Real Estate Investing For Dummies
by Eric Tyson and Robert S. Griswold
Real Estate
Investing
FOR
DUMmIES
‰
2ND EDITION
Real Estate Investing For Dummies
®
, 2nd Edition
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Copyright © 2009 Eric Tyson and Robert S. Griswold
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10 9 8 7 6 5 4 3 2 1
Contents at a Glance
Introduction ................................................................ 1
Part I: Stacking Real Estate Up Against
Other Investments ........................................................ 7
Chapter 1: Evaluating Real Estate as an Investment .....................................................9
Chapter 2: Covering Common Real Estate Investments ............................................. 25
Chapter 3: Considering Foreclosures, REOs, Probate Sales, and More ....................43
Chapter 4: Taking the Passive Approach ......................................................................61
Chapter 5: Fast Money: Small Down Payments and Property Flips ..........................75
Chapter 6: Building Your Team ...................................................................................... 83
Part II: How to Get the Money: Raising
Capital and Financing ................................................ 99
Chapter 7: Sources of Capital .......................................................................................101
Chapter 8: Financing Your Property Purchases ........................................................113
Chapter 9: Securing the Best Mortgage Terms .......................................................... 129
Part III: Finding and Evaluating Properties ............... 137
Chapter 10: Location, Location, Value ........................................................................139
Chapter 11: Understanding Leases and Property Valuation ....................................169
Chapter 12: Valuing Property through Number Crunching .....................................181
Chapter 13: Preparing and Making an Offer ............................................................... 205
Chapter 14: Due Diligence, Property Inspections, and Closing ............................... 223
Part IV: Operating the Property ................................ 259
Chapter 15: Landlording 101 ........................................................................................ 261
Chapter 16: Protecting Your Investment: Insurance and Risk Management..........293
Chapter 17: Recordkeeping and Accounting .............................................................. 303
Chapter 18: Tax Considerations and Exit Strategies ................................................. 315
Part V: The Part of Tens ........................................... 339
Chapter 19: Ten (Plus) Ways to Increase a Property’s Return ................................341
Chapter 20: Ten Steps to Real Estate Investing Success ..........................................349
Appendix: Sample Purchase Agreement ..................... 359
Index ...................................................................... 367
Table of Contents
Introduction ................................................................. 1
How This Book Is Different ............................................................................. 1
Foolish Assumptions ....................................................................................... 3
How This Book Is Organized .......................................................................... 3
Part I: Stacking Real Estate Up Against Other Investments .............. 3
Part II: How to Get the Money: Raising Capital and Financing ......... 4
Part III: Finding and Evaluating Properties ......................................... 4
Part IV: Operating the Property ...........................................................4
Part V: The Part of Tens ........................................................................ 5
Appendix .................................................................................................5
Icons Used in This Book ................................................................................. 5
Where to Go from Here ................................................................................... 6
Part I: Stacking Real Estate Up Against
Other Investments ........................................................ 7
Chapter 1: Evaluating Real Estate as an Investment . . . . . . . . . . . . . . . .9
Understanding Real Estate’s Income- and
Wealth-Producing Potential ......................................................................10
Recognizing the Caveats of Real-Estate Investing ..................................... 12
Comparing Real Estate to Other Investments ............................................13
Returns ..................................................................................................14
Risk ........................................................................................................15
Liquidity ................................................................................................ 15
Capital requirements ...........................................................................16
Diversi cation value ............................................................................16
Opportunities to add value.................................................................16
Tax advantages ....................................................................................17
Determining Whether You Should Invest in Real Estate .......................... 18
Do you have suf cient time? ..............................................................18
Can you deal with problems? ............................................................. 19
Does real estate interest you? ............................................................19
Can you handle market downturns?..................................................19
Fitting Real Estate into Your Financial Plans ............................................. 20
Ensure your best personal nancial health ...................................... 20
Protect yourself with insurance .........................................................20
Consider retirement account funding ............................................... 21
Think about asset allocation ..............................................................21
Real Estate Investing For Dummies, 2nd Edition
xiv
Chapter 2: Covering Common Real Estate Investments. . . . . . . . . . . . .25
The Various Ways to Invest in Residential Income Property .................. 25
Buying a place of your own ................................................................ 26
Converting your home to a rental .....................................................26
Investing and living in well-situated xer-uppers ............................28
Purchasing a vacation home ..............................................................29
Paying for condo hotels and timeshares ..........................................30
Surveying the Types of Residential Properties You Can Buy .................. 33
Single-family homes .............................................................................34
Attached housing ................................................................................. 35
Apartments ........................................................................................... 37
Considering Commercial Real Estate .......................................................... 38
Buying Undeveloped Land ...........................................................................39
Chapter 3: Considering Foreclosures, REOs,
Probate Sales, and More . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43
Finding Foreclosures and REOs ................................................................... 43
Foreclosures ......................................................................................... 45
Lender REO (Real Estate Owned) ......................................................51
Getting a Jump On Foreclosure and REO
Competition with Short Sales ...................................................................52
Recognizing seller bene ts .................................................................53
Comparing short sales to other properties ......................................53
Finding short-sale opportunities........................................................54
Convincing a lender to agree to a short sale .................................... 55
Looking Into Lease Options ..........................................................................57
Probing Probate Sales and Auctions ........................................................... 58
Probate sales ........................................................................................58
Real estate auctions.............................................................................59
Chapter 4: Taking the Passive Approach. . . . . . . . . . . . . . . . . . . . . . . . .61
Using Real Estate Investment Trusts .......................................................... 61
Distinguishing between public and private REITs ...........................62
Taking a look at performance.............................................................63
Investing in REIT funds .......................................................................63
Tenants in Common ...................................................................................... 65
Paying for 1031 availability and “hassle free” management ........... 66
Asking the right questions: Are TICs for you?..................................67
Triple Net Properties .................................................................................... 69
Thinking ahead about landlord/tenant division of duties ..............69
Minimizing the risks of triple net investments.................................71
Notes and Trust Deeds ................................................................................. 71
Tax Lien Certi cate Sales ............................................................................. 72
Limited Partnerships ..................................................................................... 73
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Table of Contents
Chapter 5: Fast Money: Small Down Payments and Property Flips. . . . 75
Purchasing with No Money Down ............................................................... 75
Understanding why we recommend
skipping these investments ............................................................ 76
Finding no-money-down opportunities (if you insist).....................77
Buying, Fixing, and Flipping or Re nancing ............................................... 78
The buy-and- ip strategy ....................................................................79
The buy, x, and re nance strategy .................................................. 81
Chapter 6: Building Your Team . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .83
Knowing When to Establish Your Team ..................................................... 84
Adding a Tax Advisor .................................................................................... 85
Finding a Financial Advisor .......................................................................... 85
Lining Up a Lender or Mortgage Broker ..................................................... 87
Protecting yourself by understanding lending nuances .................87
Building relationships with lenders ..................................................89
Working with Real Estate Brokers and Agents .......................................... 89
Seeing the value of working with an agent ....................................... 90
Understanding the implications of agency:
Who the agent is working for .......................................................... 91
Getting a feel for compensation .........................................................92
Finding a good broker or agent ..........................................................94
Making the most of your agent ..........................................................96
Considering an Appraiser ............................................................................. 96
Finding an Attorney ....................................................................................... 97
Part II: How to Get the Money: Raising
Capital and Financing ................................................ 99
Chapter 7: Sources of Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .101
Calculating the Costs of Admission ........................................................... 101
Forgetting the myth of no money down ..........................................102
Determining what you need to get started .....................................103
Rounding Up the Required Cash by Saving ..............................................103
Overcoming Down Payment Limitations .................................................. 105
Changing your approach ..................................................................105
Tapping into other common cash sources .....................................106
Capitalizing on advanced funding strategies .................................108
Chapter 8: Financing Your Property Purchases . . . . . . . . . . . . . . . . . .113
Taking a Look at Mortgage Options .......................................................... 113
Fixed-rate mortgages .........................................................................114
Adjustable-rate mortgages (ARMs) ................................................. 115
Real Estate Investing For Dummies, 2nd Edition
xvi
Reviewing Other Common Fees ................................................................. 119
Making Some Mortgage Decisions ............................................................. 121
Choosing between xed and adjustable ......................................... 121
Selecting short-term or long-term....................................................123
Borrowing Against Home Equity ............................................................... 123
Getting a Seller-Financed Loan ..................................................................124
Mortgages That Should Make You Think Twice ...................................... 126
Balloon loans ...................................................................................... 126
Interest-only loans ............................................................................. 127
Recourse nancing ............................................................................ 127
Chapter 9: Securing the Best Mortgage Terms. . . . . . . . . . . . . . . . . . .129
Shopping for Mortgages .............................................................................. 129
Relying on referrals ...........................................................................130
Mulling over mortgage brokers ........................................................130
Web sur ng for mortgages ...............................................................132
Solving Potential Loan Predicaments ....................................................... 134
Polishing your credit report ............................................................. 135
Conquering insuf cient income .......................................................136
Dealing with low property appraisals ............................................. 136
Part III: Finding and Evaluating Properties ................ 137
Chapter 10: Location, Location, Value . . . . . . . . . . . . . . . . . . . . . . . . . .139
Deciding Where to Invest ........................................................................... 140
Understanding the Goal: Finding Properties
Where You Can Add Value ......................................................................142
Evaluating a Region: The Big Picture ........................................................ 143
Population growth ............................................................................. 144
Job growth and income levels ..........................................................145
Investigating Your Local Real Estate Market ........................................... 147
Supply and demand ........................................................................... 148
Path of progress ................................................................................. 153
Considering barriers to entry ...........................................................154
Government’s effect on real estate .................................................. 159
Comparing Neighborhoods ........................................................................ 160
Schools ................................................................................................ 161
Crime rates .........................................................................................161
Pride of ownership ............................................................................162
Role play: What attracts you to the property?...............................163
Mastering Seller’s Markets and Buyer’s Markets .................................... 165
Understanding real estate cycles.....................................................166
Timing the real estate market ..........................................................167
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Table of Contents
Chapter 11: Understanding Leases and Property Valuation. . . . . . . .169
The Importance of Evaluating a Lease ...................................................... 169
Reviewing a Lease: What to Look For ....................................................... 171
Comprehending a residential lease .................................................171
Making sense of a commercial lease ...............................................172
Understanding the Economic Principles of Property Valuation ........... 173
Determining highest and best use ...................................................175
Comparing fair market value and investment value .....................175
Reviewing the Sources of Property-Valuing Information ....................... 176
Establishing Value Benchmarks ................................................................ 177
Gross rent/income multiplier ...........................................................178
Price per unit and square foot ......................................................... 179
Replacement cost ..............................................................................180
Chapter 12: Valuing Property through Number Crunching. . . . . . . . .181
Understanding the Importance of Return on Investment ...................... 182
Figuring Net Operating Income .................................................................. 183
Evaluating income: Moving from ction to useful gures ............184
Tallying operating expenses .............................................................187
Calculating Cash Flow ................................................................................. 189
Servicing debt .....................................................................................190
Making capital improvements .......................................................... 190
Surveying Lease Options that Affect Your Cost ...................................... 192
Comparing some of the options ....................................................... 192
Accounting for common area maintenance
charges for commercial buildings ...............................................193
Visiting the Three Basic Approaches to Value ........................................ 194
Market data (sales comparison) approach ....................................194
Cost approach .................................................................................... 197
Income capitalization approach ......................................................198
Reconciling the Three Results to Arrive at a Single Value ..................... 201
Putting It All Together: Deciding How Much to Pay ................................203
Examining the seller’s rental rate and expense claims ................. 203
Deciding which set of numbers to use ............................................204
Chapter 13: Preparing and Making an Offer . . . . . . . . . . . . . . . . . . . . .205
Negotiating 101 ............................................................................................ 205
Starting with the right approach .....................................................205
Building a solid foundation of knowledge ......................................206
Assembling attractive and realistic offers ......................................210
Preparing to Make Your Offer: Understanding Contract Basics ............ 211
Bilateral versus unilateral contracts ............................................... 212
Elements of a contract ......................................................................212
Real Estate Investing For Dummies, 2nd Edition
xviii
Addressing Key Provisions in the Purchase Agreement ........................ 215
Showing intention with an earnest money deposit .......................216
Assigning your rights ........................................................................217
Setting the closing date .....................................................................218
Using contingencies effectively ........................................................219
Ironing out straggling issues ............................................................ 221
Presenting the Purchase Agreement .........................................................222
Chapter 14: Due Diligence, Property Inspections, and Closing. . . . .223
Opening Escrow ........................................................................................... 224
Escrow instructions ........................................................................... 224
Preliminary title report .....................................................................225
Removing contingencies ................................................................... 225
Estimating the closing date .............................................................. 226
Conducting Formal Due Diligence ............................................................. 227
Reviewing the books and records ...................................................227
Inspecting the property .................................................................... 230
Negotiating Credits in Escrow ...................................................................241
Determining How to Hold Title .................................................................. 242
Sole proprietorship ...........................................................................243
Joint tenancy ......................................................................................243
Tenancy in common ..........................................................................244
Partnerships .......................................................................................246
Limited Liability Company................................................................248
Corporations ......................................................................................250
Closing the Transaction .............................................................................. 251
Estimated closing statement ............................................................ 252
Title insurance ...................................................................................253
Property insurance ............................................................................254
Final closing statement ..................................................................... 255
Deed recording and property takeover .......................................... 257
Part IV: Operating the Property ................................. 259
Chapter 15: Landlording 101 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .261
First Things First: Deciding Whether to Hire Management Help ...........261
Evaluating your situation and the possibility
of self-management ........................................................................ 262
Assessing your personal skills and interests ................................. 263
Finding and Hiring Capable Professional Management .......................... 264
Doing the research ............................................................................264
Talking money .................................................................................... 265
Having the Property Tested for Environmental Concerns ..................... 266
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Table of Contents
Deciding On Rental Policies ....................................................................... 268
Determining lease length ..................................................................268
Setting the rent ................................................................................... 269
Deciding on security deposits .......................................................... 270
Creating policies and guidelines ......................................................271
Working with Existing Tenants Upon Property Acquisition .................. 272
Meeting tenants and inspecting units ............................................. 272
Entering into a new rental agreement ............................................. 273
Increasing rents..................................................................................274
Finding Stable, Trustworthy Tenants .......................................................275
Establishing tenant selection criteria .............................................275
Advertising for tenants .....................................................................279
Showing your rental ..........................................................................280
Accepting applications and deposits ..............................................283
Verifying rental applications ............................................................284
Dealing with rental cosigners ........................................................... 286
Notifying applicants of your decision .............................................287
Reviewing and signing documents .................................................. 288
Collecting the money .........................................................................288
Inspecting the property with your tenant ......................................289
Adding Value through Renovations and Upgrades ................................. 290
Enhancing external appearances .....................................................290
Improving what’s inside ....................................................................291
Using contractors ..............................................................................292
Chapter 16: Protecting Your Investment:
Insurance and Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293
Developing a Risk Management Plan ........................................................ 293
Getting the Insurance You Need ................................................................ 294
Understanding insurance options ................................................... 295
Determining the right deductible ....................................................299
Selecting potential insurers ..............................................................299
Talking with tenants about renter’s insurance .............................. 300
Dealing with claims ............................................................................ 301
Chapter 17: Recordkeeping and Accounting. . . . . . . . . . . . . . . . . . . . .303
Organizing Your Records ........................................................................... 303
Keeping records up-to-date and accurate ...................................... 304
Filing made easy ................................................................................. 305
Knowing What You Must Account For with Rental Property ................ 307
Documenting income and expenses ................................................308
Creating a budget and managing your cash ow ...........................309
Doing Your Accounting Manually .............................................................. 310
Using Software ............................................................................................. 311
Recognizing the value of professional accounting software ........311
Identifying some of the better programs ........................................ 312
Real Estate Investing For Dummies, 2nd Edition
xx
Chapter 18: Tax Considerations and Exit Strategies . . . . . . . . . . . . . .315
Understanding the Tax Angles ................................................................... 316
Sheltering income with depreciation ..............................................316
Minimizing income taxes ..................................................................318
Exit Strategies .............................................................................................. 322
Selling outright ................................................................................... 323
Calculating gain or loss on a sale .....................................................324
Selling now, reaping pro ts later: Installment sale .......................328
Transferring equity to defer taxes ................................................... 330
Using the capital gains exclusion to earn a tax-free gain ..............334
Selling as a lease-to-own purchase .................................................. 336
Transferring your property through a gift or bequest..................338
Part V: The Part of Tens ............................................ 339
Chapter 19: Ten (Plus) Ways to Increase a Property’s Return. . . . . .341
Raise Rents ................................................................................................... 341
Reduce Turnover ......................................................................................... 342
Consider Lease Options .............................................................................. 343
Develop a Market Niche .............................................................................. 343
Maintain and Renovate ............................................................................... 344
Cut Back Operating Expenses .................................................................... 344
Scrutinize Property Tax Assessments ...................................................... 345
Re nance and Build Equity Quicker ..........................................................345
Take Advantage of Tax Bene ts ................................................................ 346
Be Prepared to Move On ............................................................................347
Add Value Through Change in Use ...........................................................347
Improve Management ................................................................................. 348
Chapter 20: Ten Steps to Real Estate Investing Success . . . . . . . . . .349
Build up Savings and Clean up Credit ....................................................... 350
Buy Property in the Path of Progress ....................................................... 351
Buy the Right Property at the Best Price Possible .................................. 351
Renovate Property the Right Way ............................................................. 352
Keep Abreast of Market Rents ................................................................... 353
Recover Renovation Dollars through Re nancing .................................. 353
Reposition Property with Better Tenants ................................................ 354
Become or Hire a Superior Property Manager ........................................ 355
Re nance or Sell and Defer Again ..............................................................356
Consolidate Holdings into Larger Properties .......................................... 356
Appendix: Sample Purchase Agreement ...................... 359
Index ....................................................................... 367
Introduction
W
elcome to Real Estate Investing For Dummies, 2nd Edition! We’re
delighted to be your tour guides. Throughout this book, we empha-
size three fundamental cornerstones that we believe to be true:
✓ Real estate is one of the three time-tested ways for people of varied eco-
nomic means to build wealth (the others are stocks and small business).
