Investing 101
If you’re like most homeowners, you have considered the idea of making a real estate investment. You’ve seen your property value go up since you purchased your home, especially over the last few years. If you personally weren’t hurt in the stock market bubble and subsequent scandals, you probably know someone who was.
Is making a real estate investment right for you? If it is, how do you do it correctly? These are the questions I am going to try to answer. Drawing on my personal experiences as a real estate investor for 25 years and what I’ve learned from my clients, I am presenting you with the information you’ll need to know to make your investment a profitable one.
To begin with, investing in real estate is a business and you need to treat it as such. Suppose you decided to invest in the stock market. No matter how much time and effort you invest in picking a stock to buy, once you buy it, you have no influence on the decisions made by that company. The only decision that you need to make is when to sell the stock. When acquiring a piece of real estate for investment, you are the only one responsible for making it a profitable venture. You will be selecting the investment property. You will be selecting tenants. You will be maintaining the property. You will decide what improvements are to be made and when they are to be done. You will see to it that rents are received when they are due and have tenants evicted when necessary. There is a commitment of time and energy that you need to make before going any further. Real estate investing is by no
means a passive investment.
Recognizing the work involved is your first step. Once you’ve accepted this you can move on. Now you need to decide how much money you are planning to invest in this new business. Yes, you will need to invest money. Despite all the books that have been written and infomercials broadcasted, promoting the concept of investing in real estate with no money down, you are going to need cash to work with. You wouldn’t expect to walk into a bank and buy a Certificate of Deposit or call a stock broker to purchase a stock without exchanging cash for them. Why would you think you could buy a piece of real estate and have tenants pay you rent on a monthly basis without spending money? Cash is your first limiting factor. The size of your cash commitment will be the determining factor as to the type, location and condition of the property you can buy.
The next logical thing to consider is your risk tolerance. Just as in the stock market, there is a range from purely speculative purchases through conservative investments. Buying a burnt out building in a depressed area that seems to be “up and coming” is a highly speculative but potentially lucrative investment. You could easily loose everything. Buying a fully tenanted 2 to 4 family home that is in mint condition in an established area would carry very little risk to loss of capital but will generate substantially less profit. Where do you belong on this risk/reward scale? Only you can decide that.
My personal recommendation is to stay on the conservative side. Your first investment needs to be a positive experience. If your first investment is a bad experience, then you will be reluctant to try another, or worse, you’ll no longer have the capital available to try again. Your first investment is also a learning experience for you. There will be mistakes made and you will learn from them. There is more room to make mistakes on a conservative investment than on a speculative one.
I’m not looking to scare you off from the concept of investing in real estate. I personally feel it is the best long term investment that can be made. Armed with the right information and realistic goals you will see how quickly your net worth grows. I’m now going to walk you through the steps you will need to take to accomplish this.
You’ve already taken the first step. You’ve recognized the facts that you will need to dedicate a portion of your free time to run this new business venture and you have accepted the fact that your availability of cash will have a major impact on what you can and cannot do.
In determining the amount of money you’re prepared to commit, you need to remember that what you invest will be tied up for a long period. Once the purchase is made, there is no fast and easy way to get your money out. There are basically 2 ways to free up cash invested in real estate. Either you sell the property or take a mortgage out on the property. Both are time consuming and come with a cost. Basically you need to hold the property for at least as long as it takes for it to appreciate enough to cover these expenses or expect to take a loss. My recommendation is to use only funds you are not planning to touch for 10 years.
Many first time investors look to use the equity they’ve built up in their primary residence as the source of capital. When using this approach you always need to keep in mind that you are committing to an additional monthly expense, the mortgage payment on this money you’re borrowing, that you will need to budget for. Another approach to increase the funds available to invest is to bring a partner to the transaction. Properly structured, this is an excellent approach for individuals to pool their resources and purchase sooner than either partner could on their own.
If you are taking this route, you need to plan on an exit strategy from the beginning. Each partner’s needs and/or goals will evolve over time. This tends to strain the relationship between the partners. The way to minimize this is through planning. From the start you need to formalize the details of the partnership. Specify the amount of money each is investing, guidelines you plan on using in selecting the property, identify the responsibilities of each partner for handling the day to day operations of the business, and most importantly, agree on how long you plan to hold onto the property.
