Mindset

I found a twenty dollar bill on the ground this week in Golden Gate Park.

Guess what I did?

I PICKED IT UP!

I didn’t assume it was too good to be true – that it wasn’t real otherwise one of the homeless people would have picked it up already.

I didn’t assume it had feces on it rendering it way less appealing than a normal $20 bill.

And I certainly didn’t fixate on the downside of bending over to pick it up, hurting my back to the tune of a $5k hospital bill and an irreparable life-long injury.

Yet these are the kinds of excuses you hear from people about investing in rental properties.

Extremely smart people state that the risk is priced in to rental property returns and explore no further.

What’s at Stake

This isn’t a matter of finding $20. This is your financial well being, whatever that means to you – retiring early, paying for your kids college, exotic vacations, you name it.

We will thoroughly dig into numbers in Part 2, but I believe you can expect over a 25% yearly return on low cost rental properties.

Humans don’t have great intuition when it comes to exponentials. You’ve probably heard the “how thick is a piece of paper folded in half 100 times?”

Investment returns are exponential as well. So instead of intuition, let’s visualize what is at stake.

Let’s compare investing $100k in the stock market with a generous 10% yearly return vs 25%, over 20 years.

That’s a huge difference! $673k vs $8.7M.

If there is one time to not be intellectually lazy, this is it. So let’s take a closer look.

Is the Risk Priced In Rental Property Returns?

When someone says the risk is priced in, they are stating that the reason the returns are greater is because it is balanced out by the risk of losing money.

Imagine a roulette wheel with 36 numbers and no zero. Betting on red, black, even, or odd pays 2 to 1. Betting on a single number pays 36 to 1.

Of course betting a single number has much greater returns, let’s bet there!

Not so fast bucko – it comes with more risk. You will lose so often that it balances out – your expected rate of return is exactly the same as betting red.

Back to rental properties. If you state the risk is priced in without calculating anything, you are stating a belief in the efficient-market hypothesis.

What is the Efficient-Market Hypothesis?

Without getting too technical, it states that all information is priced in relative to risk in an efficient market.

The $20 bill intro ran through some comedic extrapolations of the efficient-market hypothesis.

In other words if I see something that is too good to be true (free $20) in an efficient market (out there in public), there is either information I’m missing that others know (feces) or risk I’m not accounting for correctly (hurt back).

You could state that I had an information advantage – I saw the $20 bill. The whole market didn’t have access to that information, just me.

In other words, believers in the efficient-market hypothesis think it is possible to generate higher returns accounting for risk, but you need some sort of advantage.

I challenge you to not be mentally lazy and just assume the risk is perfectly priced in to rental property returns. Here are some of the advantages that let you generate greater returns.

Advantage 1 – Your Effort

It is a pain in the butt purchasing real estate.

You don’t just go on E*TRADE and a few clicks later have your $20k invested.

No no no – it takes at least a month involving piles of paperwork and lawyers. However, if the Real estate loan is sanctioned at the earliest or the respective party has the required funds with them, the process could be relatively simpler. Also, the good news is it has been done many times and is fairly mechanical after you have done it once.

But the really good news is that this keeps people out. Their laziness is your gain.

Advantage 2 – Government Encouragement

A tax code and other policies are basically a set of incentives designed to encourage certain actions from the populace.

The US government encourages individuals to own rental properties by handing out free money. It’s up to you to take advantage of it.

There is obvious tax stuff like deductions on real expenses like interest payments and fake expenses like depreciation.

Even better – a whole government agency is set up to provide cheap leverage to investors. Leverage is how you can achieve such incredible returns. (And it can be safe. Not trying to time a market like Miami, rather going for slow and steady boring cities with jobs like Memphis. See: The Thing Most Investors Don’t Understand About Leverage)

Usually only banks and big corporations have access to investment leverage like this. This is the one area an Average Joe can do it. Wahoo!

It is way affordable too. The interest rate on a credit card is around 20%. If you get a personal loan or a small business loan, I doubt you can find under 10%. And you’d have a max of 5 years to pay that back.

On a rental property it is only 5% and you have 30 years to pay it back. Isn’t that absurd in comparison?

Advantage 3 – It Isn’t an Efficient Market

The US real estate market is pretty decent at sharing information. There are things like the MLS and clear ownership through deeds.

But it isn’t perfect.

The main disruption to the efficiency is foreclosures. If someone can’t pay their bills, they get kicked out of the home and suddenly the bank owns the property. The bank doesn’t want to own a rental property (see #5 for why), so they get rid of it as fast as possible at a discount.

Other disruptions are properties that require a lot of work, which limits the willing buyers and drops the price even more than the repairs will cost. Or people who for whatever reason don’t want to go through the long 60+ day regular process of selling a home and want to unload it for cash now. This is easy to do if you use companies like Elite Home Solutions who can Sell Your House Fast in Raleigh, NC, although there are many places that offer this service in other areas across the country. Other methods are to flip homes to speed up this selling process.

There are people more than willing to take advantage of this. They put in the work to discover the deals, do the repairs, and flip it to someone like me.

Thanks to the inefficiencies in the market, everyone is happy!

Advantage 4 – Patience is Rewarded

The time frame of most investments is incredibly short.

The stock market is all about quarterly earnings. The long-term investment firms of VC and private equity are max 7 years.

In order to get the best value for your investment, it is definitely recommended that you get in touch with a professional like Lincoln Frost who has the utmost experience when it comes to private equity.

Why is it important? Well, you are building wealth to retire decades from now.

Is that an advantage? Perhaps, especially if it keeps others away.

The expected return after 1 year of a rental property is likely negative, considering the closing costs and tenant placement expenses. It just isn’t a good option to exit the investment after 1 year.

