Rules of Thumb
Knowledge is power, and in the business fields, such as real estate, many professionals use “rules of thumb” in order to minimize their risk and standardize decisions based on previous experience. Although these rules are never to be considered acceptable one hundred percent of the time, using these small advantages can help a business immensely. These parameters can help investors find good ventures, recognize potential pitfalls, and understand the competition. There are literally thousands of these rules and most are handed down by word of mouth from mentors and more experienced workers. However, websites and other resources such as starting your own business books compile many that can be applicable in any field. More specifically, real estate has a wealth of rules that can make the difference between professionals.
Real Estate rules of thumb are all intended to further the goal of making better investments, which will lead to making more money. They range from little tendencies like realizing that if you need a calculator to see how close to the profit margin you are, then you are cutting it way too close, and then to major investment decisions such as the Rule of 72. These are practical steps that can be followed by anyone. In a world that is becoming more competitive, especially in the real estate field, these standards can make a difference.
After recently meeting with a representative in the real estate field, Chad Hovde, we were able to delve into practices that he follows for his particular business. This insight allowed for an understanding of the advantages of applying these rules.
Why the Real Estate field?
Real Estate investments are often very lucrative, and if set up correctly they can be managed with low amounts of risk. They are long term tangible interests that are applicable to all people despite their age and wealth. Chad Hovde noted that, “I was interested in the field when I found that I could realize a steady income for the rest of my life by paying off on my real estate assets.” This simple rule will allow him to use his real estate interests as collateral for other investments, raise his equity, and establishes strong credit.
Pretty is not always Profitable. Profitable is Profitable.
Investors used to invest in pretty properties because the impression was that a more attractive property would appreciate faster in an increasing market. Under the new rules of real estate it is the financial numbers that lead you to profit. Real Estate is a business of numbers, capital rates, valuations, appraisals and gross net multipliers. Analyze all real estate opportunities by the numbers. Learn the calculations, the ratios, and the procedures. Buying the prettiest of all the properties doesn’t mean that you are going to make the most money. By running the numbers, you might find yourself buying the dump next door instead. Running the numbers means finding out the actual income and expenses with proper reserves. Remember that profitable real estate is always done by the numbers and not by appearance.
Also, buying the houses no one else wants, or properties that others might want to avoid, eliminates a large portion of your competition. These vacant or run down properties can be the diamonds in the rough that help you become successful in real estate investing. With a little hard work, you can turn your investment into a lifelong constant flow of income.
Watch the Pennies and you will make Dollars
Real Estate is a business of collecting the pennies. A building worth $1,000,000 generates no more than $80,000 per year. The operating expenses and income are created dynamically in Real Estate ownership. Verify all income and operating expenses. By watching the pennies you can make more dollars. Keep a close watch on all cash inflows and outflows. To cut costs, an investor might defer large projects and renovations to a later time, or complete the small maintenance projects themselves. Always remember to invest with the long term in mind unless your sole purpose is to flip the property for a profit. Focus on real estate as a great investment that produces income, tax deductions and future appreciation.
The Rule of 30-35% (Property Owners)
The rule varies from one professional to another, but whether you’re a lender, landlord, renter, or real estate investor, it’s a good idea to follow the rule of 30-35% for your loan qualifications, tenant requirements, or personal spending. The rule of 30-35% determines the affordability of home based on a fraction of the renter/buyer’s income. If a property’s mortgage payments or monthly rent is greater than 30-35% of a buyer’s income, then it is probably too expensive.
For example, if Garrett makes $3000 in take-home pay per month, he should spend no more than $900-$1050 (30-35%) in monthly payments on his home. Some property companies, such as Twin City Properties (TCP) in Bryan, TX, require tenants to earn at least three times more in monthly income than they pay in rent to the company (33%). TCP tenants who don’t meet this requirement must find a co-signer to back their contract.
Following this rule is a helpful budgeting technique that provides buyers with a framework to live within their means, having enough residual money for other necessities such as food, insurance, and savings.
The 28/36 Ratios (Lenders)
Lenders typically use the “28/36” ratio to determine whether they will make a loan out to you. Lenders use this debt to income ratio to filter out loan applications. The 28 is the percentage times your monthly income and the result you get should not exceed your housing expense. The 36 is the percentage times your monthly income and the result should not exceed your housing expense plus recurring debt. The recurring debts are things such as credit card payments, child support, car loans, and other long-term obligations.
