How to Start Investing in Real Estate

Today’s Spotlight Page is a download of Chapter One of Rent Roll Triangle.

John Wilhoit: [00:00:01] Hi this is John Wilhoit on John Wilhoit on Real Estate. Our podcast today is titled How to Start Investing in Real Estate.

John Wilhoit: [00:00:06] We have with us Darsweil Rogers. Darsweil and I've known each other for over 10 years. He's the managing partner at Cape Fear partners. Darsweil, we have quite the history together.

Darsweil Rogers: [00:00:24] We do. We've been in the space of real estate in some interesting ways so I would have to agree with you.

John Wilhoit: [00:00:32] Darsweil and I have known each other, as I shared over 10 years. We both grew up in Southern California but we didn't meet each other until we were over the age of 40. We've been around each other ever since.

[00:00:43] Darsweil has a company, Cape Fear partners. The Web site is Cape Fear Partners.com. He is an executive coach and consultant. He's been all around the country, predominantly in New York, but also in the south and has had quite a successful career for many years. If you want to contact Darsweil, his telephone number is (910) 818-5308. His is e-mail addresses is [email protected].

[00:01:20] We have a little bit of a different format based on Darsweil's extensive experience in radio. He's spent a number of years as a talk show host. So. although this is John Wilhoit On Real Estate Podcast, for these episodes, with Mr. Rogers is in essence going to be interviewing me about the topics that we're discussing. Today's topic is where do I begin my investing career in real estate. As you know, we only take about 20 minutes per episode and that's what we'll be focusing on in this podcast.

Darsweil Rogers: [00:01:53] The topic as you said is about, if I'm going to invest in real estate where do I begin. Let me ask the basic question John. Where would I begin? I mean do you could consider school or should somebody go back to school? Should they get a real estate license? We're talking about investing so why would that make sense. If you were starting out today what would you tell a person in terms of how they should begin a career as an investor in real estate?

John Wilhoit: [00:02:23] Whether you're at the age of 20, 30, 40 or 50, I always come at this topic the same way. I suggest to people that they become a homeowner. If you can be your initial volley into the world of real estate. You're doing a lot of things all at the same time. Yes, you're buying a piece of property but on top of that you're investing in something that could potentially turn into a rental at some point. It doesn't have to occur that way of course.

[00:02:55] If you're already homeowner and you want to talk about investing in real estate, we will certainly get to that within this podcast. For those that have no real estate whatsoever that's the best way. And there are a number of reasons. Number one, if you're not a homeowner you're paying rent to someone else. So, stop doing that and pay that same dollar amount into an investment or into a property that you own.

[00:03:21] Secondarily, as a homeowner you're making part of your payment each month towards the mortgage. You're gaining some equity just by paying down the mortgage a little bit each month. Those are two reasons to get into real estate as a homeowner.

Darsweil Rogers: [00:03:37] That is not what I expected you to say, that as an initial foray, but it makes perfect sense. What is it that I should know before I decide to buy a piece of property and maybe try to buy a home? What kind of homework should I do before I decide that's what I'm interested in?

John Wilhoit: [00:03:59] That falls just too easily into talking about 12 Steps to Home-ownership which is a book I just released in July of 2017. There is also an online course. Aside from educational material, what you get by investing in real estate is more than just a yield particularly if it's to become a homeowner. You're gaining a place to live. You're gaining a place to live where your dollars, instead of going into rent, are going into your home. That's why I suggest home-ownership initially as the best place for people to start investing in real estate.

[00:04:36] Let's say you're already a homeowner and you've decided that a percentage of your investment portfolio should be in real estate. Where do you start? Where is the scale? Single family, buying and other single family home, is perfectly fine. But then you only have one individual asset and it's either rented or it's not, You're either at 100 percent occupancy or you're at zero percent occupancy.

[00:05:02] Instead of doing that, my recommendation for small investors is to purchase a duplex, triplex or 4-plex, something under five units. Because it's less than five, it's not considered a commercial deal. It's considered a residential deal. Back to the home-ownership piece, you can buy one to four units and still acquire home-ownership like financing.

