Tue 1 Nov 2005
A few weeks ago I received a postcard in the mail inviting me to a seminar on buying rental property. The postcard was from the bank that I got my house mortgage through, and rental property is something that I’ve thought about doing for a long time, so I decided that I would go.
I sent email to the guy that was running the seminar, Tom Cain, and received a response back in a few hours that my spot had been reserved.
Tonight was the night for the seminar, and I didn’t really have any idea of what to expect. I had asked some other people who had accounts at the same bank, and they hadn’t gotten the postcard invitation, so I didn’t (and don’t, for that matter) have any idea what the criteria were for actually getting the invitation. Anyway, I got there and there was quite a crowd. They had probably 50 chairs set up in the main lobby of Bank Champaign with a podium at one end. There were various flavors of coffee available and a few trays of cookies, which I avoided. I found a spot near the middle of the room and sat down and waited for the event to begin.
The evening started out with Zachary McNabney (Assistant Vice President of Bank Champaign) speaking for a few minutes about the benefits of getting pre-approved for a loan. This was all old news for me. Having purchased a house, I still remember all of the nuances of that whole process. But, basically, being pre approved lets you quickly know how much house you can get a loan for, and it also gives the seller more confidence that the deal won’t fall through due to financing not being available.
Current loan rates, as of this afternoon were 6.625 on a 30 year fixed; 6.25 on a 15 year, 6.5 on a 5 year ARM with 10% down.
After Zach finished talking, Tom Cain took the podium and started by discussing his own situation. He had been at a Remax realtor conference in another town and 95% of the attendees said that they had kids, but that very few of them were involved in owning rental property. The speaker had said that if you bought a house for $80,000 with 10% down you were out $8,000. Then, the rental income could make your payments on the mortgage, and in 15 years, the house could be paid off. In that time, it would, conservatively, have appreciated to $100,000. So, for an expenditure of $8,000, in 15 years it turns into $100,000. Needless to say, that’s a pretty good return on investment.
To get started, he got a line of credit on his primary home that his family lived in. As an example, let’s say that you had an $80,000 line of credit. The houses that he has purchased were primarily in the $50-73,000 range. So, to purchase a house, he bought it outright using the line of credit on his house. So, he basically paid cash for the new property. He bought fixer-uppers. He said that he typically had put $8-8,500 in each one. Then, he got it appraised and they always ended up being appraised somewhere in the mid 80s. At that point, you get the bank involved, and get an actual mortgage on the new property (so that you can pay off your $50-73,000 + the $8-8,500) that you had initially borrowed against your house line of credit. You can mortgage 80% of the property’s value without having to pay PMI (mortgage insurance… bad stuff) so you can mortgage $85 * 0.8 or $68,000. Hopefully the $68 will cover your initial cost plus the cost of improvements, and you have your line of credit paid off. (Note to self.. If you put $8000 into the property and increase its value by 12-20k, consider just flipping the house)
So, you don’t have worry about losing your house if something went wrong. Then, the tenants can basically pay the mortgage payment each month, and it isn’t uncommon to clear $75-$100 a month on top of that. Prices that were mentioned for rent were in the $400 range for a 1 room apartment to $750 or so for a 3 bedroom house. Tom said that he always buys a home warrantee on the property when he purchases it. For ~ $300 this gets you a year of coverage if anything goes wrong in the house with the furnace, air conditioning, etc. You pay $60 per service call, and they either fix the component or give you a new one. This reduces the risk exposure for the owner.
In Champaign County, there is a loophole in the tax code that says that you can get the homestead exemption on property taxes if you write a clause into the rental agreement with the tenant that states that part of their rent each month is going to pay the property tax. Additionally, you have to put verbage in the lease that tells the tenant that they are then responsible for the payment of the property tax. If the lessor happens to be a loser, the tenant will be stuck with paying the property tax. One might say that the homestead exemption ends up being something like $500 a year*, so it could be significant. This is a loophole, and, as a lawyer discussed later on in the evening, it shouldn’t be assumed that it will always be there. They could close it at any point. It only applies to single family dwellings.
* – 2004 Champaign city tax was 7.7023% per assessed value, which is a kookie 1/3 of the actual value of the house. Anyway, the $5,000 homestead exemption times the 7 percent is $385. So, it would be $32 a month.
