Afford Anything - Ask Paula - Should I Buy a Beachfront Rental Property?

Episode Date: April 23, 2018

#126: It's time to answer real estate investing questions! Tom asks: "We're thinking about buying a duplex on a beach in a popular vacation destination in Florida. If the property stays 85 percent occupied as a short-term (VRBO) rental at current rates, the income from one unit of the duplex could cover the costs of a 30-year mortgage. "But if a recession hits, Florida real estate might tank. The rental rates or occupancy could drop. And we'd be stuck paying the mortgage out-of-pocket, which means we might not be able to retire. Should we take this risk?" Rachel asks: "Would you consider purchasing a beach house? Also, would you consider buying out-of-state?" Alfredo asks: "I own a couple of rental properties. I have to admit, my personal and business funds are completely co-mingled. I'm trying to separate these expenses, but it's a mess. If I hired professional help, how much might I pay?" Anonymous from the Northeast asks: "I'm gathering friends to invest. We live in the northeast, where home prices are expensive. I'd like to invest out-of-town. They'd like to invest locally. What talking points can you give me to convince them to invest out-of-state?" Mitzi asks: "Could you please explain the 1 percent rule-of-thumb around buying a rental property?" I answer these 5 questions in this episode. Enjoy! For more information, visit the show notes at http://affordanything.com/episode126 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything but not everything. Every decision that you make is a trade-off against something else. And that's true not just for your money, but also for how you spend your time, how you direct your energy, what you focus on. It's true for anything in your life that is a limited resource. And so the questions become twofold. Number one, what's most important to you? Not what does society say should be most important to you, but what is actually really, truly a priority in your own life? And then number two, how do you align your day-to-day actions to reflect that?

Answering those two questions is a lifetime practice. And that's what this podcast is here to explore. My name is Paula Pant. I'm the founder of Afford Anything.com and the host of the Afford Anything podcast. Every other week, we interview someone. And on the weeks in between, we answer questions that come in from the audience, from you, the community. Among these Q&A episodes, I alternate between episodes of in which I answer general personal finance questions and episodes in which I answer questions

specifically about real estate. So in other words, one out of every four episodes is one in which I answer real estate related questions. And this happens to be that one in four. If you are interested in real estate investing, listen on. And if not, that's cool. 75% of our episodes are not about this topic. So if real estate isn't your thing, have a listen to some of our other stuff. And if it is, listen on. Because today's episode, it's kind of interesting. We got a handful of questions about specifically investing out of state, and somehow I got two questions about purchasing a beach home. Now, we have about a three to four month lead time between when the questions come in and when I can answer them. We get a lot of questions,

and since on average I can only answer about four or five real estate related questions a month, that brings us about a three to four month lead time. So I think what that means is that back in January, a whole bunch of people were calling in with, hey, can I buy something on the beach? So in today's episode, we're going to talk about that. We're going to talk about out-of-state investing, and we're going to talk about vacation slash beach investing. Here we go. Our first question comes from Tom. Hey, Paula. We love your podcast. My wife and I live in the Midwest, and we are considering the purchase of a duplex on a beach in a popular vacation destination in Florida that we love. of. In about five years, we'd go there to retire and live in one half of the building. As currently

projected, it looks like current rents from BRBO would cover the 30-year mortgage and all expenses related to the property if the property stays at 85% rent it. Our research indicates that this and similar properties have had no trouble being rented at the rate for the last couple of years, but we kind of feel like the general economy might be in the late part of the economic cycle. We've heard what the last recession did to Florida real estate. We do have jobs that are recession proof, but if another recession were to cut our rental income from the property in half, depending on the timing and length,

it could make things very tight budget-wise and would almost certainly lengthen the time before we can retire. We were going to wait five years before buying a single family house in the same area, but this duplex just popped up and got us thinking about the alternative. Should we do this or should we wait? Also, how much higher would interest rates on a loan for a property that we aren't going to live in be? Tom, that's an excellent question. And first of all, I think that you have the right approach to buying a beach house.

You are taking a sober look at a spreadsheet and you're analyzing multiple scenarios and looking at many variables to see whether or not this is a rational choice. And that's exactly the approach that you should be taking. So kudos to you for having a sensible approach to a decision that many other people approach in a irrational or emotional way. A couple of comments that I want to make. Number one, the value of a property is only truly relevant at three times when you buy, when you sell, and when you refinance. Otherwise, the value of that property is noise. Conceptualize it almost like the stock market.

If you're buying an index fund, the only two times that the value of that index fund matter are when you buy and when you sell. And all of the fluctuations that happen in between, that's just a distraction. The same thing is true when it comes to property value. And that can be a much harder concept to swallow because homes are so emotional. They're tangible. They're associated with memories. But ultimately, the value of a home only matters.

when you buy, when you sell, when you refi. So don't worry if the value of the property drops, because that value is theoretical. Do, however, worry if the income from the property drops, because the income stream from that property is the variable that will have a truly deep impact on your day-to-day life, your immediate life. So if the economy tanks and if tourism drops,

and if subsequently your income from this dukeye. drops. Here's my question. Could you rent out both sides of the duplex on a traditional 12-month lease and still do okay on the deal? Now, it doesn't need to be amazing, but it needs to be enough to get you through the rough patch. And functionally, at a broader level, what this question is really asking is, do you have multiple exit strategies? Your primary strategy is short-term rentals through websites like VRBO. And based on the numbers that you've given, that sounds like a viable strategy.

