Want to know the secret to making a fortune from real estate?
It’s not actually a secret. Almost any good book on the subject will tell you that. The problem is more than 90% of those who invest in real estate have no idea what “buying right” means.
To many people, it means buying property when real estate prices are going up. That, as a practice, sometimes works. But as a strategy for getting wealthy safely? It is a very, very bad one.
The first property I invested in seemed very “cheap” when I bought it back in the late 1970s. It was a nice little Washington, D.C., apartment in a refurbished building. The landlady convinced me to buy it by showing me how much prices had been escalating.
She told me that if I bought this unit “now,” I’d stand to make a lot of money as it appreciated. To make it even easier, she got me a loan from some bank that required nothing down besides a few thousand dollars in closing costs.
When my wife and I signed the mortgage and got the keys, we felt like we had made a really good deal.
But real estate in Washington, D.C., was bubbling up in the mid-1970s, and lots of people who didn’t know a thing about real estate were jumping in. Including me.
It took me years to finally get rid of that first apartment (and the deadbeat prostitute who was renting it from me). And it cost me about $30,000 to boot.
I made many mistakes in that one transaction. But for today, I want to focus on just one: buying rental real estate without any idea of what a “good buy” really is.
When it comes to rental real estate, a good buy is getting the title to a property that can be fixed up and rented out at a profit right from the outset.
So what exactly does it mean to buy rental real estate “right”?
My answer is this: If you can buy a piece of property and have it fixed up and ready to rent for less than eight times yearly rent, you are almost certainly “buying right.”
Let me show you a specific example…
Let’s say the house you rent in your neighborhood costs $1,500 per month. That would be $18,000 in rent each year ($1,500 x 12 months). That means, as an investor in rental real estate, you should not pay more than $144,000 (8 x $18,000) for it.
This is a ballpark rule of thumb, of course. But I’ve been investing profitably in real estate now for more than 30 years (that first investment was my only loss), so I can say confidently that it’s reliable.
If you can buy rental property at that ratio, you stand a good chance of making about 8% to 10% on your money if you buy the property with cash.
This ratio I just told you about is called a gross rent multiplier (or GRM).
Eight times yearly rent is the maximum you should pay for any rental property. If you live in an area that has high property taxes and home insurance, a GRM of 7 is a better bet. Your goal is always to pay the lowest GRM you can find.
The big point here is that when you invest in rental real estate, you should be investing for cash flow, not appreciation. Your object should be to start making cash profits on your investment in the very first year.
Be aware: You can’t always find rental properties for a GRM of 8 or less. There are places where either rents are too low or property prices are too high… or both. These are places you should not invest in rental real estate.
There are also times when it is impossible or nearly impossible to buy rental real estate “right.” You certainly couldn’t have bought rental real estate for a GRM of 8 in Florida, California, Texas and other populous states in 2007 and 2008. The cost of properties back then was too high compared with their rent rolls.
But I want to stop here and reiterate the basic point I have been making. Buying cheap does not mean buying property when it “seems” cheap – either because it is shooting up or because it is cheap compared with what it was before.
The No. 1 rule to always follow is to buy rental property when you can get it at GRMs of 8 or less. If you do that, you’ll stand a great chance of having your property provide cash flow as long as you manage it well.