Three Steps to Wealth & Financial Security
Page 10
William Nickerson’s How I Turned $1,000 into a Million in Real Estate in My Spare Time - based on real estate investments in the 1930s – may have been the first manual for the private real estate investor. The book is a classic; many investors today still practice his teachings.
Roger J. Brown, PhD, a former professor at the University of California, Irvine, and San Diego State University, is the author of Private Real Estate Investing – Part I, The Basics. Dr. Brown updates Nickerson’s timeless message and elaborates on it in a framework that describes how individual real estate investors make decisions today. The book is aimed at college and graduate level students. A reader will be rewarded with insights unavailable in the typical real estate investment book available to the general public. For the more advanced student/investor, see Dr. Brown’s Private Real Estate Investing, Part II, Risk Analysis and Part III, Special Topics, as well as his web site – mathestate. com.
We also recommend books by Leonard Baron, MBA and CPA – ProfessorBaron.com - and John W. Schaub – JohnSchaub.com.Mr. Baron is a San Diego State University lecturer, real estate investor, and author of a number of real estate investment books. Vikki and I have authored several chapters in “Due Diligence 101” identified in the Appendices. Leonard loves to teach, and his students appreciate his counsel and guidance. I occasionally teach classes with him. John Schaub, who resides in Sarasota, Florida, has been teaching seminars to investors for many years. He occasionally offers classes on the West Coast. Check his web site for dates and locations.
Finally, are you sure you want to be a real estate investor? See the comments by Yale economics professor Robert Shiller, “A Negative View of Real Estate Investing” immediately below. But also see “A Positive View of Real Estate Investing” following his comments.
Recommended reading: “Investing in a Rental Home Isn’t as Safe as It May Seem”, Tara Siegel Bernard, The New York Times, March 30, 2013; “Why Home Prices Change (Or Don’t)” Robert Shiller, The New York Times, April 13, 2013; also see “Houses versus the Stock Market” in Part 3 above.
2. A NEGATIVE VIEW OF REAL ESTATE INVESTING
“Housing is a speculative, risky investment”. Robert Shiller, Yale Professor, economist, and historian of financial data
“A house can be a good investment, yet only a few actually make money investing in houses”, John W. Schaub, author, “Building Wealth One House at a Time”
Yale University Professor Robert Shiller was interviewed by Bloomberg News on Wednesday, February 6, 2013. His comments are available at Bloomberg.com/video/shiller.
From 1890 to 1990, the appreciation in housing factoring out inflation was essentially zero, and housing was not viewed as a great investment. Over the long haul, it’s hard for homes to compete with the stock market in real appreciation.
So, why is housing considered a good investment today? The answer: Investing in housing was a fad idea that took hold around 2000.
Houses must be maintained; they depreciate and go out of style. All of these are problems. And there is technical progress in housing. The new ones are better.
People who own houses lose the opportunity to invest their money elsewhere. We are too optimistic about houses. Buy them for their utility and for personal reasons not as an investment vehicle.
3. A POSITIVE VIEW OF REAL ESTATE INVESTING
“Buying one house at a time can make you wealthy”. John W. Schaub, author, “Building Wealth One House at a Time”
If you’re thinking about retirement, the (rental) income can serve as an inflation-adjusted annuity of sorts, since rents are likely to rise over time”. Tara Siegel Bernard, New York Times
Despite the negative views above, we have seen ordinary people succeed and build wealth with real estate. All had a plan; none attempted to get rich quick. All used their rental income to pay the mortgage and other costs with the goal of obtaining free and clear houses. Examples of people who succeeded are below.
A realtor in San Diego, a single woman in her mid- 60’s, worked hard all of her life, using the income from real estate transactions to buy single family houses. She then used the rental income to pay the mortgages and now owns four San Diego homes free and clear. The rents from these four properties bring in approximately $2,000 per house each month. She has four other homes with mortgages; her goal is to own all eight homes free and clear within a few years.
Compare and contrast: Many people in this lady’s age group have no retirement savings and are dependent on social security. The average monthly social security check in America – around $1,200 - is less than the income from one of her rentals.
Gary’s parents bought a four-unit building in St. Paul, Minnesota. Rental payments were used to pay the mortgage. His family lived rent free, and his dad diversified his investments by purchasing bonds each month. His parents retired at a young age to a golf course community in Arizona and lived well for many years.
A realtor in our company observed her dad purchase houses when she was a kid. He used the rent to pay the mortgages. She followed his example and now owns a twelve-unit building in San Diego, as well as numerous single-family and four-unit homes, both in San Diego and Texas.
The realtor’s son followed his mother’s example. The family had saved $48,000 for his college but he opted to attend community college. The son used the $48,000 to buy a $95,000 condo in San Diego: He put 50 percent down. The mortgage, HOA, and taxes are $500 per month. The rent is $1,200 per month. Cash flow is $700 per month—a substantial return on investment.
His plan is to use 100 percent of the positive cash flow to pay off the condo early.
