John T. Reed’s review of Rental Houses for the Successful Small Investor by Suzanne P. Thomas

Suzanne P. Thomas is a rental-house investor and home Realtor®. She bought her first rental house in ’92 and wrote this book around ’97 after buying several other houses.

Little homework

As far as I can tell from reading the book, she had little or no formal education on real estate investing—like Realtor® CCIM or Appraisal Institute courses. Her limited experience and lack of homework shows.

She appears to have had the good fortune of investing at a good place and time. But she seems to have made a mistake well-described by the old Wall Street saying, “In a bull market, everyone thinks he’s a genius.”

Modest goals

I welcome some aspects of her book. For example, she advocates modest goals like owning five rental houses free-and clear. She has the basic idea correct as you would expect of a Realtor® who sells houses and who has owned them for five years.

Unfortunately, she pontificates far beyond what she understands. The result is a lot of fuzzy, half-baked, incomplete and ultimately incorrect analysis. To a large extent, her book is most useful as an example of the incorrect thinking of the typical inexperienced investor.

Positive cash flow

The most egregious problem with the book is her discussion of positive cash flow. She says it’s possible to pay market for rental houses in great condition and still get positive cash flow. No, it isn’t. To get positive cash flow in a rental house, you have to buy it for a substantial discount—probably 20% or more—below market value—or put down much more than 20%.

12% expense ratio

On page 54, she provides numbers from one of her rental houses. Her annual rent was $13,052 after vacancy. She says her total operating expenses were $1,581. That’s an operating-expense ratio of 12%. Had she attended the commercial investment courses offered by the Realtors®, she would have learned that 12% is a ridiculous operating-expense ratio. 45% is normal and almost all residential rental properties would have operating-expense ratios between 40% and 50%.

Using a 45% operating expense ratio, you get total operating expenses of 45% x $13,052 = $5,873, not $1,581. Her net operating income would be $13,052 - $5,873 = 7,179. She says her total mortgage payments for the year were $7,947 giving her negative cash flow of -$768. She claims her cash flow was $3,524 positive.

100 times gross

I also note that the gross rent multiplier in this deal was $124,500 (purchase price) ÷ $1,135 (monthly rent) = 110. Thomas says a ratio of 100 is considered good. Actually, I think it’s out of date. My impression is that the typical house sold in the U.S. today sells for 120 or more times monthly rent. In high-priced areas like California, it’s higher than that—getting into the hundreds. So 110 is actually a better-than-average deal and it still runs negative cash flow. A more normal deal would have even more negative cash flow.

Omits and understates

What specifically is wrong with Thomas’ numbers? She lists only four types of expense: taxes, insurance, repairs, and advertising. Two dozen would be more like it. She omits capital expenses, supplies, utilities, permits, and such. Also, her vacancy and repairs allowances are too low at 5% for both combined. Normal vacancy and repairs combined would add up to about 13% of the gross rents.

She apparently uses what she deducted on her tax return that year, but that is misleading because such low numbers can be attained only by deferring maintenance and having a lucky year regarding capital items like the roof, refrigerator, hot water heater, driveway, etc. Also, Ms. Thomas is counting as building cash flow the “salary” she earns from managing the property. That takes about 3.6 hours per unit per month. If leasing agent/property manager time is worth $20 an hour, she is counting the $864 that she would have earned performing the same work for someone else as return from the property. That’s fallacious. You have to differentiate between return on your investment in the property and pay for time spent on it.

Tenants pay

Some may point out that house tenants generally pay their own utilities, sometimes including water. True, but rents reflect who pays utilities, so the 45% ratio holds in both tenant- and owner-paid-utilities buildings.

Ms. Thomas says that projecting expenses is “tricky.” Actually, it’s not. She needs my book Checklists for Buying Rental Houses and Apartment Buildings, which has an extensive section telling you exactly how to do it. When I was actively investing, my projections were extremely accurate.‘Tricky’

Stated simply, it is nowhere near as easy as Ms. Thomas says to get positive cash flow and she, herself, did not do as well cash-flow-wise as she thinks.

