Following the 4-step "Blue Chip Model"
will likely enable you to retire 5 years earlier...
1) Achieve a Price-to-Rent
Ratio of 16 or less
The key to owning a lucrative rental is to purchase in an area of relatively low home prices and high rents. That usually describes a town with a growing population, a strong economy and limited rental options. The huge majority of towns in California do not meet these criteria. A handful do. See our list of favorites on the page Lucrative Areas.
To quickly gauge if a rental is "lucrative", divide the Sales Price by the Annual Rent to get the Price-to-Rent ratio. If you put zero down on the house and had no expenses, the Price-to-Rent ratio tells you how many years it would take to pay off the property. The LOWER the P2R ratio the BETTER, since it will be paid off quicker and you'll earn much more in retirement.
Example 1: An $800K home that generates $45,000 in annual rent ($3,750/mo) makes the Price-to-Rent Ratio 17.7
Example 2: A $950K home that generates $58,000 in annual rent ($4,833/mo) makes the Price-to-Rent Ratio 16.4
Blue Chip Realty describes how lucrative a rental property is by the following Price-to-Rent ratios:
> 18 = Not lucrative. Unless there are some extenuating circumstances, this is not a strong investment.
17's = Almost lucrative. As rents rise, the property will become lucrative within a few years. Good option if can't get a "16".
16's = Lucrative. Only about 1% of rental property for sale in California meets this ratio on Day 1. This is a strong investment!
15's = Very Lucrative. Few and far between, and usually needs a big infusion of extra cash for immediate improvements.
< 15 = Supremely Lucrative. "Very Lucrative" homes will become "Superbly Lucrative" as rents rise over time. [Ex: Mill St. rental]
>> Click Here to see 2 examples how the Price-to-Rent (P2R) ratio can provide a quick "Go" or "No Go" on a potential investment or even an entire city.
As an investor, it doesn't make sense to purchase an average-priced 3BR-2BA home in Sunnyvale, CA for $1.9M when the average rent is only $3,993 (an insanely high P2R ratio of 39). It's not lucrative for the investor and far from it.
The other side of the cost spectrum is the town of Modesto, CA. Even though the homes there are much less expensive, with a 3BR-2BA home averaging $282,000, the average rent is only $1,367. That generates a P2R ratio of 17.2. Almost lucrative but you can do better!
The Price-to-Rent Ratio is used to identify lucrative properties for investors.
2) Select "Inelastic"
Renters for Enticing
There is a concept in economics called "elastic" versus "inelastic". Someone that is insensitive to price increases has an inelastic response, such as a wealthy person that will still purchase their favorite bottle of wine even if the price goes up $10. Another example is a Google worker willing to absorb a $300/month rent increase in order to stay closer to their job and avoid a 90-minute commute. That's inelastic. You'd want to be the wine seller or landlord in the above cases.
The same adjective, inelastic, can often be used to describe university students renting off-campus. For instance, imagine an upperclassman with the following housing options for next year:
Sharing a 300 sq ft on-campus dorm room with 1 roommate at $775/mo/each
Renting a 500 sq ft off-campus apartment with 2 roommates at $800/mo/each
Renting an 1,800 sq ft off-campus four bedroom home with 4 roommates at $825/mo/each
There will be subsets of students that select each option for various reasons. Some decide by themselves, some in concert with parents. For a sizable group of college students and parents (especially with a 529 college savings plan) housing costs are moderately inelastic.
>> Click here for a contrast of "rental decision processes" of college students versus a family
Imagine your college student in the above scenario called you and said "Hey mom/dad, for next year I'd like to move into a 4BR-2BA house off-campus with four of my best friends. It'll cost an average of $825/month/person. [NOTE: rarely will the student mention the total monthly rent of $4,125 -- they simply don't think this way]. It's a cool house close to campus with a large yard. We were one of fifteen interested groups that toured the home and the landlord loved our vibe and has offered it to us first. Okay?" It would be unusual for a parent to say "No, you must live on campus or rent an apartment since we only budgeted $775/month for your housing next year". It's more likely the parent will have an inelastic response and figure out how to make up the $50/month difference elsewhere, especially if they have a 529 college savings plan.
