Episode 013 - The Real Estate Show

I am 100% financially sustainable because of my rental real estate investments. But it didn’t start out that easily, so I’m going to share what worked and what didn’t work in my real estate portfolio and how, once you discover what works for you, you can scale it to the moon and live 100% financially independent and sustainable.

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Show Notes

Everyone in the financial independence community talks about real estate.  Some shows ONLY focus on real estate.  There are a lot of highly caffeinated optimists in the real estate industry, and - be warned - most of them make some sort of commission, fee, sell a video course or eBook or something, so it is very hard to cut through the sales talk and get to the honest truth.  But the one thing that is true, is that no matter what sort of economic situation people are in, whether rich or poor, we all need a roof over our heads.

This is what drove me to real estate.  The simple observation that it is a physiological need.  Food, shelter & clothing.  It meant that in bad times, you still get paid the rent.  And (hopefully) most people will pay their rent before their cell phone bill, their credit card statement, etc.  No one wants to be put out on the street with nowhere to live, so it is a great motivator for the investor to get paid.

The formula here is very simple:  You use other people’s money (in most cases, a bank mortgage) to buy property, you charge tenants rent to live in it, you take the rental income and pay the mortgage plus other costs associated with you owning title and servicing the needs of the tenants, and everyone wins.  If you do it right, you will have a profit left over afterwards.  If you do it wrong, you will be supporting it with money from some other source.

Over time, the mortgage gets paid off.  At that point, your profit dramatically increases and you have the “goose that lays the golden egg” for the rest of your life.

That’s the simple theory.  For the most part, it works.  But it has a lot of bumps and false starts along the way - which can wipe you out financially.  So this is not a business for the faint of heart, nor is it a business that is for the “quick buck” speculator.  If you are that person, you should be buying and flipping houses for sale.  Not investing in real estate for long term rental income.  The analogy here is the quick infusion of a lot of money vs. the ongoing trickle of money coming in but perpetually.  Each to their own here - you may need some startup capital of your own to get the ball rolling here, and maybe flipping property is a way to do that.  Or you just save like crazy.  But one way or another once you are on the “property train”, your outcome simply comes down to how good a business operator you are.  And as I said in episode 2 of our podcast series, in capitalism we are all businesses.  The question is whether you are at the point where you run your world like a business because if you are not, rental real estate is NOT for you.  Yes, they won’t tell you that but this is a BUSINESS and it is for BUSINESS minded people.  Don’t try this unless you have that mindset.

I’m going to assume at this point that you either have that mindset, or want to have that mindset.  If not, stop listening now because I’m going to waste your time.  There is nothing magical here - running a rental real estate portfolio is no different to running a convenience store, a manufacturing plant, a service business.  You bring in income, you pay costs and you keep the profit.  Oh and taxes.  let’s not forget about taxes.

But with all of this it sounds like you have to spend a lot of time manaing properties, etc.   Nothing could be further from the truth if you are a good business operator.  With the realization that this is a business and not some side-hustle that doesn’t deserve the same attention as building any other business enterprise, you should first prepare yourself with the knowledge of running a successful business.  My best suggestion is that before you start looking for properties to buy, get this book - The EMyth by Michael Gerber.  It will tell you how to build a business without becoming a victim to it, and it is highly applicable to building your real estate rental business.

Now I’ll tell you how my wife & I do it, and you might be able to extract something from this.  

Before I started buying rental real estate assets, I built a property management company.  It had no property to manage, but I registered the LLCs, established the website, got all the licensing under control, setup Quickbooks and property management software, etc. so I was ready for it.  The idea is that the property management company makes no money.  Yep, that’s right.  It makes nothing.  It may actually lose money.  In that case, you can take the losses and apply them to your overall tax position, so it is an advantage.  It is what I refer to as a “passthru” entity.   It collects the rents and acts as your interface to your tenants.  Once it collects rents, it then distributes that to the building owners.  In your case, your building owner is YOU.  But by having a firewall between the property management and the buildings, you set yourself up with protection along with a simple way that replace that property management company with a 3rd party one should you decide you want to travel and don’t need to be dealing with tenants all the time.

