Building your Buying Strategy When Buying Rental Property
Before we move to the tactical…let’s talk a little bit about strategy!
There are many different paths to financial freedom through Real Estate investing with rental properties. In this blog post we will discuss some popular ways that investors can think about when purchasing their first 3 to 5 properties.
The paths will be described based on:
- Experience level and buying ‘easy to manage’ properties to more ‘complicated to manage properties’.
- The second strategy will be based on the ‘availability’ of money. Meaning that you are looking to spend as little as possible every time you purchase.
- The third will be about adding value and trading up. With this strategy, you will be looking to buy a property that you can quickly add value to and/or trade to a bigger property over time (i.e. with a 1031 Exchange).
1. From Easy to More Difficult Properties
Many people are scared of Real Estate and of owning property. The thought is that there are too many parts to consider, too many people and companies to manage, and way too many ways that things can go wrong… and whether you believe all of that or not…you are right!
In education there is a lot of thought behind the concepts of learning. What is the actual process of learning? I mention this, because for the most part, we fear what we don’t understand. So, how do we accept a novel subject, a new undertaking, a new skill? By understanding it and learning it! Learning happens from a cognitive stage to a practice stage to an automatic stage.
In the cognitive stage, most people will be in their thoughts. For example, have you ever tried to juggle 3 balls? Most of us have. In the cognitive stage you will be thinking about the details involved in the action. How fast should I toss each ball?…How high should I toss them? Which ball should I toss first- the left one or the right one? What about my body? Where should my center of gravity be? Should I be looking up at the ball or at my hands as I catch and release each ball?…the list goes on.
Then you get to the next stage and you practice. You pivot and you practice. You achieve some success and then you practice. You take physical and mental feedback, you pivot, and you practice. You do this until you are proficient and you keep practicing. One day you arrive at the automatic stage.
In the automatic stage, you no longer have to think. You can now walk and juggle, you can juggle while sitting down, while standing up, and while talking. You become an expert and you are no longer thinking about the details. You are no longer in your thoughts. You take more risk and you can adapt to situations much more rapidly. “Sebastian…what’s your point?”, you may be asking? Or maybe you are intrigued and now want to juggle 3 tennis balls. I digress.
Let’s go back to real estate. In this phase (easy to more difficult), you will buy the property that you think will be the easiest to manage from where you are standing; from your perspective and life experience. Not your friends, not from mine, and not from anyone else’s. So, what you buy will differ depending what you know and what you feel comfortable with, but most people I have talked to, and in our personal experience, the easiest property to buy and manage first would be a condo! A renovated condo with a good HOA will be even easier. We bought a condo that was a fixer-upper because we wanted to add value to it, but if you are at the very beginning of your journey and want things to be easy, buy a renovated condo. You can buy your first condo as a primary residence with a small down payment. The HOA will take care of the common areas, the landscaping, the roof, and in many cases the AC system and termite maintenance. Learn to make that payment comfortably, and in 2 to 5 years you can buy the next level of comfort: a single family home.
When you buy a SFR (Single Family Residence), you will be adding the outdoor portion of the property; the maintenance and managing of that property. You have to take care of every aspect of the home including the sewer line, landscaping, roof, etc. In the future you could buy more single family homes or move on to 2, 3, or 4 unit properties. I hope that you can see how buying the condo meant less maintenance, less money upfront for a down payment, and as you move forward in time buying more properties, they will be priced higher and you will have to put more effort, energy, and experience to manage them. Spend as little as possible along the way.
2. Spending As Little As Possible
Another reason why a lot of people do not buy Real Estate is because of the elephant in the room…yes, that elephant is expensive. Kidding…but yes, Real Estate is extremely expensive to purchase. So, how do investors get around such a big expense? You have to know that when you buy an investment property you have to put down at least 20% to 25% as a down payment. On the contrary, when you buy a primary home you could put down 3.5% to 5% as a down payment. So, how are investors strategizing their purchases to spend less? Or to leverage their money and lenders as much as possible? Some of them are buying units first. Two to four units as their first purchase with an 3.5% FHA loan or up to a 5% down payment. You can use up to 75% of the income produced by the other units you buy and use it as income to be able to qualify for a bigger property. In other words, you may qualify for $600K for a single family home and at the same time, qualify for $1 million dollars for a 4-unit property with only 5% down because the lender is using the rents from the 3 other units as your future income.
