According to a Wall Street Journal article published today, a wave of foreclosures is starting to drive down prices as banks put more properties on the market. In some areas, foreclosure-related sales account for 40% of all sales. Well a few weeks ago Mike and I did our own sort of investigative reporting–we went house hunting. In later articles we’ll show you some pictures of the dumps we looked at, but for today, suffice it to say that there were some deals out there, but no steals.

When Mike and I started investing together in 2005, we were able to buy homes (including rehab costs) for about 80% of value. Today, in the same area with plenty of foreclosures, it’s about the same. If you really hunt down a great deal, you might be closer to 70% of value, but the banks aren’t giving these properties away. And when you do find a great deal, there’s almost always a lot of work to do. Take for example one peach of property we looked at that I’ll call Dead Man’s Den or DMD for short.

DMD is a four bedroom two bath cape with a detached super-sized garage on about .2 acres in middle-class America. I call it Dead Man’s Den because there was a painted outline of a body on the family room carpet (no, I’m not joking). Every surface in this house was soiled, trashed, written on, punched through or missing. The smell was difficult to identify, but let’s just say we were breathing through our mouths. The kitchen and baths need gutted to the studs. And the detached garage had fire damage. Whether it could be saved or not was unclear.

The bank was asking $48,000 for DMD (note, I don’t think the bank referred to the property as Dead Man’s Den, but I’m not sure). We guessed repairs would cost at least $30,000, but with the garage, it could go a lot higher. In addition, there were undoubtedly busted water pipes through out the house in unknown locations. So we’ll put the total cost at somewhere between $80,000 and $90,000, and that’s after a major, time consuming rehab. And the value of the home fixed up is about $110,000. So there you have a deal, but certainly not a steal.

We offered $40,000 and were out bid by one or more offers at the asking price. I don’t regret not winning the bid, other than it sure would have been fun to blog about a rental property we could legitimately call Dead Man’s Den. I’ll leave you with this chart showing the 10 metropolitan area with the most foreclosures:

Have I got a deal for you. It’s called “House in a Box” and it is exactly what you hope it’s not–a house in a box. They can be shipped right to your location for “easy” assembly and installation. Talk about a great investment. Where else can you buy a 1,150 square foot home for just $36,000 via mail order? If you are the ultimate do-it-yourselfer, a kit house may be just the thing.

One hundred years ago, Sears, Roebuck & Co. began selling the first mail-order, pre-fab homes. From 1908 to 1940 Sears sold some 75,000 mail-order homes. With 447 different styles, these homes ranged from the multi-story Ivanhoe series to the more sedate Goldenrod, a 3-room no bath affair. Well, the Sears mail-order home is enjoying something of a renaissance.

Here are a few modern day options if a House in a Box appeals to you:

Rocio Romero

Rocio Romero is the owner and principal of Rocio Romero, LLC. Rocio received her Masters of Architecture from Southern California Institute of Architecture and her Bachelor of Arts Degree in Environmental Design with a major in Architecture from UC Berkeley. At Rocio Romero, LLC, they design, manufacture, build, ship, and sell kit homes. Their flagship home is the LV series, which Romero has sold more than 150 since launching the product in 2003.

Here is what one of her model homes looks like:

Flatpak

Flatpak offers an interesting alternative, even in the mail-order home business. Homes are designed from the ground up much like my son builds homes with his legos. They don’t have standard prices, but estimate that their homes cost between $200 and $300 per square foot. I guess they don’t sell an economy model. Flatpak also has the strangest website I’ve seen in some time. But the cool part is that they’ve put pictures of their homes on Flickr.

Here’s one of the pictures you’ll find on Flickr (and the snowplow is not included in the purchase price):

Nexthouse

Empyrean International has designed and built kit homes for years. The “Nexthouse” is the newest model for a company who’s service mark is “sustainable home building systems.” They describe Nexthouse as having been

designed around a central clear-spanned living, kitchen and dining volume that opens onto a large outdoor living space through the use of a 24-foot accordion door, which is suspended from a gallery space above that also houses an automated insect screen. When lowered, this screen allows the entire main volume of the house to function as a screened room, providing a new dimension to living and encouraging passive whole-house ventilation. Built almost exclusively with wood, NextHouse brings warmth to modern design and provides a clear relationship of interior to exterior.

In other words, if you’d like to live in a screened-in porch, Nexthouse is for you. In all seriousness, the home actually looks rather nice and boasts 5,000 square feet:

Cost

As a final note, we should add that these homes aren’t all inexpensive. While Rocio Romero has a model starting at $36,000, that doesn’t include the land, permits, construction and various interior items. And one couple who recently bought the Nexthouse spent in total $800,000 for the 3,000 square foot version of the home.

I think Mike and I will wait for the first Nexthouse foreclosure before considering an investment.