Having an initial focus on a holding period will give partners the ability to work that timeframe into their own personal finances. If you agree to a 5 year holding period, and you need get your money out at year 4, you have 2 options to work with. Either find a way to defer your need for cash for a year or negotiate with your partner to accelerate the sale date. Without the preset holding period you would be totally at the mercy of your partner. Remember, just because you started with a 5 year holding period, doesn’t mean you and your partner can’t mutually agree to extend (or shorten it). It just creates a reference point for both to work from. You cannot put too much detail in this partnership agreement. The more details you address upfront, the less problems you will have along the way.
I have been involved in several partnerships over the years. I can honestly say they all worked out well in the end. I attribute this to the fact that in each case, all the partners entered into the transaction with their eyes open and realistic expectations.
Now that you know how much money there is available to invest, the next step is to see how far it will take you. The investment will need to cover the down payment on the property, transaction costs in acquiring and closing on the property, any initial repairs on the property and cash reserves. No business venture can be successful without having funds available for the unexpected. Things break, tenants vacate or stop paying rent, utility prices jump, etc. When you are financially prepared, issues like this are nothing more than an inconvenience. Without preparation, any one of these problems could escalate into a disaster.
Now your work begins. I suggest you look at a wide geographic area. Use a shotgun approach through the area with a goal to focus down to the one or two areas that you’ve decided warrant an investment. Working this way reinforces your confidence in the area (s) of your concentration. It may even introduce you into an area that you hadn’t previously considered.
In your search for a property, you are also looking for more than just an address. You are looking for neighborhood attributes, price range of the properties in the neighborhood, general condition of the neighborhood, availability of rentals and the going rate of the rentals.
Is the community dependant on cars to get to and from work? If it is, then off street parking is an important amenity. If there is any form of street parking restriction in the community, this amenity becomes a necessity. If the community depends on mass transit, then proximity to a bus stop or a train station becomes critical.
Are neighborhood properties generally well kept? What is it going to cost you to either get your property into shape or to maintain the property? You always need to remember that even though you are going to be an absentee landlord, your property is still part of the community. Your tenants will be part of the community and will be interacting with the neighbors. If the neighbors aren’t happy with you, it is going to affect your cash flow.
When analyzing a potential purchase, your goal is not to find the perfect property, it is to translate each negative issue into a present dollar value. If the property needs renovation, what is it going to cost? Will you need to work around existing tenants or will you have vacancies during construction? What is the finished product going to be worth when you’re done? Is your investment of time and money giving you a proper return?
Is the property in a prime location? If it is, you are going to be paying top dollar for it. If it’s not, does the price reflect the location? How much of a difference in rent is there between the locations?
The real estate market, just like all markets, is priced emotionally, not logically. The way to make money as an investor is to look past the obvious and look for the overlooked. This is how you make your profits. You are looking for what the market missed.
Here’s a typical scenario. You look at a 2 family house where the owner lives on the first floor and rents out the second floor. The tenant has been there for a number of years and because of this his rent is substantially below market. Knowing this, our tenant refuses to let any prospective buyers into the apartment. The current owner is making the two classic errors. First, he has allowed the tenant to fall behind the market (he’s a “good tenant” so the owner didn’t increase his rent over the years). Second, he won’t evict the tenant because he doesn’t want to lose the monthly income. Because of this the owner is having problems attracting offers. You now have the luxury of his undivided attention when you present your offer.
You agree to purchase without seeing the tenant’s apartment. Isn’t this asking for trouble? Not if it’s done properly. You can get a good idea of the size of the apartment just by seeing the first floor apartment. You assume the apartment is a mess and needs to be totally renovated. Now you simply make your offer knowing you have a renovation facing you. Don’t have the money to do the renovation? Then this is may not be the property for you unless you can come up with an alternative to cash. Borrowing additional money outside this purchase could be one solution. Bringing in a partner could be another. Inviting a contractor into the deal with you is another possibility. Your options are only limited by your creativity.
