Afford Anything - Ask Paula -- Should I Buy a Turnkey Rental Property? -- and More Real Estate Investing Question

Episode Date: August 1, 2016

#36: It's the first Monday of the month, and you know what that means ... Time for another Ask Paula episode! On today's show, I answer a handful of phone calls from listeners who posed questions about real estate investing. One caller from Atlanta said that he's thinking about buying a rental property from a turnkey investing company. (These are companies that buy, renovate and rent out properties, and then sell those properties to investors.) On the surface, this sounds appealing: all benefit and no work. But what are the drawbacks? Are those risks worth it? Should this listener buy a turnkey property? Or should he stay wary of red flags? Another caller, who says he loves real estate investing, mentioned that he's curious about the lack of compound interest in the real estate game. If you're investing in an index fund, he noted, your dividends and gains are automatically reinvested. That's not the case with a rental property. Sure, you can reinvest the cash flow from that property into buying more properties (or buying other investments, like index funds), but that's not the same thing. So ... what does this mean? When you take compound interest into consideration, are rental properties still a good deal? Or are real estate investors missing out on this crucial wealth-building tool? Another wanted to hear more details about a couple whom I mentioned in Episode 4, The Ultimate Beginner Guide to Real Estate Investing. This couple's strategy is to buy a home as a primary residence, live there for at least one year, move out, convert their former home into a rental property, and repeat. They've done this over and over, and now they're raking in the rental cash. The listener wanted more details about that strategy ... which I offered in droves. (And yes, I led myself into another little rant.) Finally, one listener called to share his success story. In an earlier episode, he asked whether he should repay his credit card debt, or save for the downpayment on a house. I told him to pay off his credit cards ... and he's now DEBT-FREE!!!!!! He tells his success story on today's show. Enjoy! Paula Learn more about your ad choices. Visit podcastchoices.com/adchoices

Welcome to the Afford Anything podcast, the show that knows you can afford anything, but not everything. So how are you going to spend your money, time, energy, all the scarce resources in your life? What's important to you, what's not, and what decisions do we make? I'm Paula Pant, host of Afford Anything, and today I'm answering your questions. The first one comes from a listener named Grady. Hi, Paula. This is Grady, Collin from Aurora, Colorado. I have a quick question for you in regards to how do I focus my effort. I currently have a... I have approximately 114,000 that I owe on my mortgage. I have approximately 85 in liquid assets.

And on top of those liquid assets, I have emergency savings account for roughly six months' worth of expenses. And then we have our retirement accounts, which we contribute approximately 20% per year of our total take-home pay. So assuming we're going to prioritize our retirement accounts and keep our savings account for emergencies, would you recommend that I throw the $85,000 worth of liquid assets towards the mortgage and pay that bad boy off as soon as possible? Or would you recommend that I don't do that? I keep the mortgage because it's a relatively low interest rate at 4%, and I keep building our assets within our investment accounts.

Keep in mind long-term goals include putting my wife through nursing school, which we would like to cash roll versus take out a loan. and we would like to start getting into Paula's realm with real estate. We want to purchase another home and rent out the current home that we are working to pay off. Any advice is much appreciated, and I love your show. Keep it up. Hey, Grady. So first and foremost, if you want a cash flow nursing school, that's the first thing that I'd look at. What's the tuition for nursing school going to be? What is the cost of her not working in other paid jobs?

