I’ve gotten some good mentors lately in real estate. One of them is the CEO of the largest commercial real estate firm in Houston, and I’m also working with a whole group of investors at LifeStyles Unlimited, several of which own thousands of units and are multi-millionaires.
I’m not an experienced investor yet (working on my second deal now), but here are a few misconceptions I had about real estate that have been completely shattered for me lately.
Myth #1: Debt is bad. Pay off your mortgage so you can own your property!
Most of us have heard this since we were little. Don’t get into debt! This statement was true, but it didn’t tell the whole story.
You see, consumer debt is what can be bad. We have a nation full of people who can’t pay off their credit cards driving around in cars they can’t afford, and it’s terrible thing.
But in investing, debt is actually a good thing because it gives you an incredible power called leverage. Let’s say you put $10k down to buy a $100k house that earned $200/month in cash flow.
You’d get $200 * 12 = $2,400 per year on your $10k investment for a 24% return.
But if you put 20% down instead or slowly paid off the mortgage over the years until you had $20k in the property. You get the same cash flow of $200/month but $2,400 on $20k is only a 12% return. That’s half as good.
The more of your money that’s tied up in the property, the worse return you will get. Any time you can borrow money at a lower interest rate, and use it to get a higher rate of return, you should stay in debt. Debt is a great tool for building wealth.
Myth #2: Repairs, Maintenance, and Unforeseen Expenses Will Make Your Cash Flow Far Less Than You Think And The Deal Unprofitable
Sure you can’t plan for everything, but people make these out to be much scarier than they actually are. The common story goes something like this: You buy that same rent house that pays you $200 in cash flow each month, but six months later the air conditioner breaks and you’ve got a $3,000 expense. That wipes out your gains for 15 months!
Fortunately, there are some ways to get around that. Here’s how…
When you buy the property, rehab it and put in a brand new air conditioner. When rehabbing, you can finance the cost of the AC (so it’s not your money). If it comes with a 5 year warranty and you sell the property in a few years, then your risk is zero.
With a fully rehabbed property and all new stuff, why not have the renter sign a lease that states they pay for all maintenance? The idea being that everything in the house is new, so if something breaks in the next year, they must have broken it. Not every prospective tenant will want to sign this, but someone will. After all, it’s a nice place at the right price. Now you have no maintenance costs.
Finally, it’s important to note that cash flow is not the entire picture for making gains in real estate. Even if the cash flow is zero or negative, the deal might still work out great in terms of capital gains, which brings us to the third myth….
Myth #3: I Can’t Find Property That Cash Flows So It’s Not Worth Buying Anything Right Now
First of all, you probably can find deals that cash flow if you learn from the right people. (I’ve been finding a couple each day in Houston based on what I’ve been shown.) But lets say you can’t.
Let’s say that $200/month deal I mentioned earlier ends up netting you $0/month or even -$100/month.
Well if you are buying real estate for capital gains or “equity capture”, then getting poor cash flow or even negaive cash flow might be ok. Just to clarify, when I say capital gains here, what I mean is that you buy the house for one price, and then it increases in value and you sell it for more a little while later.
When you start playing Cash Flow, you’ll quickly see that there is big money to be made in negative cash flow properties sometimes (new players will shy away from them, just like new investors in real life).
If your $100k house went up to $130k in a year, and you sold it for a $30k capital gain, then don’t you think it’s worth some negative cash flow. Would you pay $100/month to get $30k in 12 months? I sure would.
But how am I going to get a house that increases 30% in value in one year? I’m glad you asked…
Myth #4: Real Estate Only Appreciates 6% Per Year At Best (Less Right Now) And The Stock Market Gets 11% Per Year
So how are we going to get a house that goes up 30% in one year? Luckily, appreciation is not the only way to raise the value of a property. In fact, I don’t think betting on appreciation is a good idea at all. It’s a lot like trying to predict the stock market, too risky for me.
But if you buy a foreclosed property for 70 cents on the dollar and rehab it, then you can be quite certain you’ll get that gain. You can look at every other property in the neighborhood that is about the same size, # of beds and baths, year built, etc…sold in the last 6 months and be pretty confident about what price you can get for it. You can even look at pictures of those properties and get an idea of how nice the rehab needs to be.
These deals are out there, I’m finding them myself in the last few weeks. Now if the property happens to appreciate 6%, then it’s a nice bonus and you get more. But if the property goes down 6% then the deal still works. It does not depend at all on appreciation.
Of course, with regards to comparing real estate to the stock market, this myth is wrong for another very big reason. That 6% increase they’re talking about is on a much bigger number. If you put $10k down on a $100k house, you get the 6% increase on $100k, not $10k. Thats $6,000. But if you took that same $10k investment and bought stock that went up 11%, you’d only get $1,100. That is the power of leverage at work.
Anyway, I am still figuring this all out for myself, and I’m sure some readers will disagree with what I’ve said. There are a million opinions out there on real estate investing and one thing I strongly believe is that you shouldn’t take advice from anyone who isn’t already DOING what they are TEACHING. I have not yet become a millionaire from real estate investing, so take what I say with a grain of salt. But I do recommend you go out and get some mentors who are millionaires in real estate investing like I did. You may discover that some closely held ideas you have are really just myths.
What closely held ideas about investing and real estate did you have in the past that you now know are incorrect?