Author Topic: Opinion on this rental investment plan (too risky/unrealistic, or pretty good)?  (Read 4041 times)

HazelEyes

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I was told that the post I wrote about my investment/retirement plan contains questions about rental/real estate that I should ask here instead, so here I am.

For the sake of context, the original post details the entire plan, which also includes our incomes, expenses, lifestyle/life goals, and stock investments. If you need to see the bigger picture to assess our plan below, you can read the original thread here:
http://forum.mrmoneymustache.com/ask-a-mustachian/reader-case-study-opinion-on-this-financial-independenceretirement-plan/

Current house we live in: - Placer County area, Northern California, single-family house, purchased in 2012 for $255k (now valued at $355k). We paid 20% ($55k) on a 30-year loan at 3.625% interest rate.

The plan: - We're thinking of selling our current house, since the mello-roos at $3k a year is too high, and also we can use the money to split into two cheaper houses for greater equity gain (I think this is logical, if the market condition is similar for the two cheaper houses? Am I wrong?). The house should net us about $140k in total gain.

We'll use the money from selling the house ($140k) and add about $205k from our assets in stock, then buy approximately 6 rental properties, all in the Placer/Yuba area within 30 minutes driving distances from each other (with one of them as our new home) at roughly $230k each, all with 25% down payment, 30-yr loans, around 4.87% interest.

The 5 rentals should fetch around $1,430 on average for rent each. They will pay for their own mortgages, without much left, so we're mainly looking at the long-term equity gain, which is roughly 7% yearly gain on average (based on the past 50 years, though in the last couple of years, it's been about 20% gain each year, but then again, California is crazy like that).

(To put things in perspective, the houses in the area we want to buy, the average price was around $345k back in 2005~2006, and they're now around $230k, slowly recovering from the crash. Using the same historical average of 7% gain per year, they should be about $39.1k ten years from now. If we just look at the Bay Area, the housing prices are now already back to where they were pre-financial crash, and it only took about three years. Many houses are now getting dozens of buyers competing with cash. Our area isn't that crazy, but we're close enough to ride a little bit of that coattail. Our current house in Placer County went from $255k in 2012 to $355k currently. That's 39% increase in just two years, right after a severe financial crash.)

In ten years, we'll still owe $825k mortage on all six properties (including the one we'll be living in). If we sell off two of them (estimated to be worth around $391k each by then), we can take the $782k and also another $43k from our stock investment to pay off the $825k mortgage we owe on all six properties. So now, two of the six properties are sold and the other four are paid off. One we live in, three are still being rented out. At that point, the total value of all four properties (three rentals and the house we'll live in) should be about $1.564 mil.

The rent from the three properties should be around $1,881 each (estimated for inflation ten years into the future, using the rate of 3% rent raise limit per year as a basic guideline), so that's $5,643k total a month ($67,716 a year), and if we subtract $20k of expenses a year, we'll be left with $47.7k net income a year from the three rentals.

Does the real estate/rental part of our plan look sound? Did we overlook or misjudge anything? We are new to investing in the U.S. (though we've done it abroad for about ten years), so we're learning as we go.

SpicyMcHaggus

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This sounds like all your eggs in one basket. Are you diversified? Will you be after you pay off the homes?

Another Reader

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Betting on future appreciation or rent increases is a very poor way to invest in real estate.  Projections of compound rates of increase are guesses at best.  In my experience, they could be better described as fanciful.  One thing I can tell you is that operating expenses and the cost of capital improvements have increased at rates far exceeding the growth in rents over the last 15 or 20 years.

If you put 25 percent down on a $230k house and take a loan at the stated interest rate, your P&I will be $912.  Add another $215 for taxes and $90 for insurance, and your PITI is $1,217.  You have allowed nothing for vacancy and collection loss, maintenance and repairs, property management, or capital improvements.  Over time, you are likely to be cash flow negative.  Unless you have some very solid reserves, these alligators will bite you at some point.

