How to Buy Real Estate Right

If you want to learn how to profitably invest in real estate, I think the best way to begin is with the most important rule of real estate investing: Buy right.

You have probably heard that commandment before. Or this equivalent: “You don’t make money by selling real estate; you make it by buying it.”

This rule, however simple it sounds, is often misunderstood. To many people, it means simply buying property when it seems cheap. But that is certainly not a good idea. You don’t want any subjectivity (“seems”) involved in your buying decisions.

The first property I invested in seemed very “cheap” when I bought it back in the late 1970s. It was a nice little one-bedroom condominium apartment in a refurbished building on Massachusetts Avenue in Washington, D.C.

Our landlady convinced me to buy it by showing me how much prices had been escalating in the recent past.
She told me that if I bought this unit “now,” I’d stand to make a lot of money as it appreciated in the following few years. To make it even easier, she got me a “creative” loan from some bank, which meant I had to put down nothing but a few thousand dollars in closing costs.

When K and I signed the mortgage and got the keys, we felt like we had made a really good deal.

But Washington, D.C., real estate was bubbling up in the mid-1970s, and lots of people who didn’t know a thing about real estate were jumping in. Including me.

It took me years to finally get rid of the apartment (and the deadbeat who was renting it from me). And it cost me about $30,000 to boot.

I made so many mistakes in that one transaction that I could probably base yet another series of lessons around it, but for today, I want to focus on just one part of that mistake: buying rental real estate without any idea of what a “good buy” really was.

When it comes to rental real estate, a good buy is getting the title to a property that can be fixed up and rented out at a profit right from the outset.

From 2005-2008, millions of Americans were jumping into real estate. But they were doing just the opposite of buying right. They were buying homes at such high prices that it was impossible for them to make any cash profits from renting at all. The only chance they had for profits was if the property they bought kept appreciating in value.

In other words, they were speculating that they would be able to sell their overpriced investments one day to someone even more foolish than they were.

So, let’s get to the question: What exactly does it mean to buy rental real estate “right”?

And my answer is this: If you can buy a piece of property and have it fixed up and ready to rent for less than eight times yearly rent, you are almost certainly “buying right.”
Let me show you a specific example to make sure you understand this.

Let’s say the house you rent in your neighborhood costs $1,500 per month. That would be $18,000 in rent each year ($1,500 x 12 months). As an investor in rental real estate, you should not pay more than eight times this yearly rent amount to purchase this house if you want it for cash flow. That means you should not pay more than $144,000 (8 x $18,000) for it.

This is a ballpark rule of thumb, of course, but I’ve been investing profitably in real estate now for about 30 years (that first investment was my only loss), so I can say confidently that this rule of thumb is reliable.

If you can buy rental property at that ratio, you stand a good chance of making about 8–10% on your money if you buy the property with cash, or about 20–25% if you use a mortgage.

This ratio I just told you about is called the gross rent multiplier (or GRM).

Eight times yearly rent is the maximum you should pay for any rental property. If you live in an area that has high property taxes and home insurance, a GRM of 7 is a better bet. Your goal is always to pay the lowest GRM you can find for a rental property.

The big point here is that when you invest in rental real estate, you should be investing for cash flow, not appreciation. Your object is to start making cash profits on your investment in the very first year. If you do that, you will likely see those profits increase year after year for as long as you hold the property.

Be aware: You can’t always find rental properties for a GRM of 8 or less. There are places where either rents are too low or property prices are too high… or both. So these are places you should not invest in rental real estate.

There are also times when it is impossible or nearly impossible to buy rental real estate “right.” You certainly couldn’t have bought rental real estate for a GRM of 8 in Florida, California, Texas, and most other populous states in 2006. And you certainly couldn’t have done that in 2007 and 2008. The cost of property back then was too high, compared with the rents such properties could generate.

So the No. 1 rule to always follow is to buy rental property when you can get it at GRMs of 8 or less. If you do that, you should do very well as a rental real estate investor.

And if you want to become wealthy through rental real estate investing, you need to consider using mortgages. The reason for that is that a mortgage gives you leverage. And leverage will increase your returns.

For example, let’s say you have $100,000 to invest. You have a choice. You can buy a ready-for-rental property for $100,000 and net $10,000 every year in cash. (That would be a 10% return on the cash you invested.)

Or you can buy five properties using an 80% mortgage (that means you would use a down payment of $20,000 for each one). Each of these five properties will give you only a $5,000 return, but you will have five of them — for a total return of $25,000, or a 25% return on the $100,000 you invested! (I explain more about how to use mortgages effectively in one of the later essays in this Club series.)

I want to stop here and reiterate the basic point I have been making: Buying cheap does not mean buying property when it “seems” cheap — either because it is shooting up or because it is cheap compared with what it was before.

Buying cheap means buying properties with GRMs of 8 or less.

If you do this, you’ll stand a great chance that your property will generate cash flow as long as you manage it well. And when you buy at GRMs lower than the average in your area to boot, your chances for capital gains are also greatly improved.

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