ABCs of Buying Rental Property

Ken McElroy

📚 GENRE: Business & Finance

📃 PAGES: 208

✅ COMPLETED: May 9, 2023

🧐 RATING: ⭐⭐⭐⭐⭐

Buy Book

Short Summary

Ken McElroy has been investing in real estate for a long time. In the ABCs of Buying Rental Property, he delivers the keys to successful real estate investing, showing readers how to evaluate a property, manage tenants, and make the most of the tax advantages available to rental property owners. 

Key Takeaways

1️⃣ Advantages of Real Estate — Rental property investing is one of the best ways to build wealth ever created. From the tax deductions you can take using depreciation to cash flow, leverage, rent price increases, house appreciation, and the opportunity to build equity via a tenant’s mortgage payments, there are a ton of advantages that come with real estate investing. The government encourages real estate investing by providing a number of great benefits. Buying real estate is one of the best ways to invest your money. 

2️⃣ Get Started Now! — It’s not unreasonable to achieve complete financial independence in 5-10 years through rental properties. The key is to start as early as you can and try to acquire 1-2 units per year. On average, rental properties have produced a 19% annual return when you factor in appreciation, cash flow, and equity buildup via mortgage payments. The sooner you can begin acquiring properties, the faster you will achieve financial freedom. 

3️⃣ Don’t Be Afraid of Debt — Both good and bad debt exist. Good debt involves using Other People’s Money (OPM) to buy assets that produce income for you. Bad debt is consumer debt, like credit card debt. Don’t be afraid to use OPM from places like banks. The less you can put down on a mortgage loan in favor of borrowing, the better your ROI will be. You have to be careful and make sure the property will cash flow, but using OPM to buy real estate is a great thing. 

Favorite Quote

“The first and most important principle in searching for a rental property is this, and please don’t forget it: The market is more important than the property.”

Book Notes 📑

Ch. 1: A Note From Ken About Wealth

  • What It Takes — You don’t have to be an expert in real estate to invest in it. Real estate is one of the best investment classes in the world, and succeeding in it can put you on the fast track to financial freedom. If you do it right, the cash flow you generate can supplement the income from your job and could even allow you to leave your job down the road. Anybody can do it. In the end, you need three things to succeed in real estate: 
    • Motivation to Succeed
    • Good Work Ethic
    • Willingness to Learn 