You know, what is the cost of that lost income going to be? $85,000 can go quick when you're talking about tuition plus opportunity costs slash cost of living of somebody going to college. So there's a pretty good chance that most of that money is going to get swallowed up with that. Figure out what those costs are going to be and, you know, see how much more of the $85 grand is left. I would not use the $85 grant to pay off your mortgage and then take out a student loan for nursing school unless that student loan is going to be a significant. significantly lower interest rate than the mortgage. But you indicated that you have a mortgage with a low interest rate. So unless you qualify for some really excellent student loan, I don't think that you're going to get a better interest rate than that. So it just makes more sense to cash flow

nursing school and you'll be doing that with the $85,000, you know, and then you'll hang on to the mortgage. If after paying for nursing school there is still additional money left over, yet then it's really a values judgment in terms of do you want to prioritize investing in a rental property or do you want to prioritize getting rid of the mortgage? You know, mathematically, if you buy the right rental property, sure, mathematically it might make more sense to invest that money. But math isn't everything. There's also a values component, a priority component. Rental properties are evaluated by a measure called cap rate. Now, this measures the cash return on the property relative to the value of the asset. So, for example, if the asset is $100,000 and every year it produces an unleveraged cash

return of $10,000, that's a 10% cap rate, right? A good rental property will provide a cap rate that is going to be at least 6, 7, 8, 9%. So that should be higher than the, the interest rate that you're paying on your mortgage. That being said, sometimes paying off your mortgage lets you sleep better at night. So that's really where you got to kind of ask yourself the question. So Grady, thank you so much for asking that question. I hope that's helpful. So let's move to the next caller. Let's hear what Jason has to say. Hi, Paul. This is Jason from Atlanta. I'm interested in investing in residential rental properties. And having not done this before, I'm considering a turnkey company. I'd love to get your take on turnkey real estate investing pros and cons.

Thanks. Oh, dear. Okay. So a turnkey company as background for the listeners who aren't familiar with this, turnkey companies are companies that will find, purchase, renovate, and in some cases rent out a rental property for you so that in theory all you do is start collecting the paychecks. First and foremost, the hardest part of rental property. investing is buying the right property. That's where 99% of people get it wrong. I made up that statistic right now, but that is really where the majority of people get it wrong. They don't buy the correct property. They get something that doesn't produce good enough cash returns. They get something

that is in a neighborhood where the cap rate doesn't accurately reflect the risk. That's really where you want to put your time and effort. And a turnkey company, you know, the advantage that they have is local knowledge, but the disadvantage that they have, or I don't want to say, the disadvantage from your perspective is that they're running volume. They are not going to be, you know, as an individual investor, you're going to maybe look online at hundreds of listings and narrow it down to 10 or so of your favorites and then make offers on those 10. And if an offer gets accepted and you go under contract for the property, then you fly out there and look at it. And in addition to that, you also hire two people, number one, an inspector, and number two, a general contractor.

And you pay both of them to look through the property as well. The inspector is going to cost you between $3 to $500. The general contractor will cost you anywhere between $40 to $100 per hour. And that's just what you do when you buy a property. Even if you're buying a turnkey property, you're going to have to do the same thing. Don't buy the property without seeing it. Even if it's a turnkey property, you want to fly out there and look at it. You want to hire an independent inspector. Don't use one of theirs.

Don't even use anybody that they recommend. Find one on your own. Hire that inspector, a licensed independent inspector, and pay them to look at that property. And in addition to that, hire a general contractor. and pay that person to look at the property because the inspector can tell you what's wrong, but he or she can't tell you how much that's going to cost. That's more the GC's line of area of expertise.

So at any rate, point being, regardless of whether you buy turnkey or not, it's your responsibility to do that due diligence. You're not going to be saving yourself from the due diligence by virtue of buying a turnkey property. If you think you are, and I'm not saying that you do, but to any listener who might be hoping that that's the case, that is not the part of this process that you should be trying to make passive. That is not the part of the process that you should be minimizing. The buying is the important part. It is the most important part. The reason that you're making cash flow for the next 20, 30, 40 years into the future is because you're, you're.

put all the work into the buying part. So that's the part that you don't skimp on. Okay, so let's move on. All right. Next question comes from Rich. Hi, Paula. I'm Rich from Rich on Money.com. I love real estate and specifically running out single family homes. I own several right now debt-free. I prefer it as an investment over index funds. I feel like I can beat index funds returns and don't have to worry about the volatility in the short term. However, I'd like to know what are your thoughts on how real estate compares to index funds when you take into account the magic of compound interest. You can always take your cash flow from rentals and use it to buy more property, but I don't believe that's as powerful as compound interest in an index fund. What are your thoughts? Ooh, okay. So you're right.