But you need an escape hatch. You need a plan B. If Florida home values drop, selling is not going to be an attractive exit strategy. So you'll need a different plan B. And that's why I believe there's wisdom in buying only if the property works as a 12-month rental. And so long as it works under those circumstances,

then any supplemental income that you get from VRBOR, B.O. is a bonus. Now, I'll make a couple of other points. Number one is that even if we do enter another recession, and at some point we will. We don't know how severe that recession will be. We don't know when it will be. And we don't know if it will affect housing prices and if so, how much. It is nearly impossible to make market-based predictions about the future. So while I think you're wise to ask the question, hey, what happens if we have a recession and tourism, tanks and home values also tank and that affects the property. What do we do in that case? Absolutely, it's wise to ask that question, but I would dissuade you from making any decisions

based on your anticipation of future market conditions because we don't know what will happen and we don't know the severity of what will happen. Now, another point that I would like to make is that you're buying this property really not as an investment, but as a personal residence. As you said, you were thinking about buying a single family home that you and your wife would live in in five years. So what you're actually interested in is a personal residence in Florida. And by virtue of buying a duplex, you're trying to offset some of the costs of this personal residence. The numbers don't need to make sense as an investment. They just need to make sense within the context of your own budget.

Because you're not buying this as an investment. you're not saying, hey, you know what, I'm trying to choose between purchasing this duplex or just sticking the equivalent amount of money into an index fund. That's not your intention. Your intention is, hey, I want to live here. What's the most cost effective way to approach this? And it turns out buying a duplex might be a very cost effective way to do so. So now, how do I mitigate the risk of that duplex not collecting my projected revenue

and therefore causing me to stay in the workforce longer? Those are the questions that you're actually asking. and those are very different questions than what's the return on the property. And that's why, going back to my first point, I say, have multiple exit strategies, have a plan B, and as long as that house can sustain itself and not cause an undue hardship on you, if it had to become a 12-month rental, well, in that case, you have some downside protection. And with that downside protection, you could probably proceed ahead. Final point that I want to make, you'd also asked, how much higher would interest rates be,

for a loan on a property that you won't live in. The answer is that it depends on whether you get an investor loan versus a second home loan. Now, since for the next five years, you'll primarily be using this as an investment property, you would probably need an investor loan, which means, number one, you would have to come up with a larger down payment. Investor loans typically will require between 25 to 30%. And number two, in terms of the interest rate spread, the rates can vary. and I hesitate to give a precise number because I don't want to in any way be misleading. But what I will say is that, broadly speaking, if a person is comparing two identical homes

with the same home value and the same down payment and the same borrower credit score and the only variable is the use of the property, i.e. a primary residence versus an investment, that spread could be as little as 75 basis points or it could go up to a hundred, 150 basis points are higher. And by the way, a basis point is one-hundredth of one percent. So it's 0.01%. And the reason that I use the word basis points is that when we talk about interest rates, the reason I say basis points is because if I said, oh, it would be three quarters of a percent higher. That can be confusing. It can be misleading, right? Like three-quarters of a percentage of what? So by expressing it in terms of basis points or BIPs, as they're otherwise known, you can

kind of have a uniform language by which you communicate about interest rates. So again, the direct answer to your question, and I hate to be so general, but it really varies. I've got a mortgage banker who I've known and worked with for a couple of years. If you want to send an email to Aaron, E-R-I-N at Afford Anything.com, she's my assistant. She can introduce you to him, and he can probably give you a better answer than I can. So thank you, Tom, for calling in, and best of luck with the retirement and the Florida Beachout. Now, speaking of investment properties on the beach, our next question comes from Rachel. Hi, Paula.

My name is Rachel, and I was wondering, if you ever considered purchasing a beach house for a rental property, I would love to do that someday. But since you don't do it, it kind of makes me nervous. I would totally trust your opinion on beachfront properties being rental income properties. My second question is, do you ever consider purchasing a rental property outside of the state that you live in? I live in Arizona, and I know that in other states it can be quite a bit cheaper to purchase like a condo or even a small home to have as a rental property. But I was wondering, again, if that's something you do or would consider. and if so or if not, if you could just give me some reasons as to why or why not those would be good ideas, I would really, really appreciate your input.

Thanks so much, Paula. Bye. Rachel, so question number one, would I ever consider purchasing a beach house? Sure, if the numbers make sense, absolutely. But that's the key, if the numbers make sense. And so, Rachel, my question to you is why do you specifically want beachfront property. Is it because after running multiple spreadsheets, you've concluded that this is a wise investment with stable and healthy returns relative to its risk profile and liquidity? Or is it because

you think it's cute? If you're buying an investment, you're buying an investment. And if you're buying a vacation home, you're buying a vacation home. Don't conflate the two. Now, Tom in the last phone call is very clear about why he's buying this beachfront property. He wants a primary residence. And he wants to offset some of the costs that he's going to pay on this primary residence. That is totally fine. That is not even remotely the same thing as buying an investment. If you're going to invest, invest, and if you're going to buy something for yourself, buy something for yourself. Don't try to do both because you'll end up doing neither well. Now, that's not to say that I'm opposed to beachfront properties. I have no opposition to beachfront properties. I have an opposition to what I infer

or assume to be the premise underneath your question. Because I don't hear you saying, look, I've taken a look at occupancy rates and tenancy rates and priced rent ratios. And I have concluded that a beachfront property in this particular location gives me the type of returns that I want. And I'm just worried about, you know, perhaps some maintenance costs that I haven't thought about as a result of it being so close to water and salty air. Now, if that were your question, we would be having a very different conversation, but that's not what I hear you ask. And by the way, I said the same thing in episode 122 to a guy who called in who wanted to Airbnb a yurt. And what I said to him was, hey, awesome, yurts are cool. But do you want to do this as an investment?