Ch. 2: Why Real Estate Is a Superior Investment

  • Perks of Real Estate — There are so many things to love about investing in rental properties. A few of the great advantages include:
    • Leverage — By taking out a mortgage, you’re using Other People’s Money to acquire properties, which increases your ROI. For example, if you put 20% down to purchase a property and its value goes up 6% after one year (the average annual increase), you already earned back more than 1/4 of what you invested. In three years, you’ll have earned almost all of your money back. Meanwhile, the principle and interest on the mortgage is being paid for by the tenant via his rental payments. 
    • Cash Flow — If you do it right, your tenant’s rental payment will cover your mortgage payment, monthly expenses, capital expenditures, and vacancy protection, leaving you with a small amount of cash flow or supplemental income. 
    • Home Appreciation — Houses have appreciated in value at about 6% per year since 1940. You never want to “bank” on capital appreciation, but you are likely to gain a lot of value on the home if you hold the property for a long period of time. 
    • Building Equity — If you do it right, your tenant’s monthly rental payment will cover your mortgage payment and allow you to build equity in the home using their money. The new equity that you build over time can be leveraged for cash by either taking out a second loan or refinancing the entire loan. Essentially you can use it to buy another property. 
    • Rental Prices — Since 1940, rent prices have gone up at a clip of 5% per year, which provides a nice hedge against inflation and allows you to increase your cash flow over time. From 2000-2017, rent increased an average of 3.1% per year. 
    • Tax Deductions — With real estate, you are only taxed on cash flow/income, not equity. You can use things like maintenance costs, repairs, depreciation, property insurance, and mortgage interest payments to reduce, or completely eliminate, the income you’re reporting to the IRS. If done well, you won’t have to pay any taxes on the rental property income you are bringing in.
      • Quote (P. 16): “In many cases, real estate investors pay little or no taxes year after year, even though they are building wealth through appreciation and principal payments.”
    • Depreciation — The government allows you to depreciate the value of your house over time. Here’s how it works: When you buy a house, the government allows you to offset the income you’re making on the property by depreciating the value of the house using a 27.5 years barometer. So if you buy a property for $112,000, you can deduct $4,072 (112,000 / 27.5) every year from your rental property income. If you make $3,300 in cash flow for the year, you can completely negate that and even report a loss of $772 for the year using depreciation. You can even use the leftover depreciation to offset some of your other income.
      • Depreciation Recapture Tax — The only caveat is that you have to use the 1031 Exchange to purchase a home of greater value to avoid a depreciation recapture tax, which tries to recapture some of the depreciation you claimed when you sell the property. 
    • Cash-Out Refinance — As you pay down the mortgage and the house appreciates over time, you have the option to initiate a cash-out refinance where you essentially take out a new loan based on the home’s new appraised value and in the process pull out some of your built-up equity in the property to go out and buy another property. And because equity is not income, you aren’t taxed on what you pull out.
      • Quote (P. 18): “So now you have another $47,352 in equity. You can leave the equity in there or put it to work. Serious investors usually take the latter option. They take out a new mortgage or loan and use the equity to buy another rental property, pay off investors, or pay themselves. The equity to pay yourself, by the way, is nontaxable, because it isn’t income.”
    • Improvable — You can fix up your house to increase the value of it in the open market. The BRRRR method of real estate investing relies on this strategy — you buy a house that clearly needs a little improvement and the value of the house instantly climbs. 
    • Capital Gains Tax Rate — When you do sell your property and choose not to roll it into another one using the 1031 Exchange, you ultimately pay taxes on the capital appreciation at a lower rate than what earned income is taxed at. Earned income from a “real job” is taxed at higher rates than the capital gains tax rate set by the IRS. So even when you do have to pay taxes, you’re paying at a better rate than people paying taxes on their earned income from a corporate job.
      • Quote (P. 20): “This is another reason the rich get richer. They earn much of most of their income through investments that are taxed as capital gains, not (earned) income.”
    • 1031 Exchange — When you do decide to sell your property, if you purchase a more expensive one, you can wipe out the depreciation recapture tax on the previous property and you don’t have to pay capital gains taxes on the profit from the sale of the property. A 1031 exchange allows you to use your money, tax free, to continue investing. That’s why so many real estate experts pay so little in taxes. You only pay when you no longer reinvest the profits. The government loves real estate investors and has designed many parts of the tax code to benefit investors. This is one of them. 
  • Real Estate | Average Returns — Rental properties have produced a 19.2% average return every year when factoring in cash flow, house appreciation, and building home equity via your mortgage payment. Since 1940, homes in the United States have increased in value at an average rate of 6% per year (capital appreciation). A $35,000 down payment on one $140,000 rental property would generate $1 million in 19 years.
    • Quote (P. 13): “So the bottom line is this: If you owned just five to six small rental properties, you would generate $1 million in new assets in ten years.”
  • Return on Investment (ROI) — ROI is calculated using the following formula: total value of the investment — cost of investment / cost of investment. This will give you the return. With any investment, the ROI you want to see is dependent on what is going on in the market. If a T-Bill is delivering 4%, you have to get something well above that to justify the risk you’re taking with real estate or stocks. 
  • Establish an LLC! — Every property you own should be placed in its own LLC. By doing this, you protect yourself and your other assets, like your stock portfolio, personal home, car, and other personal possessions. If you end up getting sued by a tenant, everything is protected; the most they could get is the rental property inside of the LLC.
    • Quote (P. 22): “Every property you buy should be placed into its own individual LLC. That’s how you protect your wealth. Imagine, for instance, that one of your tenants falls in the shower and is injured. If all of your properties were under a single entity, that resident would have the legal right to pursue damages based on the entire asset value of all your investments in that entity. If, however, each property is its own LLC, that resident normally will only be able to seek damages from that entity. Your other holdings would be unaffected.”
  • Chapter Takeaway — There are a ton of advantages that come with rental property investing. Investing in real estate delivers nice returns every year through capital appreciation of the house and cash flow from rental payments. From a taxation standpoint, you can use depreciation, mortgage interest payments, maintenance repairs, and more to offset your rental property income and avoid paying taxes on it.

Ch. 3: You've Got What It Takes

  • Take the Lead — To achieve financial freedom, you have to take the lead and go the extra mile. You have to put the work in. You have to take the time to read, learn, and educate yourself. Although it’s not totally necessary, you can become financially independent fastest by running your own real estate investing business as an entrepreneur. When you do, the fruits of your labor go to you, not somebody else.
    • Quote (P. 32): “The path to financial freedom requires you to take the lead — to be motivated; to be your own boss.”
  • Economies of Scale — Once you have a few single-family homes that you’re renting out to start, consider moving up to small apartment complexes. Apartments typically produce more cash flow because you’re leveraging economies of scale (i.e. shared walls and a shared roof). Apartments are where you can really start to generate a lot of monthly cash flow. 
  • Get Started Now! — By getting started in real estate investing, you can achieve some level of financial independence in 5-20 years. The length of time will depend on your decisions, market conditions, and luck.  But if you set a goal of buying 1-2 properties or units per year, you could have 15-20 units in 10 years. If all of them are appreciating in value and delivering cash flow every month, you can really start to build your wealth.
    • Quote (P. 36): “Assuming you can buy one rental unit every year or two, five to 10 years then becomes a reasonable timeline for achieving your goal of becoming financially free. Or, alternatively, if you’re a person of patience and just want to have a couple of rentals, you can easily attain $1 million in gross revenues in less than 20 years.”
    • Quote (P. 40): “The plan I lay out in this book roughly estimates that the typical person taking a modest course of real estate investing can achieve some level of independence in five years and certainly full independence in 20 years.”
      • Takeaway — Get started! The sooner you get going with real estate investing, the more you’ll learn and the sooner you’ll start building wealth through capital appreciation and cash flow. Buying 1-2 properties every year for 10 years will put you in a great spot. Don’t wait around. 
  • Chapter Takeaway — Get started in real estate investing as soon as you can. The earlier you can start, the sooner you’ll achieve financial independence by taking advantage of capital appreciation and cash flow over the years. It’s not unreasonable to achieve solid financial independence through your rental properties in 5-10 years. 

