4 Golden Rules of Real Estate Investing
Previously, I wrote about the cartoonishly low interest rates we’re currently loving. In this post, let’s explore what we might do with the tax-free cash we just took out of our home and/or investment property. Where’s the best landing spot for all that cash—or is there even one?
Want more articles like this?
Create an account today to get BiggerPocket's best blog articles delivered to your inboxSign up for free
After over 50 years being licensed—mostly as a broker/owner—allow me to share some of what I’ve learned in that time. Here are a few points that I consider golden rules.
- Knowledge: We can’t get the answer to a question we simply don’t ask.
- Strategy: Everyone has their favorite. For most, a combination of thoughtful strategies has proven to be infinitely more productive than the one golden strategy—whatever that may be.
- Expertise: A fancy word denoting that a person has the ability to do certain things at the expert level of execution. In my experience, this concept has been nearly reduced to rubble.
- Experience: I mean actual experience, not just years in the real estate investment industry. Experience in success, learning from disastrous failure, and accepting that you’ll never know it all. You’ll also never see it all.
Investing Is Not One Size Fits All
I recently had a client pull out $540,000 via multiple refinances of several small investment properties. It was tax-free by definition. The monthly debt service on every property went down. What should he do with it? Experience screams the answer at me: There’s no one right answer for every investor. Period. End of sentence.
For this guy who’s approaching 50 years old at the speed of sound, there are a few very solid answers—or should I say, solutions. He’d worked himself into, at one time, 10 duplexes, none of which is 10 years old yet. They appreciated like crazy, due to the fortunate timing and strategic locations. At the time of purchase, I told him that they would appreciate. What fueled my belief was simple: Demographics combined with supply and demand.
He also had, over the years, acquired six figures’ worth of notes secured by homes in multiple states. They were all in first position, though that certainly isn’t required. The income isn’t totally taxable as his accountant has been able to “shelter” some of it.
The Power of Cash Flow
First, let’s talk about cash reserves, a subject some treat like dodgeball. He already has roughly $150,000 or so in reserves. Knowing him, he’ll add to that just a bit. He’s like me—meaning, conservative. Investing is just that—investing. It’s not a fun night in Las Vegas.
He bought three brand new nightly rental homes in the southern part of Utah. The homes he bought were already zoned for nightly rental, so that wasn't an issue. It's the reason I haven't entered into that market until now. The huge majority of nightly rentals around the country are illegal in one way or another.
He's now taking all the cash flow from his remaining half-dozen Texas duplexes and will speed up the principal paydown of those Utah loans one at a time. The cash flow from the nightly rentals will, of course, be added to that figure. Once the first home is paid off, the second home's loan won't last long, as the NOI (net operating income) is greater than the GSI (gross scheduled income) for the same home rented to a family of four.
Free ’n clear, those Utah homes alone will conservatively give him—wait for it—five figures of cash flow, monthly. How did we arrive at those numbers? With incredible conservatism. That’s how.
The management experts in the market told us all about demand. But we wanted to know about vacancy and operating expenses. Turns out that in a good year, the vacancy is roughly a couple months. In a down year, the vacancy runs more like four months, or twice as much. We then decided our numbers would reflect nothing but down years. See? Conservative is the way to go, as over the years, I’ve found nobody seems to mind when the numbers are better.
We then immediately added 40% operating expenses over and above the 34% vacancy factor. We’re also satisfied with the overall demand, as it comes from two completely unrelated sources. It’s already been proving itself nicely, even with COVID-19.
Note Income and Synergy
Though this post isn’t about discounted notes, I wanted you to see how they can be used for far more than making a capital gain, or simple cash flow. They can be employed in the use of actual synergy. That word has been bastardized to the point of worthlessness in this industry. Here’s the definition: The interaction or cooperation of two or more organizations, substances, or other agents to produce a combined effect greater than the sum of their separate effects.
What we’re doing here is almost laughably simple in design. We’re not just using the Utah properties’ combined cash flows to eliminate the debt but also bringing in note income to enhance that process immensely. When the Texas cash flows are added, it builds upon itself. But then we don’t apply the extra payments the way you might imagine.
We are free ’n clear one property at a time. Why? First, I’ll tell you why not. It’s not faster.
Typically, if all loans are paid down simultaneously, they’ll all arrive at the debt-free finish line around the same time as my way. However, it depends on the starting loan balance. This assumes the same amount of cash is distributed in each technique. The key reason we choose to do one at a time is that the cash flow on the newly debt-free property will then be available if life intrudes. Always be thinking worst-case scenario—aka be conservative.
Once he has one debt-free property, the second one will be debt-free much sooner, due to the massively increased cash flow. Once the second property’s loan is eliminated, the third property’s debt will be gone before he knows it. It’s about safety, right? If it’s only a matter of a few months either way for the final results, why not have one, then two, then three free ’n clear income producers on the way?
If the market changes, or the national economy cycles into unfriendly times, how happy is he going to be that he has one or two properties without loans? Kinda sorta answers itself, right? Besides, when was the last time we didn’t cycle into relatively bad times? Real synergy is the gift that keeps on giving.
Please, please, please do not think I write this as a template. What we had him do was due to his financial status. That would include job income and status; independent sources of investment income; investing experience; and most of all, his personal comfort zone. The comfort zone of the investor vetoes anything I might suggest. Think about it: Who’s going to override your comfort zone? OK, maybe The Boss, right? But you get the point.
The idea is that when you begin actually investing, you want to follow the principles that will get you to retirement with the most and best-secured income safely.
And never forget: We only spend after-tax income, right? There’s a reason why we employ some of the principles spoken of in this post. Not all these principles are applicable to all investors, or even all scenarios. We’re all different. Because we’re intelligent beings, we apply the principles that will work for us. Sounds simple, right? If only.
What golden rules do you have for investing, and do you agree with my conservative approach?
Share with a comment below!