601: Season Six Opener - Understanding the J Curve
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Episode Transcript
Welcome to Episode One of season six of the Growing Empire Show. Today is our opener for season six and we're going to talk all about the expectations when purchasing investment properties. So stay tuned.
00:16
Welcome to growing empires hosted by real estate entrepreneur and trusted investment advisor Jennifer de Jesus. Growing Empires provides insight to building wealth through passive income producing real estate investments for those who want to build and manage a more profitable real estate portfolio.
00:35
So season six is here. And our theme for this season is purchasing your first or next investment property. So what can you expect out of this season? Well, we are going to go through a very high level step by step overview of the process of purchasing investment properties. And we'll break it down to what you need to know if you're a first time investor versus if you're a very skilled and professional investor and you're looking to scale quickly. We'll break down exactly what you need to do step by step. We're going to talk about how to protect yourself from buying the wrong property. How to keep yourself from making bad deals, and yes, it does actually happen. But when you have the right team and the right guidance on your side, buying investment properties should not be a scary acquisition. We're going to talk about the importance of a right team and how to build out that team to be successful. We're going to have a couple of special guest interviews this season and one in particular that I'm super excited about is our discussion with Dave Rowan, from Rowan Financial, and his partner Jeremy Moyer, will be joining us. With those gentlemen, we're going to talk about buying vacation homes with a conventional mortgage. We're going to talk about owner occupied multi unit loans with conventional mortgages. We're going to talk about buying your first investment property with a commercial loan and what to expect. We'll talk about how to do the math before you purchase a deal and cover things like debt coverage ratio, what does that mean? What is the cap rate? How do you make sure that there's enough money left in the deal. We'll talk about taking on business partners to fuel your ability to acquire more. We'll talk about acquiring debt and Capital Partners. So again, whether you're a seasoned investor and looking to scale quickly, or you're a brand new investor looking to get started. This season is going to be perfect for you and there's going to be a lot of information for everybody. We're going to talk about due diligence time. What specifically are you looking for and how do you know if you should be accepting as-is deals, waiving inspections and how to make your offers or your bids look super competitive in a super challenging market?
02:37
So let's jump right into today's topic. And today's topic is the “J curve”. So what is the J curve? The J curve is an “illustration”. I want you to think of the way that you draw the letter “J”. If you start at the top, there's a long downstroke, a curve at the bottom, and then you're going up. That is exactly what happens upon purchase and real estate investments. Assuming that we're buying B and C class properties, and we're buying, in some cases, properties that are occupied. Sometimes they're not occupied. But for all intents and purposes, we're talking about the value add properties. So why is there a J curve, or, why is there a downstroke? Well, let's think about your analysis of the property. So when you analyze an investment property, you are always looking at cash flow. So you're looking at gross income, minus expenses, which are made up of taxes, insurance, landlord paid utilities. And then there's going to be some built in calculations that you will need to use to help protect yourself financially. And those are things like vacancy factor. It is not reasonable to think that every tenant will stay forever. So there will be some vacancy factor because there's going to be time associated, and costs, with turning over a unit. Maybe that turnover of that unit is prompted by you. Maybe that turnover of that unit is prompted by the tenant or the tenants behavior. But one way or another, during your ownership of an investment property, you're going to have tenant turnover. So they can see rate is something that people use to calculate potential loss of income during the time of a turnover or during the time of vacancy. In our market, I usually recommend that people use a calculation of 5% off the gross income. I've heard things as high as 10% and it really just depends on the market that you're in. But it also depends on the team that you're hiring to help you. If you are going to be a self managed investor, meaning that you're going to take on the management of the property, you definitely need to consider a vacancy rate much higher than 5%. If you're using a professional management company, you should ask them what their actual vacancy rate is. In our case, we are far below the national average and far below our market average and we're ranging somewhere around one and a half percent vacancy, which is considerably lower than the average. But I still encourage investors to use a 5% vacancy rate for protection. Because what you're trying to plan for is loss of rent. The next thing that you're going to build into your metric, besides the obvious gross income minus expenses, is you want to build in a fee for property management services. Now, hopefully, before you started actually buying investment properties, you've talked to different management companies, and you've gotten comfortable