URGENT TO LANDLORDS: This is "Conventional Wisdom"... And It Can Be DEADLY For Your Portfolio | Episode 128 - a podcast by Bryan Ellis - SelfDirected.org

Conventional wisdom says that you’ve got a good rental property deal if your rent equals 1% of the purchase price.  Sure, go ahead… but it’s a dangerous smokescreen that could thrash your portfolio.  I’m Bryan Ellis.  I’ll tell you exactly why RIGHT now in Episode #128.

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Hello, SDI Nation.  I’m still sounding awful, but starting to recover from my bout with pneumonia and bronchitis, thankfully.  And do you know what?  There’s NOWHERE I’d rather be than RIGHT HERE with you on the podcast of record for savvy self-directed investors like YOU!

I feel the need to gush over you guys again and how amazingly well you’re supporting this show.  I’ll just summarize that by saying… THANK YOU!  You people are awesome.

So, I had an interesting experience recently that I wanted to tell you about.

I had a great rental property investment available, and called one of my clients who had expressed an interest in acquiring new cash flow deals.  Now, who is named Cathy, is a very smart lady.  I respect her opinion.  So when she rejected the deal I offered to her rather abruptly, I was surprised.

Why did she reject it?  It’s because she has a rule… her rule is that she only wants rental properties that collect rent that’s equal to at least 1% of the purchase price of the property.  So in other words, if she pays $100,000 for a house, she wants to collect rent of $1,000 per month from that house.

For the sake of simplicity, let’s call that the 1% rule, ok?

Now, before I go on, I’d like to say that Cathy is smart enough that I have no doubt that she has criteria beyond just that one, and so Cathy, if you’re listening, please be aware this is NOT a response to you, as I’m well aware that your evaluation criteria is much more substantive than that one rule alone.  I know you’re a successful investor and I very much respect your opinion.

But your response absolutely set me to thinking about that criteria, because it is such a common notion, and one that is accepted as gospel by so many people.

But is that actually a good guide?

If that’s the primary factor in your evaluation process, the answer is NO… it’s a TERRIBLE standard.  And I’ll prove it to you right now.

Imagine you have that house that you bought for $100,000 and that you are, in fact, collecting $1,000 per month in rent.

Well, that’s great!  It’s a good foundation to start from.

But let’s throw in a few very REAL-WORLD considerations.

Let’s imagine that that house is 50 years old.  It’s structurally sound and should last many more years.  But… it’s old.  Isn’t it likely that a house that’s that old will likely require significant repairs or upgrades during the course of your ownership period?  The answer is YES, absolutely.  Even if those issues aren’t yet apparent, it’s the nature of older property that these risks are more frequently realized than with newer properties.

Ever heard of that website called Angie’s list?  It’s designed to help people find high-quality service providers in your local area.  According to them, the actual average cost of replacing a roof for their customers has been in the $11,000 to $12,000 range.

And just like that, an ENTIRE YEAR of cash flow is gone.

Same deal with air conditioners.  I know this one all too well as we’ve got to replace one of the 3 units in my family’s home.  Pricing for that covers a wide range… around a low of $3,000 up to $8,000 or more.  I’d say $4,000 is a reasonable average…

And POOF, just like that, another 4 months of rental income disappears.

Now, folks, we all know that there’s no way to absolutely prevent those kinds of issues.  But is it rational that you’re less likely to have those problems by purchasing newer, high-quality homes versus very old homes?  Yes, of course that’s rational.  And a great way to show respect for your capital.

But those kinds of issues, as expensive as they are, may never materialize… and that’s why it’s so easy to ignore the risk and move forward with overly simplistic judgment criteria like the 1% rule.  So what are some other factors that may render that standard as impotent and maybe even dangerous?

Well, there are two expense factors that you’ll ALWAYS have to think about, without exception.  Those factors are INSURANCE and PROPERTY TAXES.  And here’s the thing, my friends:  WHERE you buy property has a HUGE effect on those expenses.  Here’s what I mean:

CBS News tells us that nation wide, the average property tax bill is about $2,000 per year.  But certain states have consistently and substantially HIGHER property taxes… and that expense comes straight out of your rental income.  In New Jersey, the AVERAGE property tax bill for home owners is $3,971 per year.  That’s $2,000 per year more than average, equating to a reduction in your monthly cash flow of $166.  That’s a huge drop… and you take that hit every single month.

Texas is another good example.  Honestly, Texas is a better representation of the real issue here because I don’t see a lot of people clamoring for property in New Jersey, but there’s a lot of excitement about Texas real estate.  The average property tax bill in Texas is $3,327… over $1,300 per year more than average, equating to a drop in your net rental income of over $110 per month.

As an alternative, look at Alabama, which is actually a pretty interesting market.  Average property taxes there are $752/year.  And that happens to be one of those markets where you can still get a strong rent-to-value ratio.  Another example is this:  I’ve got a deal in Arizona right now that’s a great deal… though the rent it collects is not equal to 1% of the property value.  But do you know what?  It’s a great new property, in great condition, and it’s property taxes are a measly $683 per year.

My friends, focusing on the top-line number is short sighted.  The top-line is the amount of rent you collect.  What REALLY matters is the BOTTOM-LINE number… the amount you get to keep.

I’ll make more money on that deal in Arizona where the top line is LOWER than it would be if the same house was purchased in Texas.  And that’s because the expenses are far, far lower.  I get to keep more of the money.

Same sort of issue exists for two other areas:  Insurance and legal compliance.  Some states simply are more expensive than others for buying hazard insurance.  The national average is $1,034 per year.  But in Florida, the average is double that.  The average in Texas is 50% higher than the national average… unfortunately Texas has very high expense ratios for both property taxes and hazard insurance.  Very similar stories for Oklahoma and Mississippi too.

Bottom line?  It’s all about the BOTTOM LINE… not the top line!  The amount you collect in rent is definitely critically important.  But here’s the harsh reality:  The deal I’ve got in Arizona will cost about $1,200/year for both property taxes and insurance.  Same house in Texas costs over $4,800 per year… $400/month… for taxes and insurance.  That’s a bottom line net ADVANTAGE of $300 per month for the house in Arizona that collects “less” rent on a monthly basis.

Which one of those deals is more profitable?  The answer is obvious… but not if you allow yourself to be smoke-screened by the 1% rule.  That rule sounds wise, and it’s not a bad as part of a collection of good evaluation criteria… but so many people select rental property PURELY on the basis of that rule… and as you’ve seen, that rule as a primary guideline can easily net you FAR LESS MONEY in your pocket than other deals with lower income but SUBSTANTIALLY lower expenses.

And none of this even touches on the one factor where there’s REAL risk to your cash flow:  Legal compliance.  In some states, landlords have strong rights… and it’s fairly inexpensive to do business as a landlord in these states.  In other states, tenants have strong rights… and it’s costly and DANGEROUS to be a landlord in those states.  And where legal compliance is concerned, your costs can go from nothing at all to tens of thousands of dollars with just one bad tenant.  States like Massachusetts and New York come to mind.

My friends, I simply want you to factor in EVERYTHING that matters.  Don’t be beguiled by smoke screens like the 1% rule.  Repeat after me:  The only thing that matters is the BOTTOM LINE!

We’re done for today… may I ask a favor of you?  It would be SO HELPFUL to me if you’d go over to iTunes and leave a 5-star rating for this show, but only if you think we deserve it.  Truly, I’d be so genuinely grateful.  Thank you!

 

My friends, invest wisely today, and live well forever!

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