Paula Pant comes back to the show to discuss real estate as a path to Financial Independence.
Brad's Real Estate Story
Back in 2005, Brad bought a speculative property in North Carolina as an “investment opportunity.”
[Buying and selling bare lots] was without question one of the biggest financial mistakes of my life.
Brad was buying bare lots of land with the assumption that they would increase in value over time. Although the property lot was beautiful, its value came tumbling down with the real estate crash. Unfortunately, the real estate mistake ended up costing Brad and Laura north of $100,000, more with the compound.
This wasn't investing, this was speculation…I have learned a lot of things…investing and looking at real estate as a business. So, I think that kind of brings me to this point; where I want to move forward intelligently, but there are questions that I have.
Based on that mistake, Brad avoided real estate investing until now. However, this time he wants to go about it the right way. Since real estate is one of the three big ways that someone can achieve wealth, it is worth investigating.
Paula Pant is on the show today to help shed some light on common real estate questions.
After hearing Brad's story, Paula sympathized over how easily her real estate story could have turned out differently. Like Brad, she jumped into real estate without a lot of background research but it happened to work out in her favor.
I often say that appreciation is speculation…if you are making a decision based purely on the assumption that an asset will rise in value over time, and there is no other value that is inherent to that asset, other than your speculation of its future value…that is speculation.
Typically, the only way to make money through a bare land purchase is to rely on the appreciation. Although there are some ways to produce an income on a plot of land, that is not the approach Brad was taking.
Paula's First Property
When Paula bought her first property, it happened to work out well for her. However, she made it clear that just because her deal worked out does not mean that she approached it the right way. As outlined in Annie Duke's book, Thinking in Bets , the results are not always indicative of the right approach. Don't let the result fool you into thinking that it was a good decision.
She bought a triplex across the street from where she was renting. Although she did not understand the fundamentals of real estate at first, that first property helped her learn them.
She bought this property with the assumption that if the rent pays the mortgage, it will all work out. She made her calculations based on what the property was being sold for and the amount of rent she was paying across the street.
Listen: House Hacking With Coach Carson
Real Estate With Paula Pant
The industry of real estate covers an extremely wide swath of niches and strategies including:
- Flipping housings
- Tax liens
- Bare land speculation
- Mobile home parks
- Commercial properties
- Residential properties
So your niche might be mobile home parks. Your niche might be commercial properties such as office buildings or warehouses. Your niche might be residential properties which are defined as properties with four or fewer units. Any of those could be niches that you choose to focus on. In addition to that, you also have strategies. Your strategy might be long-term buy and hold. Your strategy might be flipping, you know there are a large number of different strategies. And depending on that combination of niche and strategy that you select, under this big umbrella universe of real estate, your experience is going to be different, your projected returns are going to be different, and the level of involvement that you will have is going to be different.
Paula took the time to investigate many of these niches and strategies and settled on long-term residential buy and hold. It is not better or worse than any other combination, but it is the strategy that works for her.
It is more important to be an expert in a narrow field than it is to find the best field. My competitive advantage comes from mastery in a given arena, rather than from picking the “best” arena.
Plus, her first property was a residential property. She felt that it made more sense to build on that first experience rather than starting from scratch. She also liked that it was easier to get a mortgage on residential properties and the sheer volume of opportunities in the residential arena.
How To Choose Your Niche And Strategy
If you are struggling to pick a niche and strategy, remember it is important to decide at some point. Don't let analysis paralysis get to you!
The only way to get ahead is to get started. And what I've seen for a lot investors, or aspiring investors, is that the fear that keeps them from going into that first deal can delay their progress by years…or worst case scenerio, it delays their progress to never. And a decade later they look back and say ‘Oh I regret that I didn't invest a decade ago'.
Take the time to do your research but do not let fear hold you back. Do your first deal without letting all the anecdotal naysayers sway you. Even if it's not an amazing deal, learning and failing forward is still progress. Don't jump in without any research but do move forward on your first deal.
The Fundamentals Of Real Estate
Paula uses a variety of formulas and classifications to winnow down her single-family rental homes.
Price To Rent Ratio
The first formula to start using is the price to rent ratio. You need to look for places that are landlord-friendly.
Price of the house divided by annual rent equals the price to rent ratio.
For example, if a home costs $300,000 and monthly rental income is $1,500 a month/$18,000 a year. Then your price to rent ratio is 16.6.
If the price to rent ratio is 10 or under, then you are in a landlord-friendly area. With a price to rent ratio over 12, 13, or 14 might make it difficult to find a good deal.
If you live in a high cost of living area, then realize you may need to buy your first rental in a different place. It is possible you'll find a good deal in a high cost of living area but unlikely.
It is a good idea to start looking at cities where you ideally have some type of connection.
Start where you might have family or other connections, where you can travel to easily. Also, access to a close airport is a plus.
