Author Topic: Diseconomies of scale  (Read 1794 times)

ChpBstrd

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Diseconomies of scale
« on: March 27, 2017, 02:25:09 PM »
NW: ~$500k
Money to invest: ~$60k
Market:
     Southern US metro area
     Unemployment rate: 3.9%
     Price of 2/1 units in B- to C neighborhoods: $40-60k
     Rents for same: $600-650/unit
     Maintenance costs are expected on the higher end.
     Expected appreciation: near zero is typical here

So I'm thinking about deal-shopping for SFH's, duplexes, or apartments in this price range. My reasons: to diversify, inflation hedge, and accellerate FIRE by earning higher ROE than unleveraged stock market holdings. All while keeping my day job.

I'm thinking about dipping a toe in on one property and in a year or two as I set up my PM and other vendor systems, consider purchasing 2-4 additional units.

The problem is, to do this right, I need to work with a lawyer to set up an LLC or similar, work with an accountant for tax purposes, work with an insurance agent to protect against liabilities, and spend valuable time shopping for a PM and properties.

By the time I get all this set up, I'd be lucky to earn 5% ROE after leverage. Yields on my little company would improve as I added more properties, because some of my fixed costs would stay the same, but it still doesn't look good on paper. My question is how does one justify getting started and pick an approach?

Running a RE company is at some level a PITA regardless of scale, but the investment of time would need to be justified by higher yields. Yet the economies of scale that enable those higher yields don't seem to be available to a non-FI part-timer like myself, who would have to hire out many functions due to a lack of time. Options include:

1) Informal Management: Just own and rent. No incorporation. Maybe just pay for PM and insurance. Keep scale low.

2) Almost a business: Scale up by hiring out more services, like accounting or minor maintenance.

3) All In: Build a scalable organization from the start. Focus on building a team of vendors. Incorporate. Everything by the book.

Thoughts? Which approach did you take to overcome the diseconomies of small scale?

waltworks

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Re: Diseconomies of scale
« Reply #1 on: March 27, 2017, 03:00:36 PM »
This isn't an economy of scale problem, really, it's a problem with the properties you're talking about. 1% rule is just a guideline, remember. If you are in low-cost, mediocre neighborhoods and expecting lots of maintenance (and no appreciation) you need to look for deals that are more like 1.5-2%, probably.

Buying houses and getting them insured is really pretty easy. You don't need to hire professionals for that. Likewise you can fairly easily set up an LLC and do your own taxes.

Also remember that unless you have a *very* trusted management company, RE is never totally passive. You will have to put time and effort into it, so it's really more running a business than "investing" in the sense that the stock market is.

-W

CareCPA

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Re: Diseconomies of scale
« Reply #2 on: March 27, 2017, 03:12:30 PM »
I don't know if this helps any, but I'm in the awkward middle stage. I have three properties, so I still have to deal with the Property Management company (who will never be as responsive or responsible as you are, no matter how good they are), but I have to do it around my full time job because they don't produce enough income to stop working full time. If I have a bunch more, then I presume it would be easier since I wouldn't have to work it around my career, and could even self-manage.

From my (limited) experience, I don't like RE just as a diversification tool - it's too much effort and time for what I actually get out of it with only a couple properties. I would, however, like to grow it into main source of income once I get past the growing pains.

Kroaler

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Re: Diseconomies of scale
« Reply #3 on: March 27, 2017, 03:51:04 PM »
Maybe Im crazy, but I would do informal for a property or 2 before making huge time commitments to non value added task.   So I rule out option 3.

ChpBstrd

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Re: Diseconomies of scale
« Reply #4 on: March 27, 2017, 04:22:51 PM »
I don't know if this helps any, but I'm in the awkward middle stage. I have three properties, so I still have to deal with the Property Management company (who will never be as responsive or responsible as you are, no matter how good they are), but I have to do it around my full time job because they don't produce enough income to stop working full time. If I have a bunch more, then I presume it would be easier since I wouldn't have to work it around my career, and could even self-manage.

From my (limited) experience, I don't like RE just as a diversification tool - it's too much effort and time for what I actually get out of it with only a couple properties. I would, however, like to grow it into main source of income once I get past the growing pains.

Extremely helpful, FrugalGrad. That awkward middle stage is what I am foreseeing.

You mentioned using the RE for retirement income. My plan would be to FIRE and then shift to all paper-based assets at some point. So any move I make would need to yield pretty well within a couple years, not decades. That's another complication for me.

ChpBstrd

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Re: Diseconomies of scale
« Reply #5 on: March 27, 2017, 04:35:53 PM »
This isn't an economy of scale problem, really, it's a problem with the properties you're talking about. 1% rule is just a guideline, remember. If you are in low-cost, mediocre neighborhoods and expecting lots of maintenance (and no appreciation) you need to look for deals that are more like 1.5-2%, probably.

Buying houses and getting them insured is really pretty easy. You don't need to hire professionals for that. Likewise you can fairly easily set up an LLC and do your own taxes.

Also remember that unless you have a *very* trusted management company, RE is never totally passive. You will have to put time and effort into it, so it's really more running a business than "investing" in the sense that the stock market is.