Over the long-term (decades), you should be able to make an annualized
return of at least 8 to 10 percent per year investing in real estate.
✓ Investing in real estate isn’t rocket science but does require doing your
homework. If you’re sloppy doing your legwork, you’re more likely to
end up with inferior properties or to overpay. Our book clearly explains
how to buy the best properties at a fair (or even below-market value!)
price. (Although we cover all types of properties, this book concentrates
more on residential investment opportunities, which are more acces-
sible and appropriate for nonexperts.)
✓ Although you should make money over the long-term investing in good
real estate properties, you can lose money, especially in the short-term.
Don’t unrealistically expect real estate values to increase every year. As
many folks experienced in the late-2000s, they don’t! When you invest
in real estate for the long-term, which is what we advocate and practice
ourselves, the occasional price declines should be merely bumps on an
otherwise fruitful journey.
How This Book Is Different
If you expect us (in infomercial-like fashion) to tell you how to become an
overnight multimillionaire, this is definitely not the book for you. And please
allow us to save you money, disappointment, and heartache by telling you
that such hucksters are only enriching themselves through their grossly
overpriced tapes and seminars.
Real Estate Investing For Dummies, 2nd Edition, covers tried and proven
real estate investing strategies that real people, just like you, use to build
wealth. Specifically, this book explains how to invest in single-family homes;
2
Real Estate Investing For Dummies, 2nd Edition
detached and attached condominiums; small apartments including duplexes,
triplexes, and multiple-family residential properties up to 20 to 30 units; com-
mercial properties, including office, industrial, and retail; and raw (undevel-
oped) land. We also cover indirect real estate investments such as real estate
investment trusts (REITs) that you can purchase through the major stock
exchanges or a real estate mutual fund.
We’ve always relied on tried-and-true methods of real estate investing and
our core advice is as true today as it was before the real estate downturn in
the late-2000s. Our book is an especially solid reference in a down economy
and will help you position yourself for the rebound.
Unlike so many real estate book authors, we don’t have an alternative agenda
in writing this book. Many real estate investing books are nothing more
than infomercials for high priced DVDs or seminars the author is selling.
The objective of our book is to give you the best crash course in real estate
investing so that if you choose to make investments in income-producing
properties, you may do so wisely and confidently.
Here are some good reasons why we — Eric Tyson and Robert Griswold —
are a dynamic duo on your side:
Robert Griswold has extensive hands-on experience as a real estate investor
who has worked with properties of all types and sizes. He is also the author
of Property Management Kit For Dummies (Wiley) and is the author of two
popular syndicated real estate newspaper columns. He has appeared for over
15 years as the NBC-TV on-air real estate expert for Southern California. And
for nearly 15 years, he was the host of the most popular and longest run-
ning real estate radio show in the country — Real Estate Today! with Robert
Griswold on Clear Channel Communications.
Robert also holds the titles Counselor of Real Estate (CRE), Certified
Commercial Investment Member (CCIM), Professional Community
Association Manager (PCAM), and Certified Property Manager (CPM) des-
ignations. He earned a bachelor’s degree and two master’s degrees in real
estate and related fields from the University of Southern California’s Marshall
School of Business.
Eric Tyson is a former financial counselor, lecturer, and coauthor of the
national bestseller Home Buying For Dummies (Wiley), as well as the author
or coauthor of four other bestselling books in the For Dummies series:
Personal Finance; Investing; Mutual Funds; and Taxes.
Eric has counseled thousands of clients on a variety of personal finance,
investment, and real estate quandaries and questions. A former management
consultant to Fortune 500 financial service firms, Eric is dedicated to teaching
3
Introduction
people to better manage their personal finances. Over the past 25 years, he
has successfully invested in real estate and securities and started and man-
aged several businesses. He earned an MBA at the Stanford Graduate School
of Business and a bachelor’s degree in economics at Yale.
Foolish Assumptions
Whenever an author sits down to write a book, he has a particular audience
in mind. Because of this, he must make some assumptions about who his
reader is and what that reader is looking for. Here are a few assumptions
we’ve made about you:
✓ You’re looking for a way to invest in real estate but don’t know what
types of properties and strategies are best.
✓ You’re considering buying an investment property, be it a single-family
home, a small apartment complex, or an office building, but your real
estate experience is largely limited to renting an apartment or owning
your own home.
✓ You may have a small amount of money already invested in real estate,
but you’re ready to go after bigger, better properties.
✓ You’re looking for a way to diversify your investment portfolio.
If any of these descriptions hit home for you, you’ve come to the right place.
How This Book Is Organized
We’ve organized Real Estate Investing For Dummies, 2nd Edition, into five
parts. Here’s what you find in each:
Part I: Stacking Real Estate Up
Against Other Investments
In this part, we explain how real estate compares with other common invest-
ments, how to determine whether you’ve got what it takes to succeed as a
real estate investor, how much money you need to invest in various types
of real estate, and the tax advantages of real estate. We also cover how to
fit real estate investments into your overall financial and personal plans.
4
Real Estate Investing For Dummies, 2nd Edition
We discuss the range of real estate investments available to you — not only
common ones (such as single-family homes and small apartments) but also
the more unusual (such as foreclosures and probate sales). An entire chapter
is devoted to passive real estate investments, including real estate invest-
ment trusts, tenants in common, triple net properties, notes and trust deeds,
limited partnerships, and tax lien certificate sales. We also cover the allure of
property flipping and buying with no or little money down. Finally, you want
to work with the best professionals that you can, so we also detail how to
interview and secure top agents, lawyers, and other real estate pros.
Part II: How to Get the Money:
Raising Capital and Financing
You can’t play if you can’t pay. This part details how and where to come
up with the dough you need to buy property. We also explain the common
loans available through lenders and how you may be able to finance your real
estate investment through the seller of the property. Finally, we share all of
our favorite strategies for finding and negotiating the best deals when you
need a mortgage.
Part III: Finding and Evaluating Properties
This section gets down to the brass tacks of helping you decide where and
what to buy. We explain how to value and evaluate real estate investment
properties: From choosing the best locations to projecting a property’s cash
flow, we have you covered. Finally, we walk you through the negotiation pro-
cess, plus all of the ins and outs of purchase agreements, inspections, and
closing on your purchase.
Part IV: Operating the Property
After you own a property, you have lots of opportunities to improve its value
and manage it well. For starters, this important part covers how to be a land-
lording genius, find and keep the best tenants, and sign solid lease contracts.
We also reveal many proven methods for boosting (legally, of course) a prop-
erty’s return and value. We don’t let tax headaches get you down as we walk
you through how to account for the annual cash flow on your property and
5
Introduction
how the tax advantages of depreciation allow you to legally pay lower taxes.
Last but not least, we share strategies for deciding when and how to sell,
including how to defer taxation on your sales’ profits while expanding your
real estate holdings if you so desire.
Part V: The Part of Tens
This part contains other important chapters that didn’t fit neatly into the rest
of this book. Topics that we cover in this section include ten steps to real
estate success and ten ways to increase a property’s return.
Appendix
This book is comprehensive, but it isn’t a book of forms. The purchase and
sale of real estate is complicated, and specific legal issues and practices
vary throughout the country. We do include a purchase agreement in the
appendix to illustrate some of the key points. However, we recommend that
you contact local real estate professionals for the forms that are specifically
drafted for your area.
Icons Used in This Book
Throughout this book, you can find friendly and useful icons to enhance your
reading pleasure and to note specific types of information. Here’s what each
icon means:
This icon points out something that can save you time, headaches, money, or
all of the above!
Here we’re trying to direct you away from blunders and boo-boos that others
have made when investing in real estate.
This icon alerts you to hucksters, biased advice, and other things that can
really cost you big bucks.
6
Real Estate Investing For Dummies, 2nd Edition
Here we point out potentially interesting but nonessential (skippable) stuff.
We use this icon to highlight when you should look into something on your
own or with the assistance of a local professional.
This icon flags concepts and facts that we want to ensure you remember as
you make your real estate investments.
Where to Go from Here
If you have the time and desire, we encourage you to read this book in its
entirety. It provides you with a detailed picture of how to maximize your
returns while minimizing your risks in the real estate market. But you may
also choose to read selected portions. That’s one of the great things (among
many) about For Dummies books. You can readily pick and choose the infor-
mation you read based on your individual needs.
Part I
Stacking Real
Estate Up Against
Other Investments
In this part . . .
R
eal estate is just one of many available investment
options, so in this part, we compare and contrast
real estate investing with alternatives you may consider.
We discuss the realities of investing in and managing
rental properties (both the pros and the cons) and how to
fit real estate into your overall personal financial plans.
We also cover the gamut of real estate investments you
have to choose from and how to begin to assemble a team
of competent professionals to assist you with the process.
Chapter 1
Evaluating Real Estate
as an Investment
In This Chapter
▶ Getting started
▶ Contrasting real estate with other financial options
▶ Deciding whether real estate is really for you
▶ Arranging your overall investment and financial plans to include real estate
W
hen Robert first entered the real estate field while attending college
decades ago, his father, a retired real estate attorney, advised that he
use his monthly income primarily to pay day-to-day living expenses and allo-
cate money each month into long-term financial investments like real estate.
This solid advice has served Robert well over the years.
It’s never too early or too late to formulate your own plan into a comprehen-
sive wealth-building strategy. For many, such a strategy can help with the
challenges of funding future education for children and ensuring a comfort-
able retirement.
The challenge involved with real estate is that it takes some real planning to
get started. Contacting an investment company and purchasing some shares
of your favorite mutual fund or stock is a lot easier than acquiring your first
rental property. Buying property isn’t that difficult, though. You just need a
financial and real estate investment plan, a lot of patience, and the willing-
ness to do some hard work, and you’re on your way to building your own real
estate empire!
In this chapter, we give you some information that can help you decide
whether you have what it takes to make money and be comfortable with
investing in real estate. We compare real estate investments to other invest-
ments. We provide some questions you need to ask yourself before making
any decisions. And finally, we offer guidance on how real estate investments
can fit into your overall personal financial plans. Along the way, we share
10
Part I: Stacking Real Estate Up Against Other Investments
our experience, insights, and thoughts on a long-term strategy for building
wealth through real estate that virtually everyone can understand and
actually achieve.
Understanding Real Estate’s Income-
and Wealth-Producing Potential
Compared with most other investments, good real estate can excel at produc-
ing current income for property owners. So in addition to the longer-term
appreciation potential, you can also earn income year in and year out. Real
estate is a true growth and income investment.
The vast majority of people who don’t make money in real estate make easily
avoidable mistakes, which we help you avoid.
The following list highlights the major benefits of investing in real estate:
✓ Tax-deferred compounding of value: In real estate investing, the appre-
ciation of your properties compounds tax-deferred during your years of
ownership. You don’t pay tax on this profit until you sell your property —
and even then you can roll over your gain into another investment prop-
erty and avoid paying taxes. (See the “Tax advantages” section later in
this chapter.)
✓ Regular cash flow: If you have property that you rent out, you have
money coming in every month in the form of rents. Some properties,
particularly larger multiunit complexes, may have some additional
sources, such as from coin-operated washers and dryers.
When you own investment real estate, you should also expect to incur
expenses that include your mortgage payment, property taxes, insur-
ance, and maintenance. The interaction of the revenues coming in and
the expenses going out is what tells you whether you realize positive
operating profit each month.
✓ Reduced income tax bills: For income tax purposes, you also get to
claim an expense that isn’t really an out-of-pocket cost — depreciation.
Depreciation enables you to reduce your current income tax bill and
hence increase your cash flow from a property. (We explain this tax
advantage and others later in the “Tax advantages” section.)
✓ Rate of increase of rental income versus overall expenses: Over time,
your operating profit, which is subject to ordinary income tax, should
rise as you increase your rental prices faster than the rate of increase
for your property’s overall expenses. What follows is a simple example
to show why even modest rental increases are magnified into larger
operating profits and healthy returns on investment over time.
11
Chapter 1: Evaluating Real Estate as an Investment
Suppose that you’re in the market to purchase a single-family home that you
want to rent out and that such properties are selling for about $200,000 in
the area you’ve deemed to be a good investment. (Note: Housing prices vary
widely across different areas but the following example should give you a
relative sense of how a rental property’s expenses and revenue change over
time.) You expect to make a 20 percent down payment and take out a 30-year
fixed rate mortgage at 6 percent for the remainder of the purchase price —
$160,000. Here are the details:
Monthly mortgage payment $960
Monthly property tax $200
Other monthly expenses (maintenance, insurance) $200
Monthly rent $1,400
In Table 1-1, we show you what happens with your investment over time. We
assume that your rent and expenses (except for your mortgage payment,
which is fixed) increase 3 percent annually and that your property appreci-
ates a conservative 4 percent per year. (For simplification purposes, we
ignore depreciation in this example. If we had included the benefit of depre-
ciation, it would further enhance the calculated returns.)