Ch. 4: Step 1 — Set Up Your Business

  • Why an LLC? — Creating an LLC for each of your rental properties allows you to protect your personal possessions, including your money in the bank, your personal home, your car, etc. A creditor or an angry tenant who is suing you cannot touch your personal items; the most they can get is the property held in the LLC. All members of the LLC can control the company, and an LLC is only taxed once, unlike a C-Corp, which is taxed twice — once at the corporate level and once when investors pay taxes on the dividends they receive. 
  • Creating an LLC — You can set up an LLC by yourself or by hiring an attorney or an accountant. Ken McElroy recommends hiring somebody to do it, but setting it up yourself is fairly easy. You will need to file an application with your state on their website and pay the required fees. The process is summarized in the following steps:
    • Choose a Name — Create a name. Make it unique but professional. 
    • Choose a Statutory Agent — This is your point of contact with the state and the public. This is the person who will be notified if you are being sued. This can be yourself. 
    • File the Articles of Organization — This just involves telling the state whether the LLC will be ‘member-managed’ or ‘manager-managed.’ The former means that some or all members of the LLC will manage the business. The latter means that one or more members will manage and the others will be passive owners. The state will send to the Articles of Organization after you pay. 
    • Register with Local Governments — File paperwork with other local government jurisdictions, if needed. 
    • Obtain an Employee Identification Number — An EIN is issued by the IRS for free and is needed. 
    • Open a Banking Account — Open a separate banking account that you can use to make business transactions. 
    • Annual Fee — Some states require you to pay an annual fee to maintain your LLC. 
  • Obtaining Credit for Your LLC — You won’t be able to acquire a loan from the bank under your LLC until you’ve established credit by using and paying off your LLC’s business credit card. The Capital One Spark Classic business credit card is widely considered the best card for new businesses. Just like an individual, the bank wants to see a financial track record for your LLC. This will take time. Until you have established strong credit, you can acquire loans with your personal credit and then transition everything to the LLC later. 
  • Do Business Under the LLC — Once you have your LLC up and running, use it for everything business-related. When you make a lease agreement with a tenant, do it under the LLC’s name. When you do business with others (landscaper, repairman, etc.), do it under your LLC’s name, not your personal name. This is one of the ways you can build credit for your LLC. 
  • Chapter Takeaway — Always, always, always put your property in an LLC! It’s fairly easy to do and can help protect your personal assets against lawsuits. 

