The IDEAL Investor Show: The Path to Early Retirement

Ep 91 Performance Criteria: What to look for when buying real estate

• Axel Meierhoefer • Season 2 • Episode 14

Share episode

More on YouTube? Check the video version on Youtube

Start taking action right NOW!

Connect with us through social! We’d love to build a community of like-minded people like YOU!


Any questions?

***

Grab my 10k/month passive income strategy and weekly newsletters at https://tinyurl.com/iwg-strategy

BOOK IS OUT! Grab Your Copy and learn how to get your feet wet in real estate investing


Hello, and welcome to another episode of The IDEAL Investor Show with Season Two where we focus on cash flow. And this episode is focusing on performance criteria. And there are a couple of different ways how you can actually evaluate the performance or the expected performance of an investment going into the future. And as you know, our focus is mainly on residential real estate. So we're looking at single family houses duplex triplex maybe up to a four Plex, and there are a couple of different criteria to look at it. So for mostly the single family and duplex, you want to separate between a property that is renovated and a property that is brand new. And in the past, what we used to do was basically apply the performance criteria of 1% for renovated properties and a little bit less than that for a brand new build to rent like new construction properties. Now the issue, as you can imagine, is that we have had and are in the middle of these really elevated interest rates. So when you think about how much difference does it make? Well, if you buy 150,000, or $200,000, single family residence, and you used to have 3% interest or 4% interest, and now it's seven or eight basically double. And you know that a large portion of your mortgage payment is the interest in the beginning of a new mortgage, a new 30 year mortgage, you're actually paying more than half of your monthly payment in interest, and only a tiny portion, in principle, meaning like you're reducing the actual amount that you got from the bank or from the lender. So the vast majority goes into interest. And if you take a normal deal that we used to have in 2020, or 19, or 2021, then you could come to a performance situation where you say, Okay, I buy $150,000-160,000 house, and I can get $1,500-1,600 a month in rent, which would be 1% of the purchase price. And that would easily give you the $200 minimum that we want to have and positive cash flow for each of our properties. Now, if that were the exact scenario and you double the interest rate, those$200 might be eaten up. Now, depending on exactly what the deal is how much you pay how much down payment back and forth, you might end up in the original calculation with 4% or 5% interest to be more than $200 a month in positive cash flow. But then as you can imagine, more and more of that positive cash flow gets eaten away, the higher the interest rate is. So the question becomes, what do we do in that scenario, now two things have to be considered, the performance used to be quite different between a renovated property and a better end property. And the reason for that was that when you take everything together to build a whole house from scratch, basically, compared to having an existing house and renovating the most important systems and bringing them all up to standard, you still had certain pieces that you did not need to address and that difference actually resulted in a different price. And so the lower obviously, the price of a similar size property in a similar location is the more your cash flow would be. That's why we've always said, Okay, if you have a brand new property, and you get a ratio instead of one person, meaning like 150,000 purchase, 1500 rent, and you get a brand new property that costs let's say 170,000, and you get 1500, the same rent, then that is not 1% anymore, that's maybe point eight or something in that area, and that was to be acceptable. So what has happened in the last few years, you all have experienced that prices, especially in 2019,2021, even into 22 of real estate in general kept increasing kept increasing, because there was so much demand. And money was cheap, up until basically the early part of 2022. So lots and lots of people besides us as investors wanted to invest in real estate, and wanted to buy real estate to occupy themselves basically buy a house with that, obviously there at any given time that way more existing properties, then brand new ones. If you think about it to build a brand new house in any existing community, you have to look at about one and a half to two years to go from okay, I'm buying a lot and now I'm going through the permitting process before you can even start in some locations depending where you are in the country. It can be even three or four. And I know of some larger developments, you know, like huge apartment complexes that took eight to 10 years in California or in Washington State to even get the permit before you could ever see that building, but the fact remains that the number of existing houses that would potentially be available for us to invest in or for somebody else to buy, versus whatever at any given time is brand new, is many, many more existing one. So what does that mean? It used to be that the existing properties were a little cheaper. And therefore, it was easier to reach the 1% rule. Now, when there was a big push, because even though prices had increased, the pandemic came to an end, money was still cheap, lots and lots of people wanted to buy single family residences. And they because of supply and demand push prices up. And they push prices to a level that the difference between a nicely renovated property and a brand new build property are not that very different anymore. So what does that mean for our cash flow situation? Well, you might, on the one hand, say, Well, if we have set a brand new property is still okay, from performance. Since we're talking about performance here. And performance criteria when it gets 2.8. Instead of 1%, you have to ask yourself, can you do the same thing with the renovated property and I would say, ideally, you don't want to do this with one little caveat that applies for both our clients for the vast, vast majority buy these properties. And I have always only bought properties that I really want to keep kind of forever or a very long period of time. So what then happens is you have these ups and downs of interest rates. And you might to some extent, also have a little bit of ups and downs. In