So part of this is behavioral, right? So when you have an index fund, that money is assuming that you check the little box that says reinvest dividends, that money is automatically reinvested. And as we know from all of the research on behavior, you're more likely to stick to anything that is automatic. So from a behavioral point of view, reinvesting dividends and gains through stock investments, through index funds, is definitely behaviorally superior. You're just much more likely to stick to it. Now, moving away from that, let's look at the math of it. Let's say that you've got a rental property and you've got cash flow from that rental property.

As you said, you can reinvest that cash flow into another property. But, and here's the but, it's going to take you a while to do that. In that interim period, your money is probably going to be sitting around, not earning very much in the way of interest. So, for example, let's say that you have a rental property that cash flows, after all expenses, $5,000 a year. And let's just assume for the sake of example that it's your only rental property. You want to make a 20% down payment on a $100,000 other rental property. And after four years, you can do that. Because you have a plan to spend this money within the next four years at the most,

you don't want to expose this money to a lot of risk, so you don't put it in index funds, since you're going to have to withdraw it quickly. So instead, you put it in, say, some laddered CDs or some conservative bond funds, you know, some funds that are maybe keeping up with inflation, but not a whole lot more. After, you know, depending on what year you're in, year one, you put this money, put $5,000 in, and you hold it there for the next four years. Year two, you put another $5,000. in. You hold it there for the next three years, year three, you know, and so on and so forth.

And then at the end of that, you have $20,000 that has earned, say, keep up with inflation and not a whole lot more. And then at that point, you buy a rental property and that rental property, let's say, has a cap rate of, we're going to say, 10%, which is better than a dividend payout that you could get in the stock market, most dividend payouts that you could get in an index fund, right? Because imagine having a stable blue chip stock with a dividend payout of 10% that's almost unheard of. And that's what you can get with the higher cap rates on properties, which is one of the advantages of property investing over index funds. So there's kind of a lot of factors that go into it. How do you actually do the math? Admittedly, it's not an apples-to-apples

comparison with compounding interest on an index fund because that's just so, number one, because it's so simple and so straightforward. And number two, because behaviorally, you just have to not interfere and it will do everything automatically for you. It will automatically reinvest those dividends and those gains. That being said, the dividends in particular are just not going to be as big. So, you know, how do you adjust for both of those? I mean, you've really got to first figure out what the returns are on real estate and then just run those side-by-side comparisons. I hope that answers your question. I feel like I've kind of answered it, but not completely. Long story short, when you ask about compounding returns, what you're really asking about is what are the total

returns over a long period of time. And with an index fund, it's very easy. to calculate that because you just look at, you know, I put in X and I continue to put in Y, and at the end of 30 years, I have Z. So that is very straightforward. With rental properties, you can make those calculations, but it's going to require a much more convoluted spreadsheet. But if you're willing to put in that work, you can run those numbers and then see what's going to give you a higher return at the end of, of whatever period of time you're looking at. I'm going to answer more questions in just a second, but I want to take a moment to encourage anyone who's listening,

who is an entrepreneur, to check out a company called Fresh Books. They make invoicing super, super easy. You can track your books. You can figure out what clients have paid you. It's just the whole thing is the platform is super, super simple and intuitive. So if you are spending a lot of time trying to track down payments and look through invoices and document your expenses and all of that, you can streamline and automate a lot of that by using FreshBooks. And you can try them for free by going to FreshBooks.com slash Paula. Again, that's freshbooks.com slash P-A-U-L-A.