This means that I have it so that my property management entity charges the market rate to provide the service of managing the property to the building owners.  They would have to pay this to a 3rd party if they wanted to, so it prepares you for detachment if you choose to do this in the future.  It also makes it an entity that generates income, therefore it is considered a bona fide entity.  It will file its own tax return as a separate entity, but it is charged by the building owners to represent the interest of the building owners with the tenants.  It has office hours, so you don’t get calls at 3AM that a tenant can’t stand their neighbor, etc.    My experience has shown that anyone that doesn’t first build a firewall between their own personal life and their “business” of managing the properties won’t stay in this game long, and the entire goal here is to play a long game with this.  That’s the only way you won’t lose your shirt in rental real estate.

I’m going to tell you that this structure should be used for each class of assets that you will acquire and own for the future.  Whether you are buying into other businesses, capital assets like vending machines, etc.  You need a way to firewall the management of those assets from you.  It also forces you to take ownership of what is making you profits and what is not.  Not understanding if an asset is a poor performer could add 10+ years to your journey to financial independence.  You won’t know this when you buy the asset.  Everything is a leap of faith here, so you need to get metrics to tell you what works and what doesn’t.  And this is where I started my story regarding rental real estate.

Our first properties

The first properties that my wife and I bought were in a small town in Australia called Mt. Barker.  We were living in Los Angeles at the time.  My wife had established a business in about the year 2000, buying surplus children’s clothing from a large national retail chain in the USA, and then sold them on eBay for big profits.  She started with nothing, but by having the willingness to just ask retail store managers what they do with last year’s stock, she managed to insert herself right before they sold it off to Ross or some other overstock company.  By doing this, she got about 3 months ahead and then sold the goods on eBay quickly.  Great little business - it didn’t last forever because eventually the corporation decided that they didn’t like individual stores making these corporate decisions and ceased providing stock to my wife.  But until that happened, she amassed great profits as a side hustle while I did my normal contracting work to pay the bills.

I’ve done episodes before on the Unconstrained Mindset as a result of someone telling me they couldn’t save up enough money to put a deposit down on buying their first rental property.  My answer to that is they had the wrong mindset.  What I’m explaining here as the method my wife used represents the RIGHT mindset, and as a result we had saved up tens of thousands in $USD.   

We made regular pilgrimage back to Australia to see my wife’s family.  On one of those trips, I was told about a major infrastructure project that was about to be completed that built a tunnel through a mountain that would connect the city of Adelaide with residents in towns in the hillside community.  Those towns were typically underserved with resources yet the residents there had to spend an hour to drive to the city for work, shopping, etc.  This tunnel would reduce that trip down to 15 minutes.

I immediately found a town that was growing based on this future speculation.  Because we had US income and my wife’s stash of cash, we managed to find lenders who were happy to lend to us at 90% LTV (loan to value), and we found two properties that we bought for about $90K each, meaning we had to put down $18K of our money.  Well it didn’t hurt that the exchange rate at the time was favorable to $USD, so while we were there we bought the properties, found a local property manager and signed the mortgages on them, and voila....   We were rental property owners.

We would get monthly statements from the property managers of tenants they got, rents received, maintenance work needed, etc.  These were single family homes.  From the income collected, we had the mortgages paid.  90% LTV mortgages were high, so we started with interest only mortgages to keep the cashflow intact with 7 year adjustable rates.  Australian mortgages typically don’t lock in like US mortgages, so you expect things to go up and down over time.  But rents can go up (at least that is what we thought).

Over the following years, it didnt’ work out so well.  We would constantly have to wire our own money back into our Australian bank accounts to supplement the shortfall between income less property management fees, less maintenance, etc. vs. the mortgages.  But I did see those mortgage balances falling all the time.  I just had to have the stomach to get through this.

What we did discover, however, is that there was a lot of government intervention in the property market in Australia.  When a tenant didn’t pay their rent on time, rather than a quick eviction process, the property manager had to negotiate with the tenant as to when they would pay because a normal eviction process could take 6 months.  That is 6 months of no income, meaning I’m supplementing the whole thing throughout.  Not a nice position to be in.

But what we did have is faith - we knew this could work if we could stay the course.  We felt that this strategy was far better than putting that money into a 401K or IRA in the USA.  Sure, there are tax advantages of doing this but I preferred to have assets that I could physically touch - not some mythical ticker symbols or bonds that a “trusted” Wall Street trader was looking after for us.  