Ch. 5: Step 2 — Get Your Investment Money

  • Home Equity — Most people are simply trying to pay off their house; when it’s all paid off and the mortgage is done, that’s considered a success. In reality, as you build equity in your home, you can refinance into another loan in order to pull some of it out and use it to buy another property. This is a cash-out refinance.
    • Quote (P. 53): “An idle asset is better thought of as a liability.”
      • Takeaway — Don’t allow yourself to let equity build up in your home without refinancing to get some of the equity out for a new property. The more equity you build in your home, the more you can take out by getting into a different loan. This is one of the ways you can start to stack properties. 
  • Good Debt vs. Bad Debt — Bad debt is things like credit card debt. Good debt is using Other People’s Money to acquire cash-flowing assets like rental properties. Good debt is nothing to shy away from! Use it to build wealth. Ideally, you should try to put down as little of your own money as possible when buying a property. By doing this, you significantly increase your ROI.
    • Quote (P. 54): “But debt is good when it’s used to grow wealth.”
    • Quote (P. 54): “A failure to understand the difference between good and bad debt is what prevents many working-class and middle-class people from achieving financial independence.”
  • Home Equity Line of Credit (HELOC) — A HELOC is a line of credit secured by your home that gives you a revolving credit line. With a HELOC, you’re borrowing against the available equity in your home, and the house is used as collateral for the line of credit. As you repay your balance, the amount of available credit is replenished – much like a credit card. This means you can borrow against it again if you need to, and you can borrow as little or as much as you need throughout your draw period (typically 10 years). Think of a HELOC as a credit card issued by your house. 
  • Adjustable Rate Mortgage (ARM) — As a home buyer, you can choose between a fixed-rate mortgage and an ARM. An ARM is a home loan with an interest rate that adjusts over time based on the market. ARMs typically start with a lower interest rate than fixed-rate mortgages, but the interest rate won’t last forever. After the initial period, your monthly payment can fluctuate wildly. 
  • Interesting Fact — You can borrow money from your 401k retirement fund. When you pay your monthly payment, the amount plus interest goes back into your retirement fund. You can borrow up to 50% of the value of your account, up to a maximum of $50,000. 
  • House Hacking — This is one of the best strategies for buying your first property and involves purchasing a small multifamily property (duplex, triplex), living in one of the units, and renting out the other units. Ideally, the rent on your other units will cover your mortgage so you can live there rent free. When you move out, you have the option of selling or keeping the property and renting out all units. 
  • FHA Loan — An FHA loan is available to all first-time homebuyers and allows you to buy a property with just 3.5% down. Because users of an FHA tend to be riskier borrowers with low credit, the mortgage does come with mortgage insurance (PMI) and the interest rate on the loan tends to be higher than a conventional loan. If you can make the numbers work, the FHA is a great loan that allows you to maximize ROI while having additional capital to spend on acquiring more properties. 
  • Chapter Takeaway — Use Other People’s Money to your advantage. You shouldn’t be scared of debt — if used wisely, it can help you acquire strong assets and lead you to financial independence. By using small down payments and borrowing the rest from a bank to acquire a property, you’re improving your chances of making a good ROI right away. Consumer debt like credit card debt is bad and should be avoided at all costs. 

Ch. 6: Step 3 — Find Your Ideal Market

  • Market > Property — The city/market you are investing in is far more important than the actual property itself. Properties in areas where home values are declining or increasing at a slower rate compared to other areas are often not a good investment. You want to invest in locations that are growing. And you want to evaluate markets on two levels:
    • General — The city
    • Submarket — The neighborhood 
    • Quote (P. 69): “The first and most important principle in searching for a rental property is this, and please don’t forget it: The market is more important than the property.”
  • Low Supply, High Demand — Ideally, you want to invest in markets where there is a low supply of housing and a high demand for renting. When you get these two factors going, you shouldn’t have trouble finding tenants and raising rent prices over time. Tax and building records can help you determine the level of supply. Demand is tougher, but you can assess it by looking at the US Census to determine occupancy rates in cities and neighborhoods. The higher the rates, the higher the demand. 
  • Drivers of Supply and Demand — There are three factors that drive supply and demand for rental properties. In the end, you want to go to places people are going. In other words, invest in areas where people are going. 
    • Employment — People flock to areas where jobs are plentiful. When jobs are plentiful and there’s a lot of employment in the market, there’s a high demand for renting. 
    • Resources — Resources attract people. People love Scottsdale, Arizona for the golf, great weather, and restaurants. People love Aspen, Colorado for the skiing. People love Venice Beach, California for the beaches. Military bases, sports arenas, universities, large businesses, and casinos attract people to the market.
    • Location — The specific area surrounding the property is crucial. The neighborhood is crucial. The restaurants, schools, and amenities around the property are important. Look for low crime and low poverty.
  • Research the Market — You can get some really good research done in about an hour. Use websites like Zillow, Trulia, Neighborhood Scout, and more to do some high-level research on the market you want to buy a property in. Look for median property value, median rent price, crime rates, home value increase, population growth, and more. You mainly want to get a good feel for the market and determine if it’s worth investing in. You want to see things trending up. 
  • Role of an Inspector — When you’re buying a property, you want to hire a property inspector. He has one job: find as many things wrong with the property as possible. Hire an independent inspector (not affiliated with your real estate agent). 
  • Keep the Receipts! — Keep great documentation in all areas of your business. Keep all receipts. This will make filing your taxes easier and will prevent issues with the IRS if they decide to audit you for any reason. 
  • Chapter Takeaway — The market is arguably the most important factor to look at when considering a rental property purchase. The property comes after that. You want to invest in markets that are showing steady growth. You want to invest in markets where the population is growing, jobs are booming, and where there are a lot of great amenities. Go where the people are going. 