prices, at least there's a little bit of a fluctuation, but interest rates, you definitely have ups and downs. And we've seen it in 2022 interest rates have basically doubled from what they were before. Now with that in mind and thinking, Okay, we're working towards our time freedom point, what we do if we were to find a property, where the price, and the ratio to rent is still between point eight and 1%. But when we do the calculation, we come out because of the high interest rate of just barely break even or maybe making $50 or $100 a month, would we make the deal. And this is really an assessment of risk, that now plays a role in the performance criteria, because the criteria to say, Okay, it's the price and the rent I can make in a fair relationship still remains. But because of the higher amount of interest, you would have to pay for the mortgage, there might still be very little or no money left. So if you believe that this elevated level of interest rates that we have for mortgages, for credit cards for car loans, and so forth, by the way, it also applies for the government, right, the government has to pay the higher interest rate to not the level that we have to pay for mortgages. But right now, the federal rate is at almost 5%. And that means the government is paying between four and 5% interest on all the debt that becomes due and needs to be renewed with Treasury bonds. So how long do we all believe? Can the government and normal people pay credit card interest car loan interest mortgage interest at that level, or maybe even slightly more if the Fed keeps increasing a little further this year? And how long will it take to come back down. So in my opinion, I would say right now, I would never buy a property that does not have at least a little bit of positive cash flow, even if it is potentially slightly less than a minimum of $200 that we have always said we want. So don't buy anything nowadays, or ever in the future that doesn't have at least a little bit of positive cash flow. At the same time, I believe that the level of interest rates that we have right now is unsustainable. It's unsustainable for the economy. But it's also unsustainable for the government. And because of that, I believe in the next two to three years, interest rates will start coming down, they don't probably gonna go all the way back down where they were at the end of 2020. But they will come significantly down. And the good thing to improve the performance of our properties is that let's say they come down and we close on a deal right now at like 8%. And right now, the regular interest rates for purchasing a house that you want to use yourself is between six and 7%. Let's just say they come down so that regular interest is again, four or four and a half and investment interest is five or five. Now, that difference of three or two and a half to 3% is substantial. And that would allow you if you refinance to that new lower rate would allow you to jump your cash flow right then and there. Right. And if it comes down further, which I don't believe that it's possible, then you could a few years later refinance again and maybe get again rates like 4% or four and a half percent, like we used to get in 2019 and 2020. But it's really an important thing that criteria to look. Is it a good year with 1% or renovated In about point 8% or so, for brand new properties is still there. But the cash flow aspect might be a little hampered due to the currently high interest rates. And you have to ask yourself, Am I willing to wait those two to three years, and then really start having the income, but you already own the asset and tenants are helping you during that time to pay down the mortgage? Even if it's only a little bit? What do you rather say? No, I'm using this for accumulation of my funds so that when interest rates come down to more reasonable rates, then I have money to buy more than one property at a time, I keep investing, I believe it's only two to three years. And I rather have the opportunities that perform to one person or point a person as explained before, rather than having then to compete again with all kinds of people because as you can imagine this, our criteria were remained the same. But when interest rates come down, all the people that have been waiting all want to get into the market all at once. So you know, I always been a fan of Steady as she goes, if something meets the criteria, I'm willing to give a little bit, even though I'm still ideally looking for $200 minimum on a single family residence. And I want to tell you, we just had somebody buy a duplex, actually two clients bought duplexes, and they made pretty much the amount of money that they expected in cash flow, and they will make even more cash flow when they refinance and in two to three years. So I hope you understand the criteria of 1%. And point 8% haven't changed. But the outcome on the positive cash flow has changed due to high interest rates. And you have to decide, am I gonna go along with that and own the asset and let tenants pay it down? And then refi in two to three years? Or do you want to wait and rather accumulate the money in a tea bond or in a savings account or in a CD or something like that, where you get at least some interest on your money while you're waiting for interest rates to come down. So that's the deal about performance criteria, the fundamental underlying criteria hasn't changed, but the interest rate environment has changed. And so you have to decide, I hope that was education helpful. If you listen to this on a podcast, I would like to ask you to download it. Give it a rating, give it a comment, because that really helps us to publish more podcasts like this. And if you see this on YouTube, please give it a like if you're not already a subscriber, please subscribe and give it a comment. And please also let me know what other topics you would like me to address in the context of generating cash flow, getting passive income and reaching the time freedom point. So that's it for now be well stay safe, and I'll catch you in the next episode. Thanks for listening. And I hope you enjoyed today's episode of The IDEAL Investor Show more info and the links we mentioned during the show in the show notes or you can go to our website at IDEO redcross.com and sign up for the Apple podcast link. And if you'd like to talk to me sign up for a strategy call. Hopefully you want to share what you learned with your network and bring more people in we are really eager to hear your comments and until next time, be well stay safe and ciao.