Or do you want to do this because you want to own that property personally and you're trying to offset the costs? And that doesn't mean don't do it. It means know what you're going into. I'll link to that episode in the show notes. You can reach the show notes at afford anything.com slash episode one to six. Or since you're already listening to this podcast anyway, just in your favorite podcast player, scroll down to episode 122. You'll be able to hear it. So that's my take on beach houses and more broadly on the thinking process that goes behind deciding what property to buy.

Now, to your second question, would I consider buying a rental out of state? Heck yeah. All of my rentals are out of state. All of my rentals are in metropolitan Atlanta, Georgia, and I myself live in Las Vegas, Nevada. Now, in fairness, at the time that I bought those properties, I was living in Atlanta. But what I discovered after I moved to Vegas is that I much prefer being an out-of-state landlord. And here's why. Number one, it forces me to run it like a business. Here's an example of that. So this one time, on move-in day, a new tenant moved in and reported that the smoke detector was chirping, signaling that the batteries needed to be replaced. Now, if I were still living in Atlanta, I would have just gone to the property, replace the batteries in the smoke detector, and that would have been the end of the story. But because I was living in Las Vegas, we had to send a contractor to that house to change out the batteries. Now, that contractor charged $25 an hour, including transit time. So between the time that it took them to get there, to change out the batteries and to leave, that ended up being a $75 battery replacement.

Now, you might hear that story and think, wait a minute, that's a case for investing locally. But it's not. Here's why. If I had been living in Atlanta and I had done that myself, I would not have developed any type of business process. I would not have systematized methodically checking the batteries prior to a tenant moving in. Like, I wouldn't have done that. I would have just gone there, perform the task, and that would have been the end of it. Living in Vegas and going through the pain of paying $75 bucks for a battery replacement,

what that did was that it caused me to immediately go into my move-in, move-out checklist and add a line item in there that said, hey, at every turnover, we're going to check the batteries. Because at every turnover, there's going to be a contractor in there anyway. So let's add this to the checklist. I only had to pay that $75 figure once in my life before that became part of the checklist. It became part of the system. And that is a perfect example of how living out of state forces you to truly, truly treat this like a business. And not just like some fly by the seat of your pants passing hobby.

Your operations in any business, it doesn't matter if we're talking about rental properties or whatever other business you're running. If you're selling shoes online, your operations will become efficient when you have. have systems, when you have processes, when you have checklists. Here's an example. This podcast, we have a podcast editorial calendar. Column A signals whether or not the episode is done and ready for editing. Column B is the release date. Column C is the episode number.

Column D is the episode title or guest. And then columns E through L are notes about the sponsors, the timestamps at which each ad space begins. And then we have completely separate processes for how we develop the audio. that I post on Instagram once a week to promote the episode. We have a different spreadsheet signaling cuts and restarts for all the edits that we make. You know how we get guests for this podcast? We also have a spreadsheet for that.

Column A is the name of potential guests that I want to reach out to. Column B is their website. Column C is their email. Column D is the name of any books that they've written. Column E is the date that we've contacted them. Column F is the outcome of that contact. And column G are any notes associated with them? that. Like maybe they're in the middle of writing a book right now, but they told us to contact

them back in six months. That is how we get guests. And it's a much more methodical way than me just like sitting in my living room dreaming up people who I might want to talk to and then shooting them an email. That, functionally, what I've just described, that is the difference between a business and a hobby. That is the difference between doing something with systems versus doing something fly by the seedy or pants. The outcome ends up being much better. once you create the systems and the processes. With rental properties, especially if you only have one or two and especially if they're local, a lot of people just treat it like a hobby and fly by the seat of their pants and then get

frustrated because they think it's taking up too much of their time. Well, of course it is if you haven't systematized it. This podcast would take like three times more time if I didn't have spreadsheets tracking every single thing. I've gone on for a bit too long, but those are the. reasons why I actually really enjoy owning out-of-state or at least out-of-town rentals. It doesn't have to be in a different state, but it needs to be far away enough that I can't just, like, cheat the system by driving over there in 15 minutes.

So I hope that helps. Oh, and Rachel, the final thing that I wanted to say, you mentioned that you live in Arizona. You don't need to necessarily go out of state. I don't know where in Arizona you live. The properties in your specific city might be expensive, but there are a lot of good rental properties in the state of Arizona. There are certainly areas there where the price to rent ratios make sense from a landlord's perspective.

So you don't even have to go that far. And then, of course, all your neighboring states, New Mexico, Nevada, Utah, those all have great rental properties as well. So you're living in the dream spot. So thank you for asking that. And good luck with your rental property journey. We'll come back to this episode in just a minute. So a couple weeks ago, I got this package in the mail.

