Real Estate Investment - 6 Stupendous Strategies
Today's availability of fairly priced--and even some undervalued--homes combined with outstanding low-payment interest rates and a solid rental market, have boosted sales. Once again, opportunity-driven investors are finding a great value. In this Real Estate report you will learn about the importance of getting positive cash flow, leveraging techniques and the benefits you can have from equity growth.
Strategy #1 - The Reasons We Invest
According to recent statistics published by the U.S. Census Bureau, 75% of multi-family investors are over the age of 45. Over half of these (51.6%) own less than five units, and they earned approximately 31% of their income from ownership of rental properties.
These statistics may surprise you, but some logical reasons explain these numbers. Most real estate investors come to the market later in life because they are concerned about their retirement and are at their highest potential earning power; some have inherited money or real estate. The U.S. Census Bureau reports that 48% have inherited a home.
There are four major reasons that an investor might choose real estate for investment.
1. Cash Flow. Yes, it is still possible in some parts of the country to have a cash flow return. In other words, after all expenses have been covered: mortgage, vacancy factor, repairs, property management, etc., there can still be some money left on the table. Most banks will not lend money to buy a property if there is no hope of a cash flow.
2. Appreciation. As a result of our growing population--a net gain of one American every 14 seconds, according to the U.S. Census population clock--we could expect to have a population in excess of 400,000,000 in 2050 compared to today's population of 286,401,757. Loosely applying the rules of supply and demand, we can rest assured that with our current immigration patterns as well as our population growth, there will be a continued need for housing over the next 50 years. You can safely assume a 4% appreciation level. Of course, some years will be better than others depending upon supply and demand, the escalation of costs and the increased costs of construction and land/infrastructures. As long as governments keep up major increases in impact fees for developers, your real estate investments will continue to appreciate.
The average single-family home sold for $23,400 in 1970; in 2000, a similar average home sold for $169,000. That is an approximate 8% annual increase. Of course, appreciation will vary with the location and condition of the property as well as the condition of the local economy.
3. Equity Build-up. You reduce your mortgage and increase your equity with every mortgage payment made on underlying debt. A portion of your payment goes toward reducing the principal. The shorter the loan period, the faster the equity builds.
4. Tax Savings. Uncle Sam allows everyone but dealers in real estate to depreciate their investment properties on schedule E when filing annual tax returns. Residential properties depreciate over 27.5 years and commercial over 39 years.
You probably like all of these opportunities to make money. Bear in mind, though, that the government needs to pay its bills and they get their share when you sell one of your investments. When you sell a property, you will be faced with a 20% capital gains tax on the increase in value of the property and the recapture of the depreciation. This cost could be deferred if you complete a 1031 tax deferred exchange to trade up from property to property.
Think through the following example: with $500,000, you can buy a $1,500,000 investment that may give you an 8% cash flow, an annual 4% appreciation, an annual equity build and a depreciation of $43,000 a year (1,500,000 X .8 = 1,200,000 (minus the land value); 1,200,000/27.5 = 43,000). This comes in at over a 20% annual return and should make you feel like you have made the right investment decision.
Regardless of the size of real estate investment, you can make a return and build up your retirement. It is important to not buy the first investment that comes along; rather, you should buy the best investment. Pick an investment that you are the most comfortable with--maybe your grandmother's duplex. This will give you a chance to make some small mistakes and plan a long-term future investing in real estate. Choose a real estate agent who has some of his or her own investments to help you and a property management company with good references.
(Note: Not all real estate investments have a fairy tale ending. It takes time, experience and a good eye for location and detail to achieve these kinds of results. On the other hand, they are achievable results.)
Strategy #2 - Don't Lose Your Shirt
There's opportunity now for investors to step in and benefit from these properties that are about to hit the market. However, despite all the hyperbole, investors can lose money in real estate--a lot of money. If you have some cash itching a hole in your bank account and you're looking for positive cash flow and possible high returns on investment, be sure to avoid these pitfalls in the foreclosure investor field.