[00:05:28] Meaning, if there's 90 percent loan-to-value mortgages available, then you can likely attain that and still have other people assisting in paying that larger mortgage. When I say a larger mortgage, larger than if you bought a single-family home and you had to pay the entire mortgage yourself. When you're buying a duplex, triplex or 4-plex there are other people assisting you (renters, tenants) in paying that mortgage.

Darsweil Rogers: [00:05:57] You raised the point. You said this from the very first time we ever met, about having a diversification of the risk. The idea of buying a duplex or 4-plex, allows you to do that. But before we get there, if you decided that you want real estate to be a part of a diversified portfolio I would say the typical person who jumps into real estate is probably putting whatever cash they accumulate initially into real estate. How do you feel about the notion that a person says I've accumulated money and I've decided I'm going into real estate and they're really putting whatever investment dollars they have strictly in real estate initially? Is that something you would say people should do or do they need to think a little bit differently?

John Wilhoit: [00:06:47] It's a matter of determining your risk tolerance and, like any financial planner, and I don't pretend to be a financial planner, if you have a financial planner or accountant on your team they're not going to recommend that if you have $25,000 in an available cash that you put all $25,000 into a single investment, right? They're going to ask you to retain some reserves personally and retain some reserves for that investment.

[00:07:14] One of the biggest mistakes that new investors make is they take that nest egg of X dollars, whether it's $10,000 or $100,000, and they lay it all on the line in a single investment. You can do that as a professional because you know exactly what you're getting into. And you know some escape hatches already before you ever get in.

[00:07:35] As a new investor, you have to watch the leverage component. You can't over leverage and utilize all your cash to make that initial investment. Because if anything goes wrong, fill in the blank on what anything means, then you're already upside down and having to scramble just to retain that investment.

[00:07:54] We all know how severe this most recent recession was. It wasn't a one or two-year event. I'm not even sure if it's over yet. It is for most people, but not for everyone. There are parts of the country where real estate prices have yet to recover back to their 2007 high. And this is 10 years later. So, you can't plan on appreciation. We cannot plan on increases in value just because we're walking around living and breathing. It doesn't work that way.

[00:08:27] If you're going into any individual investment, real estate being particularly capital intensive, then you can't use your entire cash to do so and not leave yourself with any reserves. Be very conservative with respect to leverage. As much as 75 percent loan-to-value loans sounds good, if you can get it to 70% and increase that cushion, increase free cash flow after expenses, then that's a better option for the new investor.

Darsweil Rogers: [00:08:58] There's two things that you've said and I think most people who think about starting out in real estate would not typically do. One is to buy at least a duplex if not a 4-plex, to have more than one tenant in the property to diversify your risk as well as the notion that you don't want to take your entire nest egg. and put it in real estate.

…buy at least a duplex or a 4-plex, to have more than one tenant in the property to diversify your risk…

[00:09:28] Actually you said three things. The third thing you said was even though you might actually get 90% percent loan-to-value or 80% loan-to-value, you should look to de-leverage or to have it less debt than the typical person would consider doing. Those are three things I would say are different than what the typical person jumping into the real estate would consider. Do you agree with that?

…look to de-leverage or to have it less debt…

John Wilhoit: [00:09:50] Yes. I know there's a lot of people that are into flipping homes and single-family homes. To me, I'm going to catch some flak for this I understand, while that is a business, it's a business unto itself, yet it's not a sustainable business. When you are flipping homes you're only as good as your last deal and you're always looking for another one.

[00:10:10] When you're a real estate investor or owner you own a business. Let's look at that: an atypical $250,000 property as compared to an atypical sandwich shop that also cost $250,000. Those are both operational businesses. If you buy them when they're already up and standing and running. Both have a purchase price of X  and both are already generating X dollars of revenue and cash flow. They have certain expenses.

