We’ve all seen the late night TV infomercials with the guy on a yacht surrounded by bikini models, saying how he made millions investing in real estate, and so can you—if you buy his thousand dollar insider real estate investing kit. Or, maybe you’ve seen ads from the real estate investment companies telling you how you can make 40% returns or more buying their turn-key investment properties. What’s not to like about that? If all you had to do was buy some real estate investing kit, or some property, and then sit back and relax on your new yacht, wouldn’t that be great? The truth is, those companies and promoters aren’t providing you with the full story. Those 40% returns you were promised… Well, they really are more like 8-10% once you run the numbers—if you are lucky. Before you run out and start spending all those millions of dollars you were promised, let’s take a closer look at what goes into those return claims, and discuss how you can verify the numbers on your own.
When you evaluate projected returns there are of course income projections and expense projections. Let’s first look at the income side of the equation. With most real estate investments there will be two sources of income, rent and projected future appreciation. What you need to watch out for here are bloated projections. Are these real estate investment companies padding the projected rents? What type of appreciation numbers are they building in? Make sure to find the answers to those questions.
Rents are easy enough to verify. To get an idea about how much a property would realistically rent for, you can check out online resources like Craigslist or Zillow, or better yet talk to a respected property manager in the area and ask them.
Most of these companies will simply use the higher range for rental projections— the biggest discrepancy tends to be with appreciation. When you look closer at these projections you can quickly see the problem. It is not uncommon to see built in appreciation projections of 10% per year or higher. After the real estate crash of a few years ago, hopefully you can see the problem with assuming that real estate will appreciate at a 10% clip every year—it simply is not realistic, or sustainable.
When we evaluate properties we like to look at appreciation as the icing on the cake. Of course we want to buy property in areas that have a good chance of appreciating, but at the same time we want the rental income to be able to sustain the property. We want to see great returns based solely on rental income, and then any appreciation is looked at as a bonus. That tends to be the opposite with a lot of these promoters. They try to sell you on future appreciation, and at the end of the day you get stuck with a negative cash flow property. At that point you are left praying that that the real estate market goes up. Unfortunately many times those prayers go unanswered.
Expenses tend to be where most people get lost—especially for new investors. Most novice investors simply don’t know about all the various expenses that go into a rental property. To help out, we have created a chart that shows expenses a typical rental property will incur, along with an example of what the expenses might be (note these expenses will vary greatly from one market to the next – especially property taxes and insurance):
CLOSING COSTS 1
PROJECTED RENT (Monthly)
HOME OWNER’S INSURANCE 1
Claim up to $26,000 per W2 Employee
PROPERTY TAXES 1
VACANCY PROVISION 3
MAINTENANCE PROVISION 3
Note: Estimates are indicative; subject to variation on actual properties and location.
1 Sourced from Closing.com/Zillow.
2 Based on properties marketed by HomeUnion.
3 Assumes 6% Vacancy Provision and 6% Maintenance Provision.
Of the expenses mentioned above, the ones most often excluded (or severely undershot) from inflated projections are: closing costs, vacancy and maintenance. Closing costs are a onetime cost you incur when you buy the property, so that is an easy one to evaluate, however, the other two can be a bit trickier.
Some promoters might tell you that properties in the area are never vacant, or maybe they are selling you a property that already has a tenant and therefore they don’t bother putting in a vacancy provision. Realistically, even the best properties are going to be vacant at one point or another. As a rule of thumb, we like to build in a vacancy provision of at least 6%. If you are in an area with a higher vacancy rate, you might have to bump that up to 10% or more. We like to use the higher range in our projections—just to be safe.
Maintenance can be difficult to judge as well, but becomes easier with experience. You will need to build in a higher budget with older homes, but even brand new homes will likely require some amount of maintenance. If you are a new investor, talk to an experienced property manager about typical maintenance expenses one can expect on a home like the one you are looking to buy. We recommend that you build in a maintenance budget of at least 5-8%.
In addition, you can also purchase a home warranty that will cover you in the event of major problems. Some of the better investment providers even include this with the purchase of your property.
Real estate investments can generate incredible returns for investors, however, before you get caught up in the promises of huge returns from some promoter, make sure to look closer at the numbers. Is the income being inflated? Are some expenses missing from their projections, or maybe drastically undershot? Before you buy a property make sure that you are looking at realistic projections, and that the property is going to be putting more money in your pocket every month, not taking it out.
Companies like ours (HomeUnion) can help investors like you understand the elements that lead to realistic cash flow projections. Don’t be afraid to ask for help—successful real estate investing requires a good understanding of the elements that contribute to cash flow income.
This is the third article in our series on critical mistakes real estate investors make. Make sure to check out our first article: "Single Family Real Estate Investment;" and the second article "Investing In Real Estate Doesn’t Have To Be A Local Endeavor" . Also keep an eye out for our fourth article in the series next month. If you want to get a sneak peek, we’ve made our full report on the critical mistakes real estate investors make, available for instant download on our website. If you would like to receive a copy of our free report, you can download one here.
HomeUnion is a unique real estate investment platform providing high income single-family cash flow homes nationally for real estate investors. HomeUnion finds Cash Flow Zones with favorable rental to home price ratios, stable employment and strong rental culture. HomeUnion offers these properties fully tenanted, along with Property Managers ready to stay on after the purchase. This ensures a single point of accountability and significantly reduces risk for out of state investors. In addition, rent and maintenance guarantees are available on homes in some markets. HomeUnion provides post-purchase market intelligence, portfolio analysis, and management oversight for investors.