1. Paying too much for a foreclosure. Many VA and HUD foreclosure buyers have found themselves getting caught up in the excitement of auctioning up on properties and watch, without even knowing it, their supposed cash cow die right in front of them. If you must have a 20 or 25 percent spread to make money on the purchase, then stop bidding when the price gets below that spread amount.
In simple terms, if you're bidding on a property with a $150,000 value and you intend to sell it for a 20 percent gain, then stop bidding when the price gets above $120,000. In a hot market, even foreclosures will sell at market price, but then the new owner must move in and most likely fix up a dilapidated property that has been neglected by the former owners. (Usually, when an owner is headed toward foreclosure, fixing the leaky roof or basement is the last thing on his mind, leaving it up to the "bank" to fix instead.)
2. Getting a house without clear title. Make sure you can get clear title to a property before you put your $10,000 earnest money deposit into the deal. Order a title search by an attorney to find out if you're going to have any problems taking title to the property. If you can't get title, you can't sell the property.
3. Negative or unprofitable cash flows. The whole idea behind buying a foreclosure is to buy low enough so that rent checks will cover the investor's mortgage payment, taxes, insurance and fees each month and then leave the investor some profit at the end of the month. Unless the property is in pristine condition and all the systems will last repair-free for years, you're setting yourself up for financial hardship if an air conditioner breaks or the refrigerator has a compressor attack.
The monthly cash flow should include enough to finance any breakdowns or repairs while the tenant lives in the dwelling. Negative cash flows are not deductible expenses.
4. Not taking care of little problems before they become big problems. Don't take the cheap way out on being a landlord. A house starts deteriorating from the day the builder completes its construction. Your new investment property is creating cash flow--take care of it. Keep it painted regularly, clean carpets and floors between tenants, fix broken windows, repair leaks promptly, replaced rotted wood, etc. If you let the property deteriorate until you can't rent it out any longer, you've waited too long to fix these items. In addition, to fix defects early on will save you money. If you wait, the bill doubles or even triples.
5. Failing to educate yourself on tax benefits of owning investment properties. If you're going to invest in rental property, talk with professionals in the field who know how to maximize your financial benefits from this new form of investment. Accountants, attorneys and real estate practitioners are all worth their fees as they help you avoid pitfalls, increase your gain and keep you out of trouble.
Strategy #3 - Choosing Your Investment
Beginning investors should start with small projects, just like Walter from Hawaii. He's been involved in real estate for more than 12 years and invested in various two- to seven-unit properties. Properties--both commercial and residential--in good locations have made money for him. The properties he purchased in marginal locations, with high leverage downpayments and extensive tenant turnover have not worked out for him.
Walter started with a duplex, which he later refinanced to buy a four-plex. He painted and put a new roof on the four-plex, then sold it for a seven-plex. He also bought a four-plex with one-bedroom units. He renovated the units and installed new siding, but in the end, he was lucky to receive a return on his investment.
Living in Oregon, he was far away from his investments in Hawaii and could not pay enough attention to the renovations. One moral of the story is that fixer-upper investments--like real estate investments generally--work best if you live nearby and, if possible, do the work yourself.
Other factors hampered the success of his investment, such as a market more suited to two-bedroom units rather than one-bedroom units. As for Walter, he learned more with each investment, and he also learned to be conservative.
Whether you're looking to purchase a house, duplex, 50-unit apartment project or commercial property, you need to carefully review the property's economics.
Are the rents used in your projections realistic? Are the expenses correct? Can you live with the cost of investment mortgage financing? What happens when you have a vacancy? Is there enough cash flow to cover it?
Are you putting money aside in a reserve account?
How much money do you have to spend on repairs? Some investors believe that they should never repair a property. Unit inspections in occupied units will uncover problems that can be solved while the tenants are still living there and while there is cash flow, rather than waiting for a vacancy.
