8. Margin of Safety

It was 4 am in the morning and something woke us up one night. Reading another book written by Seth Klarman, Margin of Safety, Klarman stresses that, same as Graham and Buffet do, when you buy an asset it must have a margin of safety, meaning that if the price of the asset decreases 20% you are fine because you did not pay full price. Finally, it hit us. This is the elusive concept we never understood. In this case, we were paying full price with no margin of safety if prices change and the real estate market or the economy went bust. Hoping that prices increase to be able to sell it and make a profit put us even in the worst position of speculators. 

9. Return on investment

Calculating the rate of return or return on investment (ROI) is another key step to visualize completely and across the long-term your investment. If the investment is $250K and the rental income is $25K per year, the gross ROI is 10% (let’s not including association, repairs, insurance or property taxes for the sake of simplicity). But if you buy with a mortgage, your rate of return will be reduced to the 20% down payment.

For example, $250K investment at an average mortgage rate of 5.75%, your payment will come close to $1.2K per month or $15K, to use round numbers. If the rental income per year is $25K and the mortgage payment is $15K per year, the net rental income per year is $10K. If the 20% down payment is $50K (20% over $250K) and the net rental income after a mortgage payment is $10K, your gross rent of return is 20%. Not bad for an investment. But here is where things get interesting. At this investment level of $250K, closing cost will be about $10K, so your $50K down payment will be $60K instead and the rate of return will be reduced to 16.67%.

If we add the association payments $1.5K per year, insurance $2K per year and property taxes $4K per year, out of the gross rent per year of $10K above, we ended up with $2.5K net profit ($10K rent income – $1.5K association – $2K insurance – $4K taxes). The ROI for $60K investment ($50K down payment plus $10K closing cost) and $2.5K net profit will be further reduced to 4.17%.

We can argue that buying cash will produce a similar analysis but we you just need to consider that buying in cash allows you to keep the full amount of rental income because there is no mortgage payments. Cash is king, the saying goes.

10. Loan application and approval

The process of loan approval is not similar between the mortgage broker and the bank. The latter will require more papers, including copies of the association rules and proof if you own a property free and clear.

The rate of return you get it will depend on your credit score and that your credit history does not register any bankruptcy. The bank will approve you under the condition you provide additional documentation that may include letters of explanation if you received a large deposit in your account if business profits increased or decreased and a second or third round or documents request that you satisfied before, as mentioned before.

11.Title company

Choosing a title company is critical. Better if your realtor recommended it. In case that the transaction does not go thru, it will be easier to retrieve your security deposit, providing you withdraw from the deal for reasonable cause and that is accepted within the sales agreement you signed with the buyer. We mentioned before that you need to read all the documents before you signed.

12. Realtor

You always need your own realtor. Do not work with the realtor of the seller. In our case, we partnered with a good friend who helped us a lot, but we also did the purchase of properties by ourselves and it was my wife who diligently searched and found the property we bid for. But we were never at the expense of the sellers and their realtors.

13. Documentation required

Mortgage brokers and banks require the same documentation such as tax returns, W2s, for the last two years, business returns if you have a business. But you must have filed all the tax returns before applying for financing. If not, they will deny your application and your credit will suffer because of the credit inquiry and no loan was approved or posted to your credit history.

14. Home inspection and appraisal

This is required to approve your credit application and you pay for it. The home inspection is to check that the property is in living conditions and the appraisal to determine the value of the property. Read the report carefully because it will tell you if minor fixes are needed and check if the appraisal comes for less than the sales price and ask your realtor to change the offer to match to the appraised amount. The seller will approve if you say you are considering withdrawal. Note that for a seller if the property is under contract it will be easier to sell it than starting from zero.

15. Association and maintenance

Get a copy of the rules of the association and read them so you get familiar with the rights and obligations as an owner-investor.

For maintenance, you should have read the home inspection to alert you of short-term and long-term repairs. For example, we found that the roof of the property had over 15 years and that it may need replacement soon.