Owning real estate has several tax advantages as well. You can use depreciation on the property to offset some of the income. I’m not exactly sure how this works. Property generally appreciates in value, so I’m not sure what you are depreciating out. Maybe you only depreciate out the work that you do on the property.. I’m not sure. But Tom gave an example that, a couple of years ago, he had set aside $40k for taxes on the properties, and after he played the depreciation games, he only ended up paying $7k or so.
After Tom finished talking, Pat Fitzgerald, an attorney with Meyer Capel started talking. He concentrates on Real Estate Law and seemed like a pretty knowledgeable guy. I don’t know what he charges, but I wouldn’t feel like I had an incompetent lawyer if I ended up with him. He talked about making sure that the contract to buy gives you options. This is often called a due diligence time, but the basic idea is to make sure that you give yourself time and the right to do the necessary work for a property. This might include making sure that the title is clean, making sure that the zoning matches with your intended use, geo-ground work if needed. If you buy land and plan to build, you want to make sure that it isn’t all sand, or on a cave.. that sort of thing. Making sure that there aren’t any encroachments.
He said that that one of the things that he liked about real estate investing is that it is passive money. He said that normally, you have to be doing work to get paid. But with real estate, it is doing the work whether you are or not. This goes for most investments, though. He also mentioned a tax benefit of real estate investing. With stocks, if you sell a stock and buy another the same day, you are still responsible for paying taxes on the gains from the first sale. With real estate, you can do a “1031 Exchange” and sell a piece of real estate and buy more and not having to pay taxes on the sale of the first one. You defer the payment of the taxes. (No, you don’t completely get out of paying them… you just defer them)
For the 1031 exchange, you have 45 days from the closing date on the sale to identify properties you are going to use to replace that parcel in your investment portfolio. You can choose up to 3 other properties to replace it with, or you can follow the 200% rule, where you can choose as many properties as you like, but their sum must be < = 200% of the sale price of the real estate you unloaded. Then, you have up to the lesser of 180 days or the due date of the taxes for the year in which you sold the original real estate to actually make the purchases. An example is in order. If you sold in January, you'd have until July to purchase. If you sold in December, you'd have until the tax due date, which is generally April 15. But, you can get that extended so that you can still (in effect) get your 180 days.
Using a land trust to purchase property gives you confidentiality. A developer that is trying to purchase multiple lots is an example of where this could be handy. A seller might realize that person X is willing to pay them more if they think that they have a parcel of property that person X really wants. But, by using a land trust, they would only know that Bank Champaign Land Trust #239823 is wanting to buy.
Using a LLC or S-Corporation, etc to purchase property limits personal losses in the event that something goes wrong with the property. However, if, for some reason, the individual themselves gets sued, their assets would include the LLC or S-Corp, so they would still be seized.
If you buy, definitely have property insurance, and also have liability insurance. Rule of thumb numbers would say to have a million dollars worth if you are owning as an individual, or $3-500,000 if you are owning through an LLC.
For how much the bank is willing to loan you, one rule of thumb is 1.2 * the income potential. So, if you assumed that you didn't have any external cash income, after subtracting all maintenance costs, you would need to be making, in rent, 1.2 times the expected mortgage payment to actually get the loan.
Tom said that there was an average12.8% appreciation in home prices in 2004 in Champaign County.
I managed to get can warmer out of the evening that says Bank Champaign on it, along with a pen.
There was also a piece of paper included in the packet on real estate investing using ones IRA. This is also something that I've been interested in doing. I might have to get ahold of Bank Champaign and find out some details on it.
All things considered, I'm more informed now that I was before the evening started. I would like to have more details on actually owning the rental property. I realize that this seminar was on buying, and that's fine. I would like to learn more about actually owning, though. That's what scares me. The purchase is a one time thing. But actually owning.. Could a person keep rental property rented? If it isn't rented, the monthly mortgage payment will have to come out of your pocket. The main problem, anectdotally speaking, that I've seen with rentals is that you get bad people in, and they trash the place. Then you are out serious money fixing stuff up.
Concerns and questions:
If the realtor finds a really good house, wouldn't they buy it themselves?
Are we due for a drop in housing prices?
Can you keep it rented?
How much work is it to own rental property? Are the management services worthwhile? (I'm sure the answer proffered for this question will depend on who you ask) I've seen numbers of 10-20% management fees, and more for new leases. This makes you wonder just what they do for that cash, other than take the monthly checks and call the plumber when the tenant tells them to.
Some other relevant websites:
Calculating cashflow from a rental property
Calculator to determine if an investment is profitable
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