4. BIGGEST MISTAKES BY INVESTORS
“The first defense is diversification”. John Longo, investment strategist, MDE Group, Morristown, New Jersey
“You need to have a sizable reserve fund set aside to pay for expenses, whether it’s to cover the mortgage when the property is sitting vacant or to make repairs, which novice landlords tend to underestimate”. Kenneth J. Eaton, financial planner, Overland Park, Kansas
Many who attempt to invest in real estate fail. Some of the most common errors we see are:
Attempting to be an investor without adequate education or training. We have met countless people buying investment homes who had no idea how to carry out due diligence when buying, how to evaluate return on investment, how to be a landlord, or even how to run a credit report.
Buying with negative cash flow and counting on appreciation. Eventually, these properties are typically lost to foreclosure or sold as short sales. See Part 1, Chapter 6, “Lessons Learned: Biggest Mistakes – Houses” for examples of people who put significant money into negative cash flow homes for many years.
Underestimating the cost of maintaining the properties. New investors often underestimate the costs and challenges of owning, maintaining, and managing houses. Houses are a great deal of work. Tenants can be challenging; expenses can be high. Some people love owning houses; many find that it does not work for them.
Not diversifying investments. “If you have a $600,000 portfolio, putting $300,000 into one asset class is a highly concentrated bet”. Sara Siegel Bernard, New York Times.
Not comparing, contrasting or understanding other investment options. Many blindly move forward with real estate investments without first understanding the opportunity to invest in an asset class with the potential for significantly better long term returns. See Part 3, “Compare and Contrast Different Investment Options” and “Houses vs. the Stock Market”.
Buying and owning properties in other states and cities. “I owned houses in 49 states and lost money in 48,” Jack Miller, real estate investor, financial mentor and teacher. His point: Your chances of success are best in your community where you can personally take care of the property.
Overleveraging, financing for the short term, and flipping houses. If you are going to flip houses, see our discussion about the importance of having a plan B in Part 2, Chapter 5 “Financial Plans T
hat Fail.”
Using the property as a piggy bank. Do not take money out of the property beyond the amount originally borrowed. You increase the chance of losing the house to foreclosure. You may also be creating additional tax liability if there is cancellation of debt income in a short sale or foreclosure. Consult a tax attorney or CPA.
5. GUIDELINES FOR INVESTORS, PART I
“There is a lot of . . . risk associated with rental income . . . . a lot of things can go wrong”. Christopher J. Mayer, professor of real estate, finance and economics, Columbia Business School
“Owners who did not take on a lot of debt have been able to hang on”. Paul Sullivan, New York Times, March 15, 2013
Avoid partners. The best partner is no partner. Relationships may start with the best of intentions but turn sour. If you must have a partner, ensure your partnership agreement provides for the mediation of disputes. Avoid costly protracted litigation.
Avoid fixers, war zones, and high-vacancy areas. Buy single-family houses in nice areas near your home. Entry-level homes are more likely to cash flow. Avoid luxury homes or homes near the beach. They do not cash flow.
Attempt to buy a property with tenants in place. You get the security deposit and pro-rated rent. You don’t have to go into clean, paint, update, or fix too many things in the unit. Review the current tenant’s lease, credit application, and credit report.
Buy with cash or get the smallest loan possible. Get a thirty-year amortized loan with a fixed interest rate. Know what your mortgage costs will be in the future. (Beware: When you pay all cash or make a large down payment, you lose the opportunity to invest the cash into another investment that may give you a better long term return. Do you want to lose that opportunity? See Part 3, Chapter 2, “Compare and Contrast Investment Options”.)
Ensure the property gives you substantial positive cash flow: Ensure the rent covers the mortgage, taxes, maintenance, insurance, vacancy factor (tenants do not stay forever and may default on the rent), and monthly HOA, and HOA assessments.
Use the price rent ratios as a guide. See Appendices L.
Ensure the return on investment (ROI) is acceptable to you. Most investors are comfortable with 4 to 6 percent return per year.
∘Learn to calculate return on investment. Purchase price, loan terms, appreciation rate, taxes, expenses and other factors must be considered when you evaluate a real estate investment. The books recommended in the appendices discuss this topic. Investopedia.com also has a good explanation of the concept. See investopida.com/articles/11/calculate-roi-real-estate.
∘To find a free on line calculator to help determine the rate of return on a property, go to calcxml.com/calculators/inv04 or homes.yahoo.com/calculators/investment
6. GUIDELINES FOR INVESTORS, PART II
“Train the tenant or the tenant will train you”. Author unknown
“Buying a rental property isn’t solely a financial decision. Be honest about how big a commitment owning a house will really be”. Tara Siegel Bernard, New York Times
Do not be greedy. Offer market rent or slightly below-market rent to ensure the property is occupied.
Screen and train tenants. It is better to have no tenant than the wrong tenant. Learn to be an excellent property manager. The goal is to get a good tenant who will never move and pay off your mortgage. Join your local apartment managers association for resources and guidance.
Stay in contact with tenants and treat them well. Resolve disputes by discussion and negotiation. Avoid confrontation and litigation.
In the event you have an undesirable tenant, use “cash for keys” to get them to move. Evictions take time and cost money.
Professional management is costly but may be appropriate as your holdings increase in number.