[00:10:44] You're buying an operating business even if it's a single-family home as a rental, f it's a duplex as a rental, if it's been there for any period of time and has a history. That doesn't occur in a lot start-up businesses, like home flipping. The reason that it's necessary to reduce your leverage is because increased leverage equals increased stress or anxiety because the margins are so much smaller. with respect to free cash flow, or net operating income, in our business.

…increased leverage equals increased stress or anxiety…

[00:11:15] That's why I focus so much on suggesting to people that they de-leverage or use more cash even on their initial investment. So that they are not going into the deal with their hair on fire and having to make sure that everything works perfectly.  This is hard enough when you're a full time professional in the business, even harder if it's your first investment and you don't have the experience on the property management side to make sure that the asset runs as it should.

Darsweil Rogers: [00:11:43] Let's talk about two things that you said there. The first one is free cash flow. What is free cash flow free?

John Wilhoit: [00:11:54] Free cash flow is net operating income minus expenses for financing. Net Operating Income represents how much cash is available after operating expenses for the property. If you have a property and it's generating $25,000 a year with expenses for maintenance, upkeep, utilities etc., after all those expenses the remaining cash flow is $12,500 a year.

[00:12:28] That sounds all well and good. Yet we haven't made the mortgage payment. The mortgage payment includes principal and interest and may also include insurance and real estate taxes. So out of that remaining $12,500 we have to pay that expense. Whatever cash is remaining after that expense we still have one more expense.

[00:12:52] That would be an impound account or a cash reserve account where we place anywhere from 1 to 5 percent of revenue for things such as roofs, water heaters or replacement of windows, bigger expenses. After all those are paid we have what's called free cash flow.

Darsweil Rogers: [00:13:13] The idea that a new investor would take that disciplined approach that you just talked about...that's a very disciplined approach to investing. I'm curious, in your experience, how many folks follow that sort of advice versus jumping into the middle of things? What are the implications for having not followed a good conservative approach to investing?

John Wilhoit: [00:13:47] Being an old head, having made investments in the 1980s 1990s, 2000s...those decades were a different time and place than oday. You could get away with certain things prior to 1986 changes in tax law than you can today. After that, it was still a different format with respect to the availability of financing, underwriting standards, they change like the wind. Now they're  tight. To get a mortgage today is more than just fogging a mirror. Today, there's a substantial process at every level to get a new loan. So, adding that extra layer of cash to a deal, any more, it's not necessarily compulsory, it's often an absolute necessary to get into the transaction.

[00:14:42] If you want to play in the game and still reduce your risk, that means you have to open a different Pandora's box. That different box is when you go into a transaction with other people so that everyone isn't taking on the full amount of risk.

[00:15:00] I say Pandora's box because even if it's just you and your best girlfriend, or cousins, or just family members that have decided to buy this property that's next to another property they already own... Whenever you bring more people into the transaction there still has to be someone in charge. And there has to be someone in charge that's allowed to make decisions. It can't be by committee. It can't be just when someone gets around to making decisions.

[00:15:30] Placing $10,000 into a deal doesn't give you a lot of rights. If there is a quality structure, however, that's not a bad way to go because then you're not utilizing all of your cash to put into a single investment where you own the entire property.

[00:15:48] If there's 10 people placing $10,000 into a deal  then everyone has the same amount of risk. If that same $100,000 is buying a $250,000 property now you're looking for a 60% loan-to-value new first mortgage. That's reasonable leverage. That will create cash flow and free cash flow and the investor should see some form of yield from that.

Darsweil Rogers: [00:16:15] Let me stop you. I want to talk about partners in a minute. Before we jump to the idea of having partners, let me ask the basic question; how do I pick a good property? You're telling me now that I should buy a duplex or 4-unit versus single family. Not all properties are considered equal. How do I decide what's a good property and let's just go ahead and say at a good price because they at some point go hand in hand with but there are some differences. What is your advice in terms of picking a good property and then price?