Table 1-1 How a Rental Property’s Income and
Wealth Build Over Time
Year Monthly
Rent
Monthly
Expenses
Property
Value
Mortgage
Balance
0 $1,400 $1,360 $200,000 $160,000
5 $1,623 $1,424 $243,330 $148,960
10 $1,881 $1,498 $296,050 $133,920
20 $2,529 $1,682 $438,225 $86,400
30 $3,398 $1,931 $648,680 $0
31 $3,500 $1,000 $674,625 $0
Now, notice what happens over time. When you first buy the property, the
monthly rent and the monthly expenses are about equal. By year five, the
monthly income exceeds the expenses by about $200 per month. Consider
why this happens — your largest monthly expense, the mortgage payment,
doesn’t increase. So, even though we assume that the rent increases just 3
percent per year, which is the same rate of increase assumed for your non-
mortgage expenses, the compounding of rental inflation begins to produce
larger and larger cash flow to you, the property owner. Cash flow of $200 per
month may not sound like much, but consider that this $2,400 annual income
is from an original $40,000 investment. Thus, by year five, your rental property
12
Part I: Stacking Real Estate Up Against Other Investments
is producing a 6 percent return on your down payment. (And remember, if
you factor in the tax deduction for depreciation, your cash flow and return are
even higher.)
In addition to the monthly cash flow from the amount that the rent exceeds
the property’s expenses, also look at the last two columns in Table 1-1 to
see what has happened by year five to your equity (the difference between
market value and mortgage) in the property. With just a 4 percent annual
increase in market value, your $40,000 in equity (the down payment) has
more than doubled to $94,370 ($243,330 – $148,960).
By years 10 and 20, you can see the further increases in your monthly cash
flow and significant expansion in your property’s equity. By year 30, the
property is producing more than $1,400 per month cash flow and you’re now
the proud owner of a mortgage-free property worth more than triple what
you paid for it!
After you get the mortgage paid off in year 30, take a look at what happens
to your monthly expenses (big drop) and therefore your cash flow in year 31
and beyond (big increase).
Recognizing the Caveats
of Real-Estate Investing
Despite all its potential, real-estate investing isn’t lucrative at all times and
for all people — here’s a quick outline of the biggest caveats that accompany
investing in real estate:
✓ Few home runs: Your likely returns from real estate won’t approach the
home runs that the most accomplished entrepreneurs achieve in the
business world.
✓ Upfront operating profit challenges: Unless you make a large down
payment, your monthly operating profit may be small or nonexistent
in the early years of rental property ownership. During soft periods in
the local economy, rents may rise more slowly than your expenses or
even fall. That’s why you must ensure that you can weather financially
tough times. In the worst cases, we’ve seen rental property owners lose
both their investment property and their homes. Please see the section
“Fitting Real Estate into Your Financial Plans” later in this chapter.
13
Chapter 1: Evaluating Real Estate as an Investment
✓ Ups and downs: You’re not going to earn an 8 to 10 percent return every
year. Although you have the potential for significant profits, owning real
estate isn’t like owning a printing press at the U.S. Treasury. Like stocks
and other types of ownership investments, real estate goes through
down as well as up periods. Most people who make money investing
in real estate do so because they invest and hold property over many
years.
✓ Relatively high transaction costs: If you buy a property and then want
out a year or two later, you may find that even though it has appreciated
in value, much (if not all) of your profit has been wiped away by the high
transaction costs. Typically, the costs of buying and selling — which
include real estate agent commissions, loan fees, title insurance, and
other closing costs — amount to about 15 percent of the purchase price
of a property. So, although you may be elated if your property appreci-
ates 15 percent in value in short order, you may not be so thrilled to
realize that if you sell the property, you may not have any greater return
than if you had stashed your money in a lowly bank account.
✓ Tax implications: Last, but not least, when you make a profit on your
real estate investment, the federal and state governments are waiting
with open hands for their share. Throughout this book, we highlight
ways to improve your after-tax returns. As we stress more than once,
the profit you have left after Uncle Sam takes his bite (not your pretax
income) is all that really matters.
These drawbacks shouldn’t keep you from exploring real estate investing as an
option; rather, they simply reinforce the need to really know what you’re get-
ting into with this type of investing and whether it’s a good match for you. The
rest of this chapter takes you deeper into an assessment of real estate as an
investment as well as introspection about your goals, interests, and abilities.
Comparing Real Estate
to Other Investments
Surely you’ve considered or heard about many different investments over
the years. To help you appreciate and understand the unique characteristics
of real estate, we compare and contrast real estate’s attributes with those of
other wealth building investments like stocks and small business.
14
Part I: Stacking Real Estate Up Against Other Investments
Returns
Clearly, a major reason that many people invest in real estate is for the
healthy total returns (which include ongoing profits and the appreciation of
the property). Real estate generates robust long-term returns because, like
stocks and small business, it’s an ownership investment. By that, we mean
that real estate is an asset that has the ability to produce income and profits.
Our research and experience suggest that total real estate investment
returns are comparable to those from stocks — about 8 to 10 percent annu-
ally. Interestingly, the average annual return on real estate investment trusts
(REITs), publicly traded companies that invest in income producing real
estate such as apartment buildings, office complexes, and shopping centers
has been about 10 percent. See our discussion of REITs in Chapter 4.
And you can earn returns better than 10 percent per year if you select excel-
lent properties in the best areas and manage them well.
How leverage affects your real estate returns
Real estate is different from most other invest-
ments in that you can typically borrow (finance)
up to 70 to 80 percent or more of the value of
the property. Thus, you can use your small
down payment of 20 to 30 percent of the pur-
chase price to buy, own, and control a much
larger investment. (During market downturns,
lenders tighten requirements and may require
larger down payments than they do during good
times.) So when your real estate increases in
value (which is what you hope and expect), you
make money on your investment as well as on
the money that you borrowed. That’s what we
mean when we say that the investment returns
from real estate get magnified due to leverage.
Take a look at this simple example. Suppose
you purchase a property for $150,000 and make
a $30,000 down payment. Over the next three
years, imagine that the property appreciates
10 percent to $165,000. Thus, you have a profit
(on paper) of $15,000 ($165,000 – $150,000) on
an investment of just $30,000. In other words,
you’ve made a 50 percent return on your invest-
ment. (Note: We ignore cash flow — whether
your expenses from the property exceed the
rental income that you collect or vice versa,
and the tax benefits associated with rental real
estate.)
Remember, leverage magnifies all of your
returns, and those returns aren’t always posi-
tive! If your $150,000 property decreases in
value to $135,000, even though it has only
dropped 10 percent in value, you actually lose
(on paper) 50 percent of your original $30,000
investment. (In case you care, and it’s okay if
you don’t, some wonks apply the terms positive
leverage and negative leverage.) Please see
the “Understanding Real Estate’s Income- and
Wealth-Producing Potential” section earlier
in this chapter for a more detailed example of
investment property profit and return.
15
Chapter 1: Evaluating Real Estate as an Investment
Risk
Real estate doesn’t always rise in value — witness the decline occurring in
most parts of the U.S. during the late 2000s. That said, market values for real
estate don’t generally suffer from as much volatility as stock prices do. You
may recall how the excitement surrounding the mushrooming of technology
and Internet stock prices in the late 1990s turned into the dismay and agony
of those same sectors’ stock prices crashing in the early 2000s. Many stocks
in this industry, including those of leaders in their niches, saw their stock
prices plummet by 80 percent, 90 percent, or more.
Keep in mind (especially if you tend to be concerned about shorter-term
risks) that real estate can suffer from declines of 10 percent, 20 percent, or
more. If you make a down payment of say, 20 percent, and want to sell your
property after a 10 to 15 percent price decline, you may find that all (as in
100 percent) of your invested dollars (down payment) are wiped out after
you factor in transaction costs. So you can lose everything.
You can greatly reduce and minimize your risk investing in real estate through
buying and holding property for many years (seven to ten or more).
Liquidity
Liquidity — the ease and cost with which you can sell and get your money
out of an investment — is one of real estate’s shortcomings. Real estate is
relatively illiquid: You can’t sell a piece of property with the same speed with
which you whip out your ATM card and withdraw money from your bank
account or sell a stock with a phone call or click of your computer’s mouse.
We actually view this illiquidity as a strength, certainly compared with stocks
that people often trade in and out of because doing so is so easy and seem-
ingly cheap. As a result, many stock market investors tend to lose sight of the
long-term and miss out on the bigger gains that accrue to patient buy-and-
stick-with-it investors. Because you can’t track the value of investment real
estate daily on your computer, and because real estate takes considerable
time, energy, and money to sell, you’re far more likely to buy and hold onto
your properties for the longer-term.
Although real estate investments are generally less liquid than stocks, they’re
generally more liquid than investments made in your own or someone else’s
small business. People need a place to live and businesses need a place to
operate, so there’s always demand for real estate (although the supply of
such properties can greatly exceed the demand in some areas during certain
time periods).
16
Part I: Stacking Real Estate Up Against Other Investments
Capital requirements
Although you can easily get started with traditional investments such as
stocks and mutual funds with a few hundred or thousand dollars, the vast
majority of quality real estate investments require far greater investments —
usually on the order of tens of thousands of dollars. (We devote an entire
part of this book — Part II, to be precise — to showing you how to raise capi-
tal and secure financing.)
If you’re one of the many people who don’t have that kind of money burn-
ing a hole in your pocket, don’t despair. We present you with lower cost real
estate investment options. Among the simplest low-cost real estate invest-
ment options are real estate investment trusts (REITs). You can buy these
as exchange traded stocks or invest in a portfolio of REITs through an REIT
mutual fund (see Chapter 4).
Diversification value
An advantage of holding investment real estate is that its value doesn’t
necessarily move in tandem with other investments, such as stocks or
small-business investments that you hold. You may recall, for example, the
massive stock market decline in the early 2000s. In most communities around
America, real estate values were either steady or actually rising during this
horrendous period for stock prices.
However, real estate prices and stock prices, for example, can move down
together in value (as happened in most parts of the country during the 2007–
2008 stock market slide). Sluggish business conditions and lower corporate
profits can depress stock and real estate prices.
Opportunities to add value
Although you may not know much about investing in the stock market, you
may have some good ideas about how to improve a property and make it
more valuable. You can fix up a property or develop it further and raise the
rental income accordingly. Perhaps through legwork, persistence, and good
negotiating skills, you can purchase a property below its fair market value.
Relative to investing in the stock market, persistent and savvy real estate
investors can more easily buy property in the private real estate market at
below fair market value. You can do the same in the stock market, but the
scores of professional, full-time money managers who analyze the public
market for stocks make finding bargains more difficult. We help you identify
properties that you can add value to in Part III.
17
Chapter 1: Evaluating Real Estate as an Investment
Tax advantages
Real estate investment offers numerous tax advantages. In this section, we
compare and contrast investment property tax issues with those of other
investments.
Deductible expenses (including depreciation)
Owning a property has much in common with owning your own small busi-
ness. Every year, you account for your income and expenses on a tax return.
(We cover all the taxing points about investment properties in Chapter 18.)
For now, we want to remind you to keep good records of your expenses in
purchasing and operating rental real estate. (Check out Chapter 17 for more
information on all things accounting.) One expense that you get to deduct
for rental real estate on your tax return — depreciation — doesn’t actually
involve spending or outlaying money. Depreciation is an allowable tax deduc-
tion for buildings, because structures wear out over time. Under current tax
laws, residential real estate is depreciated over 27
1
⁄
2 years (commercial build-
ings are depreciated over 39 years). Residential real estate is depreciated
over shorter time periods because it has traditionally been a favored invest-
ment in our nation’s tax laws.
Tax-free rollovers of rental property profits
When you sell a stock or mutual fund investment that you hold outside a
retirement account, you must pay tax on your profits. By contrast, you can
avoid paying tax on your profit when you sell a rental property if you roll
over your gain into another like-kind investment real estate property.
The rules for properly making one of these 1031 exchanges are complex and
usually involve third parties. We cover 1031 exchanges in Chapter 18. Make
sure that you find an attorney and/or tax advisor who is an expert at these
transactions to ensure that everything goes smoothly (and legally).
If you don’t roll over your gain, you may owe significant taxes because of how
the IRS defines your gain. For example, if you buy a property for $200,000 and
sell it for $550,000, you not only owe tax on that difference, but you also owe
tax on an additional amount, depending on the property’s depreciation. The
amount of depreciation that you deduct on your tax returns reduces the origi-
nal $200,000 purchase price, making the taxable difference that much larger.
For example, if you deducted $125,000 for depreciation over the years that
you owned the property, you owe tax on the difference between the sale price
of $550,000 and $75,000 ($200,000 purchase price – $125,000 depreciation).
Deferred taxes with installment sales
Installment sales are a complex method that can be used to defer your tax bill
when you sell an investment property at a profit and you don’t buy another
rental property. With such a sale, you play the role of banker and provide
18
Part I: Stacking Real Estate Up Against Other Investments
financing to the buyer. In addition to collecting a competitive interest rate
from the seller, you only have to pay capital gains tax as you receive pro-
ceeds over time from the sale. For details, please see Chapter 18.
Special tax credits for low-income housing and old buildings
If you invest in and upgrade low-income housing or certified historic build-
ings, you can gain special tax credits. The credits represent a direct reduc-
tion in your tax bill from expenditures to rehabilitate and improve such
properties. These tax credits exist to encourage investors to invest in and fix
up old or run-down buildings that likely would continue to deteriorate other-
wise. The IRS has strict rules governing what types of properties qualify. See
IRS Form 3468 to discover more about these credits.
Determining Whether You Should
Invest in Real Estate
We believe that most people can succeed at investing in real estate if they’re
willing to do their homework, which includes selecting top real estate profes-
sionals. In the sections that follow, we ask several important questions to
help you decide whether you have what it takes to succeed and be happy
with real estate investments that involve managing property.
Do you have sufficient time?
Purchasing and owning investment real estate and being a landlord is time
consuming. If you fail to do your homework before purchasing property,
you can end up overpaying or buying real estate with a mess of problems.
Finding competent and ethical real estate professionals takes time. (We guide
you through the process in Chapter 6.) Investigating communities, neighbor-
hoods, and zoning also soaks up plenty of hours (information on performing
this research is located in Chapter 10), as does examining tenant issues with
potential properties (see Chapter 11).
As for managing a property, you can hire a property manager to interview
tenants and solve problems such as leaky faucets and broken appliances, but
doing so costs money and still requires some of your time.
If you’re stretched too thin due to work and family responsibilities, real estate
investing may not be for you. You may want to look into the less time-intensive
real estate investments discussed in Chapters 3 and 4.
19
Chapter 1: Evaluating Real Estate as an Investment
Can you deal with problems?
Challenges and problems inevitably occur when you try to buy a property.
Purchase negotiations can be stressful and frustrating. You can also count on
some problems coming up when you own and manage investment real estate.
Most tenants won’t care for a property the way property owners do.
If every little problem (especially those that you think may have been caused
by your tenants) causes you distress, at a minimum, you should only own
rental property with the assistance of a property manager. You should also
question whether you’re really going to be happy owning investment property.