My wife continued with her business while this was going on in its infancy and we had saved up more money so we decided to duplicate the process in Arizona in 2003 after we moved here.  We found a few condos that were in HOA managed communities and bought 4 of them.  If you remember in 2003, the USA was in the aftermath of the 2001 stock market crash, and a lot of money that was in equities didn’t want to go back into equities.  They turned to the real estate market and that drove prices up.  We wanted to get in before this really hit, so we did.  We duplicated the same process with US lenders but at this time at 50-70% LTV to avoid private mortgage insurance.  Again, we used interest only loan financing with 5-7 year lock in periods.  We basically tried to duplicate what we were doing in Australia in the USA.

We learned a lot here.  Firstly since we were our own property managers now, we had to do all the work we entrusted our property managers in Australia with doing.  We had to do our own evictions, but the difference was that in Arizona, the process is quick and clean.  They have specific courts setup for residential tenancy evictions with a 97% success rate to the landlord.  This meant you could evict a tenant within 21 days following them not paying their rent on time.   This “robo-eviction” process meant that outside investors would flock to Arizona to buy rental properties rather than areas like California or New York that (like Australia) could take 6 months to evict a tenant.

We started to see positive cashflow (that is profits each month) with USA properties and losses in Australia.  We found that the profits in one could offset the losses in another, but we became increasingly disappointed with the way that the Australian rental market worked, and the lacklustre services we were getting from our property managers down there.  Now that we were property managers, you have the right and knowledge to be critical of how they were operating.

The problem, however, in Arizona was the HOA.  Each one of our condos were in neighborhoods that were managed by HOAs and they were responsible for the upkeep of the area, policing crime, etc.  There were run by elected members that were just other property owners with some spare time on their hands.  Teachers, factory workers, etc.  None had any business experience.  But no one else wanted to do the job, so they got it.  Hence they made stupid decisions and we couldn’t do much to stop it.  I had no interest in running for some position on the HOA because I didn’t live there, yet we were subjected to the stupidity.  And this cost a lot of money.  Our HOA fees went up and up and up, eventually wiping out any profits we were making.  The values on the condos reflected this poor management.  To this day, I still own one of those properties and I can tell you that I would have a hard time selling it for what I bought it for in 2005.  Yep, 14 years later those properties were a bust.

So at this point, we are stuck with two under-performing buildings in Australia and four condos with shitty HOAs.  At this time you start questioning why you got into this shitty business.

That’s where most real estate investors take a loss, sell up and get out.  We didn’t.

We realized that the Arizona rental model is best, but you can’t have HOAs running the show.  So rather than looking at single family homes or condos, we started to look at the multi-family market.  This is where you buy a building that has multiple units in it.  We liked 4 plexes.  This meant if you had one tenant that gets evicted, you still have 3 rents coming in.  In Phoenix there was a lot of areas zoned for these, which would be considered low income housing.  But they could be purchased.  In 2007, we bit the bullet and purchased one.  We got it up and running and started to see that we actually got to keep the rents coming in after paying the mortgages off, and they had a positive cashflow.  Finally, we found the magic formula.

Meanwhile, our Australian properties were still losing money on a monthly basis, but the equity value of them were skyrocketing.  This was due to the new found wealth that Australia had in selling off its natural resources to the emerging Chinese market.  It seemed that everyone down there had more money, and people wanted to buy real estate with it.  We purchased single family homes in Mt. Barker at $70K each, and at this time paid down the mortgages to about $50K, but they were worth about $300K now.  Nice.

Then 2008 happened.  Yep, that 2008.  Ouch.  Property market in the USA collapsed.  We saw two things happen - the value of the properties dropped 50%.  Phoenix was hit very hard with the GFC.  People lost their homes to foreclosures, driving down the prices.  We had auctions of abandoned buildings going on all around us.  Our own properties had devalued so much that we looked seriously at throwing in the towel, filing bankruptcy, etc.   But we didn’t.

