Assessing the Real Risk of Risk

Purchasing a home can be very stressful.  Whether it is your first home purchase, or your tenth, you still might have reservations that lead to “analysis paralysis”, where you can’t make a decision.   

A friend of mine went through this just 24 hours before closing on her first home.  She called me and walked me through some of her concerns, which included:

  • An overzealous HOA board. 
  • The unknown state of the real estate market. 
  • Some unapproved improvements to the interior of the home. 

She was very concerned about these potential issues, and about to walk away from the deal. 

So I walked her through a “Plan B” process, where we assumed the (unlikely) worst case scenario and then determined what she would do if any of those were to become reality. 

I like to use a “Plan B” process whenever I’m have concerns about making a major decision.  It allows me to assess the real risk of any given situation much easier, by looking at the solution you’d create in the event of a negative event.  

Here’s a hypothetical example of how it works: 

Concern 1: “I’m concerned that the HOA board could be overzealous, and make my living situation there untenable.” 

Worst Case Scenario:  A contentious relationship with the HOA board. 

Worst Case Solution(s):  Proactively befriend the board members, opening a dialogue.  Then run for a seat on the HOA board.  If that doesn’t work, hire an attorney to aggressively defend your rights. 

Concern 2: “I’m planning on using the profit from this home to fund some future obligations in 5-10 years.  What happens if the market shifts downwards?”.

Worst Case Scenario:  The local real estate market drops 20%. 

Worst Case Solution:  My friend is buying the property at a 20% discount to current market rates.  This allows her to better weather a downturn.  She could also alternatively rent the property (at a profit, based upon her calculations) until the real estate market recovers.  Or delay her plans and continue to live in the home. 

Concern 3: “The home has some unapproved interior alterations, such as an interior closet.  What happens if I’m forced to remove these alterations?”

Worst Case Scenario: The cost to remove these would be $1,500. 

Worst Case Solution:  Pay the $1,500. 

By looking at the (realistic) worst case scenario, you’re able to understand the real risk of any given situation – and then proactively come up with solutions to those risks.  When you buy a home for $100,000, your realistic risk isn’t $100,000.   It’s either :

  • the mortgage cost for 10 years, because the typical real estate market cycle lasts roughly 10 years, and you just need to cover the mortgage for that period of time until you can sell the property.    OR
  • the amount of equity you could lose in a market downturn if you’re forced to sell at the bottom.   I like to estimate a 20% dip, but you can choose the number that you feel most comfortable with. 

Using a “Plan B” process can not only make it easier for you to make difficult decisions, but it also has the added benefit of training your brain to think about positive outcomes versus negative possibilities.  

Try it sometime and let me know how it works for you.

How I’m Deciding Whether To Rent (Or Sell) My House

Lately I’ve been debating about selling my home in Vegas.  Spurred in part by my father (who is  by nature a fiscally cautious and reserved person), I’ve been trying to decide if now might be the time to sell the home and reinvest in another investment property. 

I started with a traditional options list – 

In the “it’s time to sell” column are:

  • The pandemic and the exodus of California have created a housing shortage in the Las Vegas area.   The market is at an “all time high”. 
  • I can sell the property and not incur capital gains taxes, qualifying under the “2 in 5 years” rule. 
  • The potential elimination of the 1031 exchange

In the “it’s time to rent” column are:

  • The potential profit, especially considering the fees incurred by the seller, doesn’t meet my objectives. 
  • The difficulty in finding a replacement rental property.
  • I have limited liability against the home. 

I then built a spreadsheet to run the numbers.  It includes the calculations if I sell the home:

From the sale price, subtract the purchase price, repair cost, commissions / fees, and if applicable the personal taxes you’ll pay on the profits.  What’s left is your net profit.  

It also includes the monthly and annual profit if I rent the home. 

From the average rental income, subtract the mortgage, the property taxes & the insurance (assuming they are not included in the mortgage payment), HOA fees, home warranty cost, average maintenance and ancillary costs.   

This will give you the net cash profit.  

Optionally, you can include the estimated earned equity you generate with each mortgage payment.  

With these numbers, I’m able to derive three base figures:

  1. The number of years of renting it will take to generate the same amount as selling. 
  2. The number of years of renting (including earned equity)  it will take to generate the same amount as selling. 
  3. The number of “rental years” it will take to pay off the home loan. 

In my case,  those numbers were:

  • 9 years to generate the same amount of income renting vs. selling. 
  • 5 years 3 months to generate the same amount of income (including earned equity) renting vs. selling. 
  • 20 years to pay off the loan with rental income.

I also looked at some of the more traditional calculations.  Dividing the annual rental income profit (cash only) by the initial downpayment is a 7.4% yield.  Including the equity increasing that to a 12.9% yield.   The same calculations based upon the current equity is 3% and 5% respectively.  

As a side note, for these calculations I did not include the cost to repair the property – as they would be the same if I sold the property or rented it.  I did , however, consider the cost the repair the property in consideration of the net profit earned if I sold the home.  

So what am I going to decide to do?   Well, honestly after the cost of repairing and selling the property, the profit upon sale isn’t tremendous.   Which also means that the potential benefit of avoiding capital gains on the sale of the home is minimal.  

I’m still working through the numbers, but I’ll let you know what I eventually decide.