If your yearly gross income is $60,000 then each month your monthly income is $5,000.
$5,000 x 28% = $1,400 maximum allowed for housing expense
$5,000 x 36% = $1,800 maximum allowed for housing expense and recurring debt
So, if you want to buy a house that requires $1400 housing expense per month then your recurring debt must be less than $400 because $1800 minus $1400 only allows for $400 for recurring debt. Also, if your recurring debt exceeds $400, then for every dollar it exceeds the amount of allowed housing expenses decreases by the same amount. For instance, if you have $1100 of recurring debt then you can only have $700 for housing expense.
Because of this, you should try to keep your debt low. Otherwise, you will not be able to qualify for a home loan that you want.
Buy a Tree, Not a Pool
Wise investors look for more in a house than just its interior, exterior, and amenities. Environment and surrounding yard amenities contribute to the value of a location as well. A common mistake made among property owners is thinking that adding a pool to a location will significantly increase its value. However, a multiple thousand dollar pool may only raise the appraised value of a home by a couple thousand dollars. With pools come liabilities and unwanted maintenance fees that can create a nuisance for buyers/tenants, while pools often go unused. In fact, on average, no more than 10% of apartment residents will ever swim in the pool simultaneously, and 80% of residents will never even use it once.
Trees on the other hand tend to create much greater value in proportion to their cost. On average, trees provide 7% of the value of a half-acre home-site, while they can provide up to 27% of the appraised value of a home. In this example, it is also helpful to note that too much of a good thing can be a bad thing. While anywhere from 1 to 29 trees may add value to a half-acre home-site, a general rule is that 30 or more trees will decrease the value. When considering real estate investments, remember that it is much more profitable to invest in properties with trees than those with a pool.
Don’t Hug the Margins. If You Need a Calculator, It’s Probably Not a Deal.
It’s important when making a deal on a property that you don’t cut it too close to breaking even. Some investors will say, “If you need a calculator, it’s probably not a deal.” The most important numbers to know when analyzing the profitability of a home-site are asking price, after-repair value, and repair costs. With these three figures you should easily be able to determine whether a property is worth investing in or not. If these numbers are such that a calculator must be used to tell whether or not you will break even, it is probably wise to pass on the offer.
While it is good to realize that most investments are not “home-runs”, making colossal returns on tiny investments, it is important for those who are new to the industry to look for deals that do not cut it close to breaking even. The first few investments you make may determine whether you stick with it or not, so look for the “home-runs”, and do not settle for deals that require intense calculations for determining payback.
The best way to make money in residential real estate is to buy the worst home on the best street.
Just like most businesses, real estate is all about location, location, location. Most people don’t realize that one of the biggest hurdles in real estate investing is learning how to find a good deal. Most often, a bad house in a good neighborhood can become a great investment with a little hard work. A good neighborhood can assure that your property will appreciate at a much better rate, and the “bad” house on it can always be remodeled. There can be strings attached that make the deal less desirable, which is why it is important to do your due diligence and determine if the property can actually become profitable. If there are too many obstacles, such as termites, foundation issues, mold, or legal problems, it could create more headache than a new investor might want to take on. Great deals do exist; very few people actually know how to find them, or even bother to.
The only thing that overcomes hard luck is hard work.
Often, deals in the real estate industry things don’t work out quite like you plan. Hidden fees may show up, renters pick up and leave or won’t leave when you want them to, or maintenance issues keep you up all night. Chad Hovde has demonstrated incredible resilience in his ventures to improve an apartment complex he invested in at a young age.
Chad shared his tough experiences from a drunken man driving through the apartment walls, to frequent loiterers. Although Chad had to work overtime to solve these issues, being well prepared by having good insurance and a creditable network saved him a lot of time and money. By working with the city, Chad has now revamped the neighborhood from new streets and sidewalks to tax abatements for other investors. Although you must work hard to get anywhere, you should also remember to “work smarter, not harder.”
6. Chad Hovde-Local Real Estate Investor/Guest speaker