The financial rewards come well down the road, but you live the day-to-day
ownership headaches immediately.
Does real estate interest you?
In our experience, some of the best real estate investors have a curiosity and
interest in real estate. If you don’t already possess it, such an interest and
curiosity can be cultivated — and this book may just do the trick.
On the other hand, some people simply aren’t comfortable investing in rental
property. For example, if you’ve had experience and success with stock
market investing, you may be uncomfortable venturing into real estate invest-
ments. Some people we know are on a mission to start their own business
and may prefer to channel the time and money into that outlet.
Can you handle market downturns?
Real estate investing isn’t for the faint of heart. Buying and holding real estate
is a whole lot of fun when prices and rents are rising. But market downturns
happen, and they test you emotionally as well as financially.
Consider the real estate market price declines that happened in most com-
munities and types of property in the late 2000s. Such drops can present
attractive buying opportunities for those with courage and cash.
None of us has a crystal ball though so don’t expect to be able to buy at the
precise bottom of prices and sell at the precise peak of your local market.
Even if you make a smart buy now, you’ll inevitably end up holding some
of your investment property during a difficult market (recessions where
you have trouble finding and retaining quality tenants, where rents may fall
rather than rise, where your property falls in value). Do you have the finan-
cial wherewithal to handle such a downturn? How have you handled other
investments when their values have fallen?
20
Part I: Stacking Real Estate Up Against Other Investments
Fitting Real Estate into
Your Financial Plans
For most nonwealthy people, purchasing investment real estate has a major
impact on their overall personal financial situation. So, before you go out to
buy property, you should inventory your money life and be sure your fiscal
house is in order. This section explains how you can do just that.
Ensure your best personal financial health
If you’re trying to improve your physical fitness by exercising, you may find
that eating lots of junk food and smoking are barriers to your goal. Likewise,
investing in real estate or other growth investments such as stocks while
you’re carrying high-cost consumer debt (credit cards, auto loans, and so on)
and spending more than you earn impedes your financial goals.
Before you set out to invest in real estate, pay off all your consumer debt. Not
only will you be financially healthier for doing so, but you’ll also enhance your
future mortgage applications.
Eliminate wasteful and unnecessary spending; analyze your monthly spend-
ing to identify target areas for reduction. This practice enables you to save
more and better afford making investments including real estate. Live below
your means. As Charles Dickens said, “Annual income twenty pounds; annual
expenditures nineteen pounds; result, happiness. Annual income twenty
pounds; annual expenditure twenty pounds; result, misery.”
Protect yourself with insurance
Regardless of your real estate investment desires and decisions, you abso-
lutely must have comprehensive insurance for yourself and your major
assets, including
✓ Health insurance: Major medical coverage protects you from financial
ruin if you have a big accident or illness that requires significant hospi-
tal and other medical care.
✓ Disability insurance: For most working people, their biggest asset
is their future income-earning ability. Disability insurance replaces a
portion of your employment earnings if you’re unable to work for an
extended period of time due to an incapacitating illness or injury.
21
Chapter 1: Evaluating Real Estate as an Investment
✓ Life insurance: If loved ones are financially dependent upon you, term
life insurance, which provides a lump sum death benefit, can help to
replace your employment earnings if you pass away.
✓ Homeowner’s insurance: Not only do you want homeowner’s insur-
ance to protect you against the financial cost due to a fire or other
home-damaging catastrophe, but such coverage also provides you with
liability protection. (After you buy and operate a rental property with
tenants, you should obtain rental owner’s insurance. See Chapter 16 for
more information).
✓ Auto insurance: This coverage is similar to homeowner’s coverage in
that it insures a valuable asset and also provides liability insurance
should you be involved in an accident.
✓ Excess liability (umbrella) insurance: This relatively inexpensive cover-
age, available in million dollar increments, adds on to the modest liabil-
ity protection offered on your home and autos, which is inadequate for
more-affluent people.
Nobody enjoys spending hard-earned money on insurance. However, having
proper protection gives you peace of mind and financial security, so don’t
put off reviewing and securing needed policies. For assistance, see the latest
edition of Eric’s Personal Finance For Dummies (Wiley).
Consider retirement account funding
If you’re not taking advantage of your retirement accounts (such as 401(k)s,
403(b)s, SEP-IRAs, and Keoghs), you may be missing out on some terrific tax
benefits. Funding retirement accounts gives you an immediate tax deduc-
tion when you contribute to them. And some employer accounts offer “free”
matching money — but you’ve got to contribute to earn the matching money.
In comparison, you derive no tax benefits while you accumulate your down
payment for an investment real estate purchase (or other investment such as
for a small business). Furthermore, the operating profit or income from your
real estate investment is subject to ordinary income taxes as you earn it. To
be fair and balanced, we must mention here that investment real estate offers
numerous tax benefits, which we detail in the “Tax advantages” section ear-
lier in this chapter.
Think about asset allocation
With money that you invest for the longer-term, you should have an overall
game plan in mind. Fancy-talking financial advisors like to use buzzwords
such as asset allocation, a term that indicates what portion of your money
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Part I: Stacking Real Estate Up Against Other Investments
you have invested in different types of investment vehicles, such as stocks
and real estate (for growth) or lending vehicles, such as bonds and CDs
(which produce current income).
Here’s a simple way to calculate asset allocation: Subtract your age from 110.
The result is the percentage of your long-term money that you should invest in
ownership investments for appreciation. So, for example, a 40-year-old would
take 110 minus 40 equals 70 percent in growth investments such as stocks and
real estate. If you want to be more aggressive, subtract your age from 120; a
40-year-old would then have 80 percent in growth investments.
As you gain more knowledge, assets, and diversification of growth assets,
you’re in a better position to take on more risk. Just be sure you’re properly
covered with insurance as discussed earlier in the section “Protect yourself
with insurance.”
These are simply guidelines, not hard-and-fast rules or mandates. If you want
to be more aggressive and are comfortable taking on greater risk, you can
invest higher portions in ownership investments.
As you consider asset allocation, when classifying your investments, deter-
mine and use your equity in your real estate holdings, which is the market
value of property less outstanding mortgages. For example, suppose that
prior to buying an investment property, your long-term investments consist
of the following:
Stocks $150,000
Bonds $50,000
CDs $50,000
Total $250,000
So, you have 60 percent in ownership investments ($150,000) and 40 percent
in lending investments ($50,000 + $50,000). Now, suppose you plan to pur-
chase a $300,000 income property making a $75,000 down payment. Because
you’ve decided to bump up your ownership investment portion to make your
money grow more over the years, you plan to use your maturing CD balance
and sell some of your bonds for the down payment. After your real estate
purchase, here’s how your investment portfolio looks:
Stocks $150,000
Real estate $75,000 ($300,000 property – $225,000 mortgage)
Bonds $25,000
Total $250,000
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Chapter 1: Evaluating Real Estate as an Investment
Thus, after the real estate purchase, you’ve got 90 percent in ownership
investments ($150,000 + $75,000) and just 10 percent in lending investments
($25,000). Such a mix may be appropriate for someone under the age of 50
who desires an aggressive investment portfolio positioned for long-term
growth potential.
Become your own landlord
Many real estate investors are actually involved
in other activities as their primary source of
income. Ironically, many of these business
owners come to realize the benefits of real
estate investing but miss the single greatest
opportunity that is right before their eyes — the
prospect of being their own landlord. Robert
has advised many business owners that they
should purchase the buildings occupied by their
own businesses and essentially pay the rent to
themselves. If you own a business that rents, do
yourself a favor — become your own landlord!
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Part I: Stacking Real Estate Up Against Other Investments
Chapter 2
Covering Common Real Estate
Investments
In This Chapter:
▶ Keeping your investments close to home
▶ Looking at residential properties
▶ Getting to know commercial real estate
▶ Studying undeveloped land
I
f you lack substantial experience investing in real estate, you should avoid
more esoteric and complicated properties and strategies. In this chapter,
we discuss the more accessible and easy-to-master income-producing prop-
erty options. In particular, residential income property, which we discuss in
the next section, can be an attractive real estate investment for many people.
Residential housing is easier to understand, purchase, and manage than
most other types of property, such as office, industrial, and retail property. If
you’re a homeowner, you already have experience locating, purchasing, and
maintaining residential property.
In addition to discussing the pros and cons of investing in residential income
property, we add insights as to which may be the most appropriate and prof-
itable for you and touch on the topics of investing in commercial property as
well as undeveloped land.
The Various Ways to Invest in
Residential Income Property
The first (and one of the best) real estate investments for many people is a
home in which to live. In this section, we cover the investment possibilities
inherent in buying a home for your own use, including potential profit to be
had from converting your home to a rental or fixing it up and selling it. We also
give you some pointers on how to profit from owning your own vacation home.
26
Part I: Stacking Real Estate Up Against Other Investments
Buying a place of your own
During your adult life, you’re going to need a roof over your head for many
decades. And real estate is the only investment that you can live in or rent
out to produce income. A stock, bond, or mutual fund doesn’t work too well
as a roof over your head!
Unless you expect to move within the next few years, buying a place prob-
ably makes good long-term financial sense. (Even if you need to relocate, you
may decide to continue owning the property and use it as a rental property.)
Owning usually costs less than renting over the long haul and allows you to
build equity (the difference between market value and mortgage loans against
the property) in an asset.
Under current tax law, you can also pocket substantial tax-free profits when
you sell your home for more than you originally paid plus the money you
sunk into improvements during your ownership. Specifically, single taxpayers
can realize up to a $250,000 tax-free capital gain; married couples filing jointly
get up to $500,000. In order to qualify for this homeowner’s gains tax exemp-
tion, you (or your spouse if you’re married) must have owned the home and
used it as your primary residence for a minimum of 24 months out of the
past 60 months. The 24 months doesn’t have to be continuous. Additionally,
the IRS now provides for pro-rata (proportionate) credit based on hardship
or change of employment. Also note that the full exemption amounts are
reduced proportionately for the length of time you rented out your home
over the five-year period referenced above.
Some commentators have stated that your home isn’t an investment,
because you’re not renting it out. We respectfully disagree: Consider the fact
that many people move to a less costly home when they retire (because it’s
smaller and/or because it’s in a lower cost area). Trading down to a lower
priced property in retirement frees up equity that has built up over many
years of homeownership. This money can be used to supplement your retire-
ment income and for any other purpose your heart desires. Your home is an
investment because it can appreciate in value over the years, and you can
use that money toward your financial or personal goals. Home Buying For
Dummies (Wiley), which Eric cowrote with residential real estate expert Ray
Brown, can help you make terrific home buying decisions.
Converting your home to a rental
Turning your current home into a rental property when you move is a simple
way to buy and own more properties. This approach is an option if you’re
already considering investing in real estate (either now or in the future), and
27
Chapter 2: Covering Common Real Estate Investments
you can afford to own two properties. Holding onto your current home when
you’re buying a new one is more advisable if you’re moving within the same
area so that you’re close by to manage the property. This approach presents
a number of positives:
✓ You save the time and cost of finding a separate rental property, not to
mention the associated transaction costs.
✓ You know the property and have probably taken good care of it and per-
haps made some improvements.
✓ You know the target market because the house appealed to you.
Some people unfortunately make the mistake of holding onto their current
home for the wrong reasons when they buy another. This situation often
happens when homeowners must sell their homes in a depressed market.
Nobody likes to lose money and sell their home for less than they paid for it.
Thus, some owners hold onto their homes until prices recover. If you plan to
move and want to keep your current home as a long-term investment (rental)
property, you can. If you fully convert your home to rental property and use it
that way for years before selling it, after you do sell you can either take advan-
tage of the lower long-term capital gains rates or do a tax deferred exchange.
For tax purposes, you get to deduct depreciation and all of the write-offs
during the ownership and you can shelter up to $25,000 in income from active
sources subject to income eligibility requirements. (Please see Chapter 18 for
more details.)
Turning your home into a short-term rental, however, is usually a bad move
because:
✓ You may not want the responsibilities of being a landlord, yet you force
yourself into the landlord business when you convert your home into a
rental.
✓ You owe tax on the sales’ profit if your property is classified for tax pur-
poses as a rental when you sell it and don’t buy another rental property.
(You can purchase another rental property through a 1031 exchange to
defer paying taxes on your profit. See the discussion in Chapter 18.)
Effective tax year 2009, you lose some of the capital gains tax exclusion if
you sell your home and you had rented it out for a portion of the five year
period prior to selling it. For example, if you rented your home for two of the
last five years, you may only exclude 60 percent of your gain (up to the maxi-
mums of $250,000 for single taxpayers and $500,000 for married couples filing
jointly), whereas the other 40 percent is taxed as a long-term capital gain.
Also be aware that when you sell a home previously rented and are account-
ing for the sale on your tax return, you have to recapture the depreciation
taken during the rental period.
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Part I: Stacking Real Estate Up Against Other Investments
Investing and living in well-situated
fixer-uppers
Serial home selling is a variation on the tried-and-true real estate investment
strategy of investing in well-located fixer-upper homes where you can invest
your time, sweat equity, and materials to make improvements that add more
value than they cost. The only catch is that you must actually move into the
fixer-upper for at least 24 months to earn the full homeowner’s capital gains
exemption of up to $250,000 for single taxpayers and $500,000 for married
couples filing jointly (as we cover in the “Buying a place of your own” section
earlier in this chapter).
Be sure to buy a home in need of that special TLC in a great neighborhood
where you’re willing to live for 24 months! But if you’re a savvy investor, you
would’ve invested in a great neighborhood anyway.
Here’s a simple example to illustrate the potentially significant benefits of
this strategy. You purchase a fixer-upper for $275,000 that becomes your
principal residence, and then over the next 24 months you invest $25,000 in
improvements (paint, landscaping, appliances, decorator items, and so on)
and you also invest the amount of sweat equity that suits your skills and
wallet. You now have one of the nicer homes in the neighborhood, and you
can sell this home for a net price of $400,000 after your transaction costs.
With your total investment of $300,000 ($275,000 plus $25,000), your efforts
have earned you a $100,000 profit completely tax-free. Thus, you’ve earned
an average of $50,000 per year, which isn’t bad for a tax-exempt second
income without strict office hours. (Note that many states also allow you to
avoid state income taxes on the sale of your personal residence, using many
of the same requirements as the federal tax laws.)
Now, some cautions are in order here. This strategy is clearly not for everyone
interested in making money from real estate investments. We recommend that
you bypass this strategy if any of the following apply:
✓ You’re unwilling or reluctant to live through redecorating, minor remod-
eling, or major construction.
✓ You dislike having to move every few years.
✓ You’re not experienced or comfortable with identifying undervalued
property and improving it.
✓ You lack a financial cushion to withstand a significant downturn in your
local real estate market as happened in numerous parts of the country
during the mid- to late-2000s.
✓ You don’t have the budget to hire a professional contractor to do the
work, and you don’t have the free time or the home improvement skills
needed to enhance the value of a home.
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Chapter 2: Covering Common Real Estate Investments
One final caution: Beware of transaction costs. The expenses involved with
buying and selling property — such as real estate agent commissions, loan
fees, title insurance, and so forth — can gobble up a large portion of your prof-
its. With most properties, the long-term appreciation is what drives your
returns. Consider keeping homes you buy and improve as long-term invest-
ment properties.