Mike has previously written about calculating the gross rent multiplier and capitalization rates as a way of making purchase decisions among prospective real estate investments. But what about measuring properties’ continued performance? As of now, we own four single-family homes. Assessing which one is our best (or worst) investment should be a snap. After all, Mike maintains an ever-expanding spreadsheet that, if printed on 8 1/2 by 11 paper and spread out on my front yard, would finally keep the neighbor’s dog from messing up my lawn. (It would also put the spreadsheet to its highest and best use.) So, within the annals of this tome, I should be able to determine how the properties compare.

But that turns out to be harder than you might think. For example, cash flow is an important number, but it’s not great for comparing properties. The problem is that each property is financed under different terms and our down payment varied from one property to another. A larger down payment will increase cash flow, and a shorter term loan will decrease cash flow, which limits the usefulness of cash flow as a point of comparison.

Return on Equity, or ROE for short, is a method of measuring performance of a real estate investment by comparing the property’s net income to its equity. ROE can help an investor determine, among properties, whether to sell and reinvest in a better performing property, or, given a decision to convert equity to cash for whatever reason, which one. It not only works for real estate, but it also works for stock investments. In fact, Warren Buffett relies on ROE to determine if and when Berkshire Hathaway will ever pay a dividend. So let’s take a look at calculating ROE, then I’ll put our properties to the test.

Calculating Return on Equity

ROE is calculated by dividing net income by the equity in the property. Net income, is determined by taking annual gross rents and subtracting all expenses, including mortgage interest (but not principal), taxes, and maintenance. Net income differs from cash flow in that net income excludes loan amortization (i.e. the principal portion of our mortgage payment), and therefore ignores differences based on the term of the loan. It differs from “net operating income” by including interest expense. The property’s equity is, of course, its market value less the amount of the outstanding mortgage(s) on the property.

The formula is relatively self-explanatory, but a couple of items deserve some elaboration.

• Maintenance Expenses: Although we know what interest, taxes, and maintenance will run, maintenance costs vary from year to year. For example, one year you may have to replace a roof and air conditioner on a home (like we did this year), and then you may go several years without major repairs. For this reason, I use an estimate of yearly maintenance costs even if the actual costs were higher or lower this year. This estimate is based on our experience to date, and it may vary from one home to another depending on the age of the property and the quality of construction. For our properties, the homes are similar enough to use the same estimate for all four homes.
• Market Value/Mortgage Balance: Both of these numbers change over time. Because ROE is calculated on an annualized basis, we must pick a point in time to determine market value and the mortgage balance. For the calculations in this article, I simply used our best estimate of market value and the outstanding mortgage balances as of today. Another approach is to take the market value and mortgage balance at the beginning of the year and average them with the market value and mortgage balance at the end of the year. While that approach may be more precise, who cares?

ROE applied to TwoWiseAcres Real Estate Empire

Using ROE, how do our properties compare? Here are the numbers (annualized) for our four properties, listed in the order in which we purchased the home and using our typical naming conventions:

• The Ranch: $2,071 / $29,458 = 7.0%
• No Basement: $2,344 / $31,278 = 7.5%
• Problem Child: $2,573 / $32,692 = 7.9%
• The Loft: $2,631 / $30,456 = 8.6%

You’ll see that the numbers trend up for properties we’ve purchased more recently. This is due in part to being more aggressive in setting rents as we purchased and to the softening of real estate prices relative to rents.

There are a couple of important items to note about these results and return on equity generally. First, ROE is static–that is, measured for a given moment–and therefore, does not include appreciation rates. If total return is the goal, a comparative analysis among properties that have significant variations in appreciation should consider appreciation rates, as well as ROE. For our properties, we do not anticipate significant differences in rates of appreciation. Second, ROE says nothing about cash flow. The Loft is our worst property as measured by cash flow, but that is primarily because it is financed on a shorter term mortgage and with the lowest down payment. However, the point of ROE is to determine which investment generates the highest income relative to equity in the property. In our case, that’s the Loft.

One final note. I’ve poked a little fun at Mike’s spreadsheet earlier on in this article, and I have to admit that I have not been completely fair. It really can be useful. In fact, I’ve included a video below to demonstrate some other possible applications for his work.

As reported on the official MONOPOLY website, in 1934 during The Great Depression, Charles B. Darrow of Germantown, Pennsylvania introduced the MONOPOLY game to the executives at Parker Brothers. They rejected it, citing 52 design errors. Unemployed like many Americans, Mr. Darrow believed in his game and began to produce it on his own. Mr. Darrow sold 5,000 handmade sets of the game to a Philadelphia department store. Monopoly was an instant success, and Mr. Darrow was unable to meet the growing demand. He returned to Parker Brothers whose executives now saw the light. In its first year, 1935, the MONOPOLY game was the best-selling game in America. In its 70+ year history, an estimated 500 million people have played the game of MONOPOLY.

And those 500 million people can be divided into two groups. Those that seem to win every time they play and the rest of us. Question: To what extent does luck determine who wins a game of MONOPOLY? Our answer to that question probably says more about us than the game. Although the role of the dice plays a part in determining the winner, the game of MONOPOLY also involves a lot of strategy and skill. And it’s that strategy and skill element of the game that can teach us a lot about real life real estate investing.

