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Real Estate Investing

Real estate investing can be a great side hustle and offer a near immediate revenue stream. While buying the house that you live in offers great tax benefits and can be a good option for building equity, real estate is ONLY a side hustle if it generates revenue. As a general rule, a second property that is not rented out should be considered consumption, not an investment.

The ideal real estate side hustle formula is simple: income = rent – (expense + mortgage). Most folks miss the boat a little on this one. In my conversations with nascent real estate investors, they simplify formula this way: income = rent – mortgage. Before I purchased by property I was in this second group. I didn’t consider the expenses before I purchase my property and it led to a loss each and every month.   

My Story 

I hate to admit it, but I started real estate investing without a plan. It began when I visited my parents in Colorado Springs. The downtown area had all the hallmarks of urban decay. Homelessness, visible drug use, and run down liquor stores and hotels were the highlights if the district. When I was visiting home one summer I happened to see an announcement that the city council approved a redevelopment of the area. Realizing that Colorado Springs is the second most desirable place to live and the fastest growing city for millennials, it instinctively felt like a good place to buy. I ran a total of zero numbers, looked at zero comparable properties, and did not negotiate on price. I just looked at the pretty picture (below) and paid the down payment. I recommend doing a total of none of these things. 

No matter how good the area is, if you don’t understand the math of the deal you’re going to lose money. 

I purchased my house as my primary residence so was able to take advantage of the terrific zero down with mortgage insurance paid by the insurance company. This is a sweetheart deal available only to first time homebuyers, but is broadly available to those in this position. The first year after purchase, I lived in the property full time until an unexpected job change led me to move abroad.  After that move, I wanted to rent out the property while I was abroad. When I originally started renting I thought the math worked like this:

	Monthly Cost	Monthly Profit
Mortgage	2253.58
HOA	250
Rent		2800

Monthly mortgage of $2253.58 and a homeowner’s association (HOA) fee of $250 equals a grand total of 2503.58 net cost per month. With rental income of 2800 I assumed I was making a net profit of 296.42 (2800-2503.58=296.42) per month. By no means enough to retire early, but not a bad way to build equity while having some cash on the side!

The problem is that this woefully underestimates the expense of owning a rental property.

Understand the other expenses

In addition to the transparent expenses paid each month, there are litanies of other expenses that fall primarily into three categories: monthly payment, annual payment, and incidentals/reserve for the future. 

Monthly Payments

• Mortgage Payment: This is the interest plus principal that you pay each month to your mortgage lender. 
• Home owners association (HOA) fee: Is your house have any shared community services like a pool, common facilities, parks, etc? If so, you’re likely on the hook for some kind of monthly HOA fee. I pay a 9 percent of my rent to HOAs each month.
• Property Management: Property management is the fee you pay someone to mange your property. This includes collecting the rent, fixing the toilet, and generally being on call should a problem arise with your tenants. A great property manager can put your investment on autopilot, but you’re paying anywhere between 7-10 percent for the privilege.
• Utilities: Water/Sewer, Electricity, Garbage, Natural gas may be paid by your tenants, but be sure to clarify that from the outset. 

Annual Payments

• Insurance: Insurance covers damage to the house, liability from accidents, that sort of thing. This is a fixed cost quoted to you, I pay 2.2 percent on monthly rent on insurance.
• Property tax:This is the annual tax paid to the local jurisdiction where the property is located. Many mortgages include this cost as part of the monthly mortgage payment, so this might fall within the “monthly payment” category. I pay 4 percent of my monthly rent to property tax.

Incidentals/reserve for the future

• Vacancy: Odds are pretty good that your rental property will not be 100% fully booked at all times. If it is, it means your rent is too low. Best to take a monthly reserve to guard against unforeseen vacancies. I reserve 3 percent of monthly rent.
• Repair: Rate of repair varies widely across properties. A newer home may need relatively minor maintenance. An older home may need a lot more. This is a line item that needs to be reserved throughout the year to guard against unforeseen circumstances. I reserve 5 percent of monthly rent.
• Capital expenditures (capex): Capital expenditures are the big-ticket items that need to be replaced from time to time but are unlikely to come up every year. Common capex expenditures include flooring, appliances, roofs, water heaters, or any other large item you should budget for but that do not occur enough to be easily accounted for. I reserve 5 percent of monthly rent. 

Make sure the numbers work

In John Schaub’s classic bookon residential real estate investing, he outlines the clearest way to make money on a new purchase. The 10/10/10 rule for buying a house states that when you buy, you make no more than a 10 percent down payment, pay no more than 10 percent interest on the loan, and buy at least 10 percent under the market. This rule guarantees an immediate profit. Unfortunately, these types of deals take time and effort to source, require non-traditional lending (banks generally require a 20 percent minimum down payment), and likely require buying via a foreclosure or from someone with money problems. 

Even if a deal is not quite as good as Mr. Schaub recommends, there are still many ways to maximize your potential return. But to do so, you need to not only understand the full costs of a property, but also extrapolate the gross operating income, net operating income, and gross scheduled income. Bookshave been written about these concepts and we will delve into them at a later time. 

Summary

To make money in real estate, you need to fully appreciate the costs and revenue of a real estate investment. In my case that I mentioned above, I lose $525.82 per month on the investment. This is OK for me because of the positive tax implications and appreciation of the asset, but everyone’s situation will be different. To illustrate this point, I’ve pasted below the costs associated with my property in Colorado. 

	January	February	March	April	May	June	July	August	September	October	November	December	Monthly	Annual
Mortgage	2253.58	2253.58	2253.58	2253.58	2253.58	2253.58	2253.58	2253.58	2253.58	2253.58	2253.58	2253.58	2253.58	27042.96
Property tax	135.32	135.32	135.32	135.32	135.32	135.32	135.32	135.32	135.32	135.32	135.32	135.32	135.32	1623.84
Insurance	62.98	62.98	62.98	62.98	62.98	62.98	62.98	62.98	62.98	62.98	62.98	62.98	62.98	755.76
HOA	250	250	250	250	250	250	250	250	250	250	250	250	250	3000
Property Mgmt (10%)	280	280	280	280	280	280	290	290	290	290	290	290	285	3420
Vacancy (3%)	84	84	84	84	84	84	87	87	87	87	87	78.3	84.775	1017.3
Repair (5%)	140	140	140	140	140	140	140	140	140	140	140	140	140	1680
CapEx (5%)	140	140	140	140	140	140	140	140	140	140	140	140	140	1680
Water/Sewer	0	0	0	0	0	0	0	0	0	0	0	0	0	0
Electricity	0	0	0	0	0	0	0	0	0	0	0	0	0	0
Garbage	0	0	0	0	0	0	0	0	0	0	0	0	0	0
Natural gas	0	0	0	0	0	0	0	0	0	0	0	0	0	0
Rent	2800	2800	2800	2800	2800	2800	2900	2900	2900	2900	2900	2610	2825.833333	33910
												Liabilities	3351.655	40219.86
												Profit	-525.8216667	-6309.86