Ch. 7: Step 4 — Find Your Ideal Property

  • Cash Flow — When it comes to analyzing properties, one of the first things you have to do is find out if the property will produce cash flow. If not, it’s not worth an investment. To cash flow, the monthly rent payment has to cover the mortgage payment, taxes, fees, maintenance, vacancy, and utilities and still produce some leftover cash that you can pocket every month. The cash flow will ideally produce somewhere between a 7-10% annual return. It must generate a better return than the T-Bill, which is a risk-free investment. 
  • Estimating Cash Flow: The 2/3 Rule — There are many tools use can use to run the numbers and find out if a property cash flows. A few of them are provided below. As a general rule of thumb, your monthly mortgage payment should not exceed two-thirds of the total monthly rent payment. That’s because the rest of the rental income needs to cover the cost of property taxes, insurance, fees, maintenance, vacancy, etc. and still produce positive cash flow. 
    • Rent Payment — You can use Zillow, Rentometer, Craigslist, and other sites to help you find what you can expect to make in rental income on a house in a certain area. Once you have this number, you can compare it to what you’ll have to pay for the mortgage and the other expenses. 
    • Mortgage Payment — Online mortgage calculators are great for showing you what you might pay each month for a 30-year mortgage. Just Google “mortgage calculator” and you’ll find one. The calculator will allow you to play with the interest rate and loan amount you need from the bank so you can see what you might pay each month. To find the national average mortgage interest rate, go to the Federal Reserve’s website here: https://fred.stlouisfed.org/series/mortgage30us. 
    • Ex. John — Let’s say a man named John wanted to buy a home in Sun City, AZ. He finds that a typical home in the area rents for about $1,300 per month. He also finds that a $140,000 30-year mortgage at a 4.5% interest rate is a good fit and allows him to buy the home he wants. By running the calculator, he finds that that mortgage generates a $709 monthly payment, which is 54% (709 / 1,300) of the rental payment. This meets the 2/3 Rule. He can then move on with his analysis by looking at other expenses. 
  • Estimating Cash Flow: Other Expenses — After you have found your expected monthly rent income and mortgage bill and determined that it meets the 2/3 Rule, it’s time to see if the rental income will also cover other expenses related to the property. These include: 
    • Property Taxes — On Zillow, you can search for homes with the same number of beds, bath, and square feet and write down how much each of the homeowners pays in property taxes. The number will be listed. You can then add up all of them and divide by the number of houses you looked at. This will give you the average yearly amount you might pay for property taxes.
    • Insurance — You can go on different insurance websites and get a quote. Or you can call a few of these insurance companies and ask what you might expect to pay for a certain policy. This will help you determine how much you might pay per year for home insurance. You may also need to buy liability insurance to protect yourself in the event someone injures themselves on your property. 
    • Advertising — You shouldn’t have to pay for anything here. You can list your property for rent on Zillow, Trulia, Craigslist, and more. 
    • Gas & Electric Utilities — Generally, the tenant pays for gas and electricity if it is a lease of 1 year or more, but it might be worth finding out how much you would potentially pay for gas/electricity and factoring that into your analysis when calculating cash flow. You can find these monthly prices online or by calling. Generally renters don’t have to pay for gas, electricity, TV, Internet, etc. if it is a short-term lease. 
    • Water, Sewer, and Trash — Most landlords pay the water, sewer, and trash bills. If the tenant were to not pay for these, the house could get nasty. You can find these prices online or by calling around. 
    • Maintenance & Repairs — Maintenance costs are difficult to predict. But real estate experts say you should put aside about 1% of the total value of the property each year. So for a $200,000 house, that would be $2,000 per year or $166 per month. 
    • Reserve Fund — You must set aside some money for big “CapEx” expenditures like replacing an AC unit or installing a new roof. You never know when these expenditures will pop up. If you aren’t prepared, these can completely knock you out. Put between 7-10% of the total rental payment into a reserve fund — 7% of a $1,300 monthly rental payment is about $91 per month. 
    • Vacancy — Similar to the reserve fund, it’s a good idea to set aside some money each month for potential vacancy. You aren’t guaranteed to keep the house occupied 24/7. Set aside about 5% of the monthly rental payment for a vacancy fund. Factor this in when doing your analysis of the property. 
  • Low Cash Flow — Even if the annual cash flow on a property isn’t great, remember that you are building equity in the house with each monthly mortgage payment. You’re also (likely) benefiting from capital appreciation as the home increases in value over the years. You should definitely make sure the property cash flows, but low cash flow isn’t the end of the world. Always remember that equity is built through three major pillars:
    • House Appreciation 
    • Cash Flow
    • Principal Payments
  • Amortization: How It Works — When you first enter into a mortgage, the majority of the monthly payment goes towards interest and a small amount goes to paying down the principal in the form of equity. As time passes, less of the payment goes to interest and more goes to the principal in the form of equity. As you keep paying the mortgage over time, you really start to build equity on the house that you can later take out via a cash-out refinance and use to buy another property. One of the great things about rental property investing is that your tenant is paying the mortgage for you and allowing you to build equity in the house basically for free. 
  • The Winning Formula — By owning 5-7 rental properties for 10 years, you can realistically earn $1,000,000. The formula is to buy properties that cash flow, raise rents over time, build equity in the house via rent payments from tenants, hope that the house appreciates in value, and pull the money out via a cash-out refinance so you can use the money to buy more units. Eventually upgrade to buying small multifamily properties or apartment complexes. 
  • Making an Offer — You should only make an offer on a house if you run the analysis and confidentially determine that you can make it cash flow. You have to be confident that the property can turn a profit every month. 
  • Due Diligence — When you and the seller agree to terms, the due diligence process begins. This process usually lasts no more than a week and allows you to inspect the entire property, inside and out. You’re looking for damages or anything that might be a problem. If you find something, you can go back to the seller to ask them to correct the issues or provide financial compensation for the damages. Hire a highly-rates independent inspector. 
  • Chapter Takeaway — Analyzing a property is crucial. Take the time to properly evaluate cash flow. You should only make an offer on a house if you feel it cash flows comfortably. If you can get a property to cash flow while appreciating in value and building equity via the mortgage payment, you can really start to build wealth.