Strategy #1–Location, Location, Location: If you could start a game by buying a Monopoly (owning all properties of a single color) of your choice, which color would you pick? Many would pick Boardwalk and Park Place, because you can charge the highest rent when some poor sap (usually me) lands on your property. Others would pick the green color group (Pennsylvania, Pacific and North Carolina) because rents are still high and you own three properties, thus increasing the chance of collecting rent. Both options would be a strategic mistake. The best color group to own is orange (St. James Place, Tennessee Avenue and New York Avenue). Because rolling a 6 or 8 from jail lands a player on the orange properties, they receive the most traffic. And while the rents aren’t as high as other properties, neither is the cost to buy or improve them. Thus, your return on investment is, on average, higher than other color groups.

Real world application: Location is critical to the real world game of real estate investing, too. Even within the same neighborhood, similar houses can vary significantly in value and rental income potential. Thus, studying the area where you invest and keeping updated on new developments is critical to successful investing. In addition, Mike and I have found that the best rental investments are not in the least expensive areas (think Baltic and Mediterranean Avenues) or the most expensive areas (think Board Walk and Park Place). We’ve found that the best rental values are in nice, safe middle class neighborhoods in decent school districts.

Strategy #2–Don’t over improve your property: So you finally nab a monopoly and have some cash to make improvements. Do you add four houses and then a hotel if you can afford it? NO! Over improving a property in monopoly can deplete your cash and make it almost impossible to ever break even on your investment. And how much you improve a property will vary from one color group to the next. The best choice depends on the cost of improvements and the potential return. For the orange color group, for example, conventional wisdom says to put 3 houses on the properties, but no more. The cost-benefit analysis doesn’t justify a fourth house or eventual hotel.

Real world application: The same is true in the real world. Mike and I buy homes that need work and improve them. But we have to watch that we don’t over improve the property. We look for improvements that increase the home’s value or rents or that help rent the property more quickly. If an improvement does neither, we don’t do the improvement.

Strategy #3–Start slow and then build up: One strategy is to aim for a monopoly on the first two sides of the board, which are the least expensive. When you gain a monopoly, buy 3 houses (and no more–see #2) as quickly as possible. Then use the cash generated from these properties to shoot for a monopoly on the more expensive side of the board. By the time you’re looking to buy the more expensive properties, you may be able to get them for a song from another player desperate for cash. So start with less expensive properties and work your way up.

Real world application: This is a good real world strategy, too. Buying less expensive properties generally involves less risk. The mortgage will be lower, which can make a huge difference if the property is vacant longer than anticipated or the tenant stops paying. Maintenance is generally less for lower priced properties. And they can still represent an excellent investment. Over time, as cash flow improves and you become more comfortable managing property, you’ll be in a good position to buy more costly properties, such as multi-family units or apartment buildings.

Strategy #4–Constantly look for great deals: When you land on a property owned by the bank, the price is non-negotiable. But as the game progresses, other players may find themselves in need of cash. That’s when great deals can surface. They get the cash they need to stay in the game, and you get a property at a good price.

Real world application: Buying foreclosure properties is the real world equivalent. All of the rental properties Mike and I own were bought from HUD. You can check out our tips and tricks for buying HUD properties here. The deals we get from HUD are far better than we could ever get buying retail. And even within the HUD listings we are very picky. We look at a lot of properties before putting in a bid, and we bid on many more properties than we end up buying. It takes work, but it pays off in the end.

Strategy #5–Know the numbers: Monopoly is a game of numbers and statistics. For example, which three spaces are landed on most frequently? Illinois Avenue, B&O Railroad and Go, in that order. On average, how many of your opponents’ rolls of the dice will it take to break even on your investment in three houses placed on the orange monopoly? According to a recent article describing MONOPOLY strategy, 9.5. How about Boardwalk with no houses? 120.52. On average, how many rolls does it take to navigate around the board once? 5. What percentage of rolls results in doubles? 17%. To win at Monopoly regularly, one must know the numbers.

Real world application: The same is true in real estate investing. When evaluating a property, know the numbers. When we evaluate a potential purchase, we find comparable rents and sales. We also know how certain property features will impact rents and our ability to rent the property quickly. For example, we’ve learned that a fenced yard and basement are very important to many renters. And we have a good idea of the difference in rent between a three bedroom and four bedroom single family home. We consider expenses, such as property tax, insurance, and estimated maintenance and vacancy costs. We check current interest rates and calculate financing costs. From these numbers, we can estimate cash flow. Knowing these numbers cold is critical to getting the most out of your investment.

