The Worst Way to Invest in Real Estate

Have you ever thought about investing in real estate? Would you try to flip your houses, or would you start creating a passive income by renting it out? Personally, I love the idea of investing in real estate and earning my passive income through rent money, but there is a good way to go about it and an absolutely terrible way.

How to Lose Your Shirt in Real Estate

During the housing boom, a popular method of real estate investing came about and showed up in books everywhere. This method focused on purchasing one house every single year for 10 years. Then, after the 10th year, you should be earning enough income to quit your day job and “retire”. At the time, since property values were on the rise, not only did you have a cash flow from rent money, but you also had a large value of equity in your 10 homes.

Of course, when the housing market plummeted, this method of acquiring passive income put quite a few people into bankruptcy. They couldn’t afford to make the payments on their properties, and the houses themselves were worth much less than what they owed the bank. So, their only option was to give it all back to the bank, start with nothing all over again, and ruin their credit for the next 10 years. This plan of acquiring 10 houses in 10 years certainly did not benefit these investors.

 Why Is This Method So Dangerous?

Think about the year you bought your first house. You picked out the perfect home and were ready to sign the dotted line. “Ready to sign your life away?” joked the real estate agent. Most people understand that a house is one of the single largest investments a person makes, and it takes a long time to pay back the loan – sometimes even more than 30 years! For some, that joke has some truth.

Now imagine doing that 10 times in 10 years! You could easily owe the bank $1,000,000 once you acquire all of your properties. At that point, life could be great IF: (1) you have all of your houses rented out, (2) each of your properties has a positive cash flow, and (3) no large incidents happen (such as roof repair or a new water heater or maybe even mold removal). I don’t know about you, but that’s a ton of “ifs”!

Over the course of one year, you can almost guarantee that some of your properties will remain vacant, some of them will not have a positive cash flow, and I can promise you that incidents WILL happen. There will always be some sort of repair on your properties – big and small, and you’ll have to be ready financially to take care of them.

A Better Method When Investing in Real Estate

Rather than take on a massive debt-load with your properties, why not take a more safe approach? If you are diligent in paying down the mortgages and creating a positive cash-flow with your investments, you could acquire those 10 houses in 20 years without any outstanding loans! Yes, it takes a little longer, but wouldn’t you rather be completely debt-free rather than owing the bank 1 million bucks?!

The method is simple – pay off your house first. This can be done with an extra mortgage payment each month (yes, this will probably require some additional income, but that’s a topic for another article) and you could do it in less than 4 years (which is what my plan is).

Once that’s taken care of, you take on your first investment property and use the funds from your old mortgage payment and the cash-flow from your investment property to pay off the new loan. With the extra income, this can be done in less than 3 years. Then you take on the next property and do the same. Repeat these steps and you’ll soon have your 10 properties without one iota of debt. With no debt, you’ll have plenty of passive income rolling in.

Which method would you prefer? Please tell me that you’d agree to move slowly and invest in properties the non-debt way.

This is a guest post by Derek from Creating A Passive Income, a website that is dedicated to hunt out every possible passive income source there is. Be sure to check it out.

18 Responses to The Worst Way to Invest in Real Estate

  1. I am definitely a fan of the slower approach. I would not want to take on more than I could manage. And like you mentioned, we have learned our lesson haven’t we.

    • We sure have! If I was really smart, I would have already had my money saved up so I could have bought my house with cash!

    • That sounds like a great idea! There are plenty of properties out there, you just have to flash some cash and be ready to pounce immediately.

  2. As long you buy properties with positive cash flow, including repairs with expecting a 10% vacancy rate and have an EF for the properties, there is no reason not to buy real estate with a mortgage. Even if you pay off your mortgage you will still have repairs, property tax and insurance to pay for so a paid off rental does not mean nothing can go wrong.

  3. Ginger. It all sounds good in theory until your vacancy rate goes up to 30% and you can no longer make your payments. You might have a ton of equity in your properties, but the bank still has the right to take it away. In my book, it’s always best to avoid debt.

    • Derek, if you have a sufficient EF and/or sufficient cash flow from other sources, you should be able to still make the payments even if you have a streak of vacancies. For example, when my property is rented most of the money goes towards retirement savings and when it is not rented I still can pay the bills, yet do not have the savings I like. However, if I tried the “conservative way”, I would be paying off debt and not putting anything away for retirement.

      • I understand Ginger, and as long as you have an excellent cash-flow, this is possible. But, there’s always the chance of losing renters and not being able to pay for some of those loans.