Ch. 8: Step 5 — Manage Your Property

  • Enforce the Rules — It’s important to not become buddies with your tenants. The relationship with your tenants should be a good one, but you want to avoid becoming “friends” with them. At the end of the day, tenants are customers. Becoming friends with them can lead to issues down the line if they don’t pay rent or are causing problems. Be nice, but keep them at a distance. And don’t make any exceptions! Hold them to the contract they signed and enforce late fees if they aren’t paying the rent on time. 
    • Quote (P. 99): “The lesson here is that kindness is not a line item on a balance sheet. If you’re going to be a successful landlord and property manager, you need to think like a business person, not a friend or social worker. Your relationships with tenants should be cordial but professional. Don’t become too chummy, as someone will assume you won’t mind getting the rent check late or that you’ll do them other financial favors.”
  • Property Management Rule 1: Maintain Your Property — There are a few keys to successful property management. The first is to maintain your property. After taking possession of your property, the first thing you should do is fix the things on the inspection list. Your No. 1 goal as a property manager is to ensure safety and respond to house-related issues promptly. A few things to keep in mind here include:
    • Smoke Alarms — Create a schedule for replacing batteries and carbon dioxide detectors. Don’t assume the residents will do this! 
    • Water & Electrical Issues — Be especially diligent about fixing water and electrical problems. An undetected leak in a pipe can produce unhealthy levels of mold, not to mention expensive damage to drywall and framing. A broken electrical outlet is dangerous to young children. Make sure tenants know to call you immediately if something like this happens. Doing so will save money and injury. 
    • Respond Quickly — Responding quickly to house-related issues will save you money. The last thing you want is a major problem to break out because you didn’t respond right away. The sooner you can fix an issue, the better. Prompt response will also make your tenant happy and increase the chances that he stays. 
    • Water Supply Knob — Make sure tenants know how to turn off the water supply to the house if a pipe breaks. That could save you thousands of dollars in repair costs. 
    • Have a List — Create a list of plumbers, electricians, and other professionals who you can turn to quickly to fix problems when you need them. You don’t want to waste time looking for these people after a problem breaks out. 
  • Property Management Rule 2: Always Do Background Checks — The biggest fear rental property investors have is a tenant who fails to pay rent. The best way to avoid this issue is to screen applicants. Every prospective tenant needs to sign a ‘tenant background authorization application’ (see below). This application should include information about the prospect’s finances, employment, and personal information. Inform the prospect that signing the application also allows you to run a background check. The cost of the background check should be paid by the prospect and can usually be put toward the first rent payment. 
    • Quote (P. 102): “Background checks are the single-most important way to deter problem renters. If convicted felons know you’ll conduct a background check, they likely will not even submit an application.”
  • Property Management Rule 3: Use a Lease — A lease agreement spells out the responsibilities of both the tenant and landlord. Remember that if it’s not in the lease, it doesn’t exist. Most leases are too short. Make sure the lease covers anything and everything that might come up. Many state governments, real estate organizations, and private companies post sample lease agreements that comply with state and federal law. You can download these free of charge. To find a lease agreement, type “lease agreement for [insert state].” Scroll until you find a .gov site for your state. You can download and add or edit the lease.
    • Quote (P. 108): “The leases for my properties are 20 pages long. That doesn’t deter people from renting the property. They rarely read the lease. The purpose of the lease is to spell out every possible event that might impact you and the tenant.”
  • Property Management Rule 4: Cordial Relationship With Tenants — Maintain a friendly relationship with tenants, but enforce every rule written in the lease. Do not go easy. At the end of the day, this is your business and the tenant is a customer who has signed a contract. You need to enforce that contract. Don’t get too close to tenants.
    • Quote (P. 109): “Your job is to provide a safe and clean home and in return you receive compensation for your efforts. Their role (tenants) is to respect the property and rules and pay their rent.”
    • Quote (P. 110): “If your tenant fails to pay rent on time, you must impose a late fee, which generally is no more than 5% of the rent (state law governs fees like this).”
    • Quote (P. 110): “Keep your relationships with tenants on a professional level. Limit the time you spend socializing with them. If your tenants think of you as a close friend, they might think you’ll give them a break when they are unable to pay their rent.”
      • Takeaway — Ultimately this is a business and you have to keep tenants at a distance. Enforce the rules of the lease. 
  • Property Management Rule 5: Evict If Necessary — In some cases, you may have to evict the tenant. It’s not pleasant, but sometimes it has to be done. Here are five legal reasons to evict a tenant:
    • Nonpayment of Rent
    • Lease Violation
    • Crime or Drug Activity
    • Property Damage
    • Expiration of Lease 
  • Chapter Takeaway — If you are going to get into real estate investing, you have to treat all aspects of it like a business, because that’s what it is. When it comes to property management, cover yourself by including every possible scenario in the lease, then make sure you enforce it. 