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and I found it very satisfying to know that all of it was non-toxic, and that's a really nice treat to find on your doorstep. Now, this package came from a certified B-Corp company called Grove Collaborative. Grove Collaborative makes it easy to discover amazing natural home and personal care products. Grove selects only the best non-toxic products, so you can shop with confidence, knowing that everything on this, their site is good for you, your family, and the planet. Here's what they do. Grove will deliver these eco-friendly natural products to your doorstep, things you need like dishwashing soap,

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Again, sign up for a free account today at mycnote.com slash paula. That's my, the letter c, note.com slash paula. Mycnote.com slash paula. Our next question comes from Alfredo. Thanks for all you do. I love your transparency and I love the fact that you are wanting to help people. I have a question. I own a couple of rental properties. I have to admit that my funds are completely commingled. I am trying my best to work myself out of that mess at the moment. And I'm having difficulty starting somewhere. Your most recent podcast discuss some of the software that you use to get things organized. But one of my main question was for professional help of a accounting and lawyers.

I'm just wondering, I wanted to have a sense as to what the fees would be for such services on a yearly basis. If you could talk about this in your podcast, I listen religiously. Thank you so much. Best to you. That's a great question. Now, first of all, don't worry about the fact that your personal and business funds have been commingled in the past.

That happens. Not everybody starts this perfectly. and the most important thing is not where you were, but where you're going. The future matters more than the past. So good for you for being on track for constantly improving your business and improving your finances. Now second, for the sake of everybody who's listening, here are some context around this question because I understand that there are going to be some people who aren't sure of

what we're discussing right now. When you own a rental property, what you'll want to do, ideally, is to separate your rental property's income and expenses from your personal income and expenses. So the way to conceptualize this and the way that I'll talk about this on today's episode is business versus personal. And the easiest way to manage this is as follows. Number one, open up a business bank account. Now, if your property is held by an LLC, this would be the LLC's account. If your property is held by yourself in your own personal name, no problem. You can still set up business banking under your own name listing yourself as the sole proprietor. You can also take out a federal EIN under your

own name as a sole proprietor. An EIN is a number that you use to identify your business for tax purposes. You may need it when you open up your business bank account. You can get it online. We'll put a link to that in the show notes. Afford Anything.com slash episode 126. Okay, so that's step one is open up a business bank account. Step two is to deposit all of the income from your rental property into your business bank account. Step three is to pay all of the expenses associated with that rental property out of that business bank account. And the simplest way to do this is by opening up a separate credit card or debit card,

whichever you prefer, that's specifically for your rental property. Pay for everything from that business credit or debit card. And then step four is to link these accounts, link the card account as well as the bank account to bookkeeping software. Now, this software will automatically pull all of that information into their platform. And that is where you can tag expenses, classify expenses, make notes, upload receipts. So log in once a month to do that. And then hire an accountant and give him or her access to the bookkeeping software. And voila, you're organized. And it's very simple. It's very straightforward. So what if you haven't done this yet? So here are a couple of tips.

First of all, start now. Start this process for all new income and new expenses moving forward. So that takes care of the present and future. Now we have to deal with the past. In terms of dealing with this past, well, a couple of issues here. So first of all, you have to deal with both the income and the expenses, right? The income should be relatively simple to track because if you've, especially if you've only got one or two rental properties, you'll only be collecting one or two payments per month.

And so going through your personal records to figure out what your income was, it shouldn't be too difficult because you don't get that many payments in a given month. So that should only take you maybe an hour or two, I would guess. That's the simple part. Now, as far as the expenses, that is the much more complicated part because you might have a lot of expenses. And so organizing this can be a cluster. So here you've got two options. Well, three options, really. You could do it yourself, and that would just be the extremely time-intensive practice of methodically combing through everything, like take a whole weekend to do this.

Option two is to hire a bookkeeper to do that, to comb through the mess and organize everything and make sense of the expenses. And option three is you could just decide not to bother with it. If you did that, you just couldn't claim those untracked expenses as tax deductions. Remember, the IRS is not going to fault you for failing to take legitimate deductions that you were eligible to take, right? They'll fault you if you go the other way around. They'll fault you if you take deductions that you couldn't take. They'll fault you if you invent or inflate your write-offs. They'll come after you for that.

But if you just have perfectly legitimate write-offs that you choose not to take and you forego those tax savings, you can do that. You can keep the past in the past and move on with your life. Or you can comb through your records or hire somebody to comb through your records and try to fix it. So you'll have to decide which is worth more of your time. If you don't take the write-offs, then functionally you're paying higher taxes. And if you hire a bookkeeper, then you're paying out of pocket for that bookkeeper. And if you're doing it yourself, then you're paying in the form of your time. So you're paying one way or the other.

The only question is, which pain do you want the most? Now, your specific question was how much is all of this going to cost? Now, the costs vary depending on a lot of factors. So in terms of accounting, we'll start with the cost of hiring a CPA. That's going to vary depending on how many houses you own, how many units, are inside of those houses, whether or not you've made upgrades that require depreciation schedules, whether or not you own other businesses and if so how many and the structure of those businesses, are they single member LLCs? Are they partnerships? What kind of businesses are they? It's going to vary

depending on other deductions that are completely unrelated to your business. Like, do you have enough health expenses that you would be able to claim a credit for that? Or are you claiming adoption credits for adopting a child? All of this, every example that I have just named, ties under the broad umbrella of the complexity of your taxes. And that's really what's going to determine how much your CPA is going to charge is how complicated are your taxes. And that's really an individual thing. So I personally have paid anywhere between 1,400 per year on the low end to more than 3,500 per year on the high end for accounting. But I am only one case study.