When they ask how you heard about us or how you heard about them, say that you heard about it through the show. Thank you so much. And let's keep going on with some questions. We have one more question and it is from Brady. Hey, Paula, I really enjoy your show. I wanted to ask a question about something that you mentioned in episode four, one of the real estate episodes in which you referenced a married couple that was making, as you put it, a shitload of money. living in their houses and then renting them after they moved and buying up another house. I just wanted to know if you could either potentially, one, have the couple on the show or to

at least find some insight into kind of some parameters like the 1% rule and how it might apply to timeframes or a house that you're living in and then planning on renting after you move out. Thanks. Cool. All right. So first and foremost, I know that. That couple is definitely not going to come on the show. I've asked them before. They are very media-shy. But to give some background to all of the listeners, this particular couple, what they did was they would buy a house as a primary residence. They would legitimately, they're very by the book people. You know, they're very law-abiding. So they would buy a house as a primary residence. They would legitimately move into it, stay there for at least a year. They typically even stayed, you know, sometimes for two. two years, but at least a year, which is what most lenders will require of you in order for it

to be considered a primary residence purchase. And then after one to two years, they would move out, rent out that property to a tenant, and buy another house as a primary residence. And they just continued to do this over and over and over. And there was another benefit to that strategy as well. If you live in a home for at least two years out of the previous five years before you sell that home, then you are exempt from $250,000 of capital gains taxes. Now, that's not a home sale of $250,000. That's $250,000 of gains. So if you bought a home for $500,000, and you, you you sold it for $750,000 making a gain of a quarter mill, you would not have to pay taxes on those gains if you lived in that home for two out of the five years prior to the sale.

And there's no limit to the number of times that you could do that. So their strategy was effective in multiple ways. First of all, the fact that they were moving into those homes and legitimately moving in, meant that they could qualify for primary resident mortgages. And in the cases in which they lived in the home for at least two years, the reason that they sometimes chose to do that, even though it slowed down their rate of home acquisition, is that that meant that they also had the opportunity open to sell that house

and not pay taxes on those gains if they decided to. You know, if values went up or if their business strategy changed or, you know, they left that door open and they did end up selling some of their properties. So, you know, they certainly took advantage of that. Now, I will say that there is a new rule that passed in 2008 that makes this a little bit more difficult. It's called the Housing Assistance Act of 2008. prior to that law being passed, you could move into a second property, make it your primary residence, live there for two years and sell it and pocket all of the profit, if, you know, up to 250K. But now the new rule post-2008 is that if you convert anything that is not a primary

residence into your primary home, you will owe tax on part of that sale money based on how long that house was used as a non-primary residence. So long story short, the taxes have gone up since 2008. You know, it's been a bit of an invisible tax hike on real estate investors since 2008. But that being said, you know, some tax benefit is better than none at all. Now, let's turn to the other portion of their strategy, which was to buy houses as primary residences. Now, Brady, you had mentioned the 1% rule of thumb. For the listeners who aren't familiar with that, that is a rule of thumb that is used as a sorting mechanism when you're looking for houses to buy. And it states that the gross rent on a house should equal at least 1% of the acquisition price.

So for every $100,000 worth of home, it should rent for at least $1,000 per month. Now, the reason that I say the acquisition price rather than the purchase price is because sometimes, you'll buy a home that costs $120,000, and then you have to put another $70,000 worth of work into it. So in that case, the total acquisition price is $190,000, you know, that's purchased plus initial repairs to get it rent ready. In that case, you would want that home to, you would want that home to rent out for $1,900. Now, what does this mean? Well, the areas in which you are most likely to find homes that meet that criteria include areas that are at least one or two hours away from high cost of living centers. Like, for example, the city of Seattle may not have homes like that, but Port Angeles, which is located, you know, about a two-hour drive away.

Port Angeles has a lot of homes that meet the 1% rule. Portland, Oregon may not, but Boise, Idaho sure does. Los Angeles may not, but Las Vegas does. San Francisco may not, but Reno does. You know, I got an email from somebody the other day who was like, oh, so if somebody lives in San Francisco, do they have to buy a house in Detroit? And I'm like, why is your brain leaping to Detroit? You know Reno is like a couple of hours from San Francisco. Also outside of that is the rest of the state of Nevada and Arizona.