Purchasing a vacation home
Many people of means expand their real estate holdings by purchasing a
vacation home — a home in an area where they enjoy taking pleasure trips.
For most people, buying a vacation home is more of a consumption deci-
sion than it is an investment decision. That’s not to say that you can’t make
a profit from owning a second home. However, potential investment returns
shouldn’t be the main reason you buy a second home.
For example, we know a family that lived in Pennsylvania and didn’t particu-
larly like the hot and humid summer weather. They enjoyed taking trips and
staying in various spots in northern New England and eventually bought a
small home in New Hampshire. Their situation highlights the pros and cons
that many people face with vacation or second homes. The obvious advan-
tage this family enjoyed in having a vacation home is that they no longer had
the hassle of securing accommodations when they wanted to enjoy some
downtime. Also, after they arrived at their home away from home, they were,
well, home! Things were just as they expected — with no surprises, unless
squirrels had taken up residence on their porch.
The downsides to vacation homes can be numerous, as our Pennsylvania
friends found, including
✓ Expenses: With a second home, you have the range of nearly all of the
costs of a primary home — mortgage interest, property taxes, insurance,
maintenance, utilities, and so on.
✓ Property management: When you’re not at your vacation home, things
can go wrong. A pipe can burst, for example, and the mess may not be
found for days or weeks. Unless the property is close to a kind person
willing to keep an eye on it for you, you may incur the additional
expense of paying a property manager to watch the property for you.
✓ Lack of rental income: Most people don’t rent out their vacation homes,
thus negating the investment property income stream that contributes
to the returns real estate investors enjoy (see Chapter 1). If your second
home is in a vacation area where you have access to plenty of short-
term renters, you or your designated property manager can rent out
the property. However, this entails all of the headaches and hassles of
having many short-term renters. (But you do gain the tax advantages of
depreciation and all expenses as with other rental properties.)
30
Part I: Stacking Real Estate Up Against Other Investments
✓ Obligation to use: Some second homeowners we know complain about
feeling forced to use their vacation homes. Oftentimes in marriages, one
spouse likes the vacation home much more than the other spouse (or
one spouse enjoys working on the second home rather than enjoying the
home itself).
Before we close out this section on vacation homes, we want to share a few
tax tips, as found in the current tax code:
✓ If you retain your vacation home or secondary home as personal prop-
erty, forgoing the large income streams and tax write-offs for deprecia-
tion and operating expenses associated with rental properties, you can
still make a nice little chunk of tax-free cash on the side. The current tax
code permits you to rent the property for up to 14 days a year — and that
income is tax-free! You don’t have to claim it. Yes, you read that right. And
you can still deduct the costs of ownership, including mortgage interest
and property taxes, as you do for all other personal properties.
✓ If you decide to maintain the property as a rental (you rent it out for more
than 14 days a year), you, as the property owner, can still use the rental
property as a vacation home for up to 14 days a year, or a maximum of 10
percent of the days gainfully rented, whichever is greater, and the prop-
erty still qualifies as a rental. Also, all days spent cleaning or repairing the
rental home don’t count as personal use days — so that’s why you paint
for a couple of hours every afternoon and spend the morning fishing!
Before you buy a second home, weigh all the pros and cons. If you have a
spouse or partner with whom you’re buying the property, have a candid dis-
cussion. Also consult with your tax advisor for other tax-saving strategies for
your second home or vacation home. And please see Chapter 18 for more tax
related information on rental properties.
Paying for condo hotels and timeshares
Timeshares, a concept created in the 1960s, are a form of ownership or right
to use a property. A more recent trend in real estate investing is condo
hotels, which in many ways are simply a new angle on the old concept of
timeshares. A condo hotel looks and operates just like any other first-class
hotel, with the difference that each room is separately owned. The guests
have no idea who owns their room.
Both timeshares and condo hotels typically involve luxury resort locations
with amenities such as golf or spas. The difference between the traditional
timeshare and condo hotel is the interval that the unit is available — condo
hotels are operated on a day-to-day availability, and timeshares typically rent
in fixed intervals such as weeks.
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Chapter 2: Covering Common Real Estate Investments
Some of the most popular projects have been the branded condo hotels such
as Ritz Carlton, Four Seasons, Trump, W, Westin, and Hilton located in the
high profile vacation destinations like Hawaii, Las Vegas, New York, Chicago,
and Miami. You can also find many foreign condo hotel properties in the
Caribbean and Mexico, and the concept is expanding to Europe, the Middle
East, and Asia.
Two types of individuals are attracted to investing in condo hotels and time-
shares. One group is investors who believe that the property will appreciate
like any other investment. The other group is people who use the condo
hotel or timeshare for personal use and offset some of their costs.
From an investment standpoint, the fundamental problem with timeshares
is that they’re overpriced, and like a condominium, you own no land (which
is what generally appreciates well over time). For example, suppose that a
particular unit would cost $150,000 to buy. When this unit is carved up into
weekly ownership units, the total cost of all those units can easily approach
four to five times that amount!
To add insult to injury, investors find that another problem with timeshares
is the high maintenance or annual service fees. Is it worth buying a slice of
real estate at a 400 to 500 percent premium to its fair market value and pay
high fees on top of that? We don’t think so.
Many owners of timeshares find that they want to vacation at a different
location or time of year than what they originally purchased. To meet this
need, several companies offer to broker or sell timeshare slots. However,
timeshare availability and desirability have so many variables — including
location, time of year, and quality of the particular resort — that it has been
difficult to fairly value and trade timeshares. As a result, resort rating sys-
tems have been developed (Resorts Condominiums International and Interval
International are two of the most well known) to compare resort location,
amenities, and quality.
The developers and operators of condo hotels love the concept because
one of the most consistently successful principles of real estate is increasing
value by fractionalizing interests in real estate. As with timeshares, the devel-
opers are able to sell each individual hotel room for much more than they
could get for the entire project.
Condo hotel operators are able to generate additional revenue from service
and maintenance fees to cover their costs of operations. Often the owners’
use of their own rooms doesn’t negatively impact the overall revenues of the
property because the rooms would have sometimes been vacant anyway.
Condo hotels allow their owners to stay in their units but often impose limits
on the amount of personal usage.
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Part I: Stacking Real Estate Up Against Other Investments
The purchaser of the condo hotel unit sees this type of investment as an
option to direct ownership of a second home and likes the ability to gener-
ate income. The professional management is another one of the attractions
to investors. The owners don’t pay a management fee to the hotel operator
unless their room is rented, and then the collected revenue is split.
Still interested in a timeshare? Read on.
Timeshares are packaged in a multitude of
ways — some resorts offer fixed units where
you vacation at the exact same unit every year
either on set dates or set numbered weeks
(though the actual calendar date may vary.
Some timeshares are available as biennial
(every other year) so you can have some vari-
ety. Some offer fixed weeks, where you have
the same week every year but may be in a dif-
ferent unit.
Timeshares aren’t just a one-time purchase;
they also have monthly or annual service or
maintenance fees. These funds are established
each year by the homeowner’s association or
resort management company. There are differ-
ent types of ownership for timeshare interests,
with fee simple, right of use, and leasehold
being the primary options:
✓ Fee simple ownership is an estate in real
estate that provides the absolute owner-
ship subject to state and local laws and
government powers such as taxation, emi-
nent domain, police power, and so on.
✓ Right-to-use are occupancy rights for a
given number of years but no actual owner-
ship interest in the property. Some states and
many foreign countries don’t allow the fee
simple ownership of timeshares so they offer
long-term lease or right-to-use agreements
that can be from 20 to 99 years. The actual fee
simple title of the real estate remains with the
resort developer or management company.
The day-to-day operations of timeshares are
typically handled by the homeowner’s asso-
ciation or a resort management company.
✓ Leasehold is an agreement between the
lessee (tenant) and lessor (owner or land-
lord) specifying the lessee’s right to use the
leased property for a given purpose and
given time at a specified rental payment.
If you’re interested in buying a timeshare,
you can talk with the developer directly; this
method may make sense if you’re looking for a
particular time of the year in the high season.
The timeshare industry typically uses a color-
coded pricing system to denote the seasonal
demand for a particular timeshare property.
Although the concept is pretty consistent, the
designation of particular colors can vary from
one resort to another. In general, the demand is
broken down into three categories:
✓ Red for the prime or high demand
✓ Yellow or white for intermediate or medium
season
✓ Green or blue for off-season or low
demand
If you’re looking for a week in the green or blue
season, you can often find much better pric-
ing from reputable resellers. The reputable is
a key and elusive term here. Among compa-
nies to consider for reselling timeshares are
RCI, Interval International, and Trading Places
International
33
Chapter 2: Covering Common Real Estate Investments
These properties are often hyped, and the expectations of the condo hotel
investor are often much greater than the reality. Investors are lured to condo
hotels by the potential for appreciation and cash flow as well as professional
management. Many investors find themselves being pressured into pre-sale
offering presentations even before the units are built. These events can be
tempting, but savvy investors need to do their own due diligence. So when
you hear a sales pitch indicating that your proposed investment in a condo
hotel unit will provide significant income from hotel rentals and cover most
or all of your mortgage and carrying costs, that’s the time to grab your wallet
and find the nearest exit.
Many investors’ first experiences with timeshares are tempting offers of a
free meal, a great discount offer to a theme park, or even a free one or two
night stay at the resort, with the catch that they have to spend some time
listening to an informational presentation. These offers usually come from
individuals contacting you in known tourist locations or when you check into
a hotel that just happens to offer condos as well. Robert remembers his first
exposure to timeshares was as a child in the early ‘70s on a family vacation
to Florida, when his parents got a free camera just for attending a seminar on
timeshares near Orlando. Even as a teenager, Robert didn’t like the obvious
pressure sales tactics he observed.
However, timeshares may make sense for you if you like to vacation at the
same resort around the same time every year and if the annual service or
maintenance fees compare favorably to the cost of simply staying in a compa-
rable resort. Remember, though, that if the deal seems too good to be true, it
is too good to be true. As with timeshares, the only folks who generally make
money with condo hotels are the developers, not the folks who buy specific
days of ownership.
Surveying the Types of Residential
Properties You Can Buy
If you’ve been in the market for a home, you know that in addition to single-
family homes, you can choose from numerous types of attached or shared
housing including apartment buildings, condominiums, townhomes, and co-
operatives. In this section, we provide an overview of each of these properties
and show how they may make an attractive real estate investment for you.
From an investment perspective, our top recommendations are apartment build-
ings and single-family homes. We generally don’t recommend attached-housing
units. If you can afford a smaller single-family home or apartment building
rather than a shared-housing unit, buy the single-family home or apartments.
34
Part I: Stacking Real Estate Up Against Other Investments
Unless you can afford a large down payment (25 percent or more), the early
years of rental property ownership may financially challenge you: With all
properties, as time goes on, generating a positive cash flow gets easier
because your mortgage expense stays fixed (if you use fixed rate financing)
while your rents increase faster than your expenses. Regardless of what you
choose to buy, make sure that you run the numbers on your rental income
and expenses (see Chapter 12) to see if you can afford the negative cash flow
that often occurs in the early years of ownership.
Single-family homes
As an investment, single-family detached homes generally perform better in
the long run than attached or shared housing. In a good real estate market,
most housing appreciates, but single-family homes tend to outperform other
housing types for the following reasons:
✓ Single-family homes tend to attract more potential buyers — most
people, when they can afford it, prefer a detached or stand-alone home,
especially for the increased privacy.
✓ Attached or shared housing is less expensive and easier to build and
to overbuild; because of this surplus potential, such property tends to
appreciate more moderately in price.
Because so many people prefer to live in detached, single-family homes,
market prices for such dwellings can sometimes become inflated beyond
what’s justified by the rental income these homes can produce. That’s exactly
what happened in some parts of the United States in the mid-2000s and led
in part to a significant price correction in the subsequent years. To discover
whether you’re buying in such a market, compare the monthly cost (after tax)
of owning a home to monthly rent for that same property. Focus on markets
where the rent exceeds or comes close to equaling the cost of owning and
shun areas where the ownership costs exceed rents.
Single-family homes that require just one tenant are simpler to deal with
than a multiunit apartment building that requires the management and
maintenance of multiple renters and units. The downside, though, is that a
vacancy means you have no income coming in. Look at the effect of 0 percent
occupancy for a couple of months on your projected income and expense
statement! By contrast, one vacancy in a four-unit apartment building (each
with the same rents) means that you’re still taking in 75 percent of the gross
potential (maximum total) rent.
With a single-family home, you’re responsible for all maintenance. You can
hire someone to do the work, but you still have to find the contractors and
coordinate and oversee the work. Also recognize that if you purchase a
35
Chapter 2: Covering Common Real Estate Investments
single-family home with many fine features and amenities, you may find it
more stressful and difficult to have tenants living in your property who don’t
treat it with the same tender loving care that you may yourself.
The first rule of being a successful landlord is to let go of any emotional
attachment to a home. But that sort of attachment on the tenant’s part is
favorable: The more they make your rental property their home, the more
likely they are to stay and return it to you in good condition — except for the
expected normal wear and tear of day-to-day living. (We discuss the proper
screening and selection of tenants in Chapter 15.)
Making a profit in the early years from the monthly cash flow with a single-
family home is generally the hardest stage. The reason: Such properties usu-
ally sell at a premium price relative to the rent that they can command (you
pay extra for the land, which you can’t rent). Also remember that with just one
tenant, you have no rental income when you have a vacancy.
Attached housing
As the cost of land has climbed over the decades in many areas, packing
more housing units that are attached into a given plot of land keeps housing
somewhat more affordable. Shared housing makes more sense for investors
who don’t want to deal with building maintenance and security issues.
In this section, we discuss the investment merits of three forms of attached
housing: condominiums, townhomes, and co-ops.
Condos
Condominiums are typically apartment-style units stacked on top of and/or
beside one another and sold to individual owners. When you purchase a con-
dominium, you’re actually purchasing the interior of a specific unit as well
as a proportionate interest in the common areas — the pool, tennis courts,
grounds, hallways, laundry room, and so on. Although you (and your ten-
ants) have full use and enjoyment of the common areas, remember that the
homeowner’s association actually owns and maintains the common areas as
well as the building structures themselves (which typically include the foun-
dation, roof, plumbing, electrical, and other building systems).
One advantage to a condo as an investment property is that of all the attached
housing options, condos are generally the lowest-maintenance properties
because most condominium associations deal with issues such as roofing,
gardening, and so on for the entire building and receive the benefits of quan-
tity purchasing. Note that you’re still responsible for necessary maintenance
inside your unit, such as servicing appliances, interior painting, and so on.
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Part I: Stacking Real Estate Up Against Other Investments
Although condos may be somewhat easier to keep up, they tend to appreci-
ate less than single-family homes or apartment buildings unless the condo is
located in a desirable urban area.
Condominium buildings may start out in life as condos or as apartment com-
plexes that are then converted into condominiums.
Be wary of apartments that have been converted to condominiums. Although
they’re often the most affordable housing options in many areas of the coun-
try and may also be blessed with an excellent urban location that can’t easily
be re-created, you may be buying into some not so obvious problems. Our
experience is that these converted apartments are typically older properties
with a cosmetic makeover (new floors, new appliances, new landscaping, and
a fresh coat of paint). However, be forewarned: The cosmetic makeover may
look good at first glance, but the property probably still boasts 40-year-old
plumbing and electrical systems, poor soundproofing, and a host of economic
and functional obsolescence.