ARMs

Ms. Thomas loves adjustable rate mortgages. I say you generally should avoid them because you must be able to afford the worst case and you usually cannot. ARMs were introduced around 1981 and rates have never gone up significantly since they were introduced. But they can. It is irresponsible to sign a loan you cannot afford if the worst case scenario occurs.

Ms. Thomas claims a number of tricks for “protecting” herself against rate increases, but her tricks are inadequate. Basically, she puts 20% down and tries to pay off some extra each month. That’s nice, but it still may not be enough to cover the worst case.

Either you can afford the worst case or you can’t. If you can’t, don’t agree to the loan. Paying extra reduces the cash flow she claims you will enjoy. It’s easier said than done. It also reduces your return on equity, which she acknowledges.

Partners

Ms. Thomas invests with partners at the drop of a hat. On page 69, she says, “Many real estate gurus warn against investing with partners because of potential disagreements.” I think “many real estate gurus” is me. I know of no other anti-partner guru.

Someone once said that a liberal is someone who hasn’t been mugged yet. Those who recommend partnerships in real estate investing have never gone through any down markets in one.

And it’s not just disagreements. There are all sorts of things that make you regret partnerships. Divorce. Death. Malfeasance. Diverging goals. Opportunities or problems that require a partner to divest. I strongly urge you never to use group ownership. I predict Ms. Thomas will agree after she logs a more meaningful amount of experience.

Present tense

Part of Ms. Thomas’ fuzzy thinking is the common mistake of describing real estate price movements in the present tense. She uses phrases like “if your area is in a slump” or “if your area is experiencing appreciation” or if you are in a hot market.” In fact, you cannot know that. You can know what prices were a month or so ago because of the statistics that are available from government and industry sources. But you cannot get more recent than that. And without a crystal ball, you cannot know the future.

In other words, you cannot know if you are “in a slump” or “a hot market.” You can only know that you were recently. Whether you will be in the future is unknown. By talking that way, Ms. Thomas and the many others who say similar things imply that real estate is far more predictable and less risky than it really is. It is extremely important that real estate investors understand the error in that.

Taxes and insurance

Ms. Thomas owned a rental house in the Austin, TX area and one in the Denver area. They were both 1,300 square feet. She noticed that prices were higher in Denver than in Texas but that the taxes and insurance were relatively higher in Texas. I find that mildly interesting. Ms. Thomas seems to think it is a great revelation, coming back to it repeatedly.

Cap rate

What she is groping toward is the capitalization rate. That is one of the best ways to analyze prospective investments. The cap rate is the net operating income divided by the property value or purchase price. Net operating income is rents and other property related income minus all operating expenses. Operating expenses are all expenses other than mortgage payments.

The cap rate will not only pick up differences between different property tax and insurance rates, it will also recognize differences between maintaining a concrete driveway versus an asphalt one, a slate roof and an asphalt shingle one, aluminum siding and wood clapboard siding, and so forth.

If I were Ms. Thomas’ instructor and she got all excited about her discovery about taxes and insurance, I would use the Socratic method to draw her to the more complete conclusion. “Are there any other expenses that would vary from property to property?”

Denver and Austin

A more accurate title for Thomas’ book would be “How I made some money in the Denver and Austin home markets in the mid-nineties.” She seems only vaguely aware of how other markets differ, but nevertheless boldly pontificates for a nationwide audience based on her brief experience in those two metro areas.

Comparing properties

She spends a lot of time telling you how to compare two good properties you are considering buying in order to determine which is best. It doesn’t work that way.

Instead, you have to establish criteria for what you are willing to buy. Then, when you find a property that meets your criteria, you must immediately buy it. If you try to line up two acceptable properties and buy the best one, you will probably lose out on both properties.

The best properties go the fastest. Thinking you can consider them two at a time is a beginner mistake. You must jump on the first acceptable one, not the best one. Same applies to hiring employees and accepting job offers.

Beliefs

Ms. Thomas has a great many “beliefs” that she hands down like tablets from Mount Sinai. For example, on page 44, “I believe that you will experience appreciation if you hold properties for at least seven years.”