with one. So that you can use their fee structure to help you identify the property. So many times, I have people come to me and they say to me, that, oh, you know, your fees are too much? Well, no, they're not, you're actually thinking a little backwards, our fees are dead smack on for the service that we provide. However, you're buying the wrong deal if you can't afford property management, professional property management. So before you actually go and acquire the property, I highly encourage you to seek out management, if that's your intention. If, you're obviously if you're going to self manage, you do still want to build in a little bit of a fee for yourself, because your time is not free. But you're going to need to know exactly what that fee structure is. Because depending on what part of the country you're in, depending on what state it is and depending on what type of service level you want, whether you want something a little bit more ala carte versus full service, that's going to drastically impact the fee for the property management services. When talking to the property management companies, you're going to also want to make sure that you do know about any other additional fees. Common, in our marketplace, would be additional fees like leasing fees. So managing a property with tenants in it is one service. But, going out and finding new tenants, marketing the property, showing the properties, helping people submit the application, that's a sales structure. And that is where leasing fees come into play. So definitely make sure that you know what your management company is going to charge. And the other key metrics that you need to use in any kind of financial analysis is repairs and maintenance reserves. So I don't want you to think of capital improvements when I think of repairs and maintenance. Because capital improvements you do need to separate from your analysis and analyze that in a different sort of way. And we'll talk a little bit about that, potentially this season. But repairs and maintenance. I'm talking strictly from an analysis perspective, a basic analysis, perspective, repairs and maintenance are the ongoing things that you should expect in the property. So there are things like upkeep of, you know, faucets, and sinks and plumbing and any electrical issues. You know, broken lights. You know, turn over the units. Those are all your general repairs and maintenance. The number that people use for this is kind of all over the board. Again, it really just depends on the part of the country that you're in. And actually, the type of property that you're buying is a big indication of this as well. I usually hear somewhere between two and 4%, for reserves for maintenance reserves. And that is an assumption of what your building is going to take year over year for maintenance. If you're buying a property that is seemingly very well maintained, and very well kept and there's a history of preventative maintenance on the building, then perhaps you can use a number lower than four or 5%. Maybe you want to use something as little as 2%. But it does matter what type of property you're buying. Now after you have that entire analysis, I want you to think about what that's telling you. Your analysis is telling you what to expect as far as vacancy. What your projected annual return is going to be. What your cash flow is going to be. You're also going to need to build in your debt service. So if you intend to leverage this property, what are your mortgage payments going to be? Are you in a flood zone? Is that something that you need to consider? Do you need to consider additional insurance policies above and beyond the typical hazard policy? So your real estate investment analysis is really about; what is a projection of what the first year should look like? Assuming that there's no major crises and assuming that your tenants adhere to your spreadsheet and, in other words, they stay as you project them to stay and your vacancy is not higher than your anticipated percentage. Your repairs and maintenance stay in line with your anticipated percentage of repairs and maintenance. And there's no additional charges beyond what you calculated for upfront. Meaning that you didn't find out after the fact that there was municipal licensing fees or tax related items that you weren't aware of. Your spreadsheet will also tell you what you likely can expect projected out for the next couple of years. And if you're not familiar with these types of spreadsheets and you want to reach out to me, I'm more than happy to share some financial analysis tools with you. In the show notes of this season, we will actually give you a link to one of the spreadsheets that we use on a regular basis for analyzation purposes. But going back to what I was just saying is that that spreadsheet only is a prediction. So many things can happen during your ownership of a property. Imagine if you had a fire. And Gosh, I hope you never experienced something so drastic, but it is possible. If you had a fire or a flood or something happened to your property, I assure you that your numbers are no longer going to be your numbers. If you buy a property and the minute you go to increase rents, everybody leaves your property, that's going to dramatically decrease your cashflow. If you are buying a building that ends up needing more renovations than you initially intended to do or plan for, that could dramatically alter the results of your spreadsheet. So in essence, what I'm telling you is that, although a spreadsheet is a good prediction tool, it's not a crystal ball. And it does not forecast what the future actually looks like. It is a goal to shoot for, and nothing more than a goal.