You don't say where in Yuba/Placer these houses are located.  What's the rental competition like?  Being so far away from major employment centers is likely to limit rental demand.  And with rent more expensive than a house payment, especially for owner-occupants, most folks willing to make the commute will do so to own, not to rent. 

There's a lot of discussion about the 1 percent per month rule for rental houses on this site.  Your ratio is 0.62 percent per month.

Nothing about this plan makes sense to me.  In your shoes, I would do a lot more reading and research about owning rentals before I wrote any checks.  This is too important to your retirement to go in blind.


waltworks

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This is a horrible plan. Housing historically appreciates at 1% over inflation or so. 7%/year is probably not going to happen long term - I mean, you never know, but it's a much bigger gamble than, say, the stock market, where at least there is a long-term historical trend to look at. You *might* win but if you lose you lose BIG buying loads of highly leveraged RE.

I will quickly echo Another Reader's points: you have made no allowances for any of the typical costs of owning rentals (maintenance, vacancy, extra insurance/legal costs, management, etc.) Worse, you are planning to multiply your folly by buying a BUNCH of places with leverage that lose money every month...

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thedayisbrave

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Betting on future appreciation or rent increases is a very poor way to invest in real estate.  Projections of compound rates of increase are guesses at best.  In my experience, they could be better described as fanciful.  One thing I can tell you is that operating expenses and the cost of capital improvements have increased at rates far exceeding the growth in rents over the last 15 or 20 years.

If you put 25 percent down on a $230k house and take a loan at the stated interest rate, your P&I will be $912.  Add another $215 for taxes and $90 for insurance, and your PITI is $1,217.  You have allowed nothing for vacancy and collection loss, maintenance and repairs, property management, or capital improvements.  Over time, you are likely to be cash flow negative.  Unless you have some very solid reserves, these alligators will bite you at some point.

You don't say where in Yuba/Placer these houses are located.  What's the rental competition like?  Being so far away from major employment centers is likely to limit rental demand.  And with rent more expensive than a house payment, especially for owner-occupants, most folks willing to make the commute will do so to own, not to rent. 

There's a lot of discussion about the 1 percent per month rule for rental houses on this site.  Your ratio is 0.62 percent per month.

Nothing about this plan makes sense to me.  In your shoes, I would do a lot more reading and research about owning rentals before I wrote any checks.  This is too important to your retirement to go in blind.
+1.  I think you have a LOT more reading/researching/learning to do.  Check out Bigger Pockets.  Personally I would not go in debt up to my eyeballs just to have the title of "real estate investor" (not insinuating that's what you are doing but just making a point).  Betting on things that are shaky at best, i.e. appreciation, as if they were a sure thing is the surest way to get yourself in deep financial doo doo.

HazelEyes

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Thanks for the replies. I'll address some of the points that were brought up and explain our situation/mentality.

@SpicyMcHaggus - We have money in stock abroad, have two apartments rentals in Japan, and are looking into stocks here in the States. The original thread contains the details of our other investments and overall plan to financial independence/retirement: http://forum.mrmoneymustache.com/ask-a-mustachian/reader-case-study-opinion-on-this-financial-independenceretirement-plan/

Another Reader - I can totally understand the concerns you raised. My husband is very cautious in his personality too, and I'm always the one who has to convince him when it comes to our financial plans. I made my money as an entrepreneur since my mid-twenties, and every single property I've purchased in the couple of decades has made really good money (except for one, which was in a country that I didn't know enough about. Won't make that mistake again)--sometimes two to three times the purchase price a few years later, but they were abroad, so it's fair to say they were anomalies. But at the same time, California is so unlike other states--it's real estate has always been kind of unique and the potential to make money off the equity gain is legendary due to the steep growth rate. My husband's family's first house in the Bay Area was purchased for around $250k, and now it's worth 1.5 mil (after remodeling). We've observed over the decades the insane growth rate of real estate in California, and it does not look like trend will change for a while.