Sorry, I'm getting a little bit off track there. My point is, if you live in a high cost of living area and do not have a flexible job, you have to be in that high cost area, then all that means is that you can't buy a home as a primary residence. You have to buy the home as an investment property. And so that means that you'll need a slightly higher down payment and you'll pay a slightly higher interest rate. That's what that means. All these people who are sending me emails being like, I can't invest because I live in Manhattan. And, you know, there's nothing cheap in this area.

And I forgot that Philadelphia exists. You know, like, all those people are assuming that the only way to buy a house is with a primary residence mortgage. I'm sorry, I know this wasn't your question. Now I'm just going on a rant. Like, is that the issue? is that you're just, I don't get it. I don't understand why people have this impression that your house has to be in your backyard, that you have to buy it with a primary residence mortgage, that you have to show up every day to turn the wrench. I mean, I live 2,000 miles away from my

properties. I live in Nevada. My properties are in Georgia, you know, and granted, I did live in Atlanta, Georgia at the time that I bought my properties. But what people forget is, is that I wasn't really in Atlanta for most of the time that I, quote, unquote, lived there. You know, I was traveling a lot. You know, that was a reason it wasn't a big deal for me to move. Very little actually changed. I'm so going on a tangent. This was not your question, even remotely.

Your question was, how did they make money? I guess I answered that. The second part of your question is what factors should you consider if you want to follow the same strategy? If you want to follow the same strategy, buy a primary residence, and I would recommend legitimately move into it. You don't want to commit mortgage fraud. So, you know, if you live in an area where you can get good rental properties, then buy a rental with a primary residence mortgage in that area. Okay, I'm going to cut myself off before I go on to too many other rants here. So let's end on a cheery note.

Now I want to play you a comment from a listener by the name of Jay. He called in earlier with a question and now he's going to update us about the aftermath. Hey, Paula, this is Jay. You answered my question in episode 29. I had a question of whether I should pay off my credit card debt or use the money I'd saved up for a down payment on a house. and I ended up paying off my credit card debt. And you were right, it was just a huge weight on my shoulders that's now gone. And now I can use whatever money I was using towards those payments to rebuild that savings for a down payment on a house. I actually did that before you answered my question, so I'm kind of glad that what I did lined up with your advice.

So thank you for that. Thanks for answering my question. And I know you wanted to hear back as to what I ended up doing. So I just wanted to let you know what I ended up doing. Enjoy the podcast. Thanks. That is so awesome. I'm really happy to hear that.

Thank you so much for calling in and letting us know. I'm super, super happy to hear that. That's it for today's show. If you have a question, please go to afford anything.com slash voicemail. And leave your question there. I'd be happy to answer it on the air. Again, that's afford anything.com slash voicemail to leave your question. Before I sign off, I want to thank our sponsor, FreshBooks, for keeping the show on the air.

Check them out. Let me know what you think. Finally, if you enjoy the show, please head to iTunes and leave us a review. That makes a huge difference in terms of growing the show and helping us land guests. So please go on over to iTunes, leave a review for the Afford Anything podcast. Don't forget to subscribe to the show so that you won't miss any episodes. And if you'd like to subscribe to our email newsletter, you can do so at podcast. Dot Afford Anything.com. Thank you so much for listening to this episode.

I really appreciate it. Feel free to reach out to me on Twitter at Afford Anything. I will catch you next week. Thanks so much. Yeah, I love the culture of a lot of sports that I can't or don't partake in. Like fishing? I was thinking surfing Playing pool

Oh like billiards Billiards Billiards Billiards Billiards Well when you say pool I just think of a swimming pool And then it confuses me

You're not hip with the lingo of the cool people You're not hip with the lingo of the cool people