Ch. 9: Step 6 — Do Your Books

  • Keeping the Books — As a beginner, you don’t have to hire an accountant or buy an accounting software to keep your books. At first, simply open an Excel document and record every single thing that falls under an expenditure and income. At the end of the year, subtract expenses from income to get your cash flow for the year. You then report that to the IRS when you file your taxes. Always keep receipts! Four keys to successful bookkeeping include:
    • Open a Business Checking Account — Open a business account so you can keep your personal and business activities separate. 
    • Select an Accounting Method — You can pick either the cash or accrual method of accounting. The cash method is popular. The cash method means you record income when you actually receive it and record expenses when you actually make a payment. 
    • Select an Accounting System — Once you get several properties, you may need to select an accounting software to help you keep track of everything. 
    • Record Income and Expenses — Now it’s time to record all income and expenses. All expenses fall into one of two categories. The fact that expenses are deductible and depreciable is one of the great things about real estate investing.
      • Deductible — Includes things like mortgage interest payments, phone and utilities used for running your business, transportation, supplies for repairs and maintenance (i.e. paint, drywall, plumbing, electrical, etc.), and use of vehicle. These can be used in full to help offset any positive cash flow/income you generate from the rental property for that particular year.  Always keep the receipts!
      • Depreciable — Includes things like start-up expenses (costs incurred before renting your property), remodeling projects (which add value to the property), loan closing costs, and the property itself (depreciated using a 27.5-year scale). For remodel projects, this does not include maintenance repairs like fixing a broken sink. Those can be fully deducted because they bring the property back to useable condition. An example of a remodel project is when you completely redo your kitchen. The project has to be depreciated over 27.5 years. So if the remodel project costs $27,500, you can only deduct $1,000 per year from your income. 
    • Quote (P. 117): “But keeping track of your financial records need not be complicated. In fact, all you need to do is keep your receipts and sort them into two piles: one for income (revenue) and one for expenditures (costs). Then, to obtain a ballpark figure of your cash flow or profit or to file your taxes at the end of the year, you simply deduct the expense total from your income total. That’s it.”
  • Chapter Takeaway — You have to keep track of your numbers so you know if your rental properties are making money or not. It’s also important to do it for tax filing reasons. Keep all of your receipts! Track income and expenses really closely. 

Ch. 10: Step 7 — File Your Taxes

  • Tax Advantages — If you earn less than $100,000 per year, you get to deduct up to $25,000 in rental property losses from any other income you earn, including your salary from a different job or income from your stock market investments. This is one of the big advantages of real estate investing. You can use deductions and depreciation to offset all of your positive cash flow from the property for the year (and therefore report a loss in income on the property even when you actually gained) AND you can use any extra deductions leftover to offset income tax on your salary or stock market gains. 
  • Schedule E Form — If you own and rent a property, you’re required to file a Schedule E Form along with your Form 1040. File your taxes for free with services like TurboTax. The tax software will take you through the following steps:
    • Property Profile — Here you will give details about the property. 
    • Income and Expenditures — Here you will have the opportunity to list out all of the income and expenses you had related to the property throughout the year. This is where all of your tracking and receipt stashing comes in handy. 
    • Calculating Depreciation — The tax software will help you calculate your total depreciation from things like the actual home/building, closing costs associated with acquiring the property, any remodel projects, and closing costs associated with getting a loan, and more. 
  • 1099 Form & W-9 Form — If you pay an independent contractor anything over $600, you have to issue them a 1099 tax form, which tells them how much they need to report on their tax return. Anything under that, you just keep the receipts and file expenses as deductions. When you hire an independent contractor, the first thing you do is give them a W-9 Form to fill out and send back to you. This form allows you to fill out the 1099 Form. You then send a 1099 form to the contractor before January 31. 
  • Case Study: John’s Rental Property — Below is a look at income, depreciation, and deductions associated with the rental property of John, a friend of Ken McElroy’s. This table shows how all of this works. Despite making $17,604 in income from his property, John was able to report a -$2,967 loss to the IRS after rounding up $20,571 in deductions and depreciation items associated with running the property. He can then use that -$2,967 to offset some of the ordinary income taxes he has from his regular job. Or he can use it to offset capital gains taxes from selling some of his stocks.
  • Chapter Takeaway — Take full advantage of the tax benefits that come with real estate investing. There are many, many depreciation and deduction items you can use to limit or avoid paying taxes on your annual rental property income. 

