property insurance agent and gave him the rundown, and he indicated an annual cost of $550 – $600 for this type of property. Given that the seller had paid $553 – I decided to use that number for this part of the calculation.

Utilities: For most residential rental properties in my town, utilities are set up in such a way that the landlord pays the water bill, but everything else is covered by the tenant. The utilities can be set up in a number of different ways, but whatever your arrangement is, you need to get a good idea on what this number will be on an annual basis.

In this situation, the seller also had the utilities arranged so that he paid ONLY the water bill. By looking at his Schedule E, I was able to see that he had paid an average of $900 per year for the past two years. Based on my own experience with my other rental properties in the area (and based on my property manager's opinion), I knew this was a solid, legitimate number to work with.

Advertising: I use a great property management company for all of my rental properties (and I recommend all my buyers do the same). Most property managers will handle the placement and eviction of all tenants as part of their service, so we'll get to this cost in the .

HOA Fees: This property is not part of a home owner's association, so this step is easy. ZERO.

Property Management: Even if you’re not going to hire a property manager like I do (most property managers will charge around 10% of your gross rent revenue), you still need to pay yourself for your trouble. The fact is – somebody, in some way, will ALWAYS have to manage this property, so regardless of who is doing the job, this is a very real expense that ought to be accounted for.

Maintenance & Repairs: Another absolute must that you need to include in your expense column is a reserve for maintenance and repairs. I always plan to set aside at least 10% of my gross rent revenue to cover the issues that will come up when my properties start falling apart (because sooner or later, it's going to happen). Even if you have a year or two where no extraordinary expenses come up, you need to let these funds accumulate. All it takes is one roof replacement, or one pipe to burst in the basement and ALL of this money will be needed immediately – so let this money build up and don’t drain this account.

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Step 4: Taxes and Depreciation

This next step is pretty simple. If you know what effective tax rate you're working with (this will depend on the investor's situation), you can plug it in and the calculator will factor this in to the final calculations of what your annual cash flow will be after taxes. I used 20% in my example.

Rental Analysis Step 5

The calculator will also do a calculation to show what the TOTAL cost will be to purchase the property (in this case, it's taking the purchase price of $27,500 + closing costs of $1,375 + deferred maintenance of $2,500 = $31,375 cash required to purchase property).

Rental Analysis Step 6

This simply shows us what the full acquisition cost will be, so there is no confusion about this deal is going to cost the investor.

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Step 5: Executive Summary

This is usually a very revealing part of the calculation process, because it gives us a good look at what kind of net revenue the property can actually be expected to generate (both before and after taxes).

In the example below, the calculator is telling me that after all expenses, the investor would be adding another $3,563 to their annual income, and then the amount they would actually keep in their pocket (after their taxes are paid) would be $3,030. This is if the investor chooses to buy this property and pay all cash for it.

In a very real way, this information is your final, decision-making data, and depending on whether the property is being bought with cash or with financing – the end results can vary widely.

Rental Analysis Step 7

Some of the numbers I always watch very closely are the Annual Cash Flow, the Cash Required to Buy and the Cash on Cash Return.

For example, let's go back to the Dashboard and change our financing strategy to buy this property with a mortgage. If we put down 20% and get a 30 year mortgage at an interest rate of 4.00% – we now have to add monthly loan payments of $105 into the mix.

What does this do to our numbers? Check out the differences…

Rental Analysis Step 8

When we use financing for a property like this, it comes with some tradeoffs. Let's look at the pros and cons of using financing to buy this property.

Pros:

  • If we utilize financing, this property (and the source of income that comes with it) will require significantly LESS cash to buy upfront.
  • The Cash on Cash Return is over 2x higher when we use the power of “OPM” (Other People's Money). In other words, every dollar we put into this property from our own pocket is going to work MUCH harder than if we had to cover the full purchase price without financing.

Cons:

  • Since we'll have to make monthly loan payments for the next 30 years, the annual cash flow is going to see a significant negative impact. Although the property will cost us less cash upfront, it's also going to produce less cash flow after the debt service is paid each month.
  • If you're scared to death of debt or if you have a personal philosophy of avoiding debt at all costs – this approach will obviously conflict with that mindset.

