All Forum Posts by: George Pauley

A few years back I had a similar question and started asking my team for advice.  More involving how much to set aside, but this ends up getting into the mechanics of how and where to put the money.  One piece of advice I got from a conservative lender was to hold back 6 months worth of operating expenses.

So, we start by having a separate bank account for the business.  When the rents come in, they go to that business bank account.  We then allow ourselves to transfer any funds above that 6-month reserve value to our personal accounts.  This is tracked as a payment to the officers of our LLC.  Which helps to make sure we don't co-mingle business and personal funds and have clear tracking of how business money is spent.

This does mean that some months we don't get to pull any personal cash out due to high expenses.  But it also means we're not writing personal checks to cover those expenses either.  

Also, as our real-estate "empire" has grown, we've made some adjustments.  With 15 rentals, 6 months of operating costs is about $70k.  That's a lot of money to leave sitting in a checking account.  So we'll take about 1/2 of that (arbitrary amount based on our comfort level) and put it in short term investments like Patch of Land.

One of my favorite aphorisms is "Do the math, and the math will tell you what to do."

The key here is that these types of questions can almost always be answered with simple math.  But, just like those dreaded word problems in math class, you have to set it up correctly.

For example, you're realtor friend suggests putting 20% down to lower your interest rate, and you're wondering if this is a good idea or not.  The first question is:  How much lower of a rate?  Let's assume that the 20% down lowers your rate from 5% to 4%.  So you save 1%.  

Now, the next questions are.  1.  Can you afford to pay the extra 1% if you don't put 20% down?  (If not, then you have to put the 20% down!)  2.  If you took that down payment and made a different investment with it, could you make more than 1% on that investment?  If you can make more than 1% in a different investment, well then you should probably put that down payment money in the other investment!

Of course, in the end, there are other considerations than just pure math.  For example, its usually a good idea to have cash reserves.  If making the 20% down payment leaves you cash strapped, then there is risk that you could lose the home during a bad economic situation.  Whether to accept this risk or not is a personal decision.  But the math moves you a long way towards coming up with informed decisions.

The same sorts of mathematical analysis can help you determine whether to buy house #1 for $200k, or house #2 for $250k.

I've been at this for 12 years, and have used a Well Fargo (my personal bank) checking account for the entire time with no problems. 

Oh God, my first investment?  I'm embarrassed to talk about it.

Brand new spec home.  4k sq ft.  $450k.  Oh and I closed on it early January 2008.  Needed $2700/mo to break even.  I was lucky to get $1800.  Had to ride that, almost instantly, underwater property for 6 years before I was able to dump it for $420k.  I was SO happy to see it go.

That said, I learned a lot.  Today I have 15 properties, all cash-flowing around $200/mo each.  And I wouldn't be where I am if I hadn't bought that first turd of a property.  I like to tell new investors that the are going to make mistakes ($$$), but they can't let that keep them from taking the plunge and investing in that first property.  The mistakes, and the lessons learned, are part of the process.

Key lessons from first property...
1.  Medium size 3/2's rent much better than giant 4k sf mini-mansions
2.  The IRS does not allow non-real estate professionals to deduct rental losses from their W2 income.
3.  Property managers, as a class, are usually horrible, but a good property manager is essential.  (Keep looking!)
4.  Rent, lower than what you want/need, is better than no rent.
5.  Underwater properties aren't really a loss until you sell the property.
6.  When you have a bad property, you can buy good properties to help make up the cash flow deficit.

Phoenix is definitely an appreciating market.  And it's HUGE.  Over 4M people.  It takes more than an hour to drive across it, on the freeway, with no traffic, speeding.  As such there are poor areas, rich areas, growing areas, declining areas.  I've lived here for 20+ years and wouldn't even pretend to give you market analysis by area.

One thing that Phoenix does have going for it is a strong and active Real Estate Investor Association. Check out AZREI, and it's sub-chapter Phoenix REIA, to hook up with lots of local investors, agents, contractors, etc. and good market analysis.

I use a property manager.  The primary reason why is because I need expertise.  I don't know how to properly screen tenants.  I don't know how to properly advertise and find prospects.  I don't know how to analyze the market to select a rent value.  I don't know how to properly (legally) handle late payments, evictions etc.  I don't know who the best contractors are in an area.  etc.

Yes I could learn those things.  But it will take me a long time to develop the level of expertise that the property manager with years of experience, who does this for a living day in and day out, has.  I have properties today.  And I need that expertise today.

I do agree that the majority of PMs are unbelievably bad at the job.  I consider finding a good one to be the hardest part of being a real estate investor.  In fact, I won't invest in an area until I have found such a PM who can service that area for me.  Once I have that PM, I usually run my prospective properties past them for approval before buying.

I'm not saying that having a PM is a requirement.  You do what's right for you.  But there are plenty of good reasons for using a PM, other than laziness and ineptitude.

I would add that I think these forums are self-policing.  If you have a bad experience with someone, post about it.  Word gets around.  If you are thinking about doing business with somebody put a post up asking everyone what their experience has been with that somebody.

I've noticed that, whatever the situation/need, it seems like there are 2-3-4 people who get recommended by everyone for that situation.  Those 2-3-4 people are usually top-notch players.

Originally posted by @Kaiser Saeed:

@Basit Siddiqi, Thank You.

For depreciation purposes, going with tax value of the property is appropriate? 

No, the depreciation value is the basis value of the property, which is accountant speak for how much did you pay for it.  :)

Also depreciation, coupled with 1031 exchange, is in my opinon, the single largest benefit to real estate investing.  First you get the depreciation benefit, which at 3% of the purchase value is not insignificant.  At a minimum it will likely keep you from owing taxes.  The drawback is that when you sell the property the IRS taxes you on all those years of depreciation in one lump sum (oversimplification, but basically correct).  But then enters the 1031 exchange.  When you sell the property, use a 1031 exchange and the depreciation on the property being sold is rolled over into the new property.  No tax.  Of course, when you sell the new property, the tax bill is even bigger.  But you can 1031 exchange again, and again.

Now for the coup-de-grace.  When you die, your heirs inherit the property, and the IRS resets the basis value of the property(s) to current market value (e.g. zillow).  In other words all that depreciation history just disappears in a puff of smoke!  Ever heard the phrase the rich get richer?  ;)

I'm in 4 different markets and have explored many others.  My experience is that neighborhood grading is a very imprecise activity.  I've seen it based on % of dwellers who rent vs own, median income levels versus surrounding area, crime levels, and my personal favorite... (we'd love to live there, my family is safe there, my family can go live with her mom while I live there, and I'd feel safer under the freeway overpass)

Anyway, when dealing out of state, I first focus on finding a competent property manager that I trust.  Then I ask them what neighborhoods I should be investing in.

There's a lot of different types of investing.  What are you looking for, appreciation, cash-flow, flipping, other?