Classes A through D is one way to look at potential neighborhoods. As you go further down the line, the neighborhoods get riskier. However, they also offer a higher potential return.
You will have higher potential returns and higher risks in a Class C neighborhood. You will have lower risk and also lower potential returns in a class A neighboorhood.
Use this framework to evaluate any city you are looking at. If you are a beginner or have a low-risk tolerance, then you might want to stick to class A or B neighborhoods.
- Class A: In this neighborhood, you might find Orange Theory Fitness, Panera Breads, Brio Tuscan Grille, and other establishments that cater to the upper class. You likely will not find great deals in this neighborhood but it is possible.
- Class B: In this neighborhood, you might find working-class residents with a safe feel. Typical chains might include KFC, Big Lots, TJ Max, or an average mall that is anchored by JCPenny's.
- Class C: Here you will find a lot of independently-owned businesses. Plus, air conditioners with cages around them because otherwise the copper might be stolen. Overall, it might feel a little bit sketchy but is still okay.
- Class D: Finally, you would not feel safe going to this neighborhood in broad daylight. Some investors call these neighborhoods “war zones” for a good reason. As an inexperienced investor, you should avoid these neighborhoods.
The 1% Rule
If you've spent any time researching real estate, then you've likely heard about the 1% rule. The rule states that the property should rent for 1% of the purchase price. For example, if you have a $100,000 home then it should be able to rent for $1,000 a month.
This rule should be used to look at purchasing a home, not necessarily retaining a home.
Landlord By Default
If you have a home but are moving, then you might consider becoming a landlord by default. You should not use the 1% rule to determine whether or not this is a financially sound move. Also, you should not use your mortgage as a barometer.
The costs of selling a home as well as associated taxes may make it easier to justify holding onto the home and renting it out. Additionally, you know the home intimately which means that you can predict major capital expenses such as a new water heater or windows.
The capitalization rate is the measure of your unleveraged income stream from a property relative to the value of the asset. Basically, it is measuring a potential dividend payment from your home.
If you wouldn't buy something with cash, don't buy it with a loan.
Using The Capitalization Rate
A home makes money in two ways; there is price appreciation and the income stream. The capitalization rate is a way to calculate whether a home you already own is a good rental property.
Calculate your capitalization rate with this:
- Calculate potential gross rent. For example, if your monthly rent is $1,800 then your potential gross rent is $21,600 annually.
- Subtract out vacancies to obtain effective gross rent. If there is a 95% occupancy rate, then in this example, effective gross rent is $20,520.
- Add in additional income streams that the property could create to find gross operating income. For example; parking fees, laundry fees, storage fees, pet fees, and more. In this example, assume that additional income is $480. This leads to $21,000 of gross operating income.
- Subtract operating overhead to find net operating income. Overhead includes repairs, maintenance, major capital expenditures, property taxes, and homeowner's insurance. If the operating overhead is $10,000 then the net operating income is $11,000.
- Take the net income and divide by the price you paid for the home equals your dividend. In this example, you bought the home for $300,000. So $11,000/$300,000 = 3.6%
If you held on to this home, then you would have an income stream or dividend of 3.6%. Remember, this is not the total return because you have not factored in appreciation. When you add in a conservative 3% appreciation for inflation, then the total return is 6.6%.
However, the national historic average of appreciation is 5%. So, the total return could end up being higher.
Short Term Rentals Compared To Long Term Rentals
Paula is focused on long-term buy and hold. Many people have touted the benefits of short-term rentals such as Airbnb and VRBO. However, Paula says that these two approaches should be categorized into two separate industries.
Short-term rentals like Airbnb are more similar to the hospitality industry than the real estate industry. You are responsible for providing consumables like clean sheets, dish soap, and other things that hotel owners are responsible for. Depending on your location, you may need to expect a higher vacancy rate than long-term rentals.
What that points to is that ‘Airbnbing' a property is so intrinsically different from being a landlord that they should not be considered the same industry. One is the hospitality industry and the other is the real estate industry.
If you are looking for a property to Airbnb, Paula recommends making sure that the property could survive as a long-term rental. In the worst-case scenario, if the Airbnb doesn't work out then you have a backup plan.
Related: House Hacking With Airbnb
Paula always recommends knowing what your goals and risks are first.
Paula's goal with real estate was to build a passive income stream to fund her life, not to get the highest possible returns. With that, she does not generally consider selling properties unless the neighboorhood slipped dramatically to a Class D.
If she wanted to buy a new property, then she would consider a cash-out refinance of one of her existing properties instead of selling.
Where To Learn More
Paula has an amazing course that dives into real estate investing. Although there is no official sales page, you can learn when the course will go live through her email list. It will reopen for students September 23-27 2019.
If you want to get started today, then check out her free eBook 7 Expensive Real Estate Mistakes To Avoid.
Also, Paula will be back on the show in the future to talk more about turn-key operations.
New to FI? Be sure to check out Episode 100: Welcome To The FI Community!