Ch. 11: Step 8 — Boost Revenues and Cut Costs

  • Rent Prices — One of the great benefits of real estate investing is your ability as a landlord to raise rent prices over time. Since 1980, rent prices have increased by 4.4% per year while inflation has increased at a rate of 3% over that same time period. Since 2012, rent prices have increased at an average of 6.5% per year.
  • Raising Rent — One of the difficult parts of being a landlord is asking people to pay more for rent, especially those who are current residents at your property. Although it’s uncomfortable, it has to be done. Over time, raising rent by 5% per year makes a huge difference compared to somebody who doesn’t raise rent prices at all. To get a good look at rent rates in your city, visit ApartmentList.com, which contains a lot of information about rental rates. 
  • Costs & Benefits of Raising Rent — Although you should slowly raise rent prices every year, you have to be careful. Rent increases are one of the biggest reasons people leave your property, and losing tenants is costly. When a tenant leaves, you have to clean and repair the unit and deal with zero cash flow because the unit is vacant. You take an immediate hit to cash flow. As a general rule, never increase rental rates by more than 5% per year. 
  • High Mortgage Rates = More Rental Demand — As mortgage rates increase, people flee to rentals. High mortgage rates price a lot of people out of the home-buying market. People decide that renting is more affordable. 
  • Chapter Takeaway — Raise rent prices over time, but be careful about it. You don’t want to drive tenants away, but you have every right to increase rent prices every year. Rent rates have increased roughly 5% per year for a long, long time. 

Ch. 12: Step 9 — Build Your Rental Portfolio

  • Other People’s Money (OPM) — One of the best ways to achieve financial freedom is to use Other People’s Money to buy assets. By putting as little as possible down to buy a house and borrowing the rest from a bank, you are both maximizing your ROI and saving capital to buy another property. The more units you own, the closer you are to bringing in enough income and equity to become financially independent.
    • Ex. $50k vs. $25k — Let’s say property values are increasing at 6% per year and you put down $50k to buy a $100k house. Your ROI would be 12% ($6k / $50k) after one year. What if instead you put down $25k and borrowed $75k? Your ROI in this case would be 24% ($6k / $25k) after one year. Maybe the best part? By putting down less of your own cash, you have also saved money that you can use to buy other assets. 
    • Quote (P. 161): “As I’ve noted before, leverage explains in large part why many people have gotten wealthy through real estate.” 
  • 1031 Exchange — The 1031 Exchange is a special section in the tax code that allows you to both eliminate the depreciation recapture tax that you would have to pay on your property AND defer the capital gains taxes you would have to pay from selling the property. The main requirement is that the purchase price and new loan amount for the new property must be the same or higher than your original property.
    • Delayed 1031 Exchange — This is the most popular of the four types of 1031 Exchanges. This one gives you 180 days to buy a replacement property after selling your original property. The funds from the sale basically go to an intermediary to hold while you’re buying a new property that has a higher purchase price than the original property. You have 45 days to identify the replacement property. 
  • Chapter Takeaway — Use Other People’s Money to your advantage. Debt that allows you to purchase cash flowing assets is good debt. Try to put as little as possible redone to maximize your ROI. Use the 1031 Exchange to save a ton of money on taxes. 

Ch. 13: Step 10 — Further Your Education

  • Personal Development & Lifelong Learning — Commit yourself to lifelong learning. Education should be viewed as a lifetime thing. Operate with a sense of curiosity and look at everything through a learning lens — there’s always something to learn. Commit yourself to personal development. Set goals. Constantly be looking to improve your skills. Focus on getting 1% better every day. Lifelong learning and personal development are key parts of a successful lifestyle. Maximize your potential.
    • Quote (P. 167): “But all of the successful people I know have one thing in common: They never stop learning.”
    • Quote (P. 168): “To thrive in a free market system, you have to continually educate yourself to keep yourself valuable.”
    • Quote (P. 169): “In addition to educating themselves, the successful people I know also emphasize personal development — pausing now and then to take stock of where they’ve been and where they want to be, as an individual and a business person.”