This is my definition of a good deal. The right price for the property at the right time for you. The above example might yield the right price, but if you don’t have the cash to do it, it’s not the right time. Knowing your own limitations is the most efficient way to stay out of trouble.
You’ve decided on a property to buy. You’ve got your contract signed and now it’s time to arrange for financing. The procedure is familiar to you; after all, you already bought your own home. There are going to be some differences this time around. You are no longer financing your primary residence, you are financing a business. From a lender’s standpoint this is a higher risk mortgage. In the mortgage market, higher risk means higher rate and higher down payment. Anything the lender can do to minimize its risk, or increase its rate of return, will be done.
Why is this the case? First, answer this question. If you are obligated to pay 2 mortgages, one on your home and one on an investment, and you only have enough money to pay one, which mortgage would you pay? It’s obvious what you would do and that illustrates the higher risk involved in the investment mortgage.
As the investor, you reap the rewards on the upside of the deal. Any profit, either in monthly cash flow or in appreciation, is yours. Say the deal goes bad, and the resale value of the property drops down below the outstanding mortgage. You will force the bank to take a loss on the mortgage. In a situation where the bank’s exposure on the mortgage is greater than the value of the property, it’s in the bank’s best interest to limit its losses. The lender may allow you to voluntarily surrender the keys to the property as payment in full for the mortgage or agree to allow you to sell the property and accept the proceeds of sale as payment in full, essentially sharing in the downside of the investment. From the bank’s prospective, their profit in the deal is limited to the interest rate you’ve agreed to pay but they have a much greater exposure to financial loss than you have.
The lender shares in all the downside risk but none of the upside potential. It’s no wonder they’re cautious!
In understanding the bank’s position, you can arrange your financing in a more professional manner. Your application package will be a concise set of facts proving that there is no unnecessary risk for the lender in approving this mortgage. This will make the approval process much smoother.
Go to Sample Small Commercial Purchase for an overview of the analysis a lender does in determining the size of the mortgage an investment property's cash flow can support.
This attitude of understanding the position of the “other side” should be present in all discussions. Besides putting yourself in a better negotiating position, it has the additional benefit in that it’s contagious. It pulls the other person into a mindset of trying to find ways to make things work instead of looking for reasons not to do business with you.
If you take the time to understand the needs of the seller, you will be in a much better negotiating posture. You will find there are other issues, other than price, that can make the deal come together.
The time between signing contract and closing on the property is very important. In most cases there is no need to rush to close. Remember, the happiest days for an investor is the time between contract and closing. It’s during that time that the investor enjoys the benefit of any market appreciation without paying for it. The investor’s ties up no more than 10% of the sales price and earns 100% of any appreciation and as an added bonus any problems with the property is still the seller’s responsibility.
During this time you should be fine tuning your plans regarding the property. If you’re taking ownership with any existing tenants, now is the time to decide if you are planning to increase the rent, how much you plan on increasing it. Perhaps you are planning to ask the tenant to vacate. Remember that you will be subject to any existing lease. This will impact when the increase can be effective, possibly the size of the increase and may restrict your ability to remove the tenant. Maybe you are considering buying the tenant out of his lease. Now is the time to decide how much of an offer you are willing to make and when is the best time to approach the tenant.
If you are considering any renovations, now is the time to decide how far you want to go and you may even have the opportunity to get your estimates in place prior to closing. This way your contractors can start immediately after you close.
Decide exactly what work you want to have done before you talk to a contractor. If you are specific in the scope of work you need to get done, understanding that no one is a mind reader, forces the contractor to be specific with his proposal. This makes your job easier in comparing prices since all contractors are then bidding on the same specifications. It also insures that you are getting what you expect as a finished job.
A common mistake I see is, investors wanting to do the work themselves as a way to save money. Their mistake is not considering all the costs involved in doing it yourself. You decide you want to renovate a kitchen. A contractor will do the job in 5 days at a cost of $15,000. You consider yourself pretty good with tools and you figure your material costs will be $7,000. Why not do it yourself and save $8,000? You plan on doing the work in your “free time”. How much free time do you have? This 5 day project done by a contractor easily turns into 5 weeks of “free time”. Now you have the loss of rent as an additional expense. “Free time” is the most precious time you have. What is the hourly cost of that time to you? Now add that cost into the equation. Suddenly you are no longer savings as much you thought, it could easily cost you more in the end.