John Wilhoit [00:16:56] Fall 2017 I'll be releasing a book entitled Rent Roll Triangle  and that book provides a single equation for rating properties irrespective of the property type.  We're trying to build out an app to go with the book and I'm not so sure that we're going to be able to do the app as quickly as we can release the book. This book, Rent Roll Triangle, will give people in essence, a very easy back-of-the-envelope equation that has a lot of power in terms of determining income elasticity.

Please consider purchasing my book How to Read a Rent Roll. In my book are equations that reflect a methodology for reviewing the financials. Beyond the financials, we also talk about demographics, sub-market analysis and selecting neighborhoods- what to look for and reference to the profile of the people that live there. Also, some methods for looking at comparative properties or competitive properties because every property is within a neighborhood and every property has other properties that it competes for residence. If you are buying an asset, it must be a competitive asset within that neighborhood.

Darsweil Rogers: [00:18:24] What you just said John, translates into a need for a person to really get educated before they step into the space of investing in real estate. You suggested a couple of your books which will without a doubt help them.

Darsweil Rogers: [00:18:43] How does one gauge, or, what would be your recommendation- or how do we know we are ready? How do I know I'm ready to delve in. How do we decide when a person should in effect take that next step into investing?

John Wilhoit: [00:19:02] I have a very succinct answer for that. Money aside (because you certainly need cash to be an investor). You can do some high leverage things.  If you are going to be an investor, and you've decided to pull the trigger, and you're still unsure then you need to bring people with you. I talk a lot in my books about building a team so that you never go it alone.

You never want to buy an investment where it's just you talking with another guy or you talking with another person, a professional, we don't care what stripe they are- and its just the two of you making the deal. That, for a new investor is all kinds of red flags. You really don't know who you're dealing with. I'm not trying to say that there are a lot of shady people in the business. But guess what; there are shady people in the business.

As a new investor you need to have a team that has experience. Let's say that you've got the team. You've hired an accountant, you've got a real estate attorney, a mortgage banker that was referred to you. You've got these people around you, but you still are not quite sure if you can really proceed with this. Well here's the hook up.

The hook up is you bring into your team a professional property manager. You don't go it alone even if it's just that single little duplex and that's going to be your baby. That's not the place where you need to have a learning curve on how to become a real estate investor because a real estate investment without a property management is D.O.A. What I mean is, there's no such thing as a piece of property that runs itself. That's how you create a circumstance that makes sure that you're not the one that has to be on point for everything when you really don't know much of anything about the investment class.

Darsweil Rogers: [00:21:03] So here is where we come back to the question about partners. You have broadened the definition of partner in my mind from beyond investing partners to the other players that you need to have on your team before you decide to make this step. Let's start with this question around having more than one investor and then could you talk about, attorney, mortgage and property manager.  Walk me through the partnership idea in terms of getting into the business.

John Wilhoit: [00:21:37] I'm really talking about pooling capital. When you're coming into a real estate investment and yours is not the only cash in the deal that presumes that there's other people bringing cash into the deal. With that, you need a vehicle whether it's an LLC or some other format so that the asset is owned in a single asset entity so that no one person owns it. You don't want to put everybody's name on title and then if something occurs whether it's a falling out or someone dies, life happens, it doesn't get murky. If it's in an LLC those interests can transfer to the family or someone can sell their interest in the LLC without disturbing the asset. Whenever you have more than one person's money in the deal, as I shared earlier, someone has to be in charge, someone has to be on point and there has to be agreement on that. If you don't have that at the very beginning then don't do the deal because it's just going to get worse from there.

Darsweil Rogers: [00:22:32] John, I think great answers. I appreciate having the opportunity to talk to you more about this. And I believe that your listeners will truly gain some benefit from it.

John Wilhoit: [00:22:46] Thanks, Mr. Rogers for being on the program today.

Darsweil Rogers: [00:22:50] My pleasure.

John Wilhoit: [00:22:54] This is John Wilhoit on John Wilhoit on Real Estate. Thanks for listening.

John Wilhoit is the Author of five books, including: "How to Read a Rent Roll: A Guide to Understanding Rental Income".  Join the conversation at JohnWilhoit.com for updates, blogs, books and podcast.