And I mean, I hesitate to throw out those numbers, again, because I don't want. want it to be misleading because the complexity of my taxes have nothing to do with the complexity of your taxes. I run multiple businesses. Will has his own stuff. We've got seven rental units. We've got a bunch of repairs. We've got depreciation schedules. We've got this. We've got that. In some years, our books have been a mess. And in other years, they've been a lot cleaner. We've got a lot going on. And our taxes, the cost of accounting reflects the complexity of our businesses and our investments and our lives. And so what any given one individual pays has no relationship to what you yourself are going to pay. So I feel like I'm in a hard point right now

because I don't want to sound like I'm dodging the question. But the most honest answer I can give is truly it depends. Now let's move to the portion of your question that might be a bit easier to answer, which is how much will the bookkeeping cost? And this can be divided into kind of two elements. You've got the bookkeeping software, and then you've got the cost of hiring a human bookkeeper. So as far as bookkeeping software, FreshBooks has a middle tier plan in which you can automatically import expenses from your bank account directly into their software. It automatically does this for you. That plan is $25 per month. And this is the part of course where I disclose that FreshBooks is a sponsor of this podcast, and you can get a month free if you go to

freshbooks.com slash Paula. So there's my little plug. There's also a bookkeeping software called Less Accounting, very intuitive, very great user interface. They're $36 a month. So those are two options, and that's the cost of either option. As far as hiring a human bookkeeper goes, because it sounds like you will need, in your case, bookkeeping as a one-time task, rather than bookkeeping on a regular basis. So what I would suggest is looking for a bookkeeper who charges an hourly rate rather than a fixed monthly recurring premium. And you can hire a freelance bookkeeper for between $25 to $35 per hour. A really good one might go up to $50 an hour. But that is about the cost of hiring a freelance bookkeeper. So those are the costs that you're looking at and those are the

options that you've got as far as I understand them. And thank you so much for calling in for asking that and most importantly, congratulations on being in a space where you are constantly improving the way that you run your properties and the way that you run your finances and your money and your life. We'll come back to this episode after this word from our sponsors. I've got a question for you. What kind of interest rate are you getting from your checking account? Well, if you are like the average person, probably not much.

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Lots of services, like banking, retirement planning, and accounting services, aren't built for people who are freelancers or who are self-employed. But fortunately, FreshBooks is. FreshBooks is cloud-based, simple, easy-to-use accounting and invoicing software that is designed for the solopreneur. When you log in, it answers the one burning question that you really want to know, which is, how's business? The notification center is like your personal assistant. It tells you what's changed since you last logged in, and it tells you what you need to deal with, like overdue invoices. And speaking of overdue invoices, if you have a client that's laid on making a payment,

fresh books will automatically send them a late payment reminder so that you don't have to have an awkward conversation. If you want to give them a try, FreshBooks is offering an unrestricted 30-day free trial, and there's no credit card required. So just give them a try. To claim it, go to FreshBooks.com slash Paula. And when they ask, how did you hear about us, type in Afford Anything. Again, for a 30-day free trial, go to FreshBooks.com slash Paula. P-A-U-L-A. And when they ask,

how did you hear about us? Type in, afford anything. All right, let's go back to the topic of out-of-state investing. That seems to be what a lot of people want to talk about. So our next question comes from Anonymous from the Northeast. Hey, Paula. I'm trying to get a couple friends together to invest in some real estate, out-of-state. But my one friend seems to think it might be a better idea if we stick local.

I'm in the Northeast, and the housing prices here, here a little bit out of our range for the first home. So I was thinking Midwest or in the south, but I'm having trouble convincing him that this is a good idea. Can you give me some talking points in order to kind of get him on board with the idea? And also, in relation to that, where should one start when looking for a real estate out of state? Should I just pick a state and do that? Or what kind of advice can you give me for starting the research process? Thank you. Bye. Ooh, what talking points can I give? All right, you asked about talking points, but before you start to talk, listen, ask and listen,

because questions are more powerful than statements. And ironically, that was a statement. So listen to, ask your friends why they are hesitant, why they want to stay local, and listen to their explanations. Because most stated explanations, in my experience, fall into one of two categories, either cost or comfort. If their explanation as to why they want to stay local is the cost, it might be that they're hesitant to outsource everything

and that they believe that by virtue of outsourcing, their profits will be run down to the point where it's not worth it. That might be one of two reasons, two common reasons. The other common reason that I often hear is comfort, meaning they might just fear the unfamiliar. You'll want to listen to their objections so that you know whether to address the cost angle or the comfort angle or perhaps some third angle. If their objection is cost, well, cost is a very easy objection to address because all you need to answer that is a spreadsheet.

Calculate the cap rates on a local property versus the cap rates on a property that you would buy in the Midwest or in the South. And then see which one has the higher cap rate. And then there you'll have it. You'll have your answer in black and white on a spreadsheet. What I found is that often when people express cost, related fears, they will cherry pick specific costs while neglecting the bigger picture. So for example, they'll say, oh, I don't want to pay a property manager while neglecting any discussion about the income expressed as a percentage of the value of the overall asset.

