Panning For Rental Property

MD new housing starts 2000-2011Gullgraver_1850_California

I know.  In today’s modern world, that’s a pretty goofy mental image: some old-timer crouching over a stream and sifting for that one gold nugget.  And yet, that’s kind of what we did when we looked for our first rental property.  I estimated that we spent ~200 hours screening properties to find The One.

Now that we’re officially on the hunt again, I figured I would detail the process we’ve used previously and are planning to use (and evolve) again.  Although, this time we’re looking for something a bit different.

So let’s start with the master plan:

  1. We have a 2br/2ba condo that is a pure investment property.
  2. We live in a 4br/2.5ba townhouse with a low enough cost structure and in a very desirable neighborhood that it should also make for a good rental.
  3. We want a single family house close to my wife’s employer, in a neighborhood with good public schools, and with a dedicated rental space.

So, the goal is to keep house #2, rent it out, and add a third rental to offset the cost of our next place.  As always, our general philosophy is buy and hold.  I guess that means we have some pretty specific requirements.  Perhaps some of these characteristics reflect others’:

  • “Class A” (lots of folks have different definitions; this is close enough for my purpose)
  • Good k-12 public schools (7+ on greatschools.org)
  • Close (<2 miles) to public transit (for us that means trains into DC)
  • Close (<1/2 miles) to a community park, ideally with running/biking trails
  • Because we’re looking to use part of our house as a rental (e.g. a big chunk of a finished basement), we need to be near our target tenants’ desired location, have a separate access, and have utilities available for the rental space
  • We’re looking to offer our tenants a studio or 1br space for between $750 and $1000 a month
  • Modest appreciation, at least keeping up with inflation.  We’re in the buy and hold space, so we’re not looking for anything that requires huge increases in value to make our investment pay off.

I’ve been doing some digging on this topic since I listened to a podcast by Paula Pant over at Afford Anything where she outlined some of the key factors she uses to invest in real estate:

  • Price to rent ratios
  • Building permits (new starts and renovations)
  • Job creation
  • Infrastructure development

Over the next few posts, I’d like to dig into some of these factors a bit as I’ll be exploring them in more depth as part of our own search.  I know there’s lots of discussion out there about “big” data.  My goal isn’t to make this into a science project, but I do believe there’s some useful data available for real estate investors, and it is not limited to subscription only sources.

Let’s start with an example.  We currently live in MD, and we’re looking for our next property in MD.  So, I started at Maryland’s open data site.  There’s a bunch of data sets to geek out with.

I’ll pick the new residential housing units data set to start.  In theory, a county with lots of growth, would be likely to offer a good opportunity.  Here’s a quick snapshot of the 24 MD counties, their total new residential housing starts from 2000 through 2011 (I couldn’t find a more recent data source).  I also included a line chart view of each county over that time period to illustrate any trends.

It looks like the top three counties from this time period were Montgomery, Prince George’s, and Anne Arundel.  On each of their trendlines, you can see upticks in the last 3-4 years.   Thinking back to that era, the 2005 BRAC was in full swing.  While it may have caused significant challenges around the country, the Ft. Meade area and it’s surrounding counties (those three) benefited from a significant influx of DOD related jobs.

What do you think?  Do new residential starts portend a good rental real estate market?  Will this trend continue in the future?  There’s always talk of the DC “bubble,” although with the current president working to limit federal government employees, the real estate sector may be in for another shake-up in this area.  Drop me a line and let me know.

How To Be Needed

Working within Corporate America, I see many folks who are enamored with the idea that they are needed.  Their employees should not make decisions without consulting them.  Need to take a business trip? Get an approval.  Need to be reimbursed for said business trip?  Get an approval.  Have an idea for a better way of doing your work? Get an approval.  Want to start your next project?  Get an approval.

It sounds annoying but still innocuous, right?

Wrong.

All these approvals are “No” gates.  They’re just speed bumps on the way to someone at some level saying, “no”.  Just try taking action without approval though.  The entire system is set up to slow down and stop any action or change.

One of the reasons I’m so intrigued by real estate is the potential for passive income.  However, I’m not on the right path yet.  I’ve started setting up a system where I’m needed for everything.  And, it’s hard for me to change, even though I know I’m the only one in my way.