What we did was to sell the Australian under-performing properties and netted a serious after tax profit.  Then took that money, and used it to pay down mortgage balances and acquired a ton of other people’s foreclosures, but using the knowledge that we had gained from knowing what worked and what didn’t.  We avoided HOAs and partnered up with other investors to purchase more properties in the multi-family market that were adjacent to ones we already had.  We were buying buildings at $75K each, that today are worth nearly $500K each.  And we were buying with cash.  My wife would run a crew of laborers that flipped those multi-family buildings and got them back on the rental market and we could leverage the management work we did on them because they were located in roughtly the same area.  One trip down there to do maintenance could cover 2 or 3 units.   When we repainted and made one of our buildings better, the whole street benefited, so we did all of our buildings and they all went up in value.  It was like squaring the ROI.

Our property management business that I talked about earlier firewalled us from this so we could scale without any major issues.  We invested more into our website, took rent payments by credit card (we were one of the first in Phoenix to do that), and created a self-running business that took care of 24 “doors”.  It wasn’t a burden - it was something my wife loves to do.  My goal was to create a real estate business that could be run from anywhere in the world by having team of local contractors available that could be sent out to fix plumbing, etc. and we built up a great relationship with law firms that could do our evictions, process serving, etc. but avoided most of that by being available (electronically) with tenants if they had issues or needed some flexibility to get through their rent payments.  It works and continues to work.

Today those properties are worth millions.  The rental cashflow that comes in is more than enough to cover our living expenses, so we are 100% financially sustainable.  But more important, with the free’d up time, I can speculate and invest in other areas meaning that I can transcend this as just a part of our overall financial picture.

What’s the take away from all of this?

If you want to get into real estate, you will fail on your first few properties.  You might get lucky and find a good one to start with at the right time, but that is a lottery ticket that few get.  You will get motivated by listening to all the real estate shows, gurus, etc. but ultimately the buck stops on your desk.   It is hard to think of real estate as a “quick buck” business.  It isn’t.  It is a long game.

If you diversify, you have a chance.  Because at any one time, you might have properties with high rents, but high expenses.  Or properties with lower occupancies but lower expenses.  Or properties with high equity values, but low rents.  You get the idea.  There are many aspects to a performing property and the stars have to align to get all of them.

The one thing, however, you have on your side is time.  If you are playing a long tame, time helps you.  Rents go up over time.  If you have a fixed mortgage, it doesn’t change, so the delta between income vs. expenses widens, meaning profits.  If you can make your entire burn rate from those profits, you never have to work another day.  But it won’t happen from day one.  It could take five or ten years.  Or longer.

But if you get 15 year fixed rate mortgages, you know that 15 years from now the tenants will have bought you an asset.  Yep, that’s a pretty good incentive to stay the course in my book.  Because in 15 years you have no idea what the world will look like, but you do know that your own ability to earn income is going to be affected by two factors (other than your age):

1.  Population growth  - more people will be in the workforce
2.  AI - less jobs will be out there for more people

Here’s your chance to have a strategy that could get you away from those meta risks.

Oh and one other thing....  Student loan debt is ravaging the spending power of the average American meaning that the barrier to entry to buying properties (despite the current extremely low interest rates) means the demand for rental property will be at an all time high.  This supply/demand curve results in higher rents, which is what you, as a landlord, want.  

Sure, there are a lot of other tricks here too.  You could “house hack” and live in one of the units while renting out the others.  Or you can use depreciation on those properties as great ways to offset taxes you are paying in other areas.  Real estate has a lot of factors that make it a very attractive proposition.

But one big one is that you do this with other people’s money.  You only need the downpayment to get into a property.  Unlike buying into equities, bonds, funds, Vanguard, etc. you don’t need 100% of the money to do this.  From day one that you get the title to the property, any market increase in its value is yours to keep, even though you have partnered with a bank to get it.

Your ability to borrow becomes critcal in being able to get into this business.  That means you have to be uber-focused on things like credit scores, etc.  You need to get your credit card debt down to nothing.  You need to learn how the credit scoring market works - you need to hvae a lot of available credit offered, but utilization of it at a very low level (at least no more than 30%).  I am self-employed from a tax perspective so that means it is way harder for me to get financing than the average W2 income worker who has been in the same job for 2 or more years.  As much as you don’t want to be that W2 worker, you can take advantage of the positive light that bankers will see you in for this.