Maybe you don’t have $15,000 available, but the work needs to be done. This is now a business decision for you to make. Do you borrow the money to do the work to get it done faster and factor in the financing costs as an additional cost? The decision is yours, just be sure to add in all the costs involved in doing it yourself. Always try to have a complete set of data before making any decision. There is nothing wrong in doing it yourself, as long as you’ve worked out the numbers first.
How much do you “fix up” an apartment? There are several issues that need to be considered in addressing this question. On the one hand you don’t want to invest any more in renovations than you absolutely have to. On the other hand you want to attract quality tenants. Better quality tenants expect to live in a better quality apartment. If you expect to rent an apartment for top dollar to highly qualified tenants then you need to go the extra mile so the apartment gets people excited to want to live there.
You need to know your market. If the area demands basic, clean space at a moderate price, then that’s what you provide. A freshly painted apartment with a clean bathroom (if in doubt, re-grout) and a clean kitchen with working appliances is what you need.
Say the area attracts higher income tenants, that is, tenants who have the financial strength to be owners but have elected to rent. These tenants have made a lifestyle decision. They are looking for a high standard of living without long term financial responsibility. To rent to this profile you need to add polish to the apartment. In renovating the apartment, use ceramic tile in the kitchen instead of vinyl, wood cabinets instead of Formica, consider installing a granite countertop and if space allows add a washer/dryer combo. Remember, here you’re not dealing with a price conscious tenant. You are dealing with someone who likes the comforts of life and is excited by “bells and whistles”.
This is a business; you need to invest money to make money. Once you rent out an apartment you can’t just ignore it. You need to be responsive to any maintenance issues that arise, especially repair issues. A leaking waste line in the kitchen is an inexpensive repair. Left unattended, the problem grows as the damage grows to include cabinet damage, flooring damage and ceiling damage to the space below. It is cheaper to address minor repairs than to allow them to grow to major repairs.
There’s another, even more important reason to be responsive. It encourages the tenant to respect your apartment. You’ve investigated and interviewed the tenant. You’ve concluded that this individual has the financial capabilities to pay the rent, he has the creditworthiness to pay his rent on time and has the character to take care of the apartment. You’re in a business, a service business. The tenant is your client and deserves to be treated as one of your most important customers. He’s more than just a repeat customer, he has signed a document committing himself to be a regular customer for a least a year. He signed this document without any substantial proof that you will maintain his home. If you’re not responsive to the care of your apartment, why should he care about how he treats the space? In the long run you have much more at stake than he has. Protect your
investment by staying on top of maintenance issues.
I’d like to tell you that a screening process exists that guarantees that you will only rent to responsible tenants. Unfortunately, there are never any guarantees in business. A tenant may skillfully pass through the screening and have no intention of ever paying the rent. You may have rented to a happily married couple that begin to have marital problems during the term of the lease and the rent stops. Maybe your tenant loses his job. Maybe he just simply looses his mind, or gets involved in drugs or alcohol. Things happen. Remember, even criminals and drug addicts have or have had an apartment and you can be sure that the landlord felt they were responsible at the time they moved in.
Dealing with a problem tenant is a frustrating and expensive situation. The frustration begins with a lack of rent payment followed by not knowing what’s happening inside the apartment and ends with having to deal with Housing Court. Your expenses add up quickly. You’re not collecting your rent, you know you are going to have to do work in the apartment, it’s only a question of magnitude, and aside from all this, you are paying legal fees.
You’ve heard the expression, “The customer is always right”. Remember, the tenant is your customer. The laws governing tenant-landlord disputes always gives the tenant the benefit of the doubt. Where the property is located will determine what degree of trouble you’re in. The first thing you need to do when you are having trouble with a tenant, is contact your attorney. You need to have an expert walk you through the eviction process so you can get possession of the apartment as quickly as possible. Think of it as high stakes board game. As you advance from step 1, to step 2, etc. you need to do everything correctly. One misstep, and you go back to the beginning and start all over. The more time you lose, the more money it costs you in lost rent. The court system will advise the tenant of what steps he needs to take, as well as advise him of his rights through the process. You,
on the other hand, are left to fend for yourself. The “consumer” (tenant) has the court to protect him from the “big businessman” (you).
