2 2 Is 4 Minus One Is Three Quick Maths First Time Real Estate Investors – Their Three Biggest Misconceptions

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First Time Real Estate Investors – Their Three Biggest Misconceptions

It is in markets like this that everyone wants to become a real estate investor. Values are down, sellers are eager to sell, and wherever you turn people are talking about the “steals” out there in the real estate market.

This can mean new clients for those of us in the real estate business – but it means new students as well. It winds up our responsibility to teach the new folks about real estate, and one of the most important ways to do that is by addressing any misconceptions they may have right from the start.

If you are considering your first real estate investment purchase, you may carry some of these misconceptions yourself. I hope I can help to educate you a bit so that you can make a more informed real estate investing decision.

Three BIG misconceptions I seem to run into over and over again are as follows:

  • THE PROPERTY THEY WANT TO BUY MUST GENERATE HUGE CASH FLOW IN ORDER TO BE CONSIDERED A GOOD DEAL.
  • This is difficult to address because, depending on the investor, this may be true. However, the first time investor usually comes into the game thinking that this is the law, without really knowing exactly why they think this way.

    The truth of the matter is that, for the most part, cash flow is necessary. No one likes to buy a piece of property that will cost them money every month. BUT, that doesn’t necessarily mean that the cash flow has to be fantastic right from the start.

    If you have any questions or need some advice or guidance in your endeavors feel free to contact me via e-mail at nick@philadelphiainvestordeals.com or by visiting my website at http://www.philadelphiainvestordeals.com. I’d be happy to help.

    I bought a Philadelphia investment property a few years back for $40,000. The tenant was paying only $250 a month for rent. My total monthly payment was $375 which meant I was paying $125 per month. Should I have walked away from that deal? Was I an idiot for buying it? The answer is no, and there is more to the story.

    The property was in need of repairs, and the ARV (After Repair Value) was about $65,000. And the tenant was a relative of the previous owner and her rent was $400 per month under market rent for the area. So I made the necessary repairs to the property during the 3 month that she remained there (total repairs cost me about $4,000) and when she moved out I rented the home for $725 per month. NOW was I an idiot for buying it? Of course not! In three months time I made $15,000 in equity and was generating $350 per month in positive cash flow.

    To take the example one step further, would it have still been a good deal if I was stuck with that first tenant for one year? How about two years? Do you see where this is going?

    Another misconception:

  • THEY CAN SIMPLY RAISE THE RENTS IMMEDIATELY TO COMPENSATE FOR LOW EXISTING RENTS ON THE PROPERTY THEY ARE PURCHASING.
  • You would be amazed how many beginners think this is the case. When I told one of my newbie investors about the deal mentioned above, he immediately asked, “Why the heck didn’t you just raise the rent as soon as you settled on the property?” When I told him that she had three more months left on her lease, he said, “That doesn’t matter, you’re the new owner. You can raise the rents.”

    NO, you can’t. The lease follows the property. Unless it is specifically stated in the existing rental agreement that the lease terminates immediately upon transfer of ownership (which it rarely, if ever, does) then the new landlord is stuck with the lease signed by the prior owner.

    So the length of the remaining lease could very well affect the buyer’s ability to purchase the property. If an investor can’t afford to carry negative cash flow for a number of months until the lease can be re-negotiated, then either the property has to be reconsidered or the deal needs to be negotiated in a different way (perhaps making the settlement contingent upon the seller getting rid of the current tenant or increasing the rent before settlement.)

  • THEY “EXPECT” TO GET THEIR MONEY OUT OF THE DEAL AS QUICKLY AS POSSIBLE.
  • When a client asks, “how long will it take for me to get my money back” I know I’ve got some educating to do. What they are asking is “Nick, I’m spending $20,000 in down payment money to buy this duplex, how long will it take before I earn that money back through rental income?”

    Seems like a valid question on the surface except that in reality they are not spending anything! The $20,000 is in reality an asset shift from a liquid asset (cash) to equity in the property they are purchasing. It is still an asset on their balance sheet and wasn’t really ‘spent’ at all. The misconception that they have “spent” their down payment money is a common one.

    What they did spend was their closing cost money (if the seller wasn’t asked to pay for those) and I will calculate the amount of time it will take for them to recoup that… but it is not as simple as taking the closing cost money and dividing it by the monthly cash flow. There is also equity build up at the end of the year that needs to be factored in.

    Here’s a real life example. Mike bought a 4-unit property from me for $120,000 and he put $12,000 down. He incurred $5,000 in closing costs (the rest of his costs were paid for by the seller.) He was out of pocket $17,000. The property generated a monthly net cash flow of $300 per month. The $12,000 is still his. He just converted the cash asset to equity. The $5,000 in closing costs is what we want to analyze. We could do a quick calculation like this: Closing Costs divided by Monthly Net Cash Flow = #of months to recoup $5,000 in closing costs divided by $300 per month net cash flow = 16.6 months. Not bad, he’ll recoup his closing cost money in around 17 months, right? Wrong! How about the equity that he accumulates at the end of year one?

    (Bear with me… here comes the math):

    In this example the average multi-unit in the area appreciates at an average rate of 3.5% per year. So at the end of year one of his ownership, the property will be worth and estimated $124,200 ($120,000 X 103.5%). So by the end of year one Mike has earned rental income of $3,600 ($300 X 12) PLUS accumulated additional equity of $4,200 ($124,200 minus original cost of $120,000)… that’s $7,800 in profit! That can be annualized at $650 per month in year one ($7,800 divided by 12 months). And that drops the length of time to recoup those costs from 16.6 months to 7.7 months ($5000 in closing costs divided by $650)!

    There are more, of course, but I seem to see these three with more frequency than many others. If you are a new investor thinking about purchasing your first property, I hope you found this article educational.

    I deal with many beginning Philadelphia and Delaware County real estate Investors, and believe me, as much as they are looking for the best Philadelphia investment properties, I insist that they learn to evaluate these properties to some degree first. It’s imperative that you as a new investor grasp some of the basic concepts so that you can make the most informed real estate investing decisions possible.

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