For example, you can buy 3 units first then go buy a condo second, then a single family home third. All with a combination or 5% down payments and FHA 3.5% down payments. You will save thousands of dollars along the way. (Of course you have to qualify for all of these loans, taking into account Loan to Value numbers, debt ratios, FICO scores, etc.)
The examples below depict the difference in money you would need. In example #1 I explain what most investors do without planning. Example #2 is what a lot of savvy investors are doing while being pro-active to spend less money as they buy the same properties!
Example #1 : Easy to Hard Properties
- 1. Buy condo first with an FHA loan at $500K, down payment $17,500.
- 2. Buy a SFR second with a 5% down payment at $600K, down payment $30K.
- 3. Two-unit home with a 20% down payment at $800K, down payment $160K.
Total down payments: $207,500.00
Example #2 : The ‘Spend As Little As Possible’ Strategy
- 1. Buy a 2 unit property with an FHA loan (3.5% down payment) at $800K, down payment $28K.
- 2. Buy a condo second with a 5% down payment at $500K, down payment $25K.
- 3. Buy a SFR 3rd with a 5% down payment at $600K, down payment $30K.
Total down payments: $83K
You can see that when you go from easy to hard you will spend about $207K compared to the second strategy which is spending the least possible, at $83K for the same number of units and for the same type of assets/properties!
3. Adding Value and Trading Up
The 3rd strategy investors have been using since the beginning of time is the power of forced equity and value, plus the power of the 1031 Exchange. In this strategy, the focus is not to find the easiest or to spend the least possible, although you will try to do both of these within reason and while being realistic. Investors would buy fixer-uppers on year 1 and within 6 to 12 months renovate the interior and exterior, add square footage, or add units to the property to double and in some cases, triple the property’s value! At that point they will refinance the properties to take out a large portion of their investment and use the funds to buy more cash flow producing properties. They could also sell the properties in a 1031 exchange to take advantage of the tax benefits and not have to pay large sums to the IRS in capital gains as they sell the assets and instead use the growth of the property or equity to buy bigger or better properties.
Some examples of value added to properties by investors are:
- 1. Renovating the interior and exterior of the properties.
- 2. Adding square footage to the home or adding additional new construction.
- units to the property to increase cash flow and/or force the value to go up.
- 3. Convert the garage to an ADU (second unit) or build new construction ADU units.
- 4. Sub-divide the lots and build properties on each new lot.
- 5. Tear down a single family home and build a multi-unit property on it.
These are just some of the many examples I have encountered in the last 11 years in this business. As you can see, just by my explanation above, there are a lot of moving parts here and it often involves a lot of math that confuses people. Don’t let this scare you away. Someone like me can take the time to explain all of this to you in detail.
This 3rd strategy is how some people go from $100K in their accounts to $1 million in just 2 to 5 years. All 3 strategies have merit. There are pros and cons to all of them, and guess what? You will end up wealthy with each of the 3 strategies above. The only difference will be in how fast you will get there and how easy one is compared to the other. Knowing these 3 strategies is important because if you choose one path it will allow you to focus on what you will be looking for and it can also save you a lot of time and energy along the way!
I do want to mention that another strategy I have encountered many times and much more than any of the 3 mentioned above has been the one where people buy 1 to 2 properties and let them sit there for many years. They do not do anything to them, they do not add value to them, they barely manage them or even think about them, and guess what? In 20 to 30 years they are paid off and worth 5 to 10 times more than what they bought them for! I am a much more active investor and work with people that are constantly moving and selling and buying, but this last strategy is one that requires very little thought and one that could help you retire rich!