Protect yourself from liability. Consult your Agent about insurance options, including defense against legal claims.
Avoid creative real estate transactions such as buying a home subject to the underlying financing unless each party has counsel and is sophisticated in real estate transactions. If you are tempted to buy a house creatively, that is, without paying off the existing financing at the time of purchase, think twice. If the seller feels they have been wronged, s/he may sue you. Plaintiff’s attorneys pursue these claims with vigor. You do not want to spend a year or more defending yourself and paying legal fees.
7. CONDOS – A MIXED BAG
“Condos are the canaries of the real estate market”. John W. Schaub
“Never get emotionally married to a deal. Maintain your objectivity, do all the analysis, and if it does not generate the economic returns you require, pass on it”. Jorge Perez, CEO, The Related Group of Florida, largest Hispanic-owned business in the U. S.
Good news: with prices typically lower than single family houses, condos, especially in entry-level neighborhoods, may have good cash flow even with home owner’s association dues (HOA), taxes, and maintenance. Bad news: see below.
Condos may be difficult to finance if the complex has a low owner-occupancy rate, poor HOA financial status, a pending special assessment, and no FHA certification.
Litigation may scare lenders and require all cash buyers—driving down the supply of buyers and the price of the home.
Condominiums are a complex, restrictive form of ownership, with Homeowner Association Boards of Directors, as well as Covenants, Conditions and Restrictions (CC&Rs). Some who buy condos later regret the purchase because of tension and conflict with HOA boards.
Condos are at their highest and best use. Improvements are limited to interior cosmetic upgrades.
The inventory of condos in most cities is typically large relative to single-family homes. Condos are typically the “canaries of the market,” that is, the first to drop in value in a market downturn.
It may be more difficult to keep tenants in small condos longterm. As a result, you may need to spend money every time a tenant moves. Tenants are more likely to stay long-term in single family homes.
8. TAX BENEFITS OF INVESTMENT REAL ESTATE
“Don’t use taxes as an excuse for making a bad real estate deal”. Leonard Baron, CPA
Have a good tax adviser on your team. Investors, unlike owner occupants, can deduct losses on real property. The following are some of the rules: Rental income is taxed at ordinary rates. Investors may be able to deduct up to $25K in losses, including depreciation if the owner has substantial involvement in managing the property.
Depreciation: Take the value of home (not the land) and divide by 27.5; deduct that amount each year against your ordinary income up to $25K. Deductions are phased out if the owner earns between $100K and $150K per year. As a result, an owner may be able to post a tax loss even if generating a profit.
The depreciation is recaptured when selling the home. That is, at the time of sale, you pay a flat 25 percent rate on the amount depreciated. Exceptions: if you exchange the house for another property (called a 1031 exchange) or keep the house until you die, you pay no tax. Heirs inherit the rental at current market value and pay no tax on the gain.
Real estate professionals—in a special category—can deduct 100 percent of real estate losses against ordinary income regardless of how high their income: Real estate professionals are defined as people who spend more than half their time each year working in a real property business and more than 751 hours a year in such business.
A real property business includes property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or a brokerage business.
Beware: it is virtually impossible to qualify as a real estate professional if you have full-time employment outside of real estate.
9. CONSIDER SHORT SALES AND FORECLOSURES
“Buy the neighborhood not the house. Select the best neighborhood you can afford. Then select a house in the lower or middle end of the price range in that neighborhood”. Rob Zache, President, Central Place Real Estate, Madison, Wisconsin
Foreclosed homes, known as REOs (real estate owned), are for experienced, more sophisticated buyers: They may be cheaper but often have multiple offers.
Property can be in poor condition.
All cash may get your offer accepted.
Property is sold without warranty.
Seller – the bank - makes no disclosures in CA.
Transaction can close quickly.
Lender’s purchase agreement is seller/bank friendly.
The buyers may lose their earnest money deposit if they do not close.
Short sales (home has negative equity, that is, debt against the home is greater than the home’s market value and lender accepts short payoff.) are for patient buyers: The property is typically in better condition.
Seller in CA is required to make full disclosures regarding property condition.
The average short sale takes about five to six months to close. All cash is not as important. Short sales sell for market value or a bit below market value. Homes are sold “as is.”
The California Association of Realtors Residential Purchase Agreement (RPA) is buyer friendly; assuming buyer does not release their contingencies, their earnest money deposit should be returned in the event the buyer does not close escrow.
10. SHOULD YOU BUY HOUSES AT A TRUSTEE’S SALE*?
“Getting a good deal can be dangerous. Nothing beats knowing what you are doing”. James M. Allen, Esq., President & General Counsel, Action Foreclosure Services, Inc., La Mesa, CA
I occasionally receive phone calls from real estate investors in a state of panic. The typical fact pattern: Investor purchased a home at a trustee’s sale. Market value of home was $500,000, and investor paid $200,000. Wow! They thought they got a deal. Subsequently, they learn to their dismay the home had a first trust deed in the amount of $500,000 and that they purchased a $500K home for $700K not $200K. Not such a good deal! What can the investor do? Answer: Investor is out of luck!