And yes, you can use equity you have in other things as part of the downpayment.  This is where it gets super risky and I would only do this (particularly with your home mortgage) if you have no other choice, and only for a very short period of time.  If the market doesn’t treat you well or let you refinance out, you could be left without a chair when the music stops, and trust me - it does stop.  2008 is when the music stopped and it took brass balls to get through that.  But thankfully over history, this is an exception and not the norm.

I return back to the very first thing I suggested for your entry into this business.  Build a property management business first to firewall yourself from the properties.  One further addition to this is that once you acquire the properties, title them in their own LLCs so that you have some legal protection against things going south.  If a building becomes party to a lawsuit, it should stop there.  I’m hopeful you never see that happening, but a bad operator can find themselves on the other end of a lawsuit from tenants or contractors that place liens on property for unpaid work, or taxing authorities that don’t get their sales tax or property tax payments, etc.  You have to run this like a business.

But in 15 years time, the mortgages are paid off.  If your real estate rents are $3500 a month for a building, after you pay the insurance, property taxes, maintenance, etc. you get to keep the rest.  And once you start with one building and have the firewall in place, it is easy to scale this.  If you are netting $2,500 a month of smart income here, and you have 4 buildings (not hard to do), that’s $10,000 a month of sustainable income for the rest of your life.  Welcome to the world of the unconstrained.

You scale this up or down as much as you want, but I can guarantee that in a world of lower interest rates on savers and retirement planning products becoming riskier and riskier as interest rates can’t deliver anything close to the spending levels for people, having real estate assets generating you at least some of your income is the only safe way I see this going forward.

You have to learn the laws in your jurisdiction regarding rents and tenant rights, etc.   One thing you have to accept is that everyone hates landlords.  You are the bad guy no matter what happens and you have to put people out on the street.   If you can get yourself comfortable with that, then you can do this.  But if not, you will need to return to the herd and find another way to get through your future.  The worst thing I see new landlords doing is to try and be the tenant’s best friend, because from our experience 3 out of 5 rental leases don’t complete to their normal termination period so you have to adopt the “bad cop” position here to protect yourself.   You start to realize that your relationship with the tenant is no more than the lease contract signed.  That the reason they are tenants and you are the landlord is that you made good financial decisions and they haven’t (yet).  Many are just dysfunctional and you need really good investigative reporting facilities to weed out the serial evictions, criminal behavior, etc. that you should screen out on rental applicants.  Good screening will save you tens of thousands of your hard earned dollars.

So that’s about it.  This is not rocket science.  It is, however, the observation that owning assets that generate income is the core center of financial sustainability.  It isn’t for everyone, but for those with the iron will to do it, it can be the greatest performing asset class you can have.

Now one thing I would say....  International diversification saved us.  Having properties in one region that were up allowed us to offset losses in other regions, and the cash to acquire other people’s disasters.  You have to rely on third party property managers here, so it is a bit of a leap of faith.  But today there are AirBnB type services for short term rentals as well as longer term ones, and we didn’t have access to that when we had our Australian properties.  We are currently investing worldwide in real estate to ensure that should we find ourselves in a 2008 GFC crisis again, we have some diversification to save the day.  I’d suggest that you build that into your plans.  Meta level economic problems are typically regional so global investing makes a lot of sense here.  Maybe not day 1, but it should be on your radar if you are looking to protect yourself for the future.

I circle back to what I was referring to in episode 10 of this podcast - the mindset of the unconstrained.  When faced with the question, “How can I buy rental property when I can’t save up any money to get a deposit?”....  Well think of my wife and her little side-hustle venture that allowed us to do this.  And maybe your first couple of properties have to to be with harder money lenders that allow you to get in with less down payment.  There are lots of options out there, and sure - some have higher risks.  You need to mitigate the risks to a level you feel comfortable.  But you can do it.  It is in your mind.  Engage the problem solving skills of your brain and anything is possible.

I would also recommend, if you haven’t read it already, get and study “Rich Dad, Poor Dad” by Robert Kiyosaki.  It is gold in this business.  

And also consider the question....  How will my life look in 15 years time if I DON’T buy income producing assets like real estate?  To me, that question is far scarier than what it takes to get started in this area.

Good luck.