The great thing about financing is that it has the potential to supercharge the growth of your real estate portfolio. When you can purchase properties quickly without tying up your own finite source of cash, you might be shocked at how quickly you can build up a MASSIVE source of wealth and income for years to come.

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Deal or No Deal?

The bottom line is this…

If we purchase this property and pay all cash for it, we can reasonably expect to be $3,030 richer at the end of each year after taxes… and it will cost us $31,375.

If we purchase this property with financing, assuming 20% down and 4.00% interest over 30 years, we can reasonably expect to be $1,945 richer at the end of each year after taxes… and it will cost us $9,375.

If you want a closer look at how I plugged all of these numbers into the PropertyREI calculator – I'll walk you through the entire process in this video below…

Want to use the PropertyREI Rental Property Calculator?

You can get it at PropertyREI.com. And remember – be sure to use Promo Code: RETIPSTER1 at checkout for an instant 10% discount.

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Making The Offer

When you know a deal makes sense on paper, it's time to make an offer.

On December 15, I prepared a very simple, one page written offer for $27,500.

A couple of days after I emailed this offer to the seller – he called me and we spent some time haggling over the price on the phone. He obviously wanted as much as possible – but $27,500 was literally my ceiling (if the price went any higher, I wouldn't have had a buyer on the other end – and I made this very clear to the seller).

On December 18 – I received the seller's acceptance via fax.

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The Necessity of Due Diligence

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Whenever you're making an offer – you have to make some assumptions. There's no practical way around this.

It's okay to assume some things (if your purchase agreement gives you the necessary wiggle room to get out of the deal) – but once your offer is accepted, you need to go through the motions of verifying that those assumptions were actually correct.

As you conduct your due diligence, there will be almost always be some “findings” that come up in your research process (i.e. – things you weren't aware of when you made your offer). The key is to know when these findings are acceptable and when these findings are a deal breaker.

Once we had this seller's official “go ahead”, I ordered a home inspection report from a company called House Master (for a grand total of $385 – which my buyer agreed to reimburse me for). House Master is one of many home inspection companies that operates in my area.

HMLogoOptionsPantone334There are a lot of home inspectors out there who do similar work…  but if you happen to have a House Master in YOUR area, I can give you my official “thumbs up” recommendation. The team that handles my inspections does a great job – and the information they provide almost always results in me negotiating a lower price.

While the inspector was there, I dropped in to do a quick visual inspection of my own.

I don't always do this (in most cases, I can trust my inspector and property manager to give me an accurate assessment), but since I live just on the other side of town, I figured it would be prudent to swing by.

Here are a few pictures I snapped of the interior and exterior with my iphone:

photo (1)

driveway

kitchen1

livingroom1

upstairsbedroom

As you can see – it was a pretty simple, small house. Not enough for anyone to retire off of, but not a bad property for a newbie investor to get their feet wet with.

A couple of days after the inspection, the folks at House Master emailed me their full, 51-page report, giving a VERY thorough overview of every observable issue that could come up with this property (honestly, it was more than I even wanted to know – and considering their job, this was a sign of a job well done).

Their report brought some pretty important issues to light – all things the seller didn't tell me about, and things that would likely impact the cash flow of this property within the first couple of years after acquisition.

The most pressing issues were as follows:

  • The furnace was still functional, but was near the end of its life (it was over 20 years old). Replacing it would definitely be a necessity in the near future, and it wouldn't be cheap.
  • The bathroom shower was leaking and needed some attention to fix the issue.
  • The roof needed some patch work.
  • Some of the siding had some holes in it and needed to be replaced.
  • The kitchen faucet was leaking and the counter top had some chips in it.

Altogether, we figured these repairs would cost approximately $5,000 to fix.

Now obviously, I don't expect any property to be 100% free of problems, but what I do expect is to understand what those problems are BEFORE anybody goes through with buying it (whether I'm buying it myself, or assigning the deal to another investor).

This was a tricky case, because I knew the seller had already come down quite a bit with his asking price, and he had no intention of going any further.