Let me explain.  I suffer from several personality flaws:

  1. I’m cheap
  2. I’m too curious about how things work
  3. I’m slow to trust
  4. Did I mention that I’m cheap?

To illustrate: we bought our condo, knowing that the interior needed to be completely refreshed.  My wife and I (and one of our good friends) spent almost 500 hours in 2 months tearing up carpeting, sanding, painting, installing flooring, cleaning, painting, installing trim, changing electrical outlets, painting, and managing 3 sets of contractors.  And that was on top of our day jobs.  We used contractors for the HVAC replacement, countertop installation, and appliance haul away and replacement.  Otherwise, it was all us.  I schlepped 800 sqft of flooring up 3 flights of stairs… hardly passive income.  That’s personality flaws 1 and 4 coming through.  We stretched our means to buy the property.  We knew going into the project that we needed to stick to our renovation budget, and that meant doing a lot of work ourselves.

Tim Ferriss’s Four Hour Work Week, Robert Kiosaki’s Rich Dad Poor Dad,  Paula at Afford Anything, Sam at Financial Samurai inspired us to act (affiliate links).  And I know they all started small, but I learned a new appreciation for the word hustle during this project.  Here’s the thing: they’ve all made it.  We’re just starting.  So, we don’t yet have systems in place to do the work for us.
When it came time to look for a tenant, we were hesitant to hire that out too.  We were curious to know who would be enjoying our new place.  (Yes, we thought of it in terms of “our”).  And that’s an unfortunate byproduct of personality defect number 2.  As much as we followed our newly established process for screening tenants, there was still some emotion associated with our selection.  In the end, things seem to have worked out OK.  And, we’re again faced with a new round of tenant screening.

We know every inch of our condo, having spent so much time renovating the place.  In our area, the renting process can be contracted out for roughly one month’s rent.  Each property can be managed (as a contract) for roughly 10% of the gross monthly rent.  Add both of those together, and our unit becomes significantly less profitable.  There’s the added uncertainty around a property manager: will they care about our property as much as we do? Will they present as good of a customer(tenant) interface as we will?  See personality defect#3 at work (Probably # 4 too)?  So, as much as we would like to have a better system in place, here’s what we we’re doing:

1. A pre-screening phone call.  We ask 7 questions of each person interested in seeing our unit.  The questions are:

  • Why are you moving?
  • When do you want to move in?
  • Are you OK with us conducting a background check as part of the application process?
  • Do you have residential and occupational references we can contact as part of the background check?
  • Is your income greater than 3x the monthly rent?
  • How many people/pets will be in the unit?
  • Have you ever been evicted?

2. Once we believe folks are good prospective tenants, we set up a time to show them the unit.  Note: I would love to transition this to an open house type of showing.

3. If they’re still interested, they fill out an application form and we proceed with background/reference/income checks.  To protect everyone involved, we’re using  TransUnion’s MySmartMove. We really like that our tenant’s personal information is protected: we don’t have to handle their data or worry about processing their application fees.  We get to see a quick summary of their current financial obligations, payment history, and a prospective tenant score.

 

    TransUnion’s Resident Score Range.

4. From there, we conduct rental history, employment, and income verification checks.  If everything checks out,

5. We review and sign the lease.  At last.

Whew!  What a process!  This being our first time screening tenants since the unit was finished, we had to invest a bit more effort to obtain interior photos, put up a detailed website, and prepare our listing on Zillow’s Rental Manager site.  We’ve spent 13.5 hours getting that all set up.  Hopefully, we’ll be able to re-use this for years to come.  In terms of screening tenants and showing the unit, we’ve spent 3.5 hours and showed the condo to 3 prospective tenants.  The third family submitted an application, and we’re processing it currently.  Keep your fingers crossed!

In a future post, I would like to revisit more of the non-recurring effort/ongoing maintenance effort and costs that we’ve experienced thus far.  From my homework in preparing to purchase this condo, I really struggled to find good data on these topics.

So, any ideas how we can systematize our rental property further and make it more of a passive income generating machine?

Wealth to Lifetime Earnings Ratio: Part 1

This is Part 1 in a short series exploring the concept of lifetime earnings vs. net worth.  It’s pretty heady stuff so I’m breaking it up into a couple of linked posts. 