The West Coast and the Sun Belt are currently better bets than investing on the East Coast. Larger cities tend to be better investments than small towns because there is a larger potential pool of tenants and buyers. Communities located on freeways also tend to be more attractive as investments because they have good access to metro areas. Vacation destinations or towns that are economically diversified will be more stable as well.
Another client had 13 houses in the 1980's and lost them all. So he went back to being a painter and started all over again one house at a time. His goal is to have 20 houses for retirement. He adds bedrooms, renovates, upgrades, and paints them, and then he either sells them so he can buy two more or holds them.
Planning an Exit Strategy
Remember that the economy, interest rates, layoffs, job opportunities and construction trends impact every investor. Watch the trends and speak with local brokers, appraisers, investors and real estate attorneys.
An investor always needs an exit strategy, preferably more than one, when he or she buys property. You need to have a vision showing when you will sell and if you will take the money and pay taxes or complete an IRS 1031 tax deferred exchange. Is your plan to have enough money for retirement? Are you going to pay off the property or refinance it and use the proceeds to buy another investment?
And what if values decline?
If you live in a depressed marketplace, you need to decide if the weak economy will last a long time or if the area will pull out of it. This information is critical to your exit strategy. If you cannot find a buyer when you're ready to sell, then what? Structure your mortgage without prepayment penalties, or make sure that your loan can be assumed. Check what the loan assumption costs will be and if financing terms will change with an assumption. Remember banks structure loans to benefit their bottom line and financing can be very hard to assume or refinance. It pays to research financing options before you make a final decision, and interest rates should not be your only focus.
You have to think ahead and be prepared for a range of possible events.
For example, you invest with your best friend and her husband, but if she gets divorced and needs the funds out of the investment to pay off her husband, what would you do? Another variable is your health or your family's health: you may have to liquidate the real estate to pay bills.
Plan your goals ahead.
Your exit strategy will help you make a better decision as you invest into the future. No one is forcing you to buy. Pick your time, and pick a property you can live with into eternity. Worst case, if the market does not move the direction you expect and the value does not go up, at least your tenants are paying off the loan.
Strategy #4 - Screening Tenants the Right Way
Zeke had been waiting a long time for this day. His Aunt Millie finally had decided that he could help her manage her investment properties. She owned three apartment properties and about ten houses, a small rental empire she had built with her husband. The income from the properties had sent Zeke through college.
Zeke was 30 now, had a young family and ran a successful carpet cleaning business, but he had always been a little envious of his aunt. Her trips three times a year to Greece and the Bahamas made him think there was a lot of gold buried under all of that real estate.
When Aunt Millie asked him to manage the Golden Meadows Apartments, a 30-unit property located close to town, Zeke was very enthused. To get started, he inspected all of the units, met all of the tenants and started collecting the rents and paying the bills. He was a tough landlord and enforced all of the rules in a rather highhanded way. Within one month, his on-site manager had quit and he had ten vacancies.
He knew he was doing something wrong, but he didn't want his aunt to know, so he borrowed the rent for the ten vacant units on his credit line and made sure his aunt got all of her money. Then he found a new on-site manager, and together they filled up the property with the next ten tenants that applied. He was never so happy as when the last tenant moved in. He thought all of his problems were solved.
Then the police called: tenant Number Ten was wanted in another state. Tenant Number Nine could not pay her second month's rent because she was unemployed and tenant Number Eight had a band and practiced all night--to the dismay of the neighbors.
Tenant Number Seven was an undocumented worker and the Immigration and Naturalization Service wanted him out of the country. Tenant Number Five had a boyfriend who moved in and broke the door down twice in one week. Tenant Number Three's dog was urinating all over the flowers and killing them. Bill collectors bothered Tenant Number Two all of the time--Zeke learned that she had no furniture in her apartment and was evicted from her last place. Tenant Number One was Zeke's wife's best friend and she never had any money to pay rent.