As important as your approach to real estate investing is, it doesn’t compare to beating your brother-in-law in MONOPOLY. So if you’re looking for more strategy tips and tricks, check out these books:

Recently, my father told me about a great conversation he had with a very nice couple from his church. (I’ll call them the Smiths to generecize the fictitious name beyond recognition.) The Smiths are 65, and both are retired. They have been married for about 40 years, raised a family, and generally lived middle-class lives. And they are real estate investors. Knowing my father is a real estate agent, the Smiths happened to strike up a conversation one day after church about their real estate investments and how those investments have provided them with a sizeable retirement income. I thought I’d outline some important points in real estate investing, and what the Smiths had to say on the subject.

1. Leverage Your Investments to Maximize Growth

The Smiths bought their first rental property, a relatively modest single-family home, when they were in their 30s. Over the years, they bought five more. In buying properties, Mrs. Smith had this rule: “We never bought another property until the last one was paid off. When one was paid off, then we started looking for another.”

2. Always Make Sure You Have Well-Drafted Leases with Tenants

The Smiths don’t use leases. None. Nada. “We just don’t use leases,” Mrs. Smith said. “All of our properties are month-to-month. We have one property where one family has lived there for 20 years. One would rent for awhile, and then they would purchase a home. Then they would move their brother in who would rent for a few years while he saved up to buy a home.”

3. Maximize Rental Income

The Smiths told my father how much they were charging monthly for a couple of their properties that are in the same neighborhood. My father and I are both pretty familiar with the area. Our estimation was that the Smiths were charging right around 30% less than market.

4. In Your Lease, Make Sure that You Contain Appropriate Restrictions on Tenant Alterations to the Property

I truly loved this part of the conversation. Mrs. Smith recounted when she was driving with her husband around a neighborhood where the Smiths owned a rental property. They drove past their rental and almost missed it. At first glance, Mrs. Smith pointed to a house and asked her husband, “Is that one ours?” Mr. Smith replied, “I think so.” It seems their long-time tenants had repainted the exterior.

Although I doubt I’ll implement the Smith’s REI strategy, the Smiths remind me of a few important lessons. First, the Smiths reinforce my belief that real estate investing, particularly in the residential REI realm, is accessible. The Smiths were smart (smarter than most, I would argue) in having an investment plan and sticking to it. But the Smiths undoubtedly didn’t have particular real estate or financial expertise. They’re regular folk who achieved their goals with a simple approach.

Second, I think investors sometimes lose sight of the point to investing. That is, that there is a point–a life goal or purpose that we want to achieve. The Smiths seemed to have succeeded in getting to where they wanted to go. I’ve been writing about measuring returns with real estate investing recently, and paying attention to returns is important to getting to a destination quicker. But it’s easy in the process to forget the part about where we’re going and how we’re getting there. Recently, in the personal finance-o-sphere, I’ve read some great articles about some important life choices that remind me of this point, such as this one and this one.

Third, there’s more than one way to skin a cat. Investors, whether in real estate, stocks, or gold bouillon arbitrage, can have a tendency to declare the universal solution to the investing equation. I have to say, this seems even more so at times in the REI world. Rob and I have chosen residential real estate as an investment vehicle. In our choices of a type of investment, as well as what we buy, how we rent, and when we sell, we have reasons that are in part return-driven, but some aren’t. Many of our decisions also reflect choices about our time, our perception of risk, and even our interests. This is not to say that it doesn’t matter what you invest in. Rather, finding the right way is less important than finding a right way. A right way, combined with a disciplined approach, will likely get you there. Because at the end of the day, it doesn’t really matter how you skinned it, as long as you end up with a naked cat.

Image Credit: by scladesma

Mike and I have been good friends for a long time. We met in 8^th grade when I started attending the school he had attended for several years. We more or less ignored each other that year. Actually, I thought he was a bit of bore. Still do. Anyway, in 9^th grade we landed in the same typing class with a teacher who was just plain mean. She really didn’t seem to like people generally, let alone wiseacre-types, so Mike and I didn’t stand a chance. We had to present a united front to confront the battleaxe, and here we are more than 25 years later investing in real estate together.

Anytime friends go into a venture together, they put their friendship at some risk. If the venture does poorly or there is a fight over money, the friendship may go down with the business venture. Just think Sonny & Cher, Simon & Garfunkel, Bill & Hillary. So here are some things to consider before going into business with a friend.

Would you make a good business partner with anybody? Some people just have to call all the shots. They want to be in charge, and they don’t have the patience or temperance to give a business partner 50% control. Hey, wait a minute. I’ve just described both Mike and me. Nevertheless, some folks are just not cut out for a 50/50 business model. If that’s you, spare your friend and your business or investment.

Would your friend make a good business partner? I have a lot of close friends that I’d never go into business with. I’d play golf with them on the weekends, watch their children, and let them watch my children. But I wouldn’t go into business with them. The reasons vary from person to person, but include (1) their lack of business savvy (I made an exception with Mike), (2) their lack of knowledge about the businesses or investments that interest you (Mike made an exception with me), and (3) their approach to business ethics (I have some friends who cross the line from time to time). The point is that good friends don’t always make good business partners. You need to know the difference.

