This is an excerpt from my forthcoming book, Growing Equity. My goal is to demystify the process of analyzing and buying income producing real estate without the condescending tone of the “Dummies” books.
It’s not what you earn; it’s what you keep that counts.
Me, and a bunch of other people.
Many years ago, I owned a restaurant. We were open 24 hours a day, seven days a week. Whether you wanted to have a nice Sunday brunch after church or sober up after the bars closed, you probably went to my place. Back then, steak and eggs would run you about $5.95. Coffee was $.20 for a bottomless cup. Yes, I am unspeakably old. My cost for a couple of eggs, hash browns and a nice New York steak was about $2.00. That’s a nice fat profit margin of 65%. But wait: I did have to pay someone to cook the food, serve it, clean up after it. I had to pay my employees’ health insurance (yes, I provided health insurance for my employees). I had to pay rent and utilities. I had to make payments on the loans I had taken out to open the restaurant. By the time the month was over, I managed to keep about 12¢ out of each dollar I took in. The rest went to pay expenses and service the debt.
Investment real estate works the same way. We receive income from renters. We pay out expenses (taxes, insurance, maintenance and debt service). Subtracting the expenses from the income gives us cash flow. If the number is negative (total expenses greater than the income) we have a negative cash flow. We have to tap other assets to cover the shortfall and keep the property running. If the number is positive (income greater than expenses), we have that beautiful thing called positive cash flow. We have money left over at the end of each month.
We can use leverage—sometimes referred to as “OPM” for “Other People’s Money”—to increase the effect of appreciation in real estate. If our investment goal is more to build net worth than to collect cash flow, we want as much leverage as possible—and that means taking a larger mortgage, but with less cash flow.
You should be aware that leverage, for all its magical ability to multiply the benefits of appreciation, is a two-edged sword. While leveraged equity increases rapidly when value goes up, it deteriorates in a heartbeat when value goes down. Our friends (*cough*) on Wall Street demonstrated this in 2007 and 2008, when the value of their mortgage bonds declined steeply. In some cases they were leveraged 100 to 1 (each dollar of equity controlled 100 dollars of asset value), so when the crash occurred, they stood to be wiped out.
It is not possible to leverage investment real estate to that extent, but you should still be aware of the risks. Even though according to Los Suenos Costa Rica real estate reports, we are not likely to see the steep drop in real estate prices any time soon, there is the risk of vacancy and unplanned repairs. If you have a rental house where you can charge $1,500 a month rent and your mortgage payment is, say, $1,200 a month, your financial situation could change for the worse if your tenant were to move out. You will have to get the house clean and ready, then find someone else to rent the property. During that time, you still have to make the mortgage payment. If this would be a severe hardship, think twice about buying rental property at this point in your life.
One way to reduce the risk of vacancy is to buy buildings with more than one unit. If you own a three unit building and one tenant moves out, you have lost only one third of your income for that time, rather than all of it. There are some additional reasons to consider multi-unit properties, but more on that later.