        Talking about your retirement, if you paid off all of the loans on 10 houses, you’d have over $1,000,000 in assets, plus you’d have a cashflow of at least $7,000 per month after insurance and taxes. I’d say that’s a pretty good retirement plan all by itself, wouldn’t you?

  4. I like the second approach. I derive a great deal of satisfaction knowing that my assets belong to me and not the bank. Plus, debt comes at a price. Since investors pay higher interest rates on mortgages, I actually like the idea of living in the properties you invest in so that you can qualify for owner occupied financing. Of course, people with school aged children wouldn’t want to live this way. But I can see it working for a single individual or childless couple who doesn’t own a load of crap they need to truck around every few years.

  5. I’ve seen both strategies described in detail and I think it depends a LOT upon your level of risk tolerance.

    It sounds like your hypothetical 10-house owner is living on 100% of their rental income and has no cash reserves. That’s living really close to the edge! This is just like living paycheck to paycheck with no emergency fund, where one misstep will lead to financial ruin.

    I think it’s really important to use the *right* amount of leverage, and not use too much.

    • I think even if there was an emergency fund, you could eventually get into trouble. After all, if additional income is not going it, but it’s all being sucked out, it will run dry.

  6. I got into the college real estate market recently, which I’ve humorously shared giant penises drawn on my sidewalks to broken windows. At least we’re cash flow positive… My plan is to basically earn the next house with the first house, even if it’s 4-5 years apart. I’m not over-leveraging or getting in more than I can afford early.

  7. I don’t think that you have to go to the extreme of having zero debt. i think the two proposals are on the different ends of the spectrum. certainly, you don’t want to fully leverage yourself but at the same time, you need to have some sort of contingency. Having a target of a certain % of equity and cash flow (of course taking into account possible vacancy rates), you should be able to accept a certain amount of risk to achieve the same or more.

    Along with your point of the shrinking market and taking undue risk, having been someone that has invested in real estate for the last 15 years (no, not full time nor a realtor), there is also the problem of people getting in when they don’t know the “other” costs – e.g. insurance, common fees (e.g. garbage), realtor fees, painters, cleaners, carpet cleaners, keeping/creating a capital reserve for improvements, etc. I’ve certainly bought a few properties from folks that have no idea what they are doing. While some call it an emergency fund, this is something entirely different – having the right financial planning.

    -R

  8. If you really want to blow the top off there is a much better way to invest than just buying 10 houses over 10 or 20 years. Why not work each house into a sandwich lease option. You lease your first house for 5 years then lease it to someone else for only 3. For example: A house worth: $150,000 You pay a lease of say $800/month to house owner #1 (this would be similar to owner financing) and you are basically paying owner #1 mortgage payment. Then you turn around and lease it to owner #2 for say $1000/month for only 3 years with option to purchase at $164,00 (based on what it will be worth in 3 years according to a 3% appreciation rate). Now at the end of 3 years you have made #200/month totaling $7200 over 3 years. Also, you now sell the house to owner #2 for the agreed upon price of $164,000. Now depending on how much the original mortgage has decreased (let’s just say it has been paid down right at $10,000 for those 3 years) you will make a gross profit of $24,000 from the sale in addition to the positive cash flow of the $7200 over the 3 year lease.

    What can be easing than that? And you have less worry about renting because owner #2 is working on purchase that home from you.

    Now if you are like me you can always have a little of owner #2 monthly lease payment go toward the final purchase price. You can still work it to have positive cash flow.

    Some may say well why charge owner #2 so much. You have to figure that at the end of 3 years owner #2 will be purchasing the house for $164,000 and based on what kind of interest rate they get could very well be such that their payment would be $1000/month at that time. So you are gearing them up to be paying that much already so it will not be a shock when they apply for the loan.

    Now the figures I have used are just estimates such as the appreciation rate. You will have to look at your own market to come up with that. But in the end it all works out the same. You make a positive cash flow and then a nice large profit when owner #2 purchases the property in 3 years.

    Why owner #1 at 5 years and owner #2 at only 3? Well just in case for some unknown reason owner #2 looses his/her job, has a traumatic illness, or any other detrimental reason that might cause them to back out before 3 years are up, you still have time to find another owner #2 to replace the first owner #2.

    I hope I have explained things without being too complicated.

    Renting can be great and a way to make a huge positive cash flow but there can be issues like you all have said about vacancy rates and the like. But in doing lease options so much of that risk is taken out of the equation. It is still there mind you, but much less.

    Investing always has risk, you just don’t have to be risky.

    Greg

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