Is the nature of the business or investment you and your friend are contemplating right for the two of you? You may have a good friend who also would make a good business partner, but the wrong business or investment. This was the biggest hurdle for Mike and me (in my opinion). We invest in real estate located where Mike and I grew up. The problem is that I now live about 7 hours away by car. So Mike is left dealing with the tenant phone calls and working with the contractors (Nice, I know!). We spent some time talking about this point and resolved that our time investment would simply not be equal. Mike is ok with that, although he does bellyache about it from time to time. I try to pull my weight in other ways, but the fact is Mike puts in more time than I do. A partnership is never equal, and you should come to terms with that (if you can) before you undertake an investment with a friend.

Are you both in agreement as to the direction of your business? You need to be clear about the direction of the business or investment from the start. If the two of you are working at different speeds or in different directions, trouble is on the way. Mike and I have not always been on the same page (although fortunately we have always been in the same chapter). Mike wants to buy real estate at a faster pace than I do. At the start of our endeavor, I was far more cautious than he and wanted to proceed at a much slower pace. Actually, I was scared to death of buying rental properties. Mike wanted to buy real estate like we were shopping at the dollar store. This required both of us to give a little (he slowed down; I sped up).

Is the business or investment financially realistic for both of you? Real estate investing, like most all business ventures, requires capital. If most or all of that capital is coming from just one of you, the potential for trouble increases substantially. Mike and I agreed from the start that the capital investment and profits (Mike, where are my profits?!) would be split 50/50. Many times, any other arrangement would add stress to the arrangement and make a bitter end to the deal and the friendship more likely.

Anytime you go into business with a friend, there is a risk that the business and the friendship could end badly. In some cases, however, it’s worth the risk. Having known Mike for more than 25 years, I trust his judgment, know how he thinks, and have confidence that he knows what he’s doing when it comes to real estate. Besides, his mom makes the world’s best chocolate chip cookies, which I made part of the deal. What could possibly go wrong?

When Rob and I set out to invest in real estate, we had a longer term strategy in mind. Our plan was to buy, rehab and rent properties, with the goal of generating a significant stream of income. In this article, I want to write about what we’ve accomplished during the last two years. As always, I’ll attempt to highlight mistakes Rob has made along the way.

Two years ago, Rob was new to real estate investing. In a way, so was I. Although I had bought and sold properties for several years, my purchases were sporadic and nearly always for purposes of re-sale. So for me, it was almost as much as a learning process. It still is. We now have a couple of years of experience with purchasing, renting, managing, and even an approach to selling. Our plan was not to buy 50 homes at once or to quit our jobs and become full-time real estate investors. We both have our day jobs–for now. But in the first two years, we think we’ve learned a lot by doing and have made significant progress. But that too is a process.

We’re up to four rental properties with a total value of about $600,000, and we’re looking around the corner at the next buy. Here’s a look at the first four.

In for a Penny. . .

In September 2005, Rob and I made our first two offers. We had discussed buying property for a couple of months. So, we set aside a weekend to look at potential real estate investments. Our main purpose was to learn. We wanted to find out as much as we could about current sale prices, neighborhoods, the condition of homes in the neighborhood, schools, and rents. We primarily focused on foreclosed homes–bank owned and HUD owned. We also looked at privately owned, listed properties, often vacant homes or homes that looked like they needed some work. We checked out a couple of multi-families owned by other investors.

We settled on single-family homes for a few reasons. I would like to say that this was the result of a sophisticated analysis of returns, but it likely had more to do with accessibility of the type of real estate investment. Rob and I were both homeowners. We could look at a single-family home and say “yeah, I could live here.” Also, although we planned to rent the properties, I was still largely evaluating the homes based on estimated profit in reselling. For us, this choice was the right one, at least for now. Single-family homes are easier to self-manage part-time. And they are easier to sell than multi-family properties.

From 30 or so homes, we identified several potential investments, but three of these homes were HUD properties that were open for bid the following Monday. All three seemed to be potentially good values. We decided to make a bid for two of the properties. As I told Rob, “we’ll be lucky to get one.”

The next day, we found out that we had bought two homes. I was excited. Rob was, well, a bit queasy. (Rob’s Mistake Number 1: Trusting my unsupported speculations concerning future events).

The Ranch and No Basement

Property Number 1 was a smallish two bedroom, two bath ranch built in 1998. We’ll call this one the “Ranch.” Property Number 2 was a three bedroom, one and a half bath two story built in 1991. We’ll call this one “No Basement.” (To eliminate the suspense, it’s because this one had no basement).

The Ranch didn’t need much. It really was in decent shape. The usual cosmetics were required–paint, some carpet, appliances, and a thorough cleaning. Also, somewhere along the way, a third bedroom was converted into a separate dining room by opening an entry directly to the kitchen. A little framing and drywall and voila, we had a three bedroom.