What is your Lifetime Wealth Ratio?  How good are you at converting earned income into net worth?  I first read about the wealth to lifetime earnings ratio on a Lifehacker post that was quoting Budgets Are Sexy.  It’s a very powerful way to look at your personal finances.

Back up a second.  What is net worth? Net worth is defined by accountants as assets less liabilities.  For normal folk that means, all the stuff (investments, house, cars, etc.) you own minus what you owe to others (student loans, mortgage, credit cards, etc.).

So, let’s get started.  Total up your assets (hypothetical values taken from here):

  • House: $800,000
  • Retirement accounts: $45,000
  • Cars: $30,000
  • Company Stock: $20,000
  • Mutual Funds: $5,000
  • Total assets: $900,000

Next, total up your liabilities:

  • Mortgage: $250,000
  • Car Loans: $40,000
  • Credit Card Debt: $10,000
  • Total Liabilities: $300,000

Subtracting total debts (liabilities) from total assets ($900,000 − $300,000 = $600,000), and we can see that this household would have a net worth of $600,000!  That sure sounds like oodles of cash piled in a giant vault somewhere, doesn’t it?  Using US census data from 2011, we can get a rough idea of where this household falls within the US population.  Note that this is all US households (not adjusted for things like head of household age, location, etc.), and this example would fall within the top 13%.

2011 Census Net Worth Distributions

Distribution of US household Net Worth.

And that’s why I think net worth is so interesting.  Earned income (aka salaries or Benjamins) is great, kind of like sugar.  But unless you convert it into something useful, it will be gone.  And you will be left with nothing but the need to fill up again with a quick hit on payday.

It’s tough to really get a good view of the what people are really worth.  The census buckets above are really coarse, and there’s no link to earned income.  However, there is a pretty cool view (yes I said that about a census table) of the different types of assets that wealthy vs. poorer households own.

Net Worth By Asset Type

2011 US Census breakdown of median net wealth by asset type

Keep in mind that the upper part of the graph is all median values for the category.  Nevertheless, seeing the total dollars visually displayed threw me for a loop, especially when you think that 45% of the US population has less than $50,000 to their name.  The goal for me was to see how rich folks allocate their dollars.  My key take away: diversify your assets.

I was floored by how many folks in the upper brackets have rental real estate in their portfolios and yet how small of a proportion of their asset base it remains.   I’m also shocked at how little is saved in retirement accounts vs. how much equity we have in our homes.  Finally, the amount Americans have “invested” in their automobiles is shameful stunning.

There is of course a chicken and egg problem here. We cannot say which came first: income producing assets or earned income. The results are pretty clear: wealthy folk have a much larger share of their wealth in wealth-producing assets. So, I’m happy to expand on that theme and put my (biased) interpretation on the data.
1) Buy fewer Maserati’s and more stocks/bonds.
2) Fully fund your retirement accounts (plural!)
3) Own your own (modest) home
4) Buy one or more positive cash-flowing rental unit(s)
5) Consider alternative investment strategies once you have covered the basics

6) Diversify your income sources

 

Next up: Lifetime Earnings.  Followed by the actual Lifetime Wealth Ratio.   Stay tuned!

Are you surprised by the asset category differences? Where does your household fall on the net worth distribution? What strategies are you using to grow your net worth?

 

How to Prepare for a Layoff

With the Great Recession officially ending in June 2009, the US economy is almost 7 years into its recovery as of May 2016. Based on recent history, that’s a long run of good times a rollin’. How far in? It’s tough to tell.  The Bureau of Economic Research keeps track of US economic cycles.  Because their announcements tend to lag a peak or a trough (by up to 21 months!), let’s take a quick look at recent historical cycles to get a crude sense of where we might be in this cycle.  If you’re an optimist, you can make a case that the US economy may still be peaking:

GoodTimesYetToCome

If you’re a pessimist, you can argue that the economy is already in decline and we’re heading for the bottom of our next economic cycle:

GoodTimesBehind

Regardless of whether you think the economic punch bowl is half empty or half full, if you work for an employer, you have some risk of a layoff to contend with. So, what is a well-intentioned employee to do!?

Let’s set aside brown-nosing, jumping ship, and prayer as possible strategies to prepare for a layoff or other disruption to one’s primary income stream (This is a financial blog after all).

As I see it, there are two basic approaches: defense and offense.