In most cases – I would keep pressing the seller to move further down (depending on their level of motivation), but rather than continuing to push this guy, I decided to adjust the “Deferred Maintenance Costs” in the PropertyREI calculator from $2,500 up to $5,000 to see what the deal would look like after accounting for these extra costs.

Cash Scenario:

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Financing Scenario:

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Fundamentally speaking, if this property was financed conventionally – it would still cash flow, it would simply reduce the cash on cash return from 20.7% to 16.4% and if the property was purchased with all cash, the cash on cash return would be reduced from 9.7% to 8.9%. The annual cash flow and net operating income would stay the same.

On both accounts, it was still a good deal… the numbers would just take a slight move in the wrong direction (though not enough to be a deal-killer). Given this, we decided to take the hit and move forward (something I don't do often, but the deal was good enough that it warranted this kind of concession from our standpoint).

The benefit we had in this case was awareness. When these problems need to be addressed – we DON'T want to be surprised or “stabbed in the back” by the seller.

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Closing Process

iStock_000016338670XSmallOnce I knew our $27,500 was still acceptable after our property inspection, I emailed our fully executed purchase agreement to the title company and they began their title search on our behalf.

Now – when I'm REALLY pinching pennies, I do have the option of doing my own title search – but considering that my buyer was going to pay a significant amount of money for this property AND it involved an assignment of contract AND we needed someone to facilitate the signing of the closing documents, handing this job over to a title company was an easy decision.

With this particular property, my intent was to “assign the contract” to a third-party buyer.

In other words, my plan was to take my purchase agreement and sell the paper to another investor (a process that some refer to as “wholesaling”).

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How Does Wholesaling Work?

When I signed this contract with this seller, they gave me the legal right to purchase this property for $27,500 within a specified period of time.

Well – if for any reason, it's not convenient for me to buy this property for $27,500 (e.g. – if I don't have this kind of cash in my pocket at any given moment), but I know another investor who would LOVE to get this deal, I am literally allowed to sell this contract to them.

This is allowed because the seller gave me their written permission to do this (it is stated very clearly as an “assignment clause” in our contract).

This kind of transaction is completed with a 1-page form called an “Assignment Agreement”. This document is signed by ME (the “Assignor”) and the end buyer (the “Assignee”). The end buyer pays me a set amount of cash for the contract and in exchange, they can jump into my shoes and take my place as the Buyer in the original purchase agreement.

When Does Wholesaling Work Best?

This type of transaction tends to work best when a property is being purchased in an all-cash transaction (i.e. – the buyer doesn't need a bank loan to purchase the property).

Why? Because whenever a bank gets involved with a real estate transaction, they have a tendency to add a lot of restrictions and rules that make it very difficult (if not impossible) for the wholesaler (i.e. – ME) to get paid.

Luckily, I was dealing with a cash buyer in this situation – which is part of what made the whole project possible.

The Assignment Fee

There are a couple of different ways that I charge assignment fees.

Method 1: If I have a property under contract for a ridiculously low price (say, 20% of market value) – I generally feel comfortable charging a sizable fee, simply because there is a HUGE profit margin available that I can pull from. If the deal makes sense, the seller will gladly pay it because even with the cost of my fee, they are still getting an awesome deal that they wouldn't have found without my help.

Method 2: If I have a property under contract for a respectably low price (say, 50% of market value) – I will charge a 6% – 10% assignment fee (similar to a realtor commission).

Now to clarify…  I am NOT a real estate agent (nor do I ever intend to become one). There is a distinct difference between what an agent does, and what I (as a wholesaler) do.

When I structure a deal like this, there is literally a purchase agreement signed between ME and the seller. Once this contract is signed, I have an marketable interest in the property.

A realtor doesn't have this kind of arrangement. Instead, they are signing an agreement whereby the seller authorizes them to market the property on their behalf in exchange for a commission if/when the property sells.

Selling property on behalf of a property owner without a license isn't legal. However, if you're selling your marketable interest in the property (via your executed purchase agreement), this is a completely different scenario. This is a very important, key difference between these two types of business arrangements.

