The Right Way to Own Investment Properties

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During the 1980s and 90s I owned a lot of real estate. It started slow and exploded into a 176 building pain in the ass. To be fair, most of the investment properties we owned were either single family homes or duplexes. A few multi-family buildings, a boarding house and a storage facility rounded out the mix.

With so many properties running through my personal accounts and a partnership with dad and brother, I learned a few things along the way. One hundred seventy six buildings is a lot of buildings. Good thing I didn’t own all of them at the same time. Mistakes were sure to happen.

By the early 2000s the real estate empire was gone. I was burnt out and sick of working with tenants. Countless property managers helped us over the years, but it was not enough. Managing over a hundred units much of the time over a footprint covering most of NE Wisconsin took its toll. To complicate matters, I also ran my accounting practice with double the employees I have today (during tax season).

Starting slow was my greatest idea. It felt good to see the passive income filling the checkbook. Our teams of contractors allowed us to buy fixer-uppers and increase the property values significantly. Our best deal was the purchase of an upper-lower duplex in my hometown for $8,000. Hard not to make a profit on those.

The Pain of Gain

The first 10 properties were fun. I still remember the first one. (Isn’t that true for most things?) 833 E North Street in Appleton, Wisconsin. A beautiful front-back townhouse. Bought it from the bank for an even $50,000. The combined rent was $980 a month without a day of vacancy and the rents rose rapidly. Ah, those were the halcyon days. Two years later I sold it for an even $75,000.

The first 10 were easy so I managed them myself. But with profits like this, I decided to make hay when the sun was shining. Before North Street was even sold we were buying up to 10 new properties a month and selling 2-3 per month. The last business day of the month was almost always spent at the title company, where we handled all our closings.

More properties over a larger geographical area required property managers. And so we did. I went from managing properties myself to managing managers. That was fun at first, too.

Finding good property managers is just as hard as finding good tenants. They are out there. Back in the 1990s they were harder to find in my area. Most property mangers back then handled large apartment complexes only. The few who handled stuff like I had were not always connected with real estate firms (where I found most good managers to exist).

The weight of too many properties took me away from what I loved most: taxes. The fun was sucked out of the whole process. Now I spent the last day of the month at the title company selling more houses than we purchased, and soon we were only selling.

Today I do not consider myself in real estate, but still own close the seven figures in RE value with only $111,000 in mortgage on my farm. It is not fair to say I am a landlord. I rent my commercial property to my practice, which is an S corporation. I have one property sold on land contract where I hold the paper and the farm, 10 acres of respite in the backwoods of NE Wisconsin.

The Itch is Back

I have been out investment properties now for over 10 years. Part of the reason for selling way back when also included my realization rents were not keeping up with real estate values in my market. Sometimes it pays more to take a profit and go home. Coupled with burnout, it was a no-brainer.

Itch or no, I have to review mistakes I made decades ago and review how the investment property environment has changed over the decades before diving back into the investment property markets

Mistake #1: I managed too many properties on my own to increase margins. In hindsight, my profits would have been higher if I would have hired all the management work done and focused on the financials only. When they said—Jack of all trades, master of none—they were thinking of me. Now you know.

Mistake #2: I got addicted to owning real estate. Younger and with a larger ego, I enjoyed the stroking I received when people mentioned the amount of property I owned. Toward the end I was buying properties that did not have the potential of earlier investments. My goal no longer focused on quality properties, but volume. Dumb, dumb, dumb! With rents stagnant, margins came down. Too much work sucked the fun out of the whole project; lower profits killed any love I had for more real estate.

Mistake #3: I stayed close to home. I bought almost all properties within 100 miles of home base. No properties were purchased outside Wisconsin. The NE Wisconsin market was no longer a great place to invest. Only the rare prize would make an investment locally worth pursuing.

After all these years the itch is back. I want to add real estate into my investment mix. Next I am going to show you how I plan to make these investments. Having learned from my mistakes I may end up with investment properties the rest of my days. You can use my template as a guide. You have to decide how you will handle your investment properties. Learn from my mistakes and successes. Real estate is a great way to build a steady flow of passive income. A small amount of money invested in the right properties can allow you an early retirement. More to the point: $100,000 invested in five good properties ($20,000 down each) could be enough to retire in some areas. If you do it right.




Buying Right

You have to buy right for this to work. Never chase a property and never rush. My second mistake above was I started to rush the process and it showed.