No Basement was older, and was in pretty rough shape. We completely remodeled the kitchen–new cabinets, sink, countertops, appliances, the works–and replaced the half bath. Wallpaper and remnants of wallpaper were everywhere. While the larger remodel projects present more challenges, I always like the part about improving the property, both for value and the neighborhood. Here are some pictures of the end result:

The Problem Child

It really was inevitable. We were bound to buy a house with the unexpected problems. So Property Number 3 presented itself. We’ll call this one the “Problem Child.”
Rob and I closed on the Ranch as soon as we could line up financing, but we pushed No Basement out as far as the contract would allow. Of course, the idea was to get a renter lined up before having to start in on the No Basement rehab, and we did. We closed on No Basement and were hip deep in the rehab process.

Then this nifty four bedroom home caught my eye. I called Rob and started with the phrase that would begin several other conversations thereafter: “There’s this house….”
And there it is. I admit it. I like buying. It’s kind of like being the successful bidder on E-bay. (Bringing us to Rob’s Mistake Number 2: Getting caught up in my buying frenzy).

Problem Child was a nice home–four bedrooms, two and half baths, and built in 2000. It was considerably larger than the Ranch and No Basement, had some issues and took a bit longer to complete. No majors though, or so we thought. The next year, we would find ourselves replacing the six year old air conditioner and, not long after, the seven year old roof. Problem Child is certainly our reminder to allow for the unexpected.

The Loft

After the rush to pick up three houses and going through the rehab and rental process into March 2006, we took a break. Limited cash was certainly a factor. So were those pesky day jobs. But we certainly intended to buy another. So, this last spring, we bought the “Loft.”

The Loft was a three bedroom, two and a half bath built in 2002. Again, not a major rehab, given the age of the house. The property had two particular advantages. It had a loft that could be finished into a nice fourth bedroom, and it had a semi-finished full basement that we could refinish to add to a bunch of extra living space. We expect, at least for now, that the Loft will be our best investment to date.

Of course, there’s always the possibility of having to rename it as “Problem Child 2”. We’ll see.

I’ll be circling back with some additional articles to talk about the numbers (purchase price, costs, rents, and returns), our experience in the rental process, how we marketed the properties, and where we expect to go from here. We will certainly be looking to buy more properties, but we have no immediate purchase plans. Then again, “there’s this house….”

So what was my return on my investment? Well let’s see, dividing my profit of $6,900 by my investment of zero. . .calculating. . .calculating–ah, infinity. Wait, I forgot that was in 60 days, so I have to annualize–infinity times 6 equals, well, infinity. (You can check my math). And if I compound that over years, assuming an equal or greater than infinite return, I should have an infinite amount on which to retire, and if my calculations are correct, I think I can retire the day before yesterday. I can really go on like this virtually infinitely, but more to the point.

When I set out to buy my first flip, I looked at about 30 houses. I found this one and made an offer. The bank countered. I re-countered. And I was in contract about 30 days after starting my search. I then arranged for financing. I went to the bank and obtained a short-term loan secured by the property. Within the 30 days after I purchased the house, I hired a painter, a roofing contractor, and a carpenter/generalist. I picked out new kitchen cabinets, carpet, paint, and other sundry finish materials. I went to the property several times a week to check the progress, during which I fired the painter and hired a new painter.

So did I make an infinite return on the property? I would say no. To a large degree, the profits I made were income from my work. In other words, I gave myself a second job. Perhaps more importantly, I sold an asset that could have produced income from that work forever–or infinitely. When Rob and I set out to purchase property two years ago, our goal was to develop income, income that would eventually allow us to achieve financial independence. Indeed, part of the equity in each property represents our work. But that portion, along with the investment of money, is invested for the longer term. Consider this–if I had held and rented that modest little property that I bought back in 1995, it would be only three more years to fully pay off the mortgage. At that time, given that there would be no further mortgage payment, rents would generate a net income of about $650 per month. Now consider if I had bought 10 homes.

If you’re new to real estate investing and you just want to get out there and start making offers, the absolute very last thing you want to hear is to be patient. So, let’s just skip right to the end—be patient. OK, we understand that this is a tough one. Frankly, we don’t like it either. Look, we want to be rich. We intend to be rich. We want you to be rich. But, while we are open to suggestions on this front, the only method of becoming instantly wealthy that we are aware of is attributed to Richard Branson, the owner of Virgin Atlantic Airways, who offered this sure fire way to become an overnight millionaire: “Start as a billionaire and then buy an airline.”

Absent sufficient capital for an investment in the friendly skies, some time will be involved, both in preparing for your first investment in real estate and in reaping the financial rewards from your investments. But perhaps we can modify the approach somewhat.

Maybe the problem with being patient is that it implies inactively waiting for something to happen. So, instead of being patient, may we suggest that you exercise tempered impatience. Actively learn, actively plan, and actively execute your plan. Do so with all speed and impatience. Just don’t skip over the first two parts. Learn impatiently; plan quickly. Here’s a Quick Start Guide to help get you moving in the right direction.