I mentioned that our current home was purchased for $255k in 2012, and now it's worth $355k. That's just two years, and after a severe financial crash too. In the Bay Area housing prices are now back to pre-crash--that's insane. But all of this is very real, and if we don't accept that it's real, we will lose out on incredible opportunities. California in some ways is a different beast from the rest of the country (except for other similarly expensive places like NY), and property value appreciation is how many people have made money from their investments here. Yes, there are risks, but based on the recent history, buying now means there's still room for nice equity growth that's beyond the standard conservative rate that applies more to the rest of the country.

If my PITI is $1,217 as you calculated, wouldn't the $1,400 rent cover it? (That's roughly the cost of rent for a house in that price range in the area.

To cover vacancies, maintenance/repairs, management, etc, we have $390k in stocks abroad that's getting 11% yearly return consistently. If we were to move that money to invest in the States, it would be lower at 7%, but it's still enough to cover the rentals' expenses.

Being away from major employment centers is one concern we did think about, but there's a military base and we were told it's easier to rent out to soldiers since the military will handle any problems should there be any (and soliers are held to a stricter code of conduct in general than typical civilian).

In fact, we already lost a great opportunity two years ago. We were already planning on buying rental homes then, and talked to the lender who got us the loan for our current house, and he talked us out of it, giving us similar reasons as you guys are. He also said we couldn't get the loan we needed anyway. We listened to him and dropped our idea. If we didn't listen to him then and went to a different lender, we would have already made money already. But now, we're working with a different lender and he actually can get us the loan we want, and though him, we could also purchase multiple rental properties all at once.

@waltworks - It might seem like a horrible plan if we're using the national average, but California is a different animal in some ways, especially with our area being affected by the Bay Area's market.

For expenses, I explained above to Another Reader.

@thedayisbrave - My hubby thinks that way too, but all of the money we've made to date has been because I was willing to take risks. If we didn't take all the past risks, we'd be be penniless by now, instead of having $700k + net assets currently (from real estate, stocks, and other investments). :D I generally believe that a certain amount of risk is necessary if you want to have higher returns in shorter amount of time. I try already try to be more conservative when planning, but I suppose it's still too risky in most people's opinion.

waltworks

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Spend an hour reading some of the buy/sell/rent threads here. Spend another hour reading stuff at Biggerpockets. Google the 1% rule and 50% rule.

Then come back and tell us why your special circumstances mean ignoring those rules is a good idea. We get the same basic question from about a half dozen people a week.

And yes, your house has appreciated a ton in a few years. So did every other house in basically the entire US. Don't feel too smug about it.

It's pretty simple - you can basically have the lifestyle you want with pretty safe investments just by doing index fund stock/bond investing. Your RE plan sucks horribly in comparison - if you want RE, find somewhere that it makes sense to buy and the numbers work, rather than just buying stuff local to you because that's where you live.

-W

Sdsailing

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One thing you are missing about California re investing is that you need to buy low, ie on the dips.  You are proposing to buy at the end of a two year run up in sacramento area prices.

Re bay area prices...are you kidding? Placer county has no similarity to the bay area.

See also my comments on other thread.

thedayisbrave

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all of the money we've made to date has been because I was willing to take risks. If we didn't take all the past risks, we'd be be penniless by now, instead of having $700k + net assets currently (from real estate, stocks, and other investments). :D I generally believe that a certain amount of risk is necessary if you want to have higher returns in shorter amount of time. I try already try to be more conservative when planning, but I suppose it's still too risky in most people's opinion.

I definitely agree... gotta take risks for higher potential reward.  Just want to caution you on thinking of appreciation as a sure thing, cause it's not.  I'm all for calculated risk taking based on due diligence and crunching numbers etc. - but betting on appreciation is just speculation, i.e. gambling.  You could win, but you could also lose.  Personally, I look at my real estate investments based on the cash flow it returns after all expenses are accounted for - I want to maximize that number.  Honestly the market price of the property does not even enter my mind.  If it appreciates in value, great! If not, that's fine.  My play is to buy and hold for the cash flow it generates.

Another Reader

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You appear to be smugly confident and disinterested in any criticism of your plan.  However, I'm so concerned that so much of your future is tied up in this scheme that I am going to take the time to respond and I'm not going to sugar coat this.  My opinion is you will lose your shirt if you do this.

