Amount Of Free Cash Flow Needed For Home Purchase First Time Real Estate Investors – Their Three Biggest Misconceptions

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First Time Real Estate Investors – Their Three Biggest Misconceptions

In such a market everyone wants to become a real estate investor. Values ​​have plummeted, sellers are eager to sell, and everywhere you turn people are talking about a “steal” in the real estate market.

That could mean new clients for those of us in the real estate business – but it could also mean new students. It ends up being our responsibility to teach new people about real estate, and one of the most important ways to do that is to clear up any misconceptions they may have.

If you’re looking to buy your first real estate investment, you may harbor some of these misconceptions yourself. I hope I can help educate you a bit so you can make more informed real estate investment decisions.

The three biggest misconceptions I keep coming across are as follows:

  • In order to be considered a good deal, the property they want to buy needs to generate huge cash flow.
  • This is difficult to address because, depending on the investor, this may be true. However, first-time investors often come into the game thinking that this is the law, without knowing why they think so.

    The truth of the matter is that, for the most part, cash flow is essential. No one likes to buy a piece of property that will cost them money every month. But, that doesn’t mean cash flow has to be extraordinary from the start.

    If you have any questions or need any advice or guidance in your endeavors feel free to contact me by e-mail at nick@philadelphiainvestordeals.com or by visiting my website at http://www.philadelphiainvestordeals.com. I will be happy to help.

    I purchased a Philadelphia investment property a few years ago for $40,000. The tenant was only paying $250 per month in rent. My total monthly payment was $375 which means I was paying $125 per month. Should I have walked away from that deal? Was I stupid to buy it? The answer is no, and there is more to the story.

    The property needed repairs and the ARV (after repair value) was about $65,000. And the tenant was a relative of the previous owner and her rent was $400 per month under the market rent for the area. So during the 3 months she lived there I made the necessary repairs to the property (total repairs cost me about $4,000) and when she moved out I rented the house for $725 per month. Now was I stupid to buy it? Of course not! In three months I made $15,000 in equity and was making $350 per month in positive cash flow.

    To take the example a step further, would it have been better if I had stuck with that first tenant for a year? How about two years? Do you see where this is going?

    Another misconception:

  • They can immediately raise rents to compensate for lower existing rents on properties they are buying.
  • You’d be surprised how many newbies feel this way. When I told one of my newbie investors about the deal mentioned above, he immediately asked, “Why didn’t you raise the rent as soon as you settled on the property?” When I told him she still had three months left on her lease, he said, “It doesn’t matter, you’re the new owner. You can raise the rent.”

    No, you can’t. The lease follows the property. Unless the existing rental agreement expressly states that the lease terminates immediately upon transfer of ownership (which it rarely, if ever) does, the new landlord is stuck with the lease signed by the previous owner.

    Therefore, the length of the remaining lease can greatly affect a buyer’s ability to purchase the property. If an investor cannot afford to carry negative cash flow for several months until the lease is renegotiated, either the property may need to be reassessed or the deal may need to be negotiated differently (perhaps settling depending on the seller getting rid of the current tenant or raising the rent prior to settlement.)

  • They expect to get their money from the deal as soon as possible.
  • When a client asks, “How long will it take me to get my money back,” I know I’ve gotten some education. What they’re asking is “Nick, I’m spending $20,000 in down payment money to buy this duplex, how long will it take me to get that money back in rental income?”

    Seems like a valid question on the surface except they don’t actually cost anything! The $20,000 is actually shifted from a liquid asset (cash) to equity in the property they are buying. It is still an asset on their balance sheet and is not really ‘spent’. It’s a common misconception that they “spent” their down payment money.

    I would calculate what they spent on their closing cost money (if the seller wasn’t asked to pay it) and how long it would take them to recoup it… but it’s not that easy to take. Closing expenses and dividing by monthly cash flow. There is also year-end equity build up that needs to be factored in.

    Here is a real life example. Mike bought a 4-unit property from me for $120,000 and put $12,000 down. He spent $5,000 in closing costs (the remainder was paid by the seller.) He was $17,000 out of pocket. The property generated a monthly net cash flow of $300 per month. $12,000 is still his. He recently converted cash assets into equity. We want to analyze the $5,000 in closing costs. We can do a quick calculation like this: Closing costs divided by monthly net cash flow = $5,000 per month divided by net cash flow $300 per month to repay $5,000 = 16.6 months. Not bad, he’ll recoup his closing costs in about 17 months, right? Wrong! What about the equity he accumulated at the end of the first year?

    (Stay with me… here comes the math):

    In this example, the average multi-unit in the area is growing at an average rate of 3.5% per year. So at the end of one year of ownership, the property will be worth approximately $124,200 ($120,000 X 103.5%). So at the end of the year Mike has earned $3,600 ($300 X 12) PLUS rental income of $4,200 ($124,200 minus the original cost of $120,000)…that’s a $7,800 profit! It can be annualized over one year at $650 per month ($7,800 divided by 12 months). And that reduces the payback period from 16.6 months to 7.7 months ($5000 divided by $650 in closing costs)!

    Of course there are more, but I see these three with more frequency than many others. If you are a new investor looking to buy your first property, I hope you found this article educational.

    I deal with many early Philadelphia and Delaware County real estate investors and believe me, as much as they are looking for the best Philadelphia investment properties, I insist that they learn to evaluate these properties to some degree. As a new investor it is imperative that you grasp some basic concepts so that you can make the most informed real estate investment decisions.

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