How I Purchased My First Rental Home

You may have previously read stories by other real estate investors, who recount overcoming seemingly insurmountable odds to purchase their first rental property, which quickly becomes an amazingly lucrative investment.  This is not one of those stories. 

There really is no reason why I should be a real estate investor today.  In high school, I ignored sage advice from my grandfather who repeatedly extolled the values of real estate.  An extremely successful businessman in his own right, he often told me that his biggest mistake was selling his home each time he was transferred to a new city by his employer.  I can still hear him tell me “We may have had to have tightened our belts for the short term, but over time those houses would have become constant streams of income”.   And while he encouraged me to attend college, he also suggested that a career as a realtor would allow me to earn an income while learning about real estate firsthand.  Young and ignorant, I dismissed his advice as hyperbole from an older generation.  

Throughout college, I continued to rent rooms and apartments from other people.  It never occurred to me that I was helping them to pay their mortgages, and built equity in their real estate investments for their futures.   This trend went on even after I graduated college, until an unfortunate turn of events found me living back at home with my mother and my stepfather.  

Perhaps “unfortunate” is too strong of a word.  I went from working 10 hour a day, six days a week doing manual labor in a hot factory in Orange, California to being laid off and lounging in my parents pool, overlooking a golf course in Las Vegas.  I still remember my response when my former employer called to invite me back to work:  “I’m good, thanks though!”. 

But my days of summer tans and endless trips to the minibar were short lived.  It wasn’t long before I’d overstayed my welcome … and honestly if it wasn’t for the fact that I’d overstayed my welcome, I’d probably wouldn’t be where I am today.   If memory serves me correctly, my parent’s exact quote was “It’s time for you to go buy your own house”.   Perhaps they didn’t put it so nicely. 

So that’s what I did.  I don’t think that my parents were envisioning me buying one of their homes, but that’s what happened.  I purchased a small three bed two bath home about 3 miles from their house.  I put 25% down against the sale price of $120,000, covering the remaining balance with a 30 year mortgage at 7.25%.   

As I look back, I’m not sure how I made it through the home buying process – I was completely clueless.   Even though I bought the house from family I still somehow ended up paying a premium vs. the market. But despite that, and the fact that the house needed a tremendous amount of work, everything ended up working out.  

The house had tenants-in-place, whose lease needed to end before I could move in.  While that was happening, I was able to find my first of many roommates – allowing me to house hack long before I knew what that actually was.  At long last, someone else was helping me to pay my mortgage and build equity as opposed to the other way around.  Though I probably didn’t realize that at the time – I was just happy to have the company.  

Nearly 25 years later, I still own that home, among others.  The fact that I overpaid for it by about ten thousand dollars isn’t nearly as big a deal anymore.   It’s a rounding error in the grand scheme of things.  

More important to me is the realization that while they didn’t have an immediate impact, the lessons of my grandfather did eventually sink through.   I just wish that would have happened at a time when he was still here, so that I could thank him. 

The Things I Don’t Put In Rental Homes

I’ve been renting homes to tenants for over fifteen years.  During that time, I’ve learned – sometimes the hard way – that you can eliminate a lot of stress and hassle by what you don’t put in a rental property.  

This week, I thought that I’d share a list of the top things that I don’t put in rental homes:

  1. A Pool or Spa

    Sure, pools and spas are very attractive to prospective tenants..  And you might be able get a few hundred dollars more rent for a rental property with a pool vs. one without one.  But the hidden costs will quickly eat up that extra profit.  Maintenance, even in warmer clients, is expensive.  Insurance is expensive.  Pools and spas are, you guessed it, expensive. 

    Better to avoid the pool or spa, and just focus on offering a clean, well kept home.

  2. Rigid Door Stops

    I saw a video about a year ago from YouTube personality Meet Kevin, where he touted the perception value of a rigid door stop over the common spring type.  And I cannot argue with him about their appearance.  They certainly are prettier … I even have them in my personal home.  

    But the rigid doorstop has one enemy.   The vacuum cleaner.  Sure enough, your tenant is going to hit them with the vacuum.  Over time, they’ll come out of the baseboards – forcing you to replace not only the doorstop but the baseboard too.  

    A better option is to go with a high end spring door stop, or a doorstop affixed to the door hinge. 
  3. Over Toilet Cabinetry

    These are a recipe for disaster.  Sure, they offer additional space, especially in smaller bathrooms.  But they’re just begging for someone to knock something into the toilet causing a potential major clog. 

    You might think to yourself “Scott, this isn’t my problem.  The tenant will just have to fix it.”  The reality is that regardless who fixes the problem, you’ll get a call from a tenant hoping that you’ll offer to fix it at no cost. 

    Why risk it.  Just don’t install it.

  4. Dog Doors

    I love pets.  But dog doors in rental properties are the worst.  First, they are always dirty and never age well.  Second, they limit your home to always being a rental for pet owners.  People who don’t own dog, let alone other pets like indoor cats, typically don’t like dog doors.
  5. Real hardwood floors

    And the final item on my list is real hardwood floors.  Unless the rental is older, and they add to the aesthetic of the building, I avoid real hardwood floors at all cost.  The expense and upkeep just don’t make economic sense. 

    It is far better to go with a nice engineered floor, which will wear much better over time.

That’s my list of things that I never put in rental homes.  I’m interested in your thoughts.  What’s on your list?