I have lived in the Bay Area for 60 years and have been professionally involved in real estate here for over 30 years.  I own a number of single family rentals myself, mostly outside California because it is very difficult to make the numbers work here.  I think I have enough knowledge and experience to have a reasoned opinion here.

The California that you speak of is San Francisco and the surrounding Bay area.  It extends to Silicon Valley and Santa Cruz to the south and Marin County to the north.  It includes the suburbs along the 680 corridor.  Lincoln, Plumas Lake, Wheatland, Olivehurst and the other towns in the "Placer/Yuba area" are not part of the Bay Area.  They are only marginally part of the Sacramento market, as outlying suburbs.  The Sacramento market has appreciated, but it has none of the economic drivers that the Bay Area has.    It has yet to fully recover, and it may be years before it does.

Buyers are limited by what the bank will lend.  As subdivisions radiate from the City core, the sentiment is "drive until you can afford the payment."  Renters have no such restrictions.  They can pay a higher percentage of their income for rent.  They can rent even though their credit may not be perfect.  They may rent because they will be in the area for only a short time.  Renters can find something close in for less than the monthly mortgage payment for the same property in the better location.  Buyers drive, renters don't.  You are out on the edge, not where most renters are.

I'm not familiar with the military bases in the area, beyond McClelland AFB.  Military bases are helpful, but they don't drive rents up like the employment centers in the Bay Area do.  In the Bay Area, there is a limited supply of housing and demand has outstripped supply since before my parents moved to Berkeley in the late 1940's and had to live in a basement mother in law suite so my father could attend UC.  There is simply no more land on which to build.  Where you are, there is vacant, buildable land as far as the eye can see.

My suggestion is that you get a disinterested third party, not the person giving you the sales pitch, to pull all of the for rent listings and the closed rental listings for the last 6 months.  See what was actually rented and how long it was on the market.  Are there property management companies in that area?  Look at their websites.  Call and ask them how fast rentals are absorbed and what rent and price increases have been like in the specific markets you are considering for the last ten years.  Ask them about tenant quality.  I guarantee you, the picture they paint won't look like it does here.

Your $1,430 rent will cover the PITI for the months the property is occupied.  It won't cover the months that the house is vacant or the tenant doesn't pay and you have to evict.  And eviction in California can be a lengthy process, sometimes taking several months.  Renovations are costly, and out there, tenants can afford to be picky.  You will have to paint and replace carpet more often to stay competitive.

If you want to feed alligators in the hopes rents and values go up, please understand and evaluate the risk.  Use assumptions and numbers appropriate to your market, not the Bay Area.  Maybe consider not putting so many eggs in the local real estate basket or at least getting in slowly.  With your uncertain income situation, the last thing you need to do is lose a lot of your nest egg on a really bad real estate mistake.


waltworks

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Already posted in the other thread but I'll say it again: you don't need this scheme. Even if it was smart, you're already pretty much set with what you have, investment-wise. But it's not even smart, it's awful.

It may be that you feel some inherent need to actively do stuff with your money. Great. Set aside $20k and go nuts with whatever mad scheme you want. Put all of the rest in some boring-ass index fund and forget about it and live your life.

-W

arebelspy

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This is a horrible plan. Housing historically appreciates at 1% over inflation or so.

Why would it appreciate over inflation.  Housing should match inflation on a macro scale on a long enough timeline.

(Particular markets will under or over perform, but trying to guess which is like trying to pick a hot stock.  YMMV on your opinions of doing either of those.)
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waltworks

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I think there is a bunch of room to argue about exactly how fast housing in general appreciates but I think we could agree that in general, it can't be much/any more than inflation. I would say it is a tiny bit faster but not much based on case Schiller numbers which are IMO the most rigorous.

My point, however badly articulated, was that housing appreciation is a crap investment most places most of the time.

W

arebelspy

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I think there is a bunch of room to argue about exactly how fast housing in general appreciates but I think we could agree that in general, it can't be much/any more than inflation. I would say it is a tiny bit faster but not much based on case Schiller numbers which are IMO the most rigorous.

