Building net worth using rules of thumb

We've been discussing net worth from many different angles lately. I wanted to visit the subject of real estate, and how several of the popular "rules of thumb" would work towards growing our net worth.

You just found a half of a duplex for sale. It's new, meaning there aren't many big items of deferred maintenance sneaking up on you. It is listed for $100,000 in a great section of town. After sizing things up, you pull out Thumb Rule #1: Rent it for 1% of the purchase price per month. That would mean we can fetch $1000 a month. Local research shows that similar units from the same builder are fetching that much rent, so you should be able to find a tenant. So, is $1000/month going to work?

After I dig up one of those handy online mortgage calculators, I punch in $100,000 value. Let's assume I already have hit the four mortgage limit, meaning I will have to put down 25%. This means I will get a mortgage of $75,000. After getting off the phone with my favorite mortgage broker, he says he can probably lock us in with a 30-year fixed, 4.5% loan. This mortgage calculator happens to have a place to enter property taxes and PMI, but not insurance. I zero out the PMI, but decide to bump up the property taxes to 1.5% to represent taxes and insurance. It spits out a required monthly payment of $505 and change.

Time to check Thumb Rule #2: Does the rent equal or exceed PITI? PITI is what real estate investors use to refer to Principal + Interest + Taxes + Insurance, i.e. the total amount needed to keep the bank happy. In this case, the answer is a clear yes. In fact, our rent is almost double the mortgage payment. In highly complex investor-speak, this is cash flow positive.

But that's not everything. Let's assume we have a day time job that supports us, allowing us to invest any extra rent into the property. In order to do that, we need to hire a property manager. Hot tip: good property management ain't free. Duh! But once found, they're worth every nickel. You want to answer the call at 2:00am about fixing a stopped toilet? I sure don't. Let's assume we can find a property manager with good credentials that charges 10% of the gross rent each month, and gives us the rest + a nice emailed report once a month. After shaving $100 of the top, we get a nice automated deposit of $900 sent to our checkbook each month. Yum!

Still looking good, right? Dang, don't say that! That would be like writing an engraved invitation for Murphy to show up and take pot shots. Now that I think about it, why don't we factor Murphy into our plan? In fact, hoping you don't into trouble is a terrible strategy in building any wealth plan, especially investment real estate. Time to deploy Thumb Rule #3: Assume 50% of rent is eaten up fees, taxes, insurance, and repairs. Is there still enough to pay the bank's Principal + Interest? Considering we started with $1000, that would mean we only get to pocket $500. Uh oh! Our mortgage payment was $505?!?!

Not so fast! The mortgage payment stated above includes taxes and insurance, and we also had to pay $100 to the property manager. In other words, taxes, insurance and property management fees are all included in that $500 hit we took with Thumb Rule #3. If we go back to the mortgage calculator and zero out that property tax field, then we can get purely Principal + Interest. Crunching it yields $380, which is still less than the $500 we get to pocket from our renters.

This means we can still pay the mortgage and be cash flow positive with $120 to spare. But we're not through yet.

Ever heard of O'Toole's corollary? Murphy was an optimist. We have factored in a decent possibility of having extra expenses that are beyond our control into monthly rent. But this assumes we have rent. What if the unit is vacant? One thing positive: no fee for the property manager. We still have to send the bank monthly mortgage payments. So, let's invent Thumb Rule #4: Set aside 12 months of mortgage payments. That adds up to $6000. Round it up to $10,000, and you should feel pretty good sleeping at night.

What does this add up to? Let's fast forward five years. Mortgage calculator says that we should have gained about $7000 in equity. Remember how the 50% rule left us with $120/month of spare cash? Added up over five years, and we have another $7200, resulting in a total growth of over $14,000. Divide it by our original investment of $25,000 down, and we will see over 56% total growth of our net worth. Take the fifth root (five years), and we get an annualized growth of about 9.4%. Not bad for a highly conservative estimate that includes getting hit hard by Murphy.

If there is an ounce of appreciation, or if we invest that extra cash flow to pay off the mortgage, we will only do better. If rent increases at any point, I won't complain. The trick is finding the right piece of property and having the discipline to set aside the cash to insulate us from issues. We must also not tap the cash flow. By plowing it back into the rental property, our success will be much stronger. For example, if we have 100% occupancy for all five years along with no repairs, but still no appreciation or rent increases, our annualized growth rate could soar to over 17%. Show me the mutual fund that works that well after factoring in the risk of Murphy taking shots at you.

Thumb rules work until they don't

So far, we have examined a piece of property on paper using spreadsheet formulas. Spreadsheet-based investing can be risky and detrimental to your financial health. That is because too many people think that is where the analysis ends. Instead, this is where things begin. When a piece of property passes all these checks, it means it MIGHT be good enough, but requires more research.

Don't shoot for a property SOLELY BASED on these rules of thumb.

There are lots of small factors that can shoot deals out of the water. Remember me mentioning at the beginning that this was half of a duplex? One of the first questions this should spur is whether or not each unit has its own utilities. Tenants that share utilities like water historically consume more because it doesn't hit them directly. There is also a side effect that if a water main breaks, it doesn't get fixed as fast, because the cost doesn't get passed on to the tenant. Water is one of the most damaging things to housing. Delays in repairing broken water pipes can translate into longer term maintenance costs as well as less net rent in your pocket due to inability to increase rent to compensate. Hot tip: split or joint water meters don't often appear on the MLS or any website. It requires boots-on-the-ground research to track down.

Another factor is the agent you use to find rental property. If you're shopping in your local area, don't bet on the agent you used to find your primary residence. They may get you in for showings, but they probably won't have much insight into the investor side of real estate.

Simply put: if something appears too simple, then it probably is. Find a piece a property for sale that meets are the rules of thumb, but it's been listed for six months? Why didn't the other investors in your area already scoop it up??? Spreadsheets may be good for turning a long list of properties into a short list, but get on site, check out the area, and call up an expert in this area to double check things.

Real estate can build wealth

Emphasis on "can." You can also buy a chunk of swampland, and spend all your money trying to drain it while fighting off the alligators. But that shouldn't be your reason to skip real estate altogether. Read, read, and do more reading. Visit places like BiggerPockets.com and learn as much as you can. Never stop. Real estate provides some of the best means to building long term, cash flowing wealth available combined with great tax laws such as depreciation. If you want to talk more, drop me a line.