Set some goals—maybe, even “the” goal

We can write multiple articles about why we think it’s necessary to set goals and how we’ve set them (and, in fact, we will). For now, we’re going to assume that you are reading this because you want to consider real estate investing as a method to achieve something else. Either that, or you’re one of those Real Estate voyeur types (“Property Peekers” in the common vernacular). TwoWiseAcres will be directed mostly to the former group. For the latter, may we suggest RealEstateHotties.Com or UnderTheClapboard.Net.

So, consider the “something else.” We suggest starting from “the” goal, sort of a financial end-game, and working backwards. For many (all?) people, this should involve defining for themselves their own concept of financial independence. Thinking in terms of the end result will allow you to determine how real estate investing will help you achieve this result. This will allow you to develop specific goals that will lead you to better decisions in buying, managing, and selling.

Determine the type of real estate investment

We’re going to answer this one—single-family homes. There you go. Check this one off your list. “Wait, wait, wait,” you say. “Doubles are a much better investment.” Or perhaps, “Commercial real estate. Now, that’s where the real money is.” Indeed, doubles, commercial real estate, apartment buildings, etc. can all be great investments. But we suggest at least starting with single-family homes. For the average new investor, single-family homes will enable you to use your existing knowledge, be easier to finance, and be easier to manage.

Start to evaluate properties

Let’s start with the assumption (and we think the right assumption) that you’re going to buy a property and hold it, at least for a period of time. In other words, you’re going to lease the property. Here we suggest, as a starting point, understanding cashflow. Cashflow simply means cash received less cash spent for the same period. Cash received is your rent payment. Cash spent includes your mortgage payment, taxes, insurance, and maintenance costs.

A quick example: You’ve determined that you can buy a house in a nice neighborhood and fix it up to rent-ready condition for $120,000. You determine that similar properties rent for $1,300 per month. Let’s assume, for the moment anyways, that you borrow all $120,000 on a 30-year loan. Your mortgage payment will be about $798. (There are about a trillion of these free mortgage calculators on the internet. Oh, look. Here’s one now: Mortgage Calculator). You determine taxes and insurance will be $245 per month and you estimate maintenance costs at $100 per month. Your monthly cashflow will be $157 ($1300 – 798 – 245 – 100).

Learn the Area/Where you will (might) buy

Again, you’re not starting from ground zero here. You already know the area where you live. You know something about school districts, “good” areas versus “bad” areas, where people work, etc. From that knowledge, narrow the search.

When we started looking for properties, we chose several areas based on what we already knew. We chose areas with good schools and nice neighborhoods, in many cases with single-family homes that had been built in the past ten years. We did some preliminary research on home prices and rents in the neighborhoods. Then we drove the neighborhoods. When we started out, we set aside two days to do nothing but look. The time spent was invaluable in gaining a picture of the neighborhoods where we would start making offers.

Look for Values in the Area

Our real estate investments have all been single-family homes, generally less than ten years old, in the “starter home” category. By “starter home”, we mean subdivision homes in nice middle-class neighborhoods. We buy this type of home because they have the broadest rental and sales market among single-family homes, and we have been able to find good buys.

So, when we started out, after determining several areas that met these criteria, we did further research on what houses in those areas were selling for and identified some for sale properties on the lower end of the price range for the area. Frequently, these were vacant and foreclosed homes. In considering whether we would buy a particular property, we considered whether we could resell the property for a profit and whether the property would have positive cashflow. While we have spent countless hours improving our analysis, consider for now a simple starting principal: “First, do no harm”. Sort of the Hippocratic Oath of real estate investing. (Rob’s editorial: While arguably attributable to Hippocrates, this quote did not actually come from the Hippocratic Oath)(Mike’s editorial: Rob’s a dork). A well-analyzed property that can be resold for a profit and be rented at a positive cashflow meets these criteria.

Setting a Budget for Improvements

If you can buy a house for $20,000, is that a good deal? Indeed, we have seen properties that we wouldn’t take if they were giving them away. Obviously, the condition of the house and, more specifically, determining the costs of putting the house in rentable or sellable condition is critical. If you are starting from little or no knowledge on this front, consider limiting your search to homes that need less work to increase value. Then learn about the costs of these improvements.

Every property that we have bought at minimum needed cosmetic improvements. These improvements almost always include new carpet, painting, and cleaning. From the square footage of a potential property investment and some general information about its condition, you should be able to start talking with potential contractors/laborers about price. Consider purchasing materials yourself. Even for cosmetic improvements, this may help save money and the process of shopping for materials will provide valuable information to help determine a budget for improvements. Talk to friends for contractor referrals and real estate investing mentors to help set a budget. Then budget for contingencies.

This part is certainly a learning process, but with some time, you will be able to estimate repair and improvement costs

Determine where the money’s coming from

Well let’s see. You’ve determined that you can buy a house in a nice neighborhood and fix it up to rent-ready condition for $120,000. You’ve also determined that other similar houses in the same neighborhood sell for $150,000. Great. Now, all you need to do is determine where you will get the money—checking or savings. OK, we understand that there is just the slightest possibility that you may not be able to cover the full nut by writing a check, so you’ll probably want to learn a little about financing.

