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"Sometimes people freeze when they set out to buy their first rental property. They want a super deal, but they don't have the experience to recognize whether they've found a bargain or a headache." Suzanne P. Thomas
Rental Houses for the Successful Small Investor
By Suzanne P. Thomas
Rental Houses for the Successful Small Investor by Suzanne P. Thomas is a great book to help people who want to become financially independent get started in real estate investing. Cash flow from real estate rental properties, Thomas writes, can be your ticket to early retirement, allowing you to live the kind of life you want.
I especially like what Thomas says about the need to save, so you have money to invest. Thomas writes, "Saving today so you won't have to work tomorrow demands discipline. It requires the ability to see into the future. Saving can be fun if you believe that every dollar saved is helping you to buy your life back. Just like the Greek slave who could earn money and save it in order to buy his freedom, you can liberate yourself from the tyranny of earning a living. If you think of your savings this way, it may make being frugal almost as much fun as spending."
So, why isn't everyone becoming financially independent by investing in real estate? Thomas explains that most people don't understand the principle of compounding wealth. Because of this, people don't remain committed to real estate investing.
To make the point, Thomas asks us to consider taking a 35-day job where we can be paid either one of two ways. First, we can be paid $1,000 daily. The other option is being paid only a penny the first day. Then, for each of the next 34 days, our income will double. The temptation is to take the $1,000 per day for a total of $35,000. But, via compounding, the penny-a-day option grows into an amazing $343,597,363.21.
Similarly, Thomas observes that many people who get started in real estate investing abandon it after only two or three years because they feel they aren't generating any noticeable dollar return on their real estate investments. Thomas advises, "You should make at least a five year commitment to real estate if you want the chance to experience substantial financial rewards." Most people abandon real estate investing when they only see the pennies in the first few days.
Thomas says that each rental property you acquire will probably take about two to three hours per month to administer and that real estate investing can be the ideal home business. She points out as few as five rental properties can provide a core, livable income in five to ten years.
The financial advice in Rental Houses for the Successful Small Investor is solid. Thomas hammers home key aspects of real estate investing.
The Chapter, Rates of Return on Rental Real Estate, is especially valuable. Thomas shows new real estate rental investors how to calculate the rate of return they are achieving on their rental properties.
This rate of return, Thomas explains, is composed of three main parts. First, there is the potential property appreciation. Second is the rental cash flow from the properties. Third is the "principal paydown," i.e., as the years pass you acquire more equity in your rental real estate. Thomas also allows for the tax saving acquired because the IRS lets you depreciate rental real estate from a tax standpoint, even though your property is probably actually increasing in value.
Rental Houses for the Successful Small Investor has a realistic discussion of the role of financial leverage in increasing rental real estate returns. The book explains how to use financial leverage effectively without taking on too much risk.
The Chapter, Rates of Return on Rental Real Estate, calculates the rate of return on one of Thomas's actual, Colorado rental properties showing how it achieved a 30% annual rate of return. Rental real estate returns tend to decrease slightly with time, Thomas explains, because as you own the property longer, more and more of the principal on the loan is paid down. Hence, you are using less and less financial leverage. So, while the return on a rental property just purchased might be 30%, the rate of return on a fully paid-for property might only be 12%.
Partially due to this factor, Thomas likes adjustable rate mortgages over fixed rate mortgages for her rental properties. While prepaying a fixed rate mortgage has the tendency to shorten the length of the mortgage, it does nothing to reduce your monthly mortgage payments, she explains. We want to keep our rental properties leveraged to increase returns, so shortening the length of the mortgage isn't fully beneficial. And, it costs money to extract cash by refinancing properties in which we already have much built-up equity, so that we can invest the money in different, and more highly-leveraged, rental real estate.
But, when we prepay on adjustable rate mortgages, Thomas explains, the effect isn't to reduce the length of the mortgage, but rather to reduce our monthly mortgage payments. This increases the investor's cash flow and allows the money to be reinvested in new real estate properties (or, as Thomas did, allows you to retire earlier).
Thomas also discusses the risks associated with choosing adjustable rate mortgages for real estate properties. She doesn't view adjustable rate mortgages as being as risky as many people think they are. Thomas says this is partially because, as interest rates rise, more people won't be able to afford home buying as an option, and there should be more renters. So, rents will probably increase with increasing interest rates.
Thomas recommends making extra payments toward principal on your rental properties' adjustable rate mortgages. This has the effect of reducing your monthly payments without shortening the length of the mortgage. Thomas shows that, by making extra payments toward principal, you can reduce your monthly payments so an increase in interest rates won't overwhelm your capacity to pay down your real estate mortgages. By reducing your monthly payments via prepayment, you will create a buffer to help shield you from increasing interest rates.
Thomas suggests that you can also diversify your real estate mortgages by having some fixed rate mortgages along with some adjustable rate mortgages.
Rental Houses for the Successful Small Investor also gives the real estate investor tremendously useful information about:
The chapter about reducing your taxes, via 1031 Tax Deferred Real Estate Exchanges, and the information throughout Rental Houses for the Successful Small Investor about reducing your taxes on real estate investments is especially valuable.
Thomas writes, "Depreciation is a wonderful tax shelter for the small investor. Whatever money you can save from the tax man today can be invested to get you to your goals that much sooner. While it's true that you will owe taxes on any gains you realize as an investor, these gains are only taxable when you sell. Instead of selling and taking the proceeds, you can do 1031 tax deferred exchanges..."
Thomas goes on to say, "Or if you can keep your properties until you die. At the time of your death the value of all your real estate becomes its basis, or its official cost according to the Internal Revenue Service. So if you buy a house for $100,000 and depreciate it down to $50,000, you would owe deferred taxes on the difference when you sell the house.... But if instead you die and leave the property to your heirs, the $50,000 basis will jump up to current market value, let's say $125,000. If the total value of your estate is below federal estate limits, your heirs won't owe any estate taxes. If they sell your properties for the value the properties had at the time of your death, your heirs won't owe any capital gains tax either. By dying, you have done more than just defer taxes-you have eliminated them!"
If you are contemplating investing in real estate and, in particular, investing in rental properties, I highly recommend buying a copy of Rental Houses for the Successful Small Investor by Suzanne P. Thomas. Rental Houses for the Successful Small Investor is highly readable and packed with useful information to help you get started in real estate investing.