And that is basically just a fancy way of saying, if you've got two houses and both of those houses rent for $2,000 per month, but one of those houses cost $200,000 and the other one cost $500,000? Well, dude, how many property managers would you have to hire to make that $500,000 house a better deal? Right? It doesn't matter if you've got a property manager and a contractor and, I don't know, a team of salsa dancers who show up and do a performance in the front yard once a month. Even with all those expenses, the $200,000 house would still be a better deal than the $500,000 dollar house in that example. So once you look at the big picture, cherry picking a specific cost or two doesn't make any sense in the larger context. And yet, people who have cost-related

objections often cherry-pick those specific costs. And to be perfectly honest, my unsubstantiated hypothesis is that they're doing this either because they haven't thought it through, or because there's some deeper hesitation going on that they're afraid to talk about. Many people cite cost as their stated reason when in fact their true motivation, their true hesitation might be fear or it might be something else, but they themselves might not be aware of it or if they are aware of it, they might not be willing to openly talk about it. So anyway, if cost is their objection, it's very easy to address that with a spreadsheet. And hey, worst case scenario, if you run the spreadsheet and it turns out that you're wrong and it would be better to invest in the Northeast,

awesome. That's something that you would want to know anyway. So there's no drawback to running the numbers to taking a rigorous look at the math. In the show notes, which are available at afford anything.com slash episode 126, I'll link to an article about how to calculate the cap rate or capitalization rate on a property. The cap rate is a measure of the income stream on a property relative to. the cost of the asset. It is essentially the rental property analog of a dividend from an index fund or a dividend on a stock. So check out that article that would show you how to calculate

the cap rate on a property and then you can calculate the cap rate on two hypothetical properties, one that's local and one that's not. Now, if it turns out that their hesitation is their comfort zone, if it turns out that their hesitation is that they are afraid of the unfamiliar, That is a much trickier topic to address because, sure, you can point them to stats and data. You can go online and look up a zip code and look at the crime map for that zip code to see what the crime rates are in the area. Certainly, you can pull data about specific localities to be able to have an idea of whether or not that location is a place where you would want to invest. And certainly, you could spend a weekend just flying there, just fly. there, go to that particular zip code that you might be eyeing, and hang out at a holiday

in for a weekend, go to the local McDonald's, sit there for two or three hours, watch the people who come in and out, walk around the streets, both early in the morning at rush hour, and late at night. Yeah, you'll get a really good idea about that neighborhood. Those are the ways that you can address some of the fear of the unfamiliar. That being said, if this is truly outside of their risk tolerance. I mean, you can't push somebody to do something that is outside of the scope of their risk tolerance as an investor. So that's why in terms of talking points, number one, before you talk, listen, and number two, find out whether the hesitation is cost or comfort or some other explanation. And then you'll know what to address. And you'll also know, I think

more importantly, whether or not it is an issue that can be addressed or should be addressed. Because if the fundamental issue is that they are just more conservative investors than this would allow for, then they might not be the right partners. Now, to the second part of your question, which is how do you go about finding an area somewhere that you would want to invest in, somewhere out of state? A few tips. Number one, you don't necessarily need, quote unquote, the best area. You need an area that has cap rates that are good at a risk profile. that is good. I see a lot of investors spin their wheels trying to figure out what's the quote-unquote best part of the country to buy real estate in. They have algorithms. They have data. They have

reams and reams of research. They're basically running a one-person hedge fund. I don't think that level of research is worth it, especially if you are an individual investor who is going to own, say, 15 or fewer rental properties. So my first tip is. is don't try to find the best area, just find an area that you believe is satisfying and go for that. And the analogy that I like to give is the Warren Buffett approach to investing. Warren Buffett never tries to buy at the best times or sell at the best times. He simply buys stocks when the prices are good enough that they make sense to buy. And he sells when the prices are, enough that it makes sense to sell. And by doing that consistently over time, he's become

the Warren Buffett that we all know today. So that is the approach that I would take. Number two, if you happen to have, and you may or may not, if you happen to have family or friends that live somewhere in the Midwest or in the South, you know, in an area with rental properties that would be a good deal, there could be a case for checking out those places. Because at a minimum you'll probably want to visit those places anyway. Like you'll probably be planning trips out there anyway if it's close family or close friends. So if you're going to travel there anyway, you can kill two birds with one stone. And plus you'll have someone to stay with.

They might let you borrow their car, etc. That being said, don't buy a house in a mediocre location or in a location that you just don't think they're going to be good returns because you happen to have people there. the reason that I became interested in buying houses in Birmingham, Alabama, is because Birmingham is a stable location. It's got hospitals, it's got universities, it's got an airport so it's easy to access in and out of. It has excellent price-to-rent ratios. It's not overly reliant on any one particular industry like Detroit was. It doesn't have snow and ice, which is one less thing I have to worry about. It has a small but growing artist and entrepreneur community.

It's got a startup community. It's got makerspaces. It's got farm-to-table restaurants. So when I look at all of those factors, I see a city where I can get great cap rates and great returns in good neighborhoods in a location that is economically diverse enough and thriving enough that the city probably won't tank. And for those reasons, I chose Birmingham as the place where I intend to buy my next rental property. That being said, I don't know anybody there. I have no family. I have no friends. I don't know anybody in Birmingham. But when Emma and I went there, my friend Emma and I, she was a guest on episode 66, when we went there last year to check out Birmingham together, not a problem. We booked a place on Airbnb. We rented a car. And for the cost of a couple hundred dollars, we were able to be able to be.

to check out Birmingham. And then we went online and we started sending emails to people who lived in Birmingham. And that's how we started making connections there. So that's why when I say, when I give the recommendation ish of checking out places where you might have family or friends, I actually am simultaneously recommending that as a strategy and also not recommending that as a strategy because there are both pros and cons to that approach. I grew up in Cincinnati, Ohio, and I'm totally open to buying a rental property there. If I don't end up buying in Birmingham, maybe my next rental property might be in Cincinnati. But the fact that I know people there, in and of itself, is not enough to make me want to invest there. I'd rather choose a city like