At The Closing Table

The closing process went very smoothly. The seller met at the office of our title agency in the morning, and my buyer met at the same office later that afternoon. During this process, the following things were transferred from the seller to my buyer:

  • Current building inspection certificate
  • Copy of the Current Tenant lease
  • Tenant Unit Condition Checklist
  • Original Tenant Application
  • Tenant Security Deposit
  • Keys to the House

My buyer then had to complete the following items with their new property manager:

  • Execute a Management Agreement
  • Execute a W-9 (IRS form)
  • Sign Up for Direct Deposit (easiest way to get paid by their property manager)
  • Hand Over the Keys to the House
  • Hand Over the Security Deposit

The transaction was seamless and there were no major hiccups along the way.

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What to Expect

During their first month of operations – my buyer earned a whopping $10 of rental income from this property (yippee).

There were a few reasons for the lackluster start:

  • The tenant only paid $600 of their $750 rent to the previous owner
  • There were some small, but immediate repairs that needed to be done
  • The property management company had to recoup their initial start-up costs

This is the reality of owning rental properties. It would be very atypical for an investor to come blasting out of the gate with their best possible outcome on the first month. It just doesn't work that way.

It's not unusual for the first month of operations to be disappointing, but there are a few things to keep in mind.

  1. Often times, rental properties suck wind in the beginning. When you're acquiring an older property with an existing tenant…  be patient. Dealing with deadbeat tenants, repairing things that should have been fixed years ago, paying for sins of the previous property owner are ALL very real possibilities immediately after you buy. For this reason, ALWAYS be conservative when you're creating your projections on a rental property. Not all sellers are “liars” – but as a general rule of thumb, don't ever assume they're telling you everything you need to know. I've dealt with a lot of reasonable, respectable sellers – but they still didn't tell me 100% of the details. Allow some room for error when you're evaluating the deal.
  2. Maintenance is something you'll always have to save for. If you're purchasing a property over 50 years old (which accounts for almost every property I look at), maintenance will be an even bigger issue to factor into your cash flow. This is okay IF you are buying the property for a low enough price. Just remember – when you buy an older property, you need to allow some room in your cash flow for some “question marks”. Be conservative and allow for some small, bad things to happen without putting you in the red.
  3. Build up a 6 month reserve and maintain it. You should always have a reserve of cash available to cover the costs of your property when it doesn't cash flow. For example, if the tenant in this property decides to stop paying his rent altogether – he's going to get evicted, no questions asked. If this happens, the property will be without revenue for at least 2 – 3 months, best case scenario (maybe even longer).

When I bought my first rental property, my property manager was very upfront with me and said:

“Plan for a net loss your first year.” 

Even though I was getting a great deal and the projections looked awesome – he was still right.

When you're dealing with some of the issues listed above, there are a lot of unknowns and things inevitably don't go as planned. Be prepared for this.

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A Look Back (One Year Later)

In this case study, we analyzed this property using the same process that has been proven by a lot of highly successful real estate investors. Our evaluation was thorough, we verified our assumptions and we took every feasible issue into account.

My buyer did end up having a lot of costs during their first year (judging by the age and known issues in the house) and they did eventually lose their tenant. However, in the months and years since, the rent price was adjusted upward to account for the stronger market for rentals that followed with the rebound of the real estate market.

Some of the known issues did take a toll on the property's profitability during their first few months of ownership – but once the repairs were made and the right tenant was in place – they were able to consistently generate the monthly cash flow that was projected in our initial evaluation. They were also able to benefit from the additional tax write-offs that came with owning rental real estate like this.

Again – this is not (nor will it ever be) a property that throws off massive cash flow, but for someone's first experience with a rental property, it's an ideal way to get started in the business.

It generates some small supplemental income for the new owners and will be relatively easy to sell whenever they decide to liquidate the property (because this is a very generic, affordable property in a densely populated part of town). These are great attributes to have in a property when it comes time to sell.

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Final Thoughts

As with any real estate investment – buying rental properties takes a lot of homework. Rental properties don't necessarily come with the glamour and huge paychecks that “flipping houses” is known for – but it is a proven method of building multiple streams of permanent income.

If you're looking to supplement your retirement income with something that comes with significant opportunities for appreciation, passive cash flow and tax benefits – buying properties (the right way) it a great way to make do it.