To top it all off, the new on-site manager ran off with the rents they collected the next month. It was Friday night, and Zeke was devastated.
Then Aunt Millie called. She mentioned a moving van at the Golden Meadows Apartments and said that the property looked trashed. He promised to be right over.
Fifteen minutes later, he was at her doorstep, telling the story while blubbering all over her.
She grew very angry, but told him that together they could work out these problems. He was surprised that she was even willing to let him be involved. She said, "One day you will inherit these properties, and I want to make sure you are successful."
So they went to work.
First she reminded him that it is illegal to discriminate based on a person's race, color, religion, age, gender, disability, sexual orientation, familial or marital status and/or source of income. And some jurisdictions, she said, had additional anti-discrimination standards.
She suggested they get rid of the troublesome tenants Zeke found, keep the good ones and start from scratch.
"First, we must screen our tenants."
She made a list for Zeke that included these items:
· The prospect must have landlord references from previous three years that are satisfactory.
· The household income must be at least three times the amount of monthly rent.
· Employment must be verified.
· The applicant must have no evictions on record.
· The applicant must have no criminal history.
· The potential tenant must possess a valid social security number and I.D. card.
· The potential tenant must not have had any collections within the last 12 months.
· The applicant must have a clear credit record showing that bills are paid on time and that credit accounts have no outstanding balances.
· The applicant cannot have filed bankruptcy within the last seven years.
· -The applicant must agree that pet policies and other standards will be followed.
"The screening will help us make sure they can pay the rent and be peaceful tenants," explained Aunt Millie. "If they cannot meet these standards, we don't want them. Even with this screening, don't take cash for rent from any tenant, and make sure that the people who filled out the applications are the ones who really moved in. Once they have moved in, the on-site manager is responsible for making sure they don't sneak in additional people to live there."
After four months of getting rid of bad tenants, screening for new ones and fixing the damages, Golden Meadows Apartments was once again showing a positive cash flow.
Zeke could live with himself, and Aunt Millie was convinced that he had learned an important lesson about tenant screening--which is what she had planned in the first place.
Zeke decided that managing rentals was more complicated then he thought, and that it took a lot of work to find that pot of gold. He learned a lot from his aunt during the next ten years before she gifted the properties to him. They became a good team, and when she finally retired, she knew that, if nothing else, Zeke would know how to screen for good tenants.
Strategy #5 - Tenant Retention Strategies
So how do individual landlords and management companies improve tenant retention? It's not easy, especially in markets where there are more units than demand.
Pricing
Given comparable units, it's sometimes best to price rents somewhat below the market, say $25 a month. At first this may seem like an annual loss of $300, but if it means renting sooner or fewer vacancies, such lost income is really a marketing cost well spent.
Incentives
Structure the lease so that the last month is free or half-price. The attraction of this benefit is that it only kicks-in when tenants complete their lease, a fair deal for everyone.
Use Tenant Marketing
In some cases current tenants have friends, co-workers, relatives, and others who might be good rental candidates. Be sure to tell current tenants when units are likely to be available.
Be a Good Landlord
Landlord/tenant relations need not be the real estate equivalent of war. Tenants must meet certain expectations and so should owners. In particular, properties should be well maintained, repairs should be made promptly and tenant concerns should be heard. The benefit: a better rent roll and a more valuable property.
Reach Out
A range of institutions have ongoing needs for rental properties--military bases, universities, hospitals and big corporations are all likely to have housing offices. Speak with housing officials. They can advise you regarding the requirements to be listed on their system and pricing information.
Survey Tenants
Every six months ask tenants to evaluate the property. Ask about matters such as cleanliness, maintenance, exterior areas, amenities, noise, parking and management.
Communicate
Communication can increase resident satisfaction. A newsletter, for example, can keep everyone informed regarding the property, community events and resident news. It's also a good place to announce improvements. A community bulletin board can also have value. Newsletters and bulletin boards can announce community events such as cook-outs and parties.