Next imagine a family with three kids deciding on whether to rent the house described above or one next door with the exact square footage, but with a den for the kids to play in instead of a 4th bedroom. They don't think of "rent-per-person" but just that the total rent is $3,625/month, $500 lower than the one next door. Their payments are coming out of their pocket - not their parents.
If the houses cost the same, which of these two properties would you rather be the owner of? The one bringing in $49,500 yearly or $43,500? If the market rents were the same, you'd probably pick the family home, but rents are not the same. House #1 produces $5000 more per year. If you're an investor, even though both houses cost the same, you'll collect an extra $75,000 with the "inelastic students" versus renting to the "elastic family" -- and be able to pay off the loan and start retirement much faster.
Blue Chip Realty favors renting to inelastic college students (and their parents with 529 plans) versus an elastic family. Another aspect of the model is to purchase a property who's location, interior and/or yard is so enticing, that multiple student groups will battle to be the ones chosen to rent it. Competition increases perceived value and desire to purchase/rent.
The Blue Chip Model is to garner premium rents by purchasing highly desired properties, pricing near top of market & promoting to inelastic renters.
Even in strong rental markets, sometimes it is only possible to get the Price-to-Rent (P2R) ratio under 17 if the property can "sleep" 5 or 6 paying renters, as shown in this real life example:
Sleeps 4: Price Midpoint = $710K. Avg rent: 4 x $825/mo x 12 mo = $39,600. P2R ratio = 17.9 -- Almost lucrative.
Sleeps 5: Price Midpoint = $840K. Avg rent: 5 x $825/mo x 12 mo = $49,500. P2R ratio = 16.9 -- Lucrative.
Sleeps 6: Price Midpoint = $948K. Avg rent: 6 x $825/mo x 12 mo = $59,400. P2R ratio = 15.9 -- Very Lucrative.
Note that increasing the number of "beds" by 50% (from 4 to 6) does not increase your cost of the home by 50% (its usually only by 20 or 30%); however, when renting to students who pay "per bed" it can increase the rental income by 50%, moving the investment from "almost lucrative" to "very lucrative". Note: it will take more IRA cash up-front to do that though.
Its not the increase in square footage that matters, but the increase in density of beds. So instead of buying a house with a living room, dining room and 3 bedrooms fitting 4 beds, you should buy the same size house with a living room (no dining room) and 4 bedrooms fitting 5 beds.
To make a self-directed IRA investment more lucrative, the Blue Chip Model is to acquire rental properties that can "sleep" a high density of renters.
4) Aggressively Pay Down
the Loan each Month
To purchase leveraged real estate in your self-directed IRA, it is likely you will need to secure a 20-year non-recourse loan (unlike conventional lenders who often offer 30-year loans, most non-recourse lenders max-out at 20-years). Nevertheless, because you'll need to put down between 50% and 55% as a down-payment (another non-recourse requirement) your rental property will be producing a positive cash flow on Day 1. Leverage this cash! Assuming you have enough reserves to cover unexpected expenses, Blue Chip Realty strongly recommends paying down additional principle on the loan each month.
Click Here to see 2 compelling reasons to pay down faster which leads to 3 great options:
REASON 1: Since it is still IRA "retirement" money, you are not allowed to withdraw it early for personal use without a penalty. Thus, you can't take out this extra cash and spend on "personal" things like a family vacation or new car, you might as well put it to good "retirement" use.
REASON 2: By paying down extra principal each month, you can reduce the life of the loan by 4 to 6 years and own the house free and clear in about 15 years, and depending on where you are in your career, you will then have three great options:
- If you are still working, your next egg will now be increasing by the monthly net rent, likely as much as $6,000 to $7,000 per month -- $72,000 to $80,000 per year!
- If you're retired, the monthly rent can be withdrawn at a low tax-rate and provide a tremendous income stream to finance any medical expenses, travel adventures or fancier bottles of wine ;-)
- If you are retired and want to sell the property, the proceeds of the sale will provide a huge increase in your next egg and extend your runway in retirement for likely over a dozen years.