Sure, I think it's done slightly better than inflation, however not like to like - houses have gotten bigger.  One single house shouldn't beat inflation, IMO (local markets aside).

Any serious investigation into why housing would appreciate at all should lead one to the conclusion that it should match inflation, IMO (at least from the half dozen angles I've attacked it).

My point, however badly articulated, was that housing appreciation is a crap investment most places most of the time.

Well... I don't know that I'd call it a crap investment.  The appreciation part matching inflation as a base of the investment is pretty solid.  Now any other returns (such as cash flow) are real returns, which is pretty sweet.
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Nords

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Being away from major employment centers is one concern we did think about, but there's a military base and we were told it's easier to rent out to soldiers since the military will handle any problems should there be any (and soliers are held to a stricter code of conduct in general than typical civilian).
Speaking as a retired military guy-- good luck with that!  Did they also mention that the military is drawing down 10% or so over the next few years?

I don't know who's telling you these half-truths, but perhaps you should contact the Legal Office at this base and ask what the Army can do for you when your mythical soldier tenants stop paying the rent (for whatever reason).

While you're at it, the JAG can give you a short primer on how your military tenants can use the Servicemembers Civil Relief Act to break the lease at any time when they're in receipt of transfer orders.
« Last Edit: August 30, 2014, 11:00:53 PM by Nords »

HazelEyes

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Thanks for all the comments. It's very helpful. I also want to say that I definitely don't want to be smug about anything--this is our livelihood and I take it very seriously. I apologize if I seem really stubborn. I came here because I wanted to get advice from people who have more experience and knowledge, and I'm very grateful for the advice I've gotten so far.

I think I was being a little defensive because we lost an opportunity to invest a couple of years ago when a loan agent talked us out of our plan, and if we had invested then, we'd have make really good money by now. I really regret getting talked out of something because I didn't have enough conviction. We were told the same thing back then--that we're already doing well and we should just enjoy life, instead of trying to invest in rentals and dealing with all the headache that comes with being a landlord.

I have been in touch with a recommended management company, and I've asked some preliminary questions and gotten answers that sounded good but not in enough detail. I have a list of question that I will ask next week and really grill them and get more information, so we can be sure that at the very least, the rental market there is good, regardless of appreciation potential. We also need to find out just how the military presence really affects the rental market there. What Nords said about the military--that definitely gives me pause.

At this point, I have to say all the voices against our plan is very sobering, and definitely makes us reexamine our situation and what risks we're willing to take. Thanks again for being generous with your time and advice--it is greatly appreciated.








waltworks

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Yep, you are just more articulate or intelligent than I am tonight - to clarify again:
-Buying RE as an inflation hedge can be smart, because it will probably keep up with inflation.
-Buying RE purely for appreciation without getting at least minimal cash flow is a bad idea in most cases.

The CS numbers are repeat sales so house size isn't a big issue there (I guess maybe if people are going nuts building additions to their houses between sales, maybe?). I think that series shows something like .5% over inflation for the last 40 years or so, but I'm too lazy to go look it up. It's not a lot, though.

-W

I think there is a bunch of room to argue about exactly how fast housing in general appreciates but I think we could agree that in general, it can't be much/any more than inflation. I would say it is a tiny bit faster but not much based on case Schiller numbers which are IMO the most rigorous.

Sure, I think it's done slightly better than inflation, however not like to like - houses have gotten bigger.  One single house shouldn't beat inflation, IMO (local markets aside).

Any serious investigation into why housing would appreciate at all should lead one to the conclusion that it should match inflation, IMO (at least from the half dozen angles I've attacked it).

My point, however badly articulated, was that housing appreciation is a crap investment most places most of the time.

Well... I don't know that I'd call it a crap investment.  The appreciation part matching inflation as a base of the investment is pretty solid.  Now any other returns (such as cash flow) are real returns, which is pretty sweet.

arebelspy

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Yeah, I think we fully agree walt.  I just wanted slight clarification on some points.  Excuse my being pedantic; thanks for clearing it up.  :)
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with two kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.