After 5 years? Maybe. But that might be more of a crap shoot on market timing and the transaction costs are still a significant chunk of the profits.

You really have to be in it for the long-haul and willing to ride out the whole cycle.

I bet you can – aren’t you investing in a 401k or IRA that you can’t touch until you are 59.5?

Advantage 5 – It’s Small Bananas

If you remember only one advantage, this is the one.

Sophisticated investors take advantage of market inefficiencies and use them to their advantage.

The return vs effort on single family home investments is great for your personal portfolio, but insignificant for a large fund with millions of dollars.

It takes too much effort that makes it impossible to invest their entire fund in rental properties. And even if they can get a 30% return on just 1% of their portfolio, that still isn’t worth their effort.

A big shot portfolio manager won’t spend his time picking up pennies, even if it is free money.

It just doesn’t scale.

Perhaps it was a little disingenuous of me to show a chart earlier climbing 25% per year all the way to $8M. When you have over say $500k invested, the simple single family home strategy will have to change. The potential returns are lowered when leverage is reduced.

What a great problem to look forward to!

Don’t Take My Word For It, Calculate

I hope this article makes you reconsider your assumption that the risk is priced in rental properties’ amazing returns.

We looked at 5 potential advantages that you have, even if it is an efficient market.

But we didn’t put numbers to it. How much of the return is simply the priced risk? How much of it is market inefficiencies?

In Part 2 I am going to run some numbers to try to answer that question.

Yet it won’t matter one smidgen if you don’t first believe:

1. The stakes are important enough for you to spend brainpower on this
2. There are theoretically advantages you have even without any real estate experience

So let’s discuss – leave a comment below and let me know what you think.

Information is dangerous.

Unless you know what to do with it that is.

Just look at Anakin Skywalker. He learned the power of The Force and was a straight A student. But he took that information and drew the wrong conclusion from it. Make a few bad decisions and before you know it, you are Darth Vader.

I guess Star Wars is on my mind…

I’m reading Evicted: Poverty and Profit in the American City which tells the stories of the poorest tenants in Milwaukee. But is also interestingly tells the story of the landlords – who are these people and how does it work being a landlord of the poor?

Let’s make sure we use this information for good.

You Don’t Have to Landlord!

This is the number one thing I want to shout out to people.

Investing in rental properties does not mean you have to be a landlord – separate those in your mind!

So so sooooo many people delay or decide not to invest in rental properties because they don’t want to deal with tenants. YOU DON’T HAVE TO – YOU CAN PAY SOMEONE ELSE TO DO IT FOR YOU! For instance, Abode Manchester letting agents can take up all the tasks required to deal with tenants. From making the tenancy legal to carrying out regular rent reviews, they can help landlords to minimize voids that can cost you money.

If more people understood that, they would take action and benefit from the incredible returns in rental property investing. Presently, there has been a rise in the demand for rental properties. For instance, many people are known to search for houses for rent northern beaches on the Internet to find properties that can be leased. That is why this could be a good time for landlords to benefit from the investments in rental properties.

Moreover, when you learn more about being a landlord, don’t put yourself in the landlord’s shoes and think “I don’t want to do that”.

Use it as information about the role of professional landlords. Appreciate how difficult it is dealing with tenants and how there are big differences between good and bad landlords.

Many Different Price Points Are Possible

The book Evicted is about C class properties. The worst of the worst.

These would be the ones you purchase for $40k move-in-ready and rent for $550 a month. Great ratios, more issues.

The book goes to show that you can make money that way.

Cartman has the correct response to this info: “wha-eva – I’ll do what I want!”

That’s not the only way to get a return. The properties I discuss are quite different: B- minimum, $80k+ that rent for $850+ a month.

The number one way to reduce tenant issues? Buy properties that attract better tenants. The typical tenant in the C class property makes $20-30k a year and relies a lot on government programs. They jump from odd job to odd job and putting food on the table each week is far from a given. (The book even goes into more C- “slum-lording” territory where the only income of $10-15k a year comes from the government.)

The typical tenant in the B- class property makes $40k a year and has a much more steady job. Not incredible career opportunities nor a ton of job security, but certainly employable.

Which one do you want to rent to?

Some Lessons from the Book

Give an inch and they’ll take a mile.

If every day is a struggle, you are willing to cut some people down to feed your kids. That’s the cold hard truth. Rent is by far their biggest expense so often their landlord becomes yet another victim in the struggle.

If a landlord allows a partial payment once, it will happen regularly. If the tenant is planning on moving out, good luck collecting any more rent. They know the only option the landlord has is evicting them, which they are going to move anyways and takes time. Free rent for a while But by far my largest learning from the book is how ineffective communication is between the landlord and tenant. Wow it is bad. Zero hope of phone or any type of digital communication. The landlord has to go in person often to collect rent, pounding on the door until they finally open. No proactive communication about an issue. An incredible number of the issues are minor and could be solved pretty painlessly. But it sure doesn’t happen.

Maybe the tenant is waiting for a broken window to be fixed and doesn’t pay the rent waiting for it to be fixed first. Issues like this can make renting a house difficult. If the tenants find themselves desperate for a window, they might be able to take matters into their own hands by contacting a replacement windows austin company, or one more local to the rented property. However, tenants need to be careful as this could lead to eviction. Ensure the contract is checked before beginning any work on the property. Then the landlord will contact broken window replacement specialists to help deal with the property issue.

Maybe they pay for something or do some work on the property and decide to deduct it from the rent. The landlord doesn’t see it that way and thinks they are paying short.

Communicate, communicate, communicate.

Interesting Read, but Draw the Right Conclusions

You can learn from the landlords of the poor, but make sure you learn the right things.

Don’t turn into Darth Vader…