The right way and the wrong way to invest in real estate

As I often do, I turned on the radio and listened to a popular anti-debt radio show. Someone called in because they were in the midst of a financial calamity.

  • They had lost their job in the past month or two
  • They had relocated to a new area
  • They owned two rentals. One was vacant and the other hadn’t seen a payment from the tenant for five months
  • The caller had filed for Chapter 7 bankruptcy ON THEIR OWN
  • All 401K funds were depleted, and this person was flat broke
  • This person had no attorney to assist with the bankruptcy, but for some reason did have an attorney involved with the real estate

I was a bit shocked at all this. As radio host said, Chapter 7 bankruptcy is the “atom bomb”. It’s where you nuke all debts and simultaneously give up all assets, except possibly your primary residency. The caller had just moved and was trying to rent out their previous residency, but was failing. The host informed the caller that everything, including their leased car was going bye-bye.

The caller tried to argue, and the host told them they were crazy for trying to do a bankruptcy without an attorney. One of his first questions was, “Why didn’t you sell the rentals?” Answer: “There was a tenant. I couldn’t do any showings.” That is the most ridiculous thing I ever heard! Let’s see if we can walk through all this and see what mistakes were made.

Rentals don’t have to be empty to be bought or sold

Rental owners buy and sell all the time. There is no requirement to empty the unit out to sell it. Perhaps the tenant was being belligerent and making it difficult if not impossible to conduct showings. This would certainly make sense if they were five months behind on rent payments. The tenant knows good and well that a new landlord would probably have them evicted with no questions asked.

Don’t allow a tenant to stay in your unit and miss five months of payments

It may seem obvious, but the caller appears to be doing the land lording themselves, and they are doing a terrible job. When someone is five months behind, it’s time to evict them. The chances of getting caught up and then being on time are near non-existent.

Maybe there is something else missing, like a tenant that knows the legal system and has managed to fight making payments as well as fight evictions. They’re out there, but they are few and far between. From everything I’ve read, tenants that get behind are usually taking advantage of the owners.

I highly doubt this person had decent cash reserves

One of the most critical aspects to owning rental property is having plenty of cash to handle vacancies, repairs, evictions, etc. Think 6-12 months of mortgage payments.

You must be ready to go through the rough patches where you aren’t collecting any rent. Without cash reserves, you will be forced to dig into other sources of liquidity like 401K or just about anything. And it will also drive you to panic and make rash judgments. Having adequate cash reserves can calm you down and allow you to weather Murphy storms.

For some things, you NEED the experts

I wouldn’t dream of entering bankrupcy without a highly competent attorney. This is an area you can really screw up. I don’t know the law and what all my options would be. I would prefer to avoid bankruptcy altogether, but if it happened, this is where avoiding legal bills can cost you a whole lot. This person instead of selling the rental unit, is essentially throwing away a valuable asset.

Another area where it pays to find top notch experts is property management. If they had a good manager, that tenant would probably be evicted and someone much better, more stable, and better qualified would be in the unit and paying rent. The rental asset would be growing in value, not becoming a nightmare.

Finally, finding someone to scout up a tenant for the other unit is a great place to invest cash reserves. I have used someone to ensure my final unit was rented, and if I get another vacancy, I wouldn’t hesitate to hire her again. This is outside my expertise and I very well don’t expect the property manager to serve my interests in that capacity.

The likely outcome

This caller is probably never going to THINK of buying real estate ever again. Debt is probably off the plate as well. That means the idea of finding quality property, renting it to well researched tenants, and having professionals manage it are non-existent.

The results? This person will probably do everything to clear out any remaining debt, and then focus on investing in index funds and other things. That means that they might build up some pile of cash to retire on, but they aren’t going to get that nice retirement. I doubt they will scrape together enough money to be enjoying big cruise trips, but instead, will probably have to get a supplementary job to make up for what they don’t have.

The thing is, they won’t know what they’re missing. Sure they’ll have some peace of mind about having no debt, but they won’t exactly be living the high life either. It’s a form of survivorship bias, where you don’t know what you’re missing, and hence happy with what you got. If they are able to scrimp together $500,000 in index funds by retirement, they’ll probably be pulling $20,000/year before taxes. Could you live on that now? What about in 15 years? They’ll never never know what it means to be pulling $10,000/month+, tax sheltered because they got spooked from sloppy DIY practices.

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