Defense:
Cash

Cold, hard cash (or in a savings account). There is no substitute for a well-stocked emergency fund.  Conventional wisdom says that when looking for a new job, plan for about 1 month for each $10,000 of compensation.  If you want a $100k/yr job, be prepared to spent ~10 months to find it.  …so, how big is your emergency fund?

HELOC

As I understand it, a Home Equity Line Of Credit is like an open credit card against the equity you’ve built up in your home. Why would anyone be interested in such a critter?

  1. It provides a leveraged way to boost your emergency fund
  2. The interest costs are type far lower than a credit card.  On the order of 3 to 6 percent these days.

Unfortunately, there are also some downsides:

  1. You could lose your house as the HELOC collateral is your home.
  2. you need to demonstrate financial stability now. It’s tough to get a bank to approve a HELOC after you’ve suffered a financial perturbation already
  3. You will be charged interest on your outstanding balance until you pay it back
  4. There is an upper limit to how much of a line of credit you can obtain. How much equity you’ve built up in your home vs. market value is an influential factor.
  5. The interest rates are adjustable ~monthly, introducing volatility

Other Loans (e.g., Personal or Student)

There’s a couple of other loan options.  Personal loans are just that: loans for any personal use.  The lending office will be looking for verification of your income, so if you want to pursue this option (e.g., HELOC not available), get started while you still can show steady income.  Interest rates can vary but be between 6 and 9 percent currently (it’s good to be the bank, isn’t it!?).   If you are currently even a part-time student, you have a pretty cool option available to you: interest deferred student loans.  You’ll have to fill out a Free Application for Federal Student Aid (FAFSA).  Rates vary between 4 and 6 percent these days.

Credit cards

This is definitely a fall back option. I think an extra credit card that is largely unused, possibly with a single bill that auto pays each month, is a great idea. It can help boost your FICO credit score by lowering your percent of revolving debt. The minute you have a revolving balance at 10, 15, or 20% interest, you’re in trouble.  But, for a short term disruption, it might enable you to pay for essentials.

 

Cut Costs

If there is a pending disruption to your earned income stream, now is a great time to review your current expenses and trim what you can.  Cable, gym memberships, other monthly entertainment subscriptions (Netflix, Hulu, Spotify, Kindle Unlimited, gaming, etc.) are all candidates.  They may not be major drivers of your budget, but they’re easy targets, and they’re pretty quick to cut.  Reduce/negotiate your wireless data plan (we’ve cut ours from almost $130/mo to $85/mo!) Bigger targets of opportunity are certainly out there: housing, transportation, etc.  But, I’ll assume they’re roughly fixed for most folks in the short run.

Offense

Diverse Income Streams

Of course, this is one of my favorites (and a prime theme of this blog).  If 95% of your income derives from your day job’s paycheck, losing that income stream is highly disruptive.  If 20% of your income comes from your day job, it’s not such a big deal.  When you have enough income from other sources, you reach the F.U. Point ℠ (that’s “Freedom Uttained”).  Hustle.  Start a business.  Start a website.  Start now.

Unearned Income

Use a portion of your current net worth to generate unearned income.  We’ll revisit this topic in much more detail in future posts.  But, here’s a quick breakdown:

  1. No risk: Set up a CD ladder to earn a bit of FDIC insured interest income on a regular basis.  These days, this amounts to a pittance, but if you shop around, you can find rates a bit better than a high-interest savings account.
  2. Minimal risk: set up a bond ladder or buy into a bond fund (with quality bonds) directing interest payments to your checking account.
  3. Higher risk: buy & hold dividend stocks directing dividends to your checking account.
  4. Crazy risk: Peer to Peer lending where you become the bank to other folks (given that the context for this post is planning for a perturbation in your earned income, this may be folly).

Jump Ship

I said I was going to exclude this from the list, but I’m bringing it back anyways.  If you’re in the fortunate spot where you are finding out about a layoff before it hits, start looking for a new gig now.  Get that resume updated and tap your internal and external networks.

Yes, I said internal…

Not all parts of a company experience a cull in the same way.  You might be able to transfer or rotate much more quickly than finding a new opportunity externally.  In parallel, leverage your external network to see who can use your awesome skills.

A special shout-out to my friend, Dan for providing the inspiration and framework for this post.