Birmingham where I don't know anybody, but that has all of the characteristics that I just named, characteristics that indicate that it may be a really good place to own rentals. I'd rather that than I would go somewhere just because it's familiar. So then my final tip, and I alluded to it in what I said in the last couple of minutes, is look for a city where you have easy access in and out of that city. Look for an area with enough people and enough resources that you have a selection of property management companies and a selection of contractors. Don't go to an area, in my opinion, don't go to an area that is so rural that you have a hard time building a team there because of the sparseness of the population,

and look for an area that is not overly reliant on just one industry, or even worse, one employer. So I hope that helps, and good luck with your property search. Our final question today comes from Mitzi. Hey, my name is Mitzi. I'm new to your website, and I don't understand the whole 1% thing, and I keep trying to get it. So I'm really new at this, and I keep reading,

but I'm not understanding how. The whole 1%, are you talking about 1% after you find all the deals? Is that what you mean? So let me know, okay? All right, bye-bye. Mitzi, welcome to the community. All right. So the 1% rule of thumb is as follows. When you are deciding whether or not a rental property is worth further investigation, when you're deciding whether or not you're interested in it, the quick back of the envelope can. calculation is called the 1% rule of thumb. And that states that a property's gross monthly income should be at least 1% of the acquisition price. So in other words, a $100,000 house should rent for $1,000 a month. A $200,000 house should rent for $2,000 a month. A $300,000 house should rent for

$3,000 a month. Now, that doesn't mean that if that house meets that criteria, you should buy it. You don't marry every cute person you see. It just means that if that house meets that criteria, you check it out. Now, here are some of the common questions that I get regarding this. First of all, a lot of people ask me, all, but what about operating expenses? How does that play into the 1% rule? The answer is it doesn't. The 1% rule of thumb is simply a very, very fast, back of the envelope, mental math inside of your head, calculation that you do when you're figuring out whether or not you want to check out a property enough to look at its operating expenses. So if you're looking at a $200,000 property and it rents for $2,000 a month, you're like,

all right, that's a maybe. Now let's take a look at what its operating costs are and see if I'm still interested. When you look at the operating costs, you'll be calculating something that It's called the cap rate or capitalization rate. That's a much more detailed equation. And again, in the show notes at afford anything.com slash episode 126, I'll put a link to an article about how to calculate the cap rate. But that's a much more detailed calculation that comes later. That's like the fourth or fifth date, right?

The 1% rule of thumb is deciding whether or not you want to get to that first date. It's the question of, am I even interested enough? enough to spend more than a second looking at this property. Now, there's another very important point that I want to make about the 1% rule of thumb. Remember how when I was describing it, I said that the property needs to rent for at least 1% per month of the acquisition price? The reason that I used the word acquisition price rather than purchase price is because the total acquisition price of a property is the cost that you pay for the property. is the cost that you pay for the property plus the cost of getting it rent ready for that first tenant. Now, here's what I mean by that.

Imagine that you're comparing two houses, right? House A and House B. House A costs $50,000, but it's a complete disaster. And it needs $150,000 worth of work to be able to just get it ready for that first tenant to move in there, to get it just to the point where it is minimally habitable. House B is in totally rent-ready condition, and it's $200,000. What is the cost of each of those properties? Well, technically, the purchase price of House A is only $50,000,

and the purchase price of House B is $200,000. So if we were using the 1% rule of thumb based on the purchase price alone, we'd be using very different numbers for House A and House B. But if we look at the 1% rule of thumb based on the total acquisition price, which I define as purchase plus repairs to get it rent ready for the first tenant, then both House A and House B have the same total acquisition price, which is $200,000 each. I think this causes some confusion because then a lot of people say,

Yeah, but what about the cost of repairs? What about the repairs and maintenance and the ongoing other costs? What about the fact that I have to replace the roof three years down the line? That's irrelevant. Those all fall under the umbrella of operating expenses. Those are all examples of repairs, maintenance, and capital expenditures. And those are operating expenses. And that, again, comes later.

The 1% rule of thumb is purely, what's it going to cost for me to buy this house and have it rent ready for tenant number one? Now, the question that nobody asks me or almost nobody ever asks me about the 1% rule of thumb, but that I think people really should ask is why? Why does this rule of thumb exist? Please, let's question the rules. So here is the logic behind this rule of thumb. If a house collects gross rent of 1% per month, then that means it collects gross rent of 12% per year, right? So a $100,000 house that rents for $1,000 per month would rent for $12,000 per year, assuming full occupancy.

So what that means is that the potential gross rent, the potential top line revenue that the house could theoretically collect, is 12% of the value of that asset. Now there is also a rule of thumb in real estate investing that's called the 50% rule of thumb. And this rule of thumb states that your operating expenses, everything from repairs, maintenance, capital expenditures, management vacancies, all of that combined will cost approximately half of all of the gross revenue that you pull in. So if a house rents for 12% per year, then then it collects net 6% per year after you pay your operating expenses. And what that means is that you are left with 6% net as an income stream on the value of that property, on the value of that asset. So this is analogous to collecting a 6% dividend on a stock. It's not the total return because the total return is the income stream plus the appreciation of the property.