Within a few years, most of the owner-occupants move on to the traditional
single-family home and rent out their condos. You may then find the property
is predominantly renter-occupied and has a volunteer board of directors
unwilling to levy the monthly assessments necessary to properly maintain
the aging structure. Within 10 to 15 years of the conversion, these properties
may well be the worst in the neighborhood.
Townhomes
Townhomes are essentially attached or row homes — a hybrid between a
typical airspace-only condominium and a single-family house. Like condo-
miniums, townhomes are generally attached, typically sharing walls and a
continuous roof. But townhomes are often two-story buildings that come
with a small yard and offer more privacy than a condominium because you
don’t have someone living on top of your unit.
As with condominiums, you absolutely must review the governing docu-
ments before you purchase the property to see exactly what you legally own.
Generally, townhomes are organized as planned unit developments (PUDs) in
which each owner has a fee simple ownership (no limitations as to transfer-
ability of ownership — the most complete ownership rights one can have) of
his individual lot that encompasses his dwelling unit and often a small area of
immediately adjacent land for a patio or balcony. The common areas are all
part of a larger single lot, and each owner holds title to a proportionate share
of the common area.
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Chapter 2: Covering Common Real Estate Investments
Co-ops
Co-operatives are a type of shared housing that has elements in common
with apartments and condos. When you buy a cooperative, you own a stock
certificate that represents your share of the entire building, including usage
rights to a specific living space per a separate written occupancy agreement.
Unlike a condo, you generally need to get approval from the co-operative
association if you want to remodel or rent your unit to a tenant. In some
co-ops, you must even gain approval from the association for the sale of your
unit to a proposed buyer.
Turning a co-op into a rental unit is often severely restricted or even forbid-
den and, if allowed, is usually a major headache because you must satisfy not
only your tenant but also the other owners in the building. Co-ops are also
generally much harder to finance, and a sale requires the approval of the typi-
cally finicky association board. Therefore, we highly recommend that you
shun co-ops for investment purposes.
Apartments
Not only do apartment buildings generally enjoy healthy long-term appreciation
potential, but they also often produce positive cash flow (rental income –
expenses) in the early years of ownership. But as with a single-family home, the
buck stops with you for maintenance of an apartment building. You may hire
a property manager to assist you, but you still have oversight responsibilities
(and additional expenses).
In the real-estate financing world, apartment buildings are divided into two
groups based on the number of units:
✓ Four or fewer units: You can obtain more favorable financing options
and terms for apartment buildings that have four or fewer units because
they’re treated as residential property.
✓ Five or more units: Complexes with five or more units are treated as
commercial property and don’t enjoy the extremely favorable loan
terms of the one- to four-unit properties.
Apartment buildings, particularly those with more units, generally produce a
small positive cash flow, even in the early years of rental ownership (unless
you’re in an overpriced market where it may take two to four years before
you break even on a before-tax basis).
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Part I: Stacking Real Estate Up Against Other Investments
One way to add value, if zoning allows, is to convert an apartment building
into condominiums. Keep in mind, however, that this metamorphosis requires
significant research on the zoning front and with estimating remodeling and
construction costs.
Considering Commercial Real Estate
Commercial real estate is a generic term that includes properties used for
office, retail, and industrial purposes. You can also include self-storage and
hospitality (hotels and motels) properties in this category. If you’re a knowl-
edgeable real estate investor and you like a challenge, you need to know two
good reasons to invest in commercial real estate:
✓ You can use some of the space if you own your own small business. Just
as it’s generally more cost-effective to own your home rather than rent
over the years, so it is with commercial real estate if — and this is a big
if — you buy at a reasonably good time and hold the property for many
years.
✓ Your analysis of your local market suggests that it’s a good time to buy.
We discuss more on this point in a moment.
Easy fixes can yield big bucks
Avoid shared housing units in suburban areas
with substantial undeveloped land that enables
building many more units. Attached housing
prices tend to perform best in fully developed
or built-out urban environments.
For higher returns, look for property where
relatively simple cosmetic and other fixes may
allow you to increase rents and, therefore, the
market value of the property. Examples of such
improvements may include but not be limited to
✓ Adding fresh paint and flooring
✓ Improving the landscaping
✓ Upgrading the kitchen with new appliances
and new cabinet/drawer hardware that can
totally change the look
✓ Converting five-unit apartment buildings into
four-unit buildings to qualify for more favor-
able mortgage terms (see the “Apartments”
section earlier in this chapter)
Look for property with a great location and good
physical condition but some minor deferred
maintenance. Then you can develop the punch
list of items with maximum results for minimum
dollars — for example, a property with a large
yard but dead grass, a two- or three-car garage
but peeling paint or a broken garage door. You
can also add a garage door opener to jazz up
the property for minimum cost. You can also
really add value to a property with a burnt-out,
absentee, or totally disinterested owner who is
tired of the property.
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Chapter 2: Covering Common Real Estate Investments
We want to be clear, though, that commercial real estate isn’t our first recom-
mendation, especially for inexperienced investors. Residential real estate is
generally far easier to understand and also usually carries lower investment
and tenant risks.
With commercial real estate, when tenants move out, new tenants nearly
always require extensive and costly improvements to customize the space
to meet their planned usage of the property. And you usually have to pay for
the majority of the associated costs in order to compete with other building
owners. Fortunes can quickly change — small companies can go under, get
too big for a space, and so on. Change is the order of the day in the business
world, and especially in the small business world.
So how do you evaluate the state of your local commercial real estate
market? You must check out, over a number of years, the supply and demand
statistics. How much total space (and new space) is available for rent, and
how has that changed in recent years? What’s the vacancy rate, and how has
that changed over time? Also, examine the rental rates, usually quoted as a
price per square foot. We help you cover this ground in Chapter 8.
One danger sign that purchasing a commercial property in an area is likely
to produce disappointing investment returns is a market where the supply of
available space has increased faster than demand, leading to higher vacan-
cies and falling rental rates. (This is called negative absorption, and what you
naturally want is a track record and projections showing positive absorption —
when the supply of space isn’t keeping up with the demand.) A slowing local
economy and a higher unemployment rate also spell trouble for commercial
real estate prices. Each market is different, so make sure you check out the
details of your area.
Buying Undeveloped Land
For prospective real estate investors who feel tenants and building mainte-
nance are ongoing headaches, buying undeveloped land may appear attrac-
tive. If you buy land in an area that’s expected to experience expanding
demand in the years ahead, you should be able to make a tidy return on your
investment. This is called buying in the path of progress, but of course the trick
is to buy before everybody realizes that new development is moving in your
direction. (Check out Chapter 8 for a full discussion on the path of progress.)
You may even hit a home run if you can identify land that others don’t cur-
rently see the future value in holding. However, identifying many years in
advance which communities will experience rapid population and job growth
isn’t easy. Land prices in areas that people believe will be the next hot spot
40
Part I: Stacking Real Estate Up Against Other Investments
already sell at a premium price. That’s what happened in most major cities
with new sports facilities (especially because these decisions often are dis-
closed well in advance of the municipality leadership vote or the ballot initia-
tive). You don’t have much opportunity to get ahead of the curve — or if you
guess wrong, you may own some costly land for a long time!
Investing in land certainly has other drawbacks and risks:
✓ Care and feeding: Land requires ongoing cash to pay the property taxes
and liability insurance, and to keep the land clear and free of debris
while it most likely produces little or no income. Although land doesn’t
require much upkeep compared with tenant-occupied property, it
almost always does require financial feeding.
✓ Opportunity costs: Investing in land is a cash drain, and of course, pur-
chasing the land in the first place costs money. If you buy the land with
cash, you have the opportunity cost of tying up your valuable capital
(which could be invested elsewhere), but most likely you will put down
30 to 40 percent in cash and finance the balance of the purchase price
instead.
✓ Costly mortgages: Mortgage lenders require much higher down pay-
ments and charge higher loan fees and interest rates on loans to
purchase land because they see it as a more speculative investment.
Obtaining a loan for development of land is challenging and more expen-
sive than obtaining a loan for a developed property.
✓ Lack of depreciation: You don’t get depreciation tax write-offs because
land isn’t depreciable.
The dangers of downzoning
Robert owned raw land for many years in an
area where a recent government action effec-
tively downzoned his property from 4 acres to
2 acres. The multi-species conservation act
designated huge swaths of undeveloped land
as mitigation habitat for “endangered plant and
animal species.” This ordinance mandated that
every parcel that wasn’t already fully devel-
oped was subject to a development limitation
of 2 acres.
Luckily for Robert, he had subdivided the origi-
nal 20 acres into 4 smaller parcels of 4 to 5
acres each or the entire 20 acres would’ve only
been allowed usage of 2 acres. Still, Robert’s 4-
to 5-acre parcels are now limited to 2 acres of
development unless Robert pays a “mitigation
fee” which is currently over $50,000 per acre!
This story illustrates the dangers of buying and
owning vacant real estate in areas where con-
servation activists are prevalent.
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Chapter 2: Covering Common Real Estate Investments
On the income side, some properties may be able to be used for parking,
storage income, or maybe even growing Christmas trees in the Northwest or
grain in the Midwest! (After you make sure you’ve complied with local zoning
restrictions and have the proper insurance in place.)
Although large-scale land investment isn’t for the entry-level real estate inves-
tor, savvy real estate investors have made fortunes taking raw land and getting
the proper entitlements and then selling (or better yet, subdividing and then
selling) the parcels to developers of commercial and residential properties
(primarily home builders). If you decide to invest in land, be sure that you:
✓ Do your homework. Ideally, you want to buy land in an area that’s
attracting rapidly expanding companies and that has a shortage of
housing and developable land. Take your time to really know the area.
This isn’t a situation in which you should take a hot tip from someone
to invest in faraway property in another state. Nor should you buy raw
land just because you heard that irresistible opening bid price adver-
tised on the radio for the government excess land auction down at the
convention center this Saturday.
✓ Know all the costs. Tally up your annual carrying costs (ongoing owner-
ship expenses such as property taxes) so that you can see what your
annual cash drain may be. What are the financial consequences of this
cash outflow — for example, will you be able to fully fund your tax-
advantaged retirement accounts? If you can’t, count the lost tax benefits
as another cost of owning land.
✓ Determine what improvements the land may need. Running utility,
water, and sewer lines; building roads; landscaping; and so on all cost
money. If you plan to develop and build on the land that you purchase,
research these costs. Make sure you don’t make these estimates with
your rose-tinted sunglasses on — improvements almost always cost
more than you expect them to. (You need to check with the planning or
building department for their list of requirements.)
Also make sure that you have access to the land or the right to enter
and leave through a public right-of-way or another’s property (known as
ingress and egress). Some people foolishly invest in landlocked proper-
ties. When they discover the fact later, they think that they can easily
get an easement (legal permission to use someone else’s property).
Wrong!
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Part I: Stacking Real Estate Up Against Other Investments
✓ Understand the zoning and environmental issues. The value of land is
heavily dependent on what you can develop on it. Never purchase land
without thoroughly understanding its zoning status and what you can
and can’t build on it. This advice also applies to environmental limita-
tions that may be in place or that may come into effect without warning,
diminishing the potential of your property (with no compensation).
This potential for surprise is why you must research the disposition of
the planning department and nearby communities. Attend the meetings
of local planning groups, if any, because some areas that are antigrowth
and antidevelopment are less likely to be good places for you to buy
land, especially if you need permission to do the type of project that you
have in mind. Through the empowerment of local residents who sit on
community boards and can influence local government officials, zoning
can suddenly change for the worse — sometimes you may find that
your property has been downzoned — a zoning alteration that can sig-
nificantly reduce what you can develop on a property and therefore the
property’s value. See the sidebar “The dangers of downzoning” in this
chapter for more details.
Chapter 3
Considering Foreclosures, REOs,
Probate Sales, and More
In This Chapter
▶ Mastering foreclosures and REOs
▶ Considering short sales
▶ Utilizing lease options
▶ Understanding probate sales and auctions
M
any real estate investors actually start their real estate portfolio con-
ventionally by buying a home for their own use for a number of years
and then purchasing a new home and renting out their first home. Other folks
have found that the best way to quickly become a real estate investor is to
purchase income-producing properties in a more unconventional manner.
In this chapter, we take a brief look at some of the most common of these
methods of acquiring real estate investment properties or participating in the
real estate market, and we tell you what we think about whether you should
pursue these options. We start off with foreclosures, REOs, and lease options.
We also cover some other, even more unusual ways to acquire real estate at
below-market prices, such as probate sales and auctions. And besides REITs
(discussed in Chapter 4), other avenues allow you to passively invest in real
estate, including triple net properties, notes and trust deeds, and limited
partnerships, which we also discuss.
Finding Foreclosures and REOs
Would you rather buy real estate at retail or at wholesale prices? Obviously
the answer is “wholesale!” Just like in the stock market, the concept of buy
low, sell high also applies to real estate.
44
Part I: Stacking Real Estate Up Against Other Investments
One of the best ways to maximize your chances of earning a good return on
your investment is to buy a property at foreclosure or as an REO. Such invest-
ments are generally a better value than a conventional purchase (but not with-
out some increased risk)!
And of course, other real estate investors are also scouring your local real
estate market for great deals. Clearly, real estate investors flush with cash
aren’t going to miss this opportunity. As an individual looking to buy just one
or two foreclosure homes in your local market, you may be surprised to find
that you’re competing with very large and sophisticated Wall Street venture
funds with tens of millions of dollars that are buying pools of bad loans or
foreclosed properties.
Foreclosures are simply properties for which the owner has failed to meet
his loan payment or other loan term obligations, forcing the lender, if they
want to get some of their money back, to take over legal ownership and con-
trol of the property (or foreclose and take title). Although more formal in a
legal sense and more time consuming, a real estate foreclosure is similar to a
lender repossessing the car from an owner who fails to make her monthly car
payments.
After completing the foreclosure process, the lender takes title, at which
point it owns the property. The lender has to maintain and manage the prop-
erty, so it turns the property over to asset managers in the lender’s in-house
real estate owned (REO) department. The asset managers may keep the day-
to-day property management in-house as well, but most lenders hire local
property management firms to inspect the property, repair any emergency
items, and essentially operate the property until the lender can sell it — usu-
ally within a few months unless the borrower has redemption rights (see the
“Redemption period” section later in the chapter). Some major lenders, like
Bank of America, call the department holding their repossessed properties
owned real estate operations (OREOs). No matter what the name, the savvy
real estate investor willing to do the extensive due diligence required to find
the rare diamonds in the rough will be rewarded.
Typically these properties are spruced up and then sold quickly for as close
to the appraised value as possible. However, with the number of foreclosures
so significant in certain areas of the country, unloading these properties will
really hit lenders hard. Robert is seeing a growing trend towards lenders
holding on to these properties and hiring local property management firms
to not only spruce up the properties but also rent them for one to three years
with the expectation that the market will improve and the lenders will recoup
much of their loan values. This trend is particularly true with private lenders.
Public lenders, like most banks, don’t always have the flexibility of keeping
these nonperforming assets on their books for regulatory reasons, but this
is a solid strategy. Real estate investors may find fewer fire-sale bargains in
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Chapter 3: Considering Foreclosures, REOs, Probate Sales, and More
the short run, but actually the recovery will be spread out over several years,
and thus there will be a steady supply of reasonably priced rental properties
as various lenders spin off some of these held assets.
