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She had let the fast profits in the market of the previous few years go to her head. She speculated in the worst sort of way.
She was betting on a quick flip and had no backup plan. For her to make the kind of money she was hoping to make, everything had to go perfectly. If anything went wrong, she had set herself up to fail big. And that’s just what she did ... to the tune of $100,000.
The Same Principles Apply If You’re Buying with Little or No Money Down
As it happened, in the preceding example, both buyers (I and the woman who bought the property from me) put 20 percent down. Yet the same principles apply even if you’re buying a property with 10 percent down, 3 percent down, or no money down.
If you are able to pull off one of these low/no-down-payment deals, just realize that the less you put down, the higher your interest payments will be, for two reasons:
1. You’re borrowing more money, so you’re paying principal and interest on more money.
2. Usually the more money you borrow (as a percentage of the purchase price), the higher your interest rate. This means the more you borrow as a percentage of the purchase price, the higher your gross rental yield should be.
Gross rental yield is simply the monthly rental value of the property multiplied by 12 and divided by the purchase price. It doesn’t take into account carrying costs or vacancies.
When I bought the property in this example, the gross rental yield was 9.9 percent.
How did I get that number?
The rental value when I bought the house was $1,500. Multiplied by 12, that works out to $18,000 a year. Divide $18,000 by the $182,000 purchase price, and you get a gross rental yield of 9.9 percent.
Step 5: Get Richer While You Sleep 205
After all expenses, I had a net rental yield of just 1.5 percent my first year. By year four, it had risen to 4.6 percent.
Now, how did I get that number?
I netted $80 a month, or $960 a year, in year one. So $960 divided by my total initial investment of $65,400 works out to 1.5 percent.
By year four, I netted $253 a month, or $3,041 for the year. Thus, $3,041 divided by the original investment of $65,400 works out to 4.6 percent. If you buy distressed or significantly undermarket properties, it’s possible to get even better yields than these. For instance, an associate recently bought two multiunit properties with an average gross yield between them of just over 11 percent. By locking in an interest rate of about 6 percent, he was able to buy both with 100 percent financing and still have positive net rents on the properties.
Those net rents are his margin of safety. And the fact that the rents are 5 percent below market is an additional margin of safety, because he can raise them when current leases come due—if he so chooses.
The moral, then, is to always take a hard look at what your carrying costs for a property are going to be. Then make sure your rental income will more than cover those costs.
And the bigger the margin, the better.
How to Use Rental Values to Know When the Price Is Right
Asking prices and actual sales prices can’t tell you whether the property you’re investing in has a built-in margin of safety. For that, you need rental values.
For any neighborhood that you’re thinking of buying into, you should thoroughly research the rental values as well as the sales prices. You can easily do this in a number of ways.
First, make it a habit to call on every property you see for rent and find out what they’re asking. Browse through your local newspaper. You can also call real estate agencies that specialize in rentals and ask what they have available.
Any time you get a rental quote—whether it’s on a house or an apartment—file that information. Investing just a few minutes a day in this kind of research can make you very knowledgeable about your local rental values in a matter of a week.
If there are not many rentals currently available in the neighborhood and you’re having a hard time gathering information, call your
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local office of HUD and ask to speak to the person in charge of the Section 8 program.
Section 8 is the rent-subsidy program I was complaining about at the beginning of this chapter. It’s usually bad for the neighborhood because it brings in junkies, prostitutes, and drug users (as well as some very nice single mothers with numerous children from deadbeat lovers), but it’s great for the landlords who get subsidized rent for their overpriced buildings. That’s because HUD pays for all or some of the rent of low-income people. The pay scale is based on the income the person makes and the size, type, and location of the property.
HUD has FMR guidelines for different areas. For instance, the HUD FMR for a 2/1 apartment in Smithtown might be $700. I haven’t invested in HUD programs myself, but my colleague Justin Ford, with whom I collaborated in producing a home-study course on real estate (Main Street Millionaire—www.earlytorise.com/mainstreet.cfm) has. He says that HUD’s guidelines are often close to the market price for non—Section 8 renters as well. Sometimes, however, you may come to the conclusion that the market will bear more than the FMR number. However, the FMR can serve as a good base number.