It’s All White Noise

What is white noise? If you are not old enough to remember tube televisions, white noise is the static you would get when either the antenna isn’t picking up a signal or when there isn’t a source plugged in. It was a white/grey screen that played this scratchy and empty sound. In order to resolve the static, you would adjust the rabbit ears (adding tin foil if you are a level 10 master) or blow into the Nintendo cartridge until it worked. The thing is, the static is annoying. White noise can fill an empty room if the volume is up and drive you crazy, so you have to find a way to fix it or turn the TV off. What is the white noise in real estate investing?

“You’re going to be stuck paying that mortgage when your renter doesn’t pay!”

“You are going to be a landlord? Good luck. . . I had an uncle that went belly up in ‘08”

“We will see how you do when a tenant trashes your house!”

These are things even seasoned investors hear all the time. All the bad things that can and sometimes do happen to us. How do you get past all of this? How do you recover from big blows? How can you prevent it from happening? Furthermore, how do you even get started with so much negativity from the start? The best thing I have learned is to listen to people that are successful in what you want to do. Second and third hand accounts of failure are just that. It's not from “the horse's mouth”. And if the horse is saying it, take a look at their experience and then evaluate if what they are saying has merit or not. Let’s dive into a few topics that are the WHITE NOISE behind Real Estate Investing (REI)

White Noise Myth #1

“What happens when the tenant doesn’t pay and you are stuck paying the bill?”

This can happen. It has happened to us and it can likely happen to you. I like to think of this scenario in a reference to football. From 1917 until 1939, football players wore only hardened leather helmets. It wasn’t until 1939 that Riddell created a hard plastic helmet to protect players from further head injuries. Over the years, the helmet has been advanced to protect players even better. Players, coaches and fans could all see that this was a high contact sport and there should probably be more protection to the most vital part of our body. This layer of protection is used to hedge against injury so players could keep playing. Just like in REI, we too need to hedge against injury with some sort of protection. In the event that your tenant is not paying, what type of protection can you have to prevent or resolve the issue. 

You should reflect on how you got to this point. Most often, investors end up in this situation due to a lack of diligent screening. A well thought out screening process must be put in place to make sure your future tenants are not only financially able to satisfy their obligation to pay rent, but also to see how their history has been paying others. This is why we look at credit scores, job history and income statements. While we do not have a set credit score that determines a future tenant's acceptance, it goes into consideration along with many other factors. A good screening process is one of the best helmets you can invest in no matter where you are in your investing journey. 

One book that really helped us get started was The Book on Managing Rental Properties by Heather and Brandon Turner.

Have a strong lease. A well structured lease can help you when a tenant isn’t paying. Make sure you have the ability to cancel the lease when the tenant stops paying and begin the eviction process. Check with your state laws and local ordinances before putting anything on paper. David Tilney has a great class that helped us structure our lease in ways to protect both the landlord and the tenant. You can learn more about his course here. We highly suggest getting some education on a strong lease that will work in your favor!

Bottom Line: create a strong screening process and have a strong lease.  

White Noise Myth #2

“You are going to be a landlord? Good luck. . . I had an uncle that went belly up in ‘08”

We have been investing in Real Estate only since 2017, so we were not there in 2008 when many landlords lost some if not all of their portfolios. We do, however, have many colleagues that were there and weathered the storm. How do you create a hedge of protection against something like this in the future? What does this helmet look like? 

All of the statistics used can be found here

First you want to look at the likelihood that this will happen again. While what we saw in 2008 was historical, it is not too likely we will see something of that magnitude again. The banks learned a valuable lesson along with home buyers and investors. Regulations and red tape have been put in place to help prevent it. In 2005-2007, it was likely you could get a home loan so long as you had a heartbeat and the ability to sign some papers. Today, it is a long process to get a home loan and banks are very strict on their policies. 

Secondly you want to look at the data of how much rent decreased in 2008 and the years that followed to see what your buying guidelines should be. What I mean by this is, when you run numbers on a potential property, make sure that after all expenses are taken into consideration, you are left over with enough cash flow that would allow a decrease in rent. 

While some of my colleagues say they reduced rents to keep people in their homes during 2008 (reduction of 10-15%) data shows that on average, rents did NOT decrease, they in fact increased! This should not be a reason to not hedge against it, nonetheless. You should always be prepared for a rent decrease. 

So why did homeowners lose their homes if it wasn’t because of non payment? ARMs. Adjustable Rate Mortgages. Many mortgages that were given out to homeowners were ARMs. When housing prices decreased and the market was starting to plunge, mortgage companies adjusted mortgage rates and homeowners now had a higher payment to make. Many of them were unable to make these payments and were forced to sell. With their loans being highly leveraged (they put very little cash down on the property) and their home now being worth less than what they paid for it, homeowners were forced to just walk away from the property. They foreclosed and let it go back to the banks. 

Answer: Make sure that whatever loan package you are signing up for is something that you can reasonably fulfill. There are so many types of loans out there and you should just be cognizant of their obligations. ARMs are very dangerous if your profit margins are slim. Also be aware of short-term loans with high interest rates. If you think you can flip a house in 3 months, you might want a 6-12 month term just in case something goes wrong. The best exit strategy is to have several back up plans for when things don’t go as planned. My suggestion is to make sure your loan package is a fixed rate or that you purchase your investment property using OPM (other people's money/private money). How do you use OPM? That will have to be discussed at a later time as it can be pretty in depth.

Bottom Line: educate yourself!

White Noise Myth #3

“We will see how you do when a tenant trashes your house!”

Just like myth #1, you can hedge against this in your screening process. While that doesn’t always prevent it, it greatly reduces the risk. So what do you do if this happens? This is why we have reserves. If you are not tucking away some of that cash flow you make each month for this “rainy day” then you are doing yourself a disservice. How much is enough? That all depends on your risk tolerance. If you are scared to death that a tenant will destroy your property, then you should probably tuck away a decent amount (10-20% of cash flow). If you are not too scared of this, then a healthy amount may be just 5%. 

Aren’t they responsible for paying this? 

Yes they are and you should absolutely try and get it. The problem is that while you can try to get the money to cover the damages, it is likely to be in court for months and you need to get your property back up and rented again. You will have to foot the bill until it can be handled in court. Don’t count on getting back every penny or any penny at all. Often, getting money from a person that would destroy your property is like getting “blood from a turnip”. We still have a judgment against one of our first (inherited) tenants for almost $8,000. We will likely never see it. Sometimes this is just the cost of doing business. 

One thing I hear a mentor of ours tell the REIA meetup we attend is that “You will get education in one of two ways. You can pay for a seminar, a book, a class, etc. or you can learn it on the streets. One is going to be far more expensive than the other. That's for you to decide.” 

Bottom Line: have reserves!  

So are you going to hear the white noise and just turn the TV off or are you going to grab the tin foil, adjust your rabbit ears and find a way to turn the white noise into something that works.