Real estate investors use a variety of methods to finance purchases–private investor funds and partnerships, seller financing, and options, to name a few. We suggest that, if possible, you begin with the somewhat more conventional approach and learn about financing that will be available from traditional lenders–i.e. banks. The “if possible” part means that you have good (or at least reasonably good) credit and sufficient income to justify the loan. The less traditional approach, often called “creative financing”, may offer opportunities to expand your real estate investments in the future (or to start quicker when the “if possible” simply is not), but is probably best after gaining additional experience.

So, here are some quick thoughts on more traditional financing to help you get started. Instead of, or at least in addition to, contacting larger retail banks (i.e. all the national banks that you’re familiar with and where you probably have your checking account), speak with a few smaller local lenders. They are more likely to handle real estate loans for smaller investors as “portfolio loans” with less rigid down payment requirements. Largely, this is because they are frequently willing to loan based on a percentage of the (higher) improved value of the property rather than the purchase price. In other words, they may require 20% equity in the home, but part (maybe all) of the equity will be derived from the improvements that you do rather than cash out of your pocket.
Finally, learn what rates and terms are available for real estate investment loans. Then shop around. We’ve found that terms vary widely among portfolio lenders and, after all, learning these terms will provide the largest component of costs in determining cashflow for a potential investment.

Now that you’ve patiently read through the (Impatient) Beginning Investor’s Guide, we hope we’ve provided some useful direction to get you started. We’ll continue to post to each of these topics, and we’ll wait for your comments–impatiently.

Have you wanted to invest in real estate, only to find fear of the unknown getting in your way? For every person who has ever bought a rental property, I bet 50 people have wanted to, but have been to afraid too act. The fact is, if it weren’t for partnering with Mike, I never would have over come my fear and uncertainty of REI. So what are some of the common fears and how can you address them? Read on–

My Fears Then

REI can be very profitable for those willing to take the plunge. It’s that first dip into the pool, though, that can be the hardest. Here are some things that I was afraid of when I first began investing in real estate:

• Paying too much for the property
• Buying a property with hidden defects
• Underestimating the costs of rehab
• The rehab process
• Not finding a good tenant and the right rent
• Dealing with problem tenants and possible eviction
• Taking out a large mortgage on the property
• Liability if somebody got hurt on the property

That’s a lot of fear, and you may have others that I’ve missed. But that’s what I was afraid of when Mike and I bought our first rental property. Fortunately, there are some ways to address these fears.

What I did

• Embrace your fears: Not all fear is bad. All investments have risk, and some of the fear is there to tell you to make sure you’ve thoroughly evaluated the investment you’re about to make. So don’t just sweep your fear under the rug. Recognize, identify and address it. Instead of being fearful of “paying too much”, I started to ask what I should pay for a property and how to deal with the possibility of being wrong. Instead of imagining “hidden defects”, I started learning about what can go wrong with a property and how much it costs to fix potential problems. By recognizing and identifying ambiguous fears, I started to think of solutions to potential problems.

• Do your homework: Real estate is an active investment, which is part of the fun. Research the value of comparable homes to make sure you’re getting a good deal. Interview contractors and get multiple bids to ensure the best quality rehab at a reasonable cost. Understand the eviction process in your city or town in case you need to use it. The point is, knowledge reduces fear. Doing your homework and being prepared is a great way to address those nagging uncertainties. Does doing your homework take some effort? You bet. But the potential profits can be well worth it.

• Find a “Mike”: Finding a knowledgeable investor or mentor is invaluable. Before Mike and I bought our first property, he had already bought and sold several properties (sometimes called “flipping” in the current parlance). Mike knew the tips and tricks to buying, rehabing, and selling. Even Mike had a “Mike”—his father, who has invested in real estate for decades. You can look for an investor that’s willing to show you the ropes. Local realtors and real estate investing groups are great places to meet those that can help you with your first property.

• Recognize that you’ll make mistakes: Nobody’s perfect. Mike and I have made mistakes (mostly Mike), but fortunately, none of them has been major. But real estate investing is a learning process. What you learn from your first property you’ll use with your second property, and so on.

• Take it slow: Rome wasn’t built in a day, and neither was a real estate empire. While we’re all anxious to grow our investments, a slow start will allow you to spend more time on each property and reduce the risk of a major, costly mistake.

My Fears Now

That’s the thing about fears. You can reject some, change others, and deal with them, but they’re always going to keep coming to some extent (kind of like Mike’s edits to my TWA posts). So with some experience under my belt, what are my fears today? Here are some:

• Missing a good buying opportunity
• Failing to maximize a property’s rental value
• Over-improving a property
• Rising interest rates

The list is a lot shorter and the fears are more about missed opportunities than they are about fear of the unknown. I guess they call that experience.