Five Things to Consider Before Buying Rental Real Estate
Learning from Other People Mistakes
Experience is a dear teacher, but fools will learn at no other. Benjamin Franklin.
As I bought 30+ units in the last 10 years, I can better identify what went wrong with my first investment. Looking back at this time, I see that I made several fundamental mistakes. This impaired my ability to finance and my motivation for other deals. Retracing the story help new investors:
Back in 97, my father in France strongly recommended that I buy the unit next to his. His neighbor was keen to sell and his asking price was very low. I was working on a good job in London. I did not run the number because I always trusted my father's judgment.
When I look back at this, I think he did not run the numbers because he trusted my judgment.
The price was indeed low but the area could not support high rents. The rental numbers did not make sense but I hope something good would end up happening since there was so euphoric about becoming a landlord.
When numbers don't seem to make sense, you should just bid much lower or pass.
I asked a ten-year mortgage at around 5% without considering the tax deductibility of interest. That mortgage had such high payments that it was not self-financing.
This prevented me from buying further assets in the next 10 years. While the housing market was booming my cash was tied up to finance rehab after unprofitable tenants move. The bank was ready to give a 25-year mortgage, and given the tax law, this was a win-win.
I did not consider tax rules: my 10-year mortgage was too short, and the interest cost reduced so quickly that I soon had little to offset against my income (the French tax system does not allow deduction of depreciation) and that small rental income was taxed at a ridiculous rate bringing net yield from 3% to 1%.
I sold the apartment with 220% appreciation in 20 years, but this turns out to be a 5.6% annual compound return. I would have achieved more from investing in Paris. Since the great financial crisis, I saw the value of investing in a stable asset and did a few dozen deals in other countries.
5 most important to Consider Before Investing in Rental Real Estate
Unpacking the experience, here are the 5 most important to check before investing in rental real estate
.1 Own your choice: you are the person making the decision, you should not buy something because someone thinks it is a good deal, you need to compare this purchase to other asset and own the decision.
.2 Invest in properties where numbers make sense: most properties have too small a margin of safety or numbers that don't make sense. You should take your proforma with the understanding that surprises do tend to happen, but they almost always are negative surprises.
.3 Know how much you can borrow: financing one of the most important aspect of investment. You need to find the right rate and lender for your project. You do need self-financing projects if you want to be able to scale your purchases.
.4 The tax rate is probably the most important number: there are ways you can invest and then lose most of your income through tax. What matters is your income after tax, and you need to know about taxation rules for all the alternative assets you consider. The impact of financing on tax needs to be checked.
.5 Know who the decision maker is, understand what he wants and negotiate your entry point: the money is made when you buy the property. Market prices tend to hover around the self-financing point. Having a lower entry point allows you to have self-financing investments and a margin of safety.
Those are five fundamental things to consider before buying. Don't be overwhelmed, once you are set up to analyze deals, and negotiate them, you can enjoy the process and analyzing 20 deals not take much more time than 1, and as for so many things in life, this is just a number's game.
One last advice: Caveat emptor.
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