So if we assume that a property appreciates, which means rises in value, at 3% per year, then that 6% dividend or income stream plus that 3% growth in value combines to form a total 9% return. And so essentially by using the 1% rule of thumb, we are screening properties for their likelihood of producing a 9% or greater total return. assuming that your operating costs consume half of your gross revenue and assuming that the property keeps pace with inflation. And that is the logic behind the 1% rule of thumb. So hopefully that helps clarify that rule of thumb a little bit better. And again, I just want to emphasize this is purely a back-of-the-end float first pass. It's an indicator of whether or not it's worth your time to look deeper into a particular property.

It is not a buy signal. Thank you so much for asking that question and welcome to the community. All right, now I have an exciting announcement. My real estate income report videos are up on YouTube. A couple of years ago, I think back in 2015, I pledged to start disclosing all of the income and the expenses from my rental properties. I decided to publicly put that out there in the world so that you could see at a minimum one case study, my own case study, of how much money I make and spend and then net in my money.

all of my own rental property investments. I started with the intention of posting monthly updates on the blog and then that turned into like maybe every two or three months and then that turned into like every now and again. And I haven't posted anything in 11 months because I'm very bad at being consistent. But actually I'm good at being consistent on the podcast. The blog, however, and YouTube are a different story. But I have created finally real estate income report videos that cover June through December of 2017. That's one video. And then I also have another video that covers all of 2017, the entire year in review, so that you get that big picture view of how much my rental properties pulled in over the course of the year 2017. And I'll just

spoiler alert right now. In 2017, the rental properties grossed $125,000. And after all expenses, including the mortgages, they netted $43,000. So that is my net passive income, my net cash flow in the year 2017. If you want the details and more importantly the context behind that, head to YouTube.com slash afford anything. Again, that's YouTube.com slash afford anything where you can check out these real estate income report videos. And also while you're there, please subscribe to my YouTube channel. So that is major announcement number one. We've been working on these videos forever. And big, big,

big thanks to Aaron, who is a crucial part of the Afford Anything team behind the scenes. She is the video genius who makes these things shine. Announcement number two is huge congratulations to all of the contest winners. We recently did an Instagram giveaway for free copies of your Money or Your Life by Vicky Robin. So congratulations to the contest winners. We have notified those winners through Instagram, and they are MC Angel, the jungle VIP, and Adam MVA. So congratulations to the three of you for winning a free copy of Your Money or Your Life by Vicky Robin. And for everyone else, please follow along on Instagram at Paula Pant, where you will be able to see snippets of interviews that we do with guests. You'll check out new book giveaways that we do. And

And generally you'll just see the behind the scenes of what goes on in day-to-day life. So come follow along, Instagram at Paula Pant. Another huge announcement, and I announced it on Instagram first. The T-shirts have launched. The Afford- Anything store is finally, finally launched. Woo! We've got a lot going on, right? So Afford Anything now officially has an Amazon store,

and we are selling three different types of T-shirts. One of them, you remember I mentioned Emma earlier in the? this episode. She was a guest on episode 66. The theme of that episode was to take radical responsibility over your life. Emma, by the way, for those of you who might remember, she was the one who was dropping F bombs all over breakfast. So in honor of her, in honor of episode 66 and that hilarious and somewhat controversial interview, we have created a t-shirt that says take radical responsibility, and you can see me wearing a picture of that shirt on Instagram. So that is one of the three shirts on the Afford Anything store.

We also have a shirt that says you can do anything just as soon as you stop trying to do everything, which, of course, as you know, is the cornerstone of the Afford Anything philosophy. And we've got a shirt that says eat, sleep, invest, repeat. You can get your favorite shirt by going to afford anything.com slash store. That's affordanything.com slash store. And I want you to know 100% of the profits that we make from the sale of these shirts will be donated. to charity water. And in case you're wondering how much that is, that's exactly $5.38 per shirt for every shirt that we sell will be given to charity water. My goal is to raise

enough money so that we, as the Afford Anything community, this group of awesome podcast listeners can sponsor a water project. And I want to do this by the end of this year. Now, it's going to cost a minimum of $10,000 to sponsor a water project. And by water project, I mean something like digging a well. Now, it might not be a well exactly. It might be biosand filters. It depends on the needs of that particular community. But it'll cost a minimum of 10,000, possibly 12 to 15 on the higher end, to fully sponsor a project somewhere in the world. And this project will bring clean drinking water to approximately 300 people living in some of the poorest communities. I mean, we're talking about people who do not have running tap water in their homes.

Our goal is to bring water to people who do not have the luxury of being able to just get it from a tap. And in order to do this, we're selling these shirts. So please head on over to Afford Anything.com slash store. Pick up a couple of shirts and help us bring water to a community that needs it. By the way, on my blog at Afford Anything.com, it's not going to be up yet, But at some point within the next week or two, I'm going to put a very, very long detailed post that walks you through the behind the scenes of everything that went into this project, both the design and manufacturing and distribution of the shirts, as well as the partnership with Charity Water. So that's coming up at some point within the next week or two on afford anything.com. Okay, we've covered a lot of stuff.

So just to recap, you can see the actual income and expenses from my rental. properties at YouTube.com slash afford anything. You can follow along my day-to-day life on Instagram at Paula Pant and you can pick up a t-shirt at afford-anything.com slash store. And all the proceeds from the sale of the shirt will go to Charity Water. Thank you so much for tuning in. If you enjoy this podcast, please subscribe to us on YouTube or buy a shirt. My name is Paula Pant. I'm the host of the Afford- Anything podcast. I'll catch you next week.