-W

Yep. The rent/price ratio in my area (probably all areas) is highest at the low end of the market. I suspect ROE peaks somewhere in the middle. The low end of my market are houses worth 25-30k that rent for $450-500, or 1.7-1.8%. Yet, I doubt those slumlords actually get rent more than 9 months out of the year.

In all fairness, there probably is appreciation of rents and property values of around 1-2%, or about inflation. It's almost too subtle to see.

By insurance, I meant a liability policy that would protect my other assets. I suspect this would not be much cheaper while I own one property  than when I own 5, so it's a diseconomy of small scale.

Blindsquirrel

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Re: Diseconomies of scale
« Reply #6 on: March 31, 2017, 08:35:32 AM »
   Would self manage the first couple and see how you like it. Setting up an LLC does not require a lawyer, just file the form with your state gove and call the IRS to get a tax ID number and you are good to go. The accounting for the LLC is more detailed than just as a person who rents a house. Head on over to www.biggerpockets.com and you can learn more about RE investing from some very astute investors. I would shoot for 2% in a b- area if not higher. Good luck!

Bobberth

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Re: Diseconomies of scale
« Reply #7 on: March 31, 2017, 03:56:21 PM »
If this property is close to where you live, I also suggest you self manage at first. Most of the work in real estate is at the beginning: finding a property, fixing up the property, finding a tenant and the first few weeks once a tenant moves in and discovers any issues. After that, its pretty much depositing checks every month with an occasional phone call/text/email. Right now I can't imagine paying 8%-10% of rents each month for management which essentially comes down to what day I can stop by the bank. Eventually I will employ management as I travel more and longer but for now it's an easy way to reinvest more money into obtaining FIRE.

I had one lawyer tell me you HAVE to not only have an LLC, you should do this more complicated multiple trust/partnership structure as LLC law isn't that old and settled. Another told me not to worry about an LLC and just have sufficient liability insurance instead. His view was that piercing corporate veils and LLCs is first year law school stuff it's that easy and in practice they don't provide that much protection. You can make your business structure as complicated or simple as you want. Just stay within your risk tolerance.

Insurance is taken care of in an hour or two total-bid out some companies, see if the coverage is what you want (especially with $40k-$60k properties), then set up payment arrangements. Done

If you already have someone doing your taxes, adding real estate will cost additional but it's not really a problem for you. Just keep your receipts and turn them over once a year. If you do your own taxes and start with one rental, filling out Schedule E really isn't all that hard to do.

As for your time involvement, like Walt said, real estate is a business. It takes time and effort on your part. Even if you think you are outsourcing everything, it will never be completely hands-off like a stock/bond/fund investment. You will still be directly involved if the PM brings in a bad tenant or a furnace goes out. That is something you are going to have to decide on your own if you want to pursue or not.

For me, I never felt that I was making any money with my rentals until number 6 (I did jump from 3 to 6 quickly though). Rent came in, expenses went out and the bank account never seemed to move much. Think about it, out of that $600/month in rent, how much are you really going to keep? 50% Rule says $300 minus financing. If you pay all cash that is $3,600 after one year. Cash is not going to add up fast in the beginning. But experience and learning does. If you self manage instead of paying a PM 10%, your annual cash flow increases $720. That is a 20% increase.

From my experience, of your 3 goals, Yes to accelerating FIRE. But No to diversification and an inflation hedge. I'm in St. Louis and the most I have paid for a rental is $48k ($58k all in) so I am in a similar market. Prices in this price range haven't moved much since 2008. Part of the reason, a large part in my opinion, is that most banks don't make loans less than $50k so this isn't a homeowner friendly price point. Even finding someone to loan less than $100k is hard to do. That helps make it a great market to buy to rent out. However, liquidity will be a problem. So don't count on keeping up with inflation as your only market may be other investors if you need to sell (your $40k house may be "worth" $41k after a year of inflation but you may not be able to find a buyer willing **and** able to pay $41k so is it really worth that?). Personally my end game is to switch from renting to selling via owner financing and realizing gains over time.

St. Louis has a bunch of 2/1 houses as well. I have converted several dining rooms to a 3rd bedroom and have been able to increase the value, rental amount and desirability substantially by spending maybe $500 to frame a wall, drywall it, add some electrical outlets and a door. That may be something you can look for in your 2/1 market as a way to boost your returns.

zephyr911

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Re: Diseconomies of scale
« Reply #8 on: April 11, 2017, 05:37:32 PM »
I think of the financing as an inflation hedge more than the property itself.

SeattleCPA

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Re: Diseconomies of scale
« Reply #9 on: April 11, 2017, 07:20:53 PM »
From my (limited) experience, I don't like RE just as a diversification tool - it's too much effort and time for what I actually get out of it with only a couple properties. I would, however, like to grow it into main source of income once I get past the growing pains.

This seems very true to me. Basically you're running a small business. And that small business can be a powerful force for building wealth and creating an income stream. But it doesn't on its own diversify.

BTW, on another topic, I see people (clients) take a while to learn the ropes and become efficient, effective managers.Which makes sense...