11:27
The episode will continue in just a moment. The best investments with the highest potential for a solid return always start with the right real estate purchase. But it's not just about a flips potential margin or how fast you can ready a property for leasing. It's about creating a future of financial stability for yourself and for your family. One that supports the lifestyle that you want. If you're an active investor and purchase, renovate and lease your own properties, and you love the process, the chase and the returns, you're in the right place listening to the show. Especially this season, because we're talking about a deep dive into how to purchase the best property for you. However, if you're more of a passive investor, and one who wants to diversify your stock portfolio with real estate, but you don't want to get involved in the active management of those properties, you're also in the right place. As we serve both types of investors. To gauge where your real estate investment tolerance sits and what would be the best fit to grow your income with real estate, I invite you on a call with me. To book your call visit growingempires.com and click book a consult. That's g-r-o-w-i-n-g-e-m-p-i-r-e-s.com and I'll help you choose the best real estate model to help you achieve your real estate investment goals.
12:35
Your spreadsheet is something that you should spend some time talking to your property manager about because if you have the right business partner, I assure you that that business partner will want to know what your goals are for the property and what you're projecting as far as your outcome of return on investment for the first year and, and years beyond that. But there's so many things that go into the success of that outcome. And the decisions that you make are more a part of that than anything else. For example, let's just say you know that you need to dramatically increase the rents because that's the only way the numbers are going to work because you bought the building too high. Well, the minute you go in and you start increasing rents, you could have everybody in that building leave. So if everybody left today, you have no income. But you still have expenses on that building. And now you've prompted a turnover, which is adding expenses to your building and to your cash flow. So you're going to want to really think about the strategies that you're taking. One of the things that I usually recommend to investors is, give the building 30 days. 30 days. And the reason I say that is because you'd never buy somebody's best investment, you're going to find something, I assure you ,you will find something that you didn't plan on. Either the tenants are not as good as you thought. Or, you need more money for repairs and maintenance than you had expected. But something is going to adjust itself. Perhaps the tenants don't pay rent anymore. Maybe they lose a job. Maybe it's so perfectly timed right after settlement. But one way or another, you're going to experience something that probably was not necessarily in line with what you had initially projected with your spreadsheet. But I do want you to think about the decisions that you make because they are very impactful to your overall results of your cash flow. So give the building 30 days. What does that mean? Well, for 30 days, I want to see how the tenants pay. Do they pay on time? How many maintenance calls do you get on the building? I want to give time to actually go and inspect the building and get to know the tenants a little bit better. When there's a bunch of people going into a building when the buildings are being shown in the heat of the real estate process, tenants sometimes don't even want to be home. So you may not have had an opportunity to really get to know the tenants or to really talk to them about their experiences in the building. And their comments are going to give you a really good indication of where you should really be focusing your strategies. Do they like living in that building? Has the building been good to them? Meaning have they had a lot of maintenance issues? And when they had maintenance issues, did the previous owner attend to them quickly? Or did he leave those things linger? Because if he left things linger, there's a good possibility that there's additional damages that you were not anticipating. But let's see how those tenants pay. Are they good paying tenants? Do they let you know what you need to know about the building or are they cause for conflict in your building? If we find that we have tenants that do not behave the way that we really need them to be for a nice, quiet, habitable building that people are proud to live in, then the first thing you might want to do is get rid of those tenants. And depending on the type of lease that they have, will depend on how long that's going to actually take. It could be something as quick as a couple of weeks to a month, it could be several months, just depending on the term of that lease. If you have a great first month, and you've got good paying tenants, and the building has been in good repair, and there hasn't been too many things that crept up, it will be time to start thinking about the capital improvements that you might have thought about or planned for, if there are any. And now it's time to think about how you can increase rents. Depending on how far away you are from where you want to be, you may want to think about is it time to turn over a unit. But with that turnover comes expense, and time most importantly. So let's just say we have to get a unit from a couple $100 to $1,000. Well, we know that the tenant that's living there, paying five or $600, probably can't afford