Fair Notice
If you're going to raise rates, then give tenants adequate notice--as much in advance as possible. Where applicable, rent control laws may have minimal notification requirements, but landlords are not prevented from giving notice well in advance of statutory requirements.
The nature of the landlord-tenant relationships is often one of complaints and disputes--but it doesn't have to be this way. Landlords can do their part, and the result can be increased retention rates, fewer vacancies and greater property values.
Strategy #6 - Five Keys to Successful Negotiation
Negotiation is a complex matter and all transactions are unique. Both sides--buyer and seller--want to feel that the outcome favors them or at least represents a fair balance of interests. In the usual case, there is a bit of bluff, some give-and-take and neither party gets everything they want.
So how do you develop a strong bargaining position, one that will help you get the most from a transaction? Experience shows there are five basic keys that will determine who wins at the negotiating table.
1. What Does the Market Say?
At various times we're in a "buyers" market, a "sellers" market or a market where supply and demand are roughly equal. If possible, you want to be in the market at a time when it favors your position as a buyer or seller.
Because all properties are unique, it is possible to buck general trends and have more leverage than the marketplace would seem to allow. For instance, if you have a property in a desirable neighborhood with few sales, you may be able to get a better deal than elsewhere. Or, if you're a buyer who can quickly close, that might be an important negotiating chip when dealing with an owner who just got a new job 500 miles away.
2. Who Has Leverage?
If you're on the front page of the local paper because your business went bust--and the buyer knows it--you have less clout in the bargaining process. Alternatively, if you're among six buyers clamoring for that one special property, forget about dictating an agreement--the owner can sit back and pick the offer which represents the highest price and best terms.
3. What are the Details?
A lot of attention in real estate is paid to transaction prices. This surely makes sense, but the key to a good deal may be more complex.
Consider two identical properties that each sell on the same day for $275,000. The houses are the same, the sale prices are the same, but are the deals the same? Maybe not. For instance, one owner may have agreed to paint the property, replace the roof, purchase a new kitchen refrigerator and pay the first $5,000 of the buyer's closing costs. The second owner made no concessions.
In this example, the first house was actually sold at discount--the $275,000 purchase price less the value of the roof repairs, closing credit and other items. If you're a buyer, this is the deal you want. If you're a seller, you would prefer to be the second owner and give up nothing.
4. What About Financing?
Real estate transactions involve a trade--houses for money. We know the house is there, but what about financing? There are several factors that impact the money issue:
Has the buyer been pre-qualified or pre-approved by a lender? Meeting with a lender before looking at homes does not usually guarantee that financing is absolutely, unquestionably available--a loan application can be declined because of appraisal problems, title issues, survey findings and other reasons.
But buyers who are "pre-qualified" or "pre-approved" (these terms do not have a standard meaning around the country) at least have some idea of their ability to finance a home and know that they are likely to qualify for certain loan programs.
The result is that pre-qualified buyers represent less risk to owners than a purchaser who has never met with a lender. If the seller accepts an offer from a buyer with unknown financial strength, it's possible that the transaction could fail because the buyer can't get a loan. Meanwhile, the owner may have lost the opportunity to sell to a qualified buyer.
The lower the interest rate, the larger the pool of potential buyers. More buyers equal more potential demand, good news for sellers.
Alternatively, high rates or even rising rates may drive buyers from the marketplace--and that's not good for anyone.
It used to be that downpayments were a major financing hurdle--but not anymore. For those with good credit, loans with 5 percent down or less are now widely available. In fact, 100 percent financing--mortgages with nothing down--are now being made by conventional lenders. Reduced downpayment requirements are good for both buyers and sellers.
5. Who Has Expertise?
Imagine you're in a fight. The other guy has black belts in 12 martial arts--and you don't. Who's going to win?
Brokers have long represented sellers, and now buyer brokerage is entirely common. In a transaction where one side has representation and the other does not, who has the advantage at the bargaining table?
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