1. It depends on the property. Some have not appreciated over that time.

2. Appreciation per se may not be enough. It must appreciate more than enough to compensate you for the wait and any negative cash flow you suffered in the interim. The meaningful version would be, “All real estate investments show a satisfactory return if you hold them for at least seven years.” That also would be a false statement. It’s just not that simple.

On page 82, she says, “Most tenants prefer single-family homes over other types of rental units.” I doubt that very much. Most tenants want only one or two bedrooms, and they do not want maintenance responsibilities. She cites no source or even data from her own experience.

Inflation and population

She points to inflation and population growth as the proof that real estate values will go up. It’s not that simple. I have seen inflation go up while property values were falling. Prices are determined by supply and demand, not inflation and population. There is such a thing as overbuilding, which affects the supply side of the price equation. Thomas goes on like this throughout the book.

Sweat equity

On page 62, Thomas tells that her sister and brother-in-law traded fix-up labor for 50% ownership of two properties. That’s fine, but she should have added that the equity thus received is taxable income, same

as cash, in the year they receive it.

Borrow down payment

On the next page, she tells of borrowing a down payment and closing costs from her mother. That must be disclosed to the lender. I do not know if she did. But I do know that she did not tell her readers about the need for disclosure. Failure to disclose such a material fact violates 18 USC 1001, the law that put Martha Stewart in jail.

Saving

On page 64, Thomas says, “Saving is an old-fashioned method of acquiring enough capital to make investments.” That statement, from what otherwise appears to be a levelheaded woman, is the best evidence so far of how screwed up the minds of real estate investors are as a result of the ubiquitous nothing-down movement.

For the record, saving is the main way to acquire investment capital at the beginning of your career. To describe saving as old-fashioned is nuts.

Thomas’ discussion of lease-options is good as far as it goes. But she discusses only those lease-options where you are the lessee-optionee (tenant-buyer). The more common application is where the investor is the lessor-optionor (landlord-seller).

Nearly new

Thomas prefers two- to four-year-old houses. She wants to avoid the costs of initial installment of window coverings, landscaping, and so forth. I commend her on recognizing those hidden costs of new homes. But those hidden costs do not make two- to four-year-old houses the best investments.

Thomas seems almost unaware of the non-MLS-new-home market—foreclosures, partial interests, execution sales, and so forth. Her strategy seems to be almost entirely speculation on market-wide appreciation. That is the most popular, widespread approach, but it is mindless. If that is your approach, write a fortune cookie, not a book. It is based on a religious (no scientific evidence that it is correct) belief in near constant appreciation in home prices. Such a belief requires brief experience in few markets. People who have longer, more geographically diverse knowledge of real estate know it’s nowhere near that simple.

5% discount

Thomas brags of buying a $139,000 house for $132,000 on page 91—a 5% discount. Settling for such small margins—and thinking you did great—is a near universal beginner mistake in all businesses, not just real estate.

In fact, the transaction costs in real estate—both out-of-pocket and the value of your time—are so great that you must get at least a 20% discount to consider the transaction profitable at that point. There is also the issue of the margin of error in appraisals. How sure are we that it was worth $139,000?

House vs. apt. building

Thomas says houses are better investments than apartment buildings. I tend to agree, but not for some of the reasons she gives. She says house tenants are more financially stable than apartment building tenants. Not in my experience. My apartment tenants were newlywed couples and mature singles. My house tenants were large groups of young singles. I wanted Ozzie and Harriet and David and Ricky, but no such family ever applied to rent a three-bedroom house from me.

Some enchanted closing

Perhaps the worst advice in the book is that, contrary to what everyone else says, you should buy only properties that you fall in love with. Many of the weak points in the book involve this sort of, “Truth is whatever my feelings and intuition tell me it is” thinking. That is the correct mindset for a poet, not a real estate investor.

Investing is fundamentally a mathematical exercise. The investor’s objective is to maximize a ratio: after-tax net income ÷ equity.