Join the discussion 32 Comments

  • Paolo says:

    should interested to exchange some financial metrics ?

    • Seth Williams says:

      Hey Paolo! I guess… though I’m not sure I fully understand your questions. Can you elaborate?

  • Dave Miller says:

    Great rundown on your process, Seth. I’m pretty experienced but I still love to see how other investors analyze their rental purchases – it’s a lot less cut & dried compared to rehabs! I love how you look and multiple metrics & are willing to be realistic with those numbers. Thanks for pulling back the curtain on your process!

  • Nathan Gesner says:

    Great outline, but it’s missing one crucial piece. What was the seller’s motivation to sell the home for 1/3 of market value and 50% of his purchase price? If he was retiring, it seems he would want at least what he put into it. Was he also divorcing? Was he fed up with bad tenants?

    There must be a reason he was so motivated to unload and that is what I would like to know!

    • Seth Williams says:

      Hi Nathan, great question. To elaborate on that – this blog post explains how I did a direct mail campaign to find the guy: https://retipster.com/findingmotivatedsellers1

    • lynn miller says:

      It really doesn’t matter why a seller wants to get rid of house for below its value. If it is an issue with the house, your inspector will show/tell you that. (Make sure you put that in your contract offer). My contracts allow me to back out if the inspection shows that I need to sink more money into the house than planned. Often when this happens, I AM ABLE TO NEGOTIATE WITH THE SELLER AS OPPOSED TO KILLING THE DEAL. Hint: Find an inspector that is critical of every little nail pop. His final repair number is a crucial negotiating tool for bargaining with your sellers.
      Don’t get hung up on personal issues. This is a business and has to be treated as such or you will lose money.
      The only thing you have to focus on is; will the house make you money? If yes, buy it. If no, keep looking.

  • Chris says:

    Wow, incredible article. You pretty much covered everything. I’m currently looking to buy some rental properties, mortgage them, and let the rent pay them off… Hopefully within 10 or so years after purchase. Any recommendations for cities in the U.S. with low purchase price but high rental rates?

  • Nicole Owens says:

    I currently don’t do rental properties but find this article very informative. I might start looking further into rental investing. Thank you for the great article!

  • Matthew Rockett says:

    I think purchasing with cash in this market is definitely the way to go. Right now with the market as hot as it is being over leveraged is very risky if you are buying multiple properties. Rents may go down in the event of a real estate bubble but with a free and clear strategy you’re not as vulnerable to the volatility.

    • Seth Williams says:

      Thanks for sharing your thoughts Matthew! I agree – the market is pretty hot right now… makes it even more important to understand the numbers of every deal (and the potential consequences behind them).

    • lynn miller says:

      I completely agree. I use hard money for my flips and use the profits to purchase rental properties for cash. I also keep all my properties with a management company. I’m too busy to deal with tenants. I have a deal that my lessee’s sign; I If they are on time with the rent, keep the place nice and have a generally good relationship with the management company, I do something special for them twice a year. C0uld be carpet for a room, a new stove or other appliance,(goes in storage for a flip) a gift certificate to Walmart, Target, etc. My renters LOVE it! I get to be their first priority when it comes time for them to pay their bills!

  • Hakim says:

    Hey Seth, great article as usual.
    Do you have any recommendations or insight as to how to come up with a solid estimate for rehab costs, especially when investing virtually in properties out of state? I’m trying now to wrap my head around this and get a good handle on how to effectively nail down rehab costs (without needing to learn how to be an expert contractor, but enough for my needs if you know what I mean). What are your thoughts??

    • Seth Williams says:

      Hi Hakim – great question. I haven’t done many projects with huge rehabs, but I typically do have to do electrical upgrades, new furnaces and/or roofs. In those cases, I just ask my property manager what they think I should set aside – and in some cases I’ll actually have a contractor visit the property during the inspection process to give me a better idea on what I’ll have to dump into the property.

      Once you’ve talked to these kinds of contractors a time or two (on your third or fourth property), you’ll start to develop your own expertise in the typical costs of these kinds of things. As with anything, the more you do it, the easier it gets.