When considering foreclosures and REOs, be sure to perform the necessary
research:
✓ Inspect the property and determine the physical condition and the cost
of any needed work. Be careful to rule out environmental concerns.
✓ Review a preliminary title report to see whether the property has any
unpaid tax liens or encumbrances.
✓ Appraise the property and establish your target price and a firm maxi-
mum bid so that the emotions of bidding don’t lead you to overpay.
Foreclosures
The term foreclosure actually describes a process by which a lender takes
title to a property on which a loan is in default. The two most common high-
risk mistakes homeowners make that lead to foreclosure are
✓ Failing to make the mortgage payments as required: For example,
homeowners who overstretched and bought their homes using up to
100 percent financing (they made little or no down payment towards the
home’s purchase price) and were, in effect, living on the edge.
✓ Borrowing too much when refinancing: Low interest rates combined
with the tremendous increase in real estate values in most parts of the
country in the early- to mid-2000s led many homeowners to refinance
their properties. Although there’s nothing wrong with refinancing, as
long as you don’t borrow too much, some lenders promoted 110 to 120
percent loans that tempted homeowners to pull all of their equity — and
more — out of their homes. The recent trend towards no-documentation
or stated-income loans also greatly contributed to the real estate mess
of this period.
The flawed theory was that real estate values only increased, so these
folks were simply tapping their future equity. However, one slight stum-
ble with a loss of a job or a drop in income, a serious illness, death, or
divorce can lead to a missed mortgage payment or two and ultimately,
foreclosure. That’s what happened to millions of property owners who
were overextended with mortgage debt when the real estate market
turned against them in the late-2000s. Although some folks couldn’t
afford to keep up with their payments, others chose to walk away from
properties worth less than their outstanding mortgage balance.
46
Part I: Stacking Real Estate Up Against Other Investments
But properties can also be subject to foreclosure for other reasons:
✓ Owners fail to meet other loan requirements. Examples include not
maintaining proper insurance coverage or not keeping the property in
good physical condition.
✓ Absentee owners are unable to effectively manage the property. Good
property managers regularly visit and inspect their properties. This
level of involvement isn’t practical from a distance.
This category of foreclosures is extremely prevalent in many of the most
popular real estate investment markets for out-of-town speculators such
as Las Vegas and Phoenix. If you’re in these markets you may be able
to pick up some great bargains, but don’t make the same mistake that
the earlier investors made when they purchased properties out of their
comfort zone.
✓ Owners walk away from serious problems. Some properties fall into
foreclosure because the property has serious and irreversible problems
that are so bad that the current owner chooses to walk away rather than
deal with them. Environmental hazards and serious physical problems
where the cost of repair can exceed the value of the property (such as
cracked slabs) often top the list. (In Chapter 12, we cover research you
can perform to help avoid these types of problems.)
Many foreclosure properties also fall into this category because some real
estate investors felt that the market was so strong that literally any property
they bought would increase in value. Although this may have been true to a
certain extent in some markets for a couple of years, the reality is that inves-
tors who bought properties without conducting proper due diligence often
found that they had purchased white elephants, or properties that they can’t
sell for what they paid for them (or even rent out to cover their carrying costs).
More mortgage monkey business
Leading up to the mortgage crisis of 2008, lend-
ers often pushed borrowers toward piggyback
loans, which are two or more loans (usually
from different lenders) used to purchase a
property. The three most popular piggyback
loan programs are the 80-20-0; the 80-15-5; and
the 80-10-10 loans. In each of these loan pro-
grams, the first number is an 80-percent first
mortgage, the second number is the amount of
the second mortgage, and the last number is
the percentage of the purchase price the buyer
paid in cash. The 80-10-10 loan (80 percent first,
10 percent second, and 10 percent down) was
especially popular because it was designed to
save the borrower the added cost of private
mortgage insurance (PMI).
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Chapter 3: Considering Foreclosures, REOs, Probate Sales, and More
Before you pursue foreclosure properties, determine the type of foreclosure
process commonly used in your state. Check with your favorite lender, real
estate agent, real estate attorney, or title company representative to find this
information. Your state falls under one of two categories:
✓ Deed of trust state: When a loan is placed in a deed of trust state, the
property title is held in the name of a third party or trustee. If the loan
payments aren’t made as promised or the loan is in default for another
reason, the trustee can foreclose or take back the property. No court
action is necessary, so a foreclosure in a deed of trust state can happen
in 60 to 120 days. This process is referred to as nonjudicial foreclosure.
Be sure to check that you have the latest information on federal, state,
and even local efforts by legislators and courts that have been quite
aggressive in extending the timelines to give borrowers more time to
avoid foreclosure.
✓ Mortgage state: In a mortgage state, no trustee or third party is named.
When a mortgage goes into default for nonpayment or other breach, the
holder of the mortgage must go to court and seek legal remedies includ-
ing judicial foreclosure, which can take much longer than a nonjudicial
foreclosure.
Foreclosure properties aren’t that hard to find. Whether you’re in a deed of
trust state or a mortgage state, the filing of a Notice of Default (NOD) or a
judicial foreclosure lawsuit are matters of public record. An additional public
notice announcing a pending foreclosure sale must be published in a local
legal newspaper. The timing of the publication prior to the sale varies by state.
Many title companies and real estate firms track the Notices of Default and all
the steps right through to the actual foreclosure. This information is public
record and filed with the county recorder or equivalent, but subscribe to one
of the local services offering this information via daily or weekly e-mails or
faxes, because gathering this information on your own is time consuming.
Technically, there are four steps, and thus four buying opportunities, for a
property subject to the typical foreclosure process. Knowing these steps,
which we outline in the following sections, and the techniques or negotiating
points necessary at each step to motivate the owner or lender is essential to
mastering one of the best strategies of buying real estate at below market or
wholesale prices.
Preforeclosure
Every potential foreclosure begins when the owner misses a payment on her
debt service or is notified in writing by the lender that a condition or term of
her loan isn’t being met. The preforeclosure stage is the period of time before
the lender formally files the Notice of Default, which triggers the legal foreclo-
sure process.
48
Part I: Stacking Real Estate Up Against Other Investments
The period of time before the formal foreclosure begins is an important buying
opportunity: You can get in ahead of competing investors to identify proper-
ties on which the owner is delinquent on mortgage payments or violating
other conditions of her loan. The key is to track and locate these defaulting
owners.
This is the time when you want to offer a solution to the owner that’ll get her
out of the property and preserve her credit status so she can purchase prop-
erty in the future. Also, every owner facing a mortgage delinquency needs
some cash to pay for moving and relocation costs. Understanding the motiva-
tion of the owner and lender can allow you to formulate an investment strat-
egy that meets everyone’s needs and allows you to own a property before it
becomes heavily exposed on the local multiple listing service!
Notice of Default
The first formal legal action in the foreclosure process is the filing of a Notice
of Default. If the owner wasn’t concerned when he first began missing loan
payments, the filing of the Notice of Default should be a real wake-up call.
An owner who has received the Notice of Default is likely to be motivated to
sell because she knows that the lender has begun the formal steps toward
repossessing her property. But not all owners facing foreclosure are aware
that the late charges, penalties, and hefty legal fees further erode their shaky
financial position. They may not understand the logic that if they can’t make
their regular monthly payments, they’re unlikely to catch up and pay all of
the additional costs, which can literally double the delinquent amount.
The 60 to 90 days following the filing of the NOD are a great time to offer solu-
tions to an owner facing a foreclosure. Most owners truly believe that their
financial problems are temporary, so make your offer sensitive to the fact
that preserving the owner’s credit record is a key consideration: If you can
buy the property quickly at a discount and then cure the default or pay off
the delinquent mortgage, the seller only has the slow payments on his credit
report rather than a foreclosure (or possibly a bankruptcy, which is often the
only alternative for owners who are unwilling to voluntarily resolve their cash
flow problems). Preserving credit has always been a key motivator to owners
who are delinquent on their mortgage payments. However, legislative efforts
in 2008 to forgive defaults have changed the dynamics significantly, and many
homeowners are simply walking away with little concern that their credit will
be an obstacle to entering the homeownership ranks at a future date.
Determine the loan balance and the value of the property to ensure that the
owner has equity. Generally, the more equity the better, because this equity
allows you to provide the owner with some quick cash so he can cover the
costs of vacating the property and finding a new place to live. It’s also this
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Chapter 3: Considering Foreclosures, REOs, Probate Sales, and More
equity in the property that provides you with a profit potential after all of
your costs of acquisition plus the required repairs and upgrades to maximize
the resale value of the property.
Some real estate gurus recommend that you simply offer a nominal amount of
cash to the owner facing a default and then begin making the payments on the
existing loans or, in other words, purchase the property subject to the current
loans. Be wary that the lender may not allow you to just step into the shoes of
the original borrower and may still declare the loan to be in default. Have your
legal advisor (see Chapter 6) look for an assumption clause in the loan docu-
ments that would allow you to properly assume the loan. Usually this process
requires a loan application and a fee. You may also want to watch out for a
due on sale clause that accelerates the entire loan and makes it due immedi-
ately upon the transfer of the property to a new owner. Foreclosure transac-
tions aren’t risk free; your legal advisor can tell you the potential downside of
your proposed transaction with a defaulting buyer.
Many of the problems that occur in buying foreclosures can be avoided by
structuring the purchase offer to require the owner to vacate the property
immediately. It’s difficult for an owner to lose her home, and it’s often even
more difficult for her to accept the fact that she’s no longer the owner when
she’s still living in the property.
Foreclosure sale
Although the foreclosure process varies from state to state, the main differ-
ence is whether the loan is secured with a mortgage that requires a judicial
foreclosure or by a deed of trust, in which case the nonjudicial process is
used (for an introduction to these two types of states, see the beginning of
this section).
✓ Judicial foreclosure: In a judicial foreclosure, the lender files a lawsuit
against the borrower to get the property. Like any other lawsuit, it begins
with the serving of a summons and complaint upon the borrower (along
with any other parties with junior liens or encumbrances against the
property). If the borrower responds, the court holds a hearing and rules
that either the borrower has presented a legitimate issue (and alternate
payment terms are arranged) or the lender is permitted to foreclose.
The most common scenario is that the borrower doesn’t respond and
the lender receives a judgment by default and can proceed to have a ref-
eree appointed by the court. The lender then advertises the sale for four
to six weeks and then, if full payment hasn’t been made, a public sale is
held, typically on the courthouse or town/city hall steps. The time frame
for this entire judicial foreclosure process is usually between 4 and 6
months, although the process can take as little as 3 months to as long as
12 months.
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Part I: Stacking Real Estate Up Against Other Investments
✓ Nonjudicial foreclosure: In a nonjudicial foreclosure state, lenders are
allowed to foreclose without a lawsuit, using the power of sale provi-
sions of the deed of trust. The deed of trust actually has three parties
to the original loan agreement — the borrower (grantor), the lender
(beneficiary), and the trustee who actually holds title during the term of
the loan. In the event the borrower defaults, the trustee files a Notice of
Default and a Notice of Sale in a legal newspaper.
As with the judicial foreclosure, if the loan in a nonjudicial foreclosure
isn’t fully reinstated prior to the date and time of the trustee’s sale, the
public auction or sheriff’s sale occurs on the steps of a prominent public
location in town such as a courthouse. If no one bids, the lender bids
the amount of its loan plus accrued penalties and fees and takes title to
the property. This is the most common scenario unless the property is
desirable and has equity, in which case many interested bidders may
compete in a free-for-all.
Bidding on and purchasing properties at the foreclosure sale can be exciting
and even profitable if you do your homework and know everything about a
property before you bid. But getting a little lazy or going with your gut feeling
can lead to a disaster, and it often takes quite a few home runs to offset even
one disaster. Something as simple as an unrecorded tax lien or latent physical
problems like a cracked slab or expansive soil can turn your lemonade back
into a lemon! Be sure to get a title report showing clear title and an owner’s
title insurance policy.
Redemption period
Some states allow the borrower the right to redeem her property after the
sale during a redemption period in which she can pay the full amount owed,
including the loan balance, late charges, legal fees incurred by the lender,
and all of the costs of sale, and get title to the property back. The length
of the redemption period varies from state to state. This period is also an
opportunity to reach an agreement with the borrower for her deed. If suc-
cessful, the purchaser then essentially obtains the borrower’s redemption
rights and has the right to redeem the property.
Even if you’re the successful purchaser at the foreclosure sale, you still have
to give the borrower the opportunity to redeem the property per the state-
required redemption period. Don’t make significant improvements only to
have the borrower redeem the property and then thank you for renovating his
distressed property from the worst on the block to the model home!
Because the majority of properties at a foreclosure sale end up with the
lender (because most properties aren’t desirable investment properties at
this time due to foreclosure risks and limited due diligence, as we discuss
in this section), you have a great opportunity to make a deal with the lender
just after the foreclosure sale and before they’ve incurred the expense of
hiring an agent to market and sell the property.
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Chapter 3: Considering Foreclosures, REOs, Probate Sales, and More
You may also be able to make a better deal if the property has significant
deferred maintenance or code violations, because the local building inspector or
code enforcement departments know when a deep-pocketed lender has title to
the property, and they expect all citations for substandard conditions or code
violations to be corrected immediately. You may be able to relieve the lender
of this liability while allowing yourself to negotiate a favorable transaction.
Lender REO (Real Estate Owned)
Because titles to the majority of foreclosed properties end up with the
lender, you may find that your next opportunity to purchase the property
is from the lender’s real estate owned (REO) department that specializes
in handling foreclosed properties. Some investors have found that this is
one of the best times to buy a property because they’re not dealing with an
emotional or unreliable owner. Discovering the ins and outs of the lenders’
policies and procedures of disposing of these foreclosed properties can be
invaluable to your goal of buying real estate at below market prices.
The days of stealing prime REO properties from the Resolution Trust
Corporation (RTC) are gone. The RTC was a quasi-federal government entity
established by congress to dispose of the tremendous number of foreclosed
assets of the major lenders during the real estate market downturn in the
early ’90s. Due to the numbers of properties and the relative inexperience of
and limited due diligence by the RTC in some areas of the country, a once-in-
a-lifetime real estate investment opportunity did fall into the lap of savvy real
estate investors who had large amounts of cash, could act quickly, and then
had the financial horsepower to ride out the market downturn.
Lender REOs remain one of the favorite strategies for the late-night infomer-
cial gurus, but the reality is that the lenders are neither foolish nor benevo-
lent. Although these nonperforming loans are a negative on their balance
sheet, they’re not going to sell a property below its market value just to get it
off their books.
The ethics of foreclosures
One of the most difficult moral dilemmas facing
real estate investors is the ethics of negotiat-
ing with an owner facing a foreclosure. Are you
helping her or are you a vulture seeking to profit
upon the misfortune of another? You must walk
a fine line in many of these situations.
Although there’s some value to a distressed
seller in a quick transaction that provides
needed cash, pushing too hard for a bargain
can be unethical. Robert uses the “pillow test”
to guide his conscience: Can you fall asleep at
night and not feel guilty about your moral and
ethical conduct?
52
Part I: Stacking Real Estate Up Against Other Investments
The disposition specialists in the REO department are professionals who
understand the real estate markets well and are usually wired into the
best real estate brokers in the market. These real estate brokers are often
compensated as a percentage of the sales price and thus also motivated to
achieve the highest value as is reasonably possible.