the $1,000. Otherwise, they would be living in an apartment that's likely much nicer than where they're living now. So that's going to require you to turn over the unit. If you give the tenant notice today, they move out in a couple of weeks, they could first potentially sub pay. Now you may have a good security deposit on them. But I assure you that security deposit is usually not more than one or one and a half months, maybe two months at a max. So you don't have a whole lot of time to turn over the unit and still cover your expenses. And remember, security deposits can only be used for tenant damage, or for breaking the lease or lease term. So if they don't pay rent, you certainly can use their security deposit, if they do damage, you can use their security deposit. But if they pay you up to the day that they're leaving, and they're good paying tenants, and they left the union nice condition, they're entitled to their security deposit back. So who's going to pay for the renovations? Well, that's you the landlord. And for you to get a unit to look like it's worth $1,000, when it currently is at five or $600, it's going to require some amount of repairs, those repairs affect drastically your bottom line. And we need to start thinking financially about those decisions. So for example, if we're going to spend $10,000 on a unit, and I'm only going to get $500 more for rent, I want you to divide those two numbers and figure out how many months or years does it take me to actually recoup that money? And is that a smart investment. And that's a really good strategy to use. Anytime you're doing any kind of turnovers to your building. Does it make sense for the amount of money that you're going to recoup. You also need to think about loss of rent during the time that you're turning over the unit. So if you're going to sub out the work, because perhaps you don't have a professional property manager, and you didn't pre plan for this event, you could be losing two, three months worth of rent. And then you have the cost of marketing on top to find a replacement tenant as well as the timeframe to find a tenant and secure a tenant in the unit for new occupancy. So these are some of the things that create that J in that J curve. It's the dramatic change of what your spreadsheet says to what reality is. So when you're buying investment properties, I always say expect that the first year is not profitable. If you could sustain the expenses on the building for the first year without having any true real profit, then you've bought a good deal. If you cannot financially afford, or are not willing, to cover the cost or your expenses, then you might be buying the wrong type of deal for you. The J curve is not necessarily apparent in all types of properties. For example, if you're doing a flip, there's no income. There's no income on the property. It's all expense, no income, but hopefully it's a short amount of time. Then the minute you sell that property, you recoup your investment and you walk away, you buy another deal. So maybe instead of a year's worth of time covering costs, you're covering the costs for six months or so until you rehab the property and then turn around and sell it. So it's a much shorter timeframe to recoup your investment. If you're buying A class properties or properties that have been recently developed or a brand new construction, you would expect that they will be stable. However, they are dramatically impacted by the market fluctuations. So if all of a sudden we have an economic change, that stability that you once saw could be not the same in the future. So if you're buying A class properties, I would, you know, intend to, I would expect that they maintain more of a baseline. No real curve. But any economic changes will provide waves in your baseline. How do you protect yourself from the J curve? You protect yourself by knowing exactly what to expect going in. If you prepare in advance, and you think about your strategies, and you talk over those strategies with a good professional property management company, they will likely be able to help you pre plan for some of these events, like turnovers, and they will help you strategize to make the best financial decision. They will help you identify where we go too far with renovations. Because you never want to spend more than the unit is really worth to the occupant. But with proper planning, the J curve is not going to be so scary. It's going to be something that you're going to ride out and then year 2 and beyond is going to look ever so sweet. I encourage you to buy value add multifamily properties. They historically have the best return on investment and provide the most opportunity for upside. And because of the distress in some cases, you likely can buy them at very deep discounts. But please know, before you buy anything, what your analysis should look like. Make sure that you've done all of your research, you've talked to your property management company, you know exactly what fees need to be structured in. You never want to identify a property management company after you bought the property. Because you very well could have potentially bought a property too high. Part of being a savvy investor is buying the right deal at the right price. And to do that you need to have facts and you need to be prepared. I hope you got a lot out of today's show. I hope you understand the J curve. And I hope that when you go to buy your first or next investment property, you have nothing but success. And until next time, take care.
22:39
For more information about how Jennifer can help you plan, develop and manage a strong real estate investment portfolio visit growingempires.com