  • Laurie says:

    I think that having a rental property can be a worthy investment as long as you go about it in a smart way. Great breakdown of your process and experience, very informative – thanks for sharing!

  • justin says:

    This post is so helpful. I’m new to the rental properties thing but I’ve had help from The Joan Kelly Group so it hasn’t been too much of a headache. But this post has a lot of good info and points.

  • Morgan says:

    Seth,

    Solid information. This case study seems to pencil for a cash buyer but as you mention, many do not have $30k to pay out of pocket. The financing scenario on the other hand just doesn’t seem to produce a reasonable return in relation to the amount of work it takes to stabilize this investment. With an annual return of $1,945, it would take almost 6 years just to cover the $11k downpayment alone.

    Is this a typical annual return for entry-level investors with less than $10k cash to put down?

    Thanks

    • Seth Williams says:

      Yeah, this one isn’t necessarily a cash cow, but as with most rental property investments – it takes quite a bit of capital to produce a relatively small stream of passive income (granted, that stream of passive income will last your for life – which is a big deal… but it still requires a big investment on the front end). There are better deals out there too, but I wouldn’t say this one is particularly bad – but the numbers are admittedly small.

      That’s one of the downsides when you’re ONLY depending on rental properties to build your portfolio. If you don’t have a solid source of income to invest in them, it could take a long, long time (and/or a lot of debt) to build up a big source of rental property income. That’s why I rely on things like land investing to act as the “cash machine” that feeds my rental property portfolio. With both working together, the overall business model makes a lot more sense.

  • Young Earner says:

    Hey Seth,

    I’m reading through all of your articles right now as for I want to get into the real estate investment business.

    The articles have been very helpful indeed! I’m wondering, is it a feasible idea for a teenager to get into this kind of business? I’m 16.

    Thanks again for the great content,
    Allen

    • Seth Williams says:

      Hey Young Earner! Thanks for checking out the blog (yours looks great as well)!

      As I’m thinking it through, I can’t think of any apparent reason (based solely on age) why a 16 year old couldn’t get started in this business. There may be some occasions where you’d need to be 18 or older in order to do certain tasks… but honestly, I can’t even think of any examples where that would come into play. Nevertheless, if you have someone you can rely on who meets that age requirement, it shouldn’t be difficult to get over that obstacle if it ever comes up.

    • Nathan Gesner says:

      You must be 18 or older to sign legal documents (with some exceptions). You’ll be hard pressed to qualify for a car loan of $10,000 so I doubt they’ll loan you ten times that to purchase a home. In other words, you are unable to purchase and hold property unless you can pay cash and partner with an adult that can sign documents.

      At your age you should focus on education, building credit, and saving money. Your best option is to find a pro that will mentor you. You can learn some skills like swinging a hammer, assessing a property for renovation costs, finding deals, the art of negotiation, market analysis, and much more. When you are legal and able, you will have the necessary knowledge and skills to invest wisely.

      • Seth Williams says:

        Thanks for chiming in with that sound advice Nathan – I appreciate your insights! I wasn’t aware of all those details (as I never tried to invest at age 16)… but they do make sense.

  • Paige says:

    These are awesome tips for a first time home buyer! A great company in Corona, CA helped ease my first time home buying – bmhpropertymanagement.com.

  • Long Game Investing says:

    Yes, but how do you find the right location for investing in a rental property? Here’s a nice list of the Best Cities for Tech Sector Growth and Rental Property Investment: https://longgameinvesting.com/best-cities-for-tech-sector-growth-and-rental-property-investment/

  • Alex says:

    Holy cow this was awesome. I have it bookmarked. I was looking for exactly this, someone to walk through every step of the process with real numbers. Thanks for taking the time to put this together (I am sure it took you some serious time).

    • Seth Williams says:

      Glad to hear you liked it Alex! Thanks for letting me know!

      It did take an eternity to put it together… but it was totally worth it. 🙂

      • Alex says:

        Quick follow up question, what software are you using with the screenshots of bar graphs and pie charts?

  • Jessica says:

    Thank you for sharing wonderful ideas! I was struggling on what to do or what to look for in buying rental properties. This helped me a lot.

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