The only angle a real estate investor usually has with an REO is financing and
the continued operating losses that often occur because the lender is merely
holding the property and isn’t willing to invest the time and money necessary
to enhance the property physically and reposition it to perform better in the
market.
Sales are as-is, and lenders are often exempt from the standard disclosure
rules.
When lenders have an excessive number of REOs, they become more flexible,
but they’re often limited by the Office of Thrift Supervision (OTS), a govern-
ment agency that oversees many savings banks and savings and loan associa-
tions and routinely audits their loan portfolio and their REOs.
Getting a Jump On Foreclosure and
REO Competition with Short Sales
Savvy real estate investors know that the best properties are the ones that
aren’t exposed to the open market where the competition has a chance to drive
up the price. They also know that the best deals can be made with motivated
FHA/VA repos
Government agencies such as the Federal
Housing Administration (FHA) and the
Department of Veterans Affairs (VA) guarantee
loans made by lenders to qualified individuals.
When these home buyers fail to make their pay-
ments, the lender goes through the foreclosure
process and ultimately repossesses the house.
The government pays the lender the guaran-
teed loan amount and then takes possession of
the property.
These FHA and VA repos are then listed for sale
through real estate agents approved by the
Department of Housing and Urban Development
(HUD). Typically, real estate investors don’t find
these properties as attractive as some other
real estate investment opportunities, because
they’re usually offered at or just a shade under
market prices. Qualified first-time home buyers
should look for these FHA/VA repos, because
they’re often available with favorable financing,
including low, or no, down payments.
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Chapter 3: Considering Foreclosures, REOs, Probate Sales, and More
sellers — and there’s not much stronger motivation for a house seller than to
know that they’ll soon lose their property to foreclosure and find their credit
ruined.
These homeowners don’t have any equity, and the existing debt on the prop-
erty exceeds the current loan balance. If the owners were to sell the prop-
erty, they would owe the lender more money than they’d receive from the
sale. In the late-2000s real estate market downturn, this was true for increas-
ing numbers of properties. This is the concept and strategy behind short
sales. A short sale occurs when you buy a property from the owner and have
an agreement with the lender or lien holder that it will accept an amount that
is less than its loan balance as payment in full.
Recognizing seller benefits
With the advent of subprime and zero-down-payment loans in the mid-2000s,
combined with the decline in home values, many owners found that they had
negative equity in their homes in the late-2000s; they literally couldn’t afford
to sell the properties because the sale proceeds wouldn’t cover the loan bal-
ance (a situation known as being upside down).
Many of these owners had other financial challenges and little savings to fall
back on, so they were unlikely to be able or willing to continue making their
debt service payments on the upside down property. An owner in this situa-
tion is a prime candidate for a short sale.
The current owner or seller receives no proceeds from a short sale but will
find it a quick exit strategy from a troubling situation, with the goal of mini-
mizing damage to his credit (because he will likely want to be a homeowner
again someday). Another benefit to the current owner is that the real estate
investor is likely looking for a great tenant, and who would be a better tenant
than the current occupant of the property? The current owner may no longer
own the property, but he can at least continue to live there and not disrupt
his life completely. Being able to remain in the property also avoids some of
the stigma of losing the house. Plus, immediately having a tenant can help
you get a loan for the property.
Comparing short sales to other properties
Many real estate investors find that buying foreclosures or REO properties
can be challenging. With foreclosures, the public sale is published and read-
ily known to all interested real estate investors, but there is limited informa-
tion and rarely an adequate opportunity to conduct proper due diligence.
Foreclosure properties can be full of surprises!
54
Part I: Stacking Real Estate Up Against Other Investments
You often find that the best properties at the foreclosure auction attract the
attention of other (often sophisticated) buyers who are prepared to pay more
for the property than you are if they know they can make a good deal down
the road. You also need to have 10 percent of the purchase price in cash and
immediately have to find a loan for the balance within 30 days, whereas with
the short sale you can usually negotiate for a sale closing date that gives you
more time to find financing. A short sale also helps you avoid the complica-
tions of a borrower redemption possible with a judicial foreclosure.
Tracking down the property information for REO properties can be challeng-
ing, and the lenders or their agents may not be cooperative with requests
for inspections or details about the condition of the property. Though the
reputation for REOs is that lenders are anxious to sell these properties at any
price, the reality is that they often go for pretty close to the full market value
when discounted for the condition and quick sale terms that they require.
Find properties that are in preforeclosure — that is, properties where the
owner is delinquent on her debt service payments — and make a deal to buy
the property from the owner before she loses it anyway and ruins her credit.
These situations became more common with the excessive use of highly lever-
aged financing where borrowers had loans that were equal to (or even greater
than) the full value of the property when it was acquired. Some borrowers took
out second loans, and the combined debt exceeded the value of the property.
Finding short-sale opportunities
The concept sounds much easier than it is to actually execute. The main
problem is trying to identify the properties where the owner of the property
is behind on payments but the lender hasn’t filed a Notice of Default.
With foreclosures, you can generally find lists available from real estate
agents and even the lenders themselves, or you can drive through the neigh-
borhoods that appeal to you and find signs that say “bank owned”. But with
preforeclosure properties that are still owner-occupied and candidates for
a short sale, there may not be an indication that anything is wrong. This is
particularly true with many lenders now being asked to be extra patient with
borrowers who are a little behind on their mortgage payments.
If you’re looking for these opportunities, there are many ways to find them.
Some companies specialize in assisting homeowners who know they’ll have
difficulty in making their mortgage payments; they work with the owners and
the lenders to try and make loan modifications or alternative payment plans.
These attempts may be successful, but many times they aren’t, and they pro-
vide one source for identifying owners who are short-sale candidates.
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Chapter 3: Considering Foreclosures, REOs, Probate Sales, and More
Another way to identify potential short sale properties is when the mortgage
holder sends a Notice of Default. But this document is public information, so
many other real estate investors may be in contact with the owner seeking to
arrange a short sale.
Just like in a regular foreclosure, you can find this information, and in the
early days of the preforeclosure period many buyers may be willing to con-
sider a short sale. Of course, you need to convince the lender and not just
the current owner.
Note that lien holders may have purchased the underlying loan at a discount,
and they may be more willing to negotiate with you to accept less money,
which will enhance the prospects of a sale of the property. Your research will
often reveal whether the loan that is in default has recently been sold; this is
important information that can assist you with your negotiating strategy.
The concept of short sales often comes up if you have foreclosures in your
area, but be careful: You need to check out the property just as thoroughly.
You actually should have a better opportunity and better access to the prop-
erty. It’s not as bad as with foreclosure properties, but it has been our experi-
ence that short sale properties can also be properties that the owner is willing
to walk away from for a reason. So be very careful because what may seem
like the deal of the century may actually be a money pit.
Convincing a lender to agree
to a short sale
In addition to the difficulty inherent in finding an opportunity for a short sale,
you may also have a difficult time convincing the lender to agree to a short
sale. The recent trend by the federal government has been to require lenders
to work with borrowers at an unprecedented level of patience and coopera-
tion. Some lenders become overwhelmed with the large numbers of nega-
tive equity loans and the thousands of requests they receive to restructure
financing. On one hand, lenders are motivated to consider short sales, but
they’re also under pressure to formulate a workout strategy with the current
borrower. This trend may actually reduce the motivation for lenders to coop-
erate with short sales.
The viability of short sales is really a function of the lenders and their busi-
ness strategies to minimize their losses. The lenders know that the payments
aren’t being made and it’s inevitable that they’ll complete the foreclosure,
have to hold the property for some period, and incur costs before they ulti-
mately sell it.
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Part I: Stacking Real Estate Up Against Other Investments
If they have a large number of nonperforming loans on their books, they may
be motivated to quickly make a few short-sale deals. However, our experi-
ence has been that some lenders with few delinquent loans are actually more
willing to agree to a buyer proposing a short sale because they want to cut
their losses quickly and not risk government intervention or negative public-
ity. Lenders that participate in short sales are always secretive about it too.
One recent legislative change that has really helped owners of properties
who want to work out a short sale is the Mortgage Forgiveness Act of 2007.
Previously, mortgage debt that was forgiven or canceled by a lender had to
be included on the borrower’s tax return as taxable income. Under this new
law, any loan that was used to buy, build, or substantially improve the bor-
rower’s principal residence (not second homes or investment properties)
qualifies for the exemption from taxation as ordinary income. A refinance
loan for the same purposes also qualifies. The lender is required to report
the debt cancellation to the IRS on Form 1099-C, and the borrower must file
Form 982. This law is scheduled to expire as of January 1, 2010, but may be
extended. Be sure to seek the advice of your tax professional before agreeing
to any short sale.
You need to send the lender a short sale package with the following
information:
✓ A hardship letter or proof from the borrower that he is unable to con-
tinue to make mortgage payments.
✓ Copies of the borrower’s income tax returns.
✓ Information on the current condition of the property with contractor
estimates or proposals to make any needed repairs property.
✓ The estimated value of the property and your offer for the property.
Short sales in Hollywood
The short-sale concept has received a lot of
notoriety, and late-night gurus promote semi-
nars touting that they can teach you every-
thing you need to know about short sales. Even
Donald Trump has gotten into the game. Trump
made the headlines when he proposed a short
sale to help retired TV host Ed McMahon and
his wife from losing their home in Beverly Hills.
The McMahons were apparently $643,597
behind in payments on their $4.8 million loan.
The Donald offered to buy the house, with
Countrywide Home Loans taking a discounted
payoff, and allow the McMahons to continue to
live in the property as renters. Ultimately, the
parties reached another solution, but this was
a well-known example of how the short sale
process works.
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Chapter 3: Considering Foreclosures, REOs, Probate Sales, and More
The lender will want to verify current market conditions where the loan
balance is greater than the current value of the property. They’ll obtain a
Broker’s Price Opinion (BPO) or quick appraisal of the property. This figure
acts as the basis for their negotiations with you, with the goal of achieving as
close as possible to the BPO.
The one common denominator to short sales with all lenders is that short
sales require a lot of phone calls and investigative legwork to even find out
whether the lender is open to receiving an offer for less than the current
loan balance. Each lender has a different organizational structure for various
individuals or departments that handle non-performing loans. Some lenders
have automated phone systems that can be helpful and allow you to get right
through to people you need; others are best described as “voice mail jail.”
Live operators are probably already familiar with what you’re looking for,
and you just need to describe that the purpose of your call is to find some-
one in charge of loss mitigation or foreclosures. If all else fails, you should
contact the customer service department and ask to speak to someone who
is authorized to make sales on preforeclosure properties. Have the property
address and the borrower name and loan number (if available).
These transactions aren’t likely, and are a sure bet to take at least 30 to 90 days
(or even more) because most lenders are now much more inclined to work
with the current borrower if at all possible. Our advice is that short sales can
be effective in limited circumstances and only if you have the ability to reach a
decision-maker at a lender that is inclined to participate. The real estate inves-
tor looking for just one property may find that the effort exceeds the return
and that there are better ways to locate and purchase rental properties.
Don’t forget that with short sales, you need to have some cash as well as be
preapproved for loans so that you can make deals quickly. Lenders that are
willing to agree to short sales are going to require all cash and won’t be will-
ing to offer any sort of financing. Lenders that are likely to be sources of funds
for your loan on a short sale are going to be selective about making loans on
non-owner-occupied rental properties. Your credit worthiness and having
an established banking relationship is helpful if you’re going to be successful
with buying short sales.
Looking Into Lease Options
A lease option is an excellent way to control and eventually purchase a prop-
erty without the significant cash investment in a down payment. A lease
option is essentially two different types of contracts combined into a single
agreement. You have a lease (rental agreement), which has all of the usual
terms, but the tenant also has the unilateral right to buy the property under
certain terms and conditions in the future.
58
Part I: Stacking Real Estate Up Against Other Investments
A lease option obligates the owner to sell the property but doesn’t obligate
the tenant to buy. This is a unilateral contract until the tenant exercises the
option and a bilateral contract is created. One of the key issues with lease
options is the option price (purchase price) that the buyer must pay. This
figure can be a fixed price based on current market value, but often it’s a
future projected value based on anticipated appreciation with set time limits
for exercising the option. For example, a home valued at $200,000 today
may be offered as a lease option with an option price of $210,000 that can be
exercised anytime in the next 12 months in a market where the seller expects
appreciation of 5 percent per year. Of course, a savvy buyer doesn’t exercise
the option if the option price exceeds the market value of the property.
Lease options are much easier to find, and much more favorable deals can be
made, when there are limited buyers, and sellers are anxious to sell. Lease
options are most commonly used with single-family homes and condos, but
the concept can be used with any type of property. Overall, in virtually all
areas of the country, the demand for lease options is greater than the supply.
Remember that lease options aren’t just a great way for real estate inves-
tors to buy property; they’re also an opportunity for many first-time home
buyers to ease into home owning. They’re often in high demand relative to
their supply, so lease options are rarely advertised; you may even need to
run your own ad seeking lease options. Another way to track down a possible
lease option is to respond to ads for “house for rent.” When you own a prop-
erty that you want to use a lease option to sell, a small ad often brings a large
response. Check out Chapter 16 for more information on using a lease option
as an exit strategy.
Probing Probate Sales and Auctions
A discussion of the more unusual real estate investments must include pro-
bate or sales of properties in estates. Also, auctions are becoming a more
popular way to dispose of real estate, particularly because of the continued
expansion of the Internet.
Probate sales
Even more reliable than taxes, death creates opportunities for the purchase
of good real estate at attractive prices. Every day someone in your area dies
and leaves behind real estate that his heirs may not have any desire to retain.
These properties are sold in probate sales by executors of the estate with the
assistance of probate attorneys (or by the public administrator if the owner
dies without a trust or will).
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Chapter 3: Considering Foreclosures, REOs, Probate Sales, and More
Know the laws and rules regarding probate sales in your area, because wait-
ing periods and even court confirmation may be required before the sale is
finalized. Also, these sales are often subject to overbids. A potential buyer
can use the overbid process to appeal directly to the court (before the court
issues the order approving the probate sale) to outbid you and purchase the
property for more than the current offer under consideration. Generally, the
right to overbid requires an offer that exceeds the existing offer by at least 5
percent. Be aware that this possibility exists, and be prepared to raise your
bid. Just be careful not to get caught up in a bidding war and overpay for a
property. Set a maximum price for yourself before you begin bidding.
Robert has a friend who bought a one-of-a-kind beachfront property in San
Diego at significantly below market value from the estate of an elderly gentle-
man who died and left the property to his son. Apparently, the son had no
interest in living near the ocean because of the noise and traffic that accompa-
nies beachfront properties. So, the son contacted a real estate broker. He was
anxious to sell the property, including the house and two rental units, for not
much more than the value of the land alone. The real estate broker and Robert’s
friend were surfing buddies and because the broker owed Robert’s friend a
favor, the broker was glad to give him the first shot at this once-in-a-lifetime
opportunity!
Real estate auctions
Real estate auctions, in which companies claim to be selling prime real
estate at below-market prices, have become one of the most popular ways
for builders and investors to market their excessive inventory of properties
in some areas. Don’t confuse these auctions with the foreclosure sales that
are referred to as auctions in some regions. We’re talking about public auc-
tions where antiques or collectibles may also be sold on the same afternoon.
In strong real estate markets, even new home builders have turned to pri-
vate auctions to sell their new homes in an attempt to generate interest and
excitement in areas where demand is low.
Private individuals, government entities, and companies that specialize