There is a lot of advice on how to buy properties floating around. They are not my concern. My accountant mindset thinks differently. I don’t care about the 1% rule for rents or, fingers-crossed, potential appreciation of the property or tax advantages. These things are used by real estate agents so it is easier to sell the property. Just because rents are 1% of the purchase price does not make it a good buy. Future appreciation is hope and I have an adage about hope: Hold out both hands. Wish in one and shit in the other and see which fills up first. Sorry to be blunt, but you never consider any appreciation in the property value when buying an income property. (Okay, there might be a few instances. You are on your own in those cases. Leave me out of it.) And tax advantages are a stupid reason to buy a property. If you want to buy for tax deductions, I have a bridge I would like to sell you. Cheap!

Rule #1: When I calculate the profitability of a property, I do so as a no-money down deal even though I will put money down. Here is why. If I put enough money down any property will turn a profit. But what about your investment? My rule is simple: My investment must return at least as much as the cost of capital. If the bank has a 4% mortgage rate, then my investment sure as hell better do at least that good.

Therefore, I use a mortgage payment as if I financed the whole darn thing for my illustration.

Rule #2: Allowances must be made for vacancies and repairs. The market the property is in and the property’s condition will determine the vacancy and repair allowances.

Rule #3: The cost of a property manager must be included in your expenses. If you don’t you are valuing your time at zero. Stupid! As you will see below, I will never manage investment properties again. My time is too valuable for me to do something I really don’t like doing.

Example: Let’s run some numbers to see if we can add a certain property to our portfolio. I live in a part of the country where you can buy a small home in livable condition for under $50,000, so play with me.

You found a nice 4-plex (multiunit buildings usually have a lower cost per unit, making it easier to cash flow) for $120,000. A 15-year mortgage at 4% gives you an $888 per month mortgage payment. In Wisconsin we have high property taxes so we will say this property owes $3,600 per year in local taxes. Rent is $500 per unit.

Time to plug some numbers (per month):

Rent: $2,000

Mortgage Payment: $888

Property Tax: $300

Insurance: $75




As you can see, the 1% rule would be a disaster in most Wisconsin markets for several reasons, property taxes being the most notable. $1,200 in rent would not cover the most basic cash flow needs.

Now we add other expenses. Some of them are non-cash most months, but significant when they show up. Vacancy rates, maintenance costs and property management fees are generally low in my area.

Repair Allowance: $200

Vacancy Allowance: $50

Property Management Fee: $50

Of course I picked a deal that would work. If my mental math is right, I’ll make $437 per month on a no-money down deal with a property manager doing the day-to-day work. Any down payment will increase the cash flow and the expected monthly profit. Certain expenses (repairs and vacancies) could be higher or lower.

This illustration is not to show you what to buy, but rather, the mechanics of the accounting I do prior to buying. Yeah, I know, most properties don’t make the cut.

Rule #4: Your local market is almost certainly not going to be the best place to invest! It sucks, I know. But on a brighter note, if you buy in a different market you will be more motivated to hire a manager.

For now I would stay within your own country to keep things simple. If you educate yourself, you may consider properties in world markets. The tax preparation surrounding most investment properties is generally small, even when you own in multiple states. The worst market in the U.S. is New York City for preparing taxes. Any rent controlled cities are also more problematic from a management perspective.

Dirty Little Secret the Wealthy Accountant Knows

As an accountant I see what works and what doesn’t. Of all the bankruptcies I see in my office, the most come from landlords. Landlords are also one of the wealthiest groups of people in my office. What gives?

Investment properties have risks many people ignore. They think it is all easy money. Seminars around the U.S. charge massive sums to teach people how to flip houses with no work and zillions in instant profits. It ain’t so. Good investment properties take time to find. Not every property fits the bill and flipping is a tough game. When you flip a house you make a quick profit, but an investor will hold the property for years, collect rent, watch the property increase in value and pay less in tax than the flipper. And don’t start with the like-kind exchange BS. If I buy a property for $100,000, collect $200,000 in rent over the next 10 or so years and sell the property for $220,000, I will make more than the pittance you made flipping.

Flipping is the mindset of losers! Not that I never flipped a house when the price was right, but short-term thinking is not the path to riches. In over 30 years as an accountant I never once had a client with a consistently high income flipping house. Many declared bankruptcy, however.

Now my landlord clients, they are a different story. Some of those guys went broke too, usually because they leveraged too much. I also have numerous success stories of clients hitting it out of the park that owned and managed investment properties. A steady stream of passive income beats a quick lump of cash any day. In the end my income stream beats the tar out of your flipping and while you are hunting for the next flip, I am reading a book at the beach (if I did that sort of thing).




Owning Right

Buying the property right is the only way to win the investment property game. But buying is only a small part of the process. Now that you own the property you need to manage it. The temptation is to save a few dollars and manage the thing yourself. With the many rules ever changing, I recommend against doing it yourself. You can remind me I am a hypocrite in the comments below. But my days of busting tail doing it all alone are over. I learned my lesson. The question now is: Will you learn from my mistakes or experience the same groin kicks I did?