We deal with the vast array of personalities in everything we do. At our jobs, shopping, driving even in our own homes we see the diversity of personalities that make up the human race. Tenants are people. As a real estate investor, your success or failure will depend on this assortment of personalities. You try to do everything you can to weed out the troublesome ones, but you will not have a perfect record. Problems will arise and you will have to learn to deal with them.
As in any investment, you should periodically analyze the investment. You should do this on a 3 to 5 year schedule. You should be reviewing the cash flow. Is the property performing as you expected? Is the rental income increasing, decreasing or is it stagnant? Tenant turnover, is it excessive? Is this becoming a high maintenance property? What’s happening with the neighborhood? Are property values increasing or decreasing? Is this trend unique to this neighborhood or typical for the overall area? How much equity do you now have in the property? Should you be cashing out?
You conclude from this analysis that you’re not happy with your investment and want to move on. Now what do you do? First thing to consider is how strong is the current real estate market? This might be a good time to sell, or maybe you may want to wait 6 months or a year for the market to improve. Do you have a vacancy coming up? If you do, you are probably better off marketing the property with one vacant apartment instead of it being fully leased. This opens your set of potential buyers to those looking to use the property as an owner-occupied property.
If your equity position is substantial and you are looking to purchase another property you need to consider doing a 1031 tax free exchange. Real estate is one of the investments (because it is considered a business by the Internal Revenue Code) in which you can trade assets without trigging an immediate capital gains tax. The details of a 1031 exchange is beyond the scope of this paper but simply put it permits you to exchange one property for one or more properties while at the same time deferring any tax that would be due if you sold the property. There is a specific series of steps that must be completed in a fixed timeframe to properly execute the exchange, so speak with your accountant before taking the first step. Just keep this option in mind when the time comes to sell any investment property.
You may conclude that you like how this investment is performing and you’d like to take some of the profits out. In this case you want to either take a second mortgage on the property or refinance the existing mortgage. The current rate environment and the amount of cash you are looking to take out will determine which approach is more beneficial. There is no tax due on this money, since you haven’t sold anything, just borrowed more money. This money could be used to buy another property or for any personal reason.
You may decide to do nothing. You are happy with the performance of the investment and you have no reason to tap into the equity today. This is a perfectly valid position to take. This analysis becomes a check point for your investment. If you’ve been lax in raising your rents or you’ve been deferring certain upgrades on the property, this analysis will highlight those errors.
At all times you need to have an idea of what your property is worth. Situations will come up where you are offered the opportunity to sell your property and you weren’t looking to sell it. It may be that a neighbor approaches you or a tenant may be interested in becoming an owner. Any time you have the opportunity to sell a property at a price you feel is more than it’s worth, you should seriously consider accepting the deal. Don’t fall in love with your investments. They serve one purpose, to increase your net worth, and nothing else. If you have the chance to sell at an attractive number, take it. You will be able to find a better priced property to replace it, pocketing the spread in pricing.
You will only be able to capitalize on this situation, if you have a good idea of property values. Knowledge is power. The more you know the more profitable your business will be. This is the ultimate goal, isn’t it?
There are no sure things in life. Real estate investing is no exception. If you decide to enter the realm of real estate investing, you will never be bored. There is always something you will need to deal with. If you compare real estate investing to any other business venture, it is one of the safest. Want proof? There is no other business venture, that from the very beginning, conventional lending channels will fund. As I pointed out earlier, the lender shares heavily in the downside risk of the endeavor. With no track record, you will have a lender support 70 to 80% of the cash needed to buy the first property. Their willingness to do this is proof of the low risk level of this form of investing.
Be confident in your decision to go forward. Be conservative in your targeted profits. Take the time to do your research. Be prepared for the unexpected. Don’t lose sight of the big picture. Most of all be patient. The profits will come over time. Good Luck!
Sample Small Commercial Purchase
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