Rule #1: Get a property manager. The rules are different is every community. A property manager does this stuff for a living and has all the forms in-house. They also have a steady stream of potential tenants. Besides, when you buy income properties, are you looking to create a job for yourself or an income stream? Good. Then hire the manager.

Property managers are everywhere. Good ones usually work in a Realtor’s office. Many states require property managers also be licensed real estate agents. Those ladies already work this stuff every day and know what they are doing. Let them do it! They are worth every penny you pay them. They also know the right rent to charge. Do you?

Property managers usually work this way:

They rent out the property, collect rents and the security deposit, pay the mortgage out of those funds, handle necessary maintenance, pay all other expenses out of funds received, subtract their fee and deposit the remainder in your bank account. Now you know how people retiring early can travel the world while owning investment properties. The biggest issues are buying right and management.

Note: If a major expense arises (roof, furnace replacement) you will need to provide funds to cover those costs as the monthly revenue will not be enough. Might I suggest paying these expenses with a credit card that has a large cash back bonus?

Property managers don’t want extra work, either. Good managers keep on top of maintenance issues so you can plan accordingly and they don’t have to field late night calls from tenants.

Real estate is like any other business today. Only the crazy people (anyone thinking perhaps of a crazy accountant from Wisconsin) handles every facet of the process themselves. You’re the investor! You buy the properties right. Let the management pros do their job. They are better at it.

Now you can start looking for the next awesome deal or maybe travel a bit.

(Final recommendation: I would consider keeping the repair and vacancy allowance in a money market account. Then you will never be short when the need arises. The more properties you own, the easier it is to spread costs around. If your finances can easily handle any repair expense then you can disregard this suggestion.)


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Keith Schroeder

19 Comments

  1. TJ on February 1, 2017 at 11:59 am

    There is a lot of great advice here. I was very fortunate with my real estate (buying in 2010 when valuations were super low and being a beneficiary of the first time homebuyer tax credit). I’m so thankful that i recognized my experience as luck rather than skill. I hear so many horror stories of people with too much leverage.

    Even though my mortgage payment was never super high, not having the mortgage, whether it was personal or rental, feels so freeing and I feel like it creates more options for me. The reality is my property wasn’t all that great in terms of cash flow, so I’m happy I could get out while it was still qualified as a personal asset and could avoid most of the taxes.

    • Keith Schroeder on February 1, 2017 at 12:14 pm

      Leverage is the killer, TJ. My intentions with investment properties this time is to put down 20% and then use cash flow to kill the mortgage fast. I’m sure I’ll have more to share when I finally pull the trigger.

  2. Ryan on February 1, 2017 at 12:02 pm

    As a fellow WI property owner and landlord of a couple properties I look forward to reading about your ventures back into real estate. The property taxes do suck and I choose to self-manage for the time being and it takes little time for my small portfolio. I’ve been reluctant to go full bore as it seems you did when you were young.

    • Keith Schroeder on February 1, 2017 at 12:17 pm

      One thing to remember, Ryan; I may not buy properties in Wisconsin this time around. When I was in Florida in January I looked at a few properties to dip my toe in. I want a better feel from several markets so I cherry pick an above average market.

  3. Todd on February 1, 2017 at 4:12 pm

    Hi Keith, it’s great to see this post! I feel like you mentioned it was coming last year, so I imagine it’s been in process for a while.

    It’s interesting to see P&I as a proxy for the cost of capital. I have generally just looked at properties on a no-leverage basis and compared the earnings yield to other available options.

    I would love to see some real numbers when you do finally pull the trigger. I’m looking at deals now and with the recent run up in property prices, I haven’t found any to get too excited about yet… but I’m sure I will.

    • Keith Schroeder on February 1, 2017 at 8:22 pm

      Current property prices are an issue, but rents have also increased in many markets. You are right about the P&I. I start with P&I, knowing full well the principal portion is really profit. My first goal is always cash flow from day 1. Depending on the property I may use the interest only as an expense. But remember, you need to feed the property if it is cash flow negative, even if it shows a profit before depreciation.

  4. How NOT To Buy A House - Financial 180 on February 20, 2017 at 7:53 am

    […] Rental real estate can also make you good passive income, if the property is chosen carefully and the math works out. Our property was unfortunately not one of […]

  5. Stephanie on March 1, 2017 at 3:23 pm

    Hi Keith,
    Based on your formula, this kills any investment in real estate in a market like Seattle’s. Homes purchased for $550-600+ will rent for $2700-3000. Would you adjust your formula for an expensive coastal city? Or does it just mean that investors should avoid real estate in a city like this?

    • Keith Schroeder on March 1, 2017 at 5:28 pm

      Once you start adjusting, Stephanie you keeping doing so until there is no profit. Many markets are not worth investing in. I know my formula excludes many. many markets and with good reason. I want to generate an excellent return or do something else.

      • Stephanie on March 1, 2017 at 5:53 pm

        Thanks Keith for your insight!

  6. Jake on May 12, 2017 at 9:44 am

    Hey Keith – Enjoyed this article. Got here through the “fighting the profit train” article you just published.

    Question for you about choosing a market: What have you found to be the best way to discover better markets? Are there some good resources out there that have properties across the country? I can search for days on Zillow and the likes, but it’s tough to nail down a market to search in.

    Like Stephanie in the comment above, I’m out on the west coast (near Seattle, but not in), and many markets here are overpriced.

    Just thought of another question.. how much value do you put on local vacancy rates?

    Thanks!

    • Keith Schroeder on May 12, 2017 at 10:19 am

      Jake, there is no easy way to find hidden value. If it was easy everyone would be doing it. I always tell people to do what Warren Buffett does all day: read and research. That is where you will find diamonds in the rough. Zillow is a good resource, but don’t neglect reading national news. It is the offbeat stuff which will point you in the right direction. In my opinion, the west coast is not a place to invest in real estate right now unless you find a steal within a hot market. Unlikely, but possible, I guess.

      Vacancies are important, the direction more so. A market with elevated, but declining vacancies could be a market on the upswing and worth considering.

      All in all, real estate is a tough animal, contrary to popular wisdom. Keep your ears open. Some of my best deals came from strange places, such as a local government looking to unload a property. That is why you don’t have time to do it all. If you are the investor you keep searching for value while others do the maintenance, management, etc.

  7. Jake on May 12, 2017 at 1:22 pm

    Keith – thanks for the feedback. I’ve been interested in real estate for a while now, but have yet to pull the trigger on anything. You have a good point about looking outside your local area. As you can likely guess, I’ve only looked locally. Perhaps it’s time I spread my search beyond my PNW home!

    Keep up the thoughtful articles.

  8. Nick on June 21, 2017 at 8:23 pm

    Hi Keith, enjoyed the article but one thing stood out – do you really only pay $50 / month for someone to manage a $2,000 revenue property? This works out to 2.5% and in my market it is in 8-10% regime. Do you do something special to have such a low cost or is this standard in your market?

    • Keith Schroeder on June 21, 2017 at 8:40 pm

      Nick, it could be market specific. Property management fees can be all over the place and are negotiable. For example, I have a client with commercial property I handle. The “real” property manager gets two months rent when they get the thing leased. No more. Even if it is a five year or longer lease. My fee is includes consulting and taxes for a set fee mostly centered around paying the few bills and preparing the taxes optimally for the partners.

      The numbers I used, Nick, are not indicative of a real world example. I want people to see a number and then plug in the number in their situation. There was no intention to mislead.

      • Nick on June 21, 2017 at 9:57 pm

        Thank you Keith for clarifying… now only jealousy over your ultra low real estate taxes remains…

  9. Chris on June 23, 2017 at 10:31 am

    Hi Keith, what are you thoughts about interest only mortgages? You could also possibly unload the property before the principle period kicks in. Would love to know your thoughts.

    • Keith Schroeder on June 23, 2017 at 10:54 am

      I don’t, Chris. I know interest rates are low and the “right” move might be to leverage to the hilt, investing the proceeds. Unfortunately that strategy also carries risk. When a 2008 comes around the debt load also amplifies the negative effect on net worth and some people will buckle under the strain. I prefer a more stable approach. (My Dave Ramsey training is starting to show, isn’t it?) Even if I had a better deal on an interest only mortgage I would probably pay some principle too.

      Low interest rates have me waffling on the issue of home mortgages. I have a small mortgage and can’t pull the trigger to retire it completely. But deep down inside I know maximizing results is not the only goal. Peace of mind pops into my head.

      There will be no stern looks from this accountant if you do get an interest only mortgage. I understand completely what you are trying to do. Readers of this blog are responsible enough to invest the difference. I guess if the interest only mortgage contains a margin of safety by including 30% or more equity I might be happier.

      How is that for dodging a question with a straight answer, Chris?

      • Chris on June 26, 2017 at 1:34 pm

        That is actually a very good answer to my question! I was also thinking along the lines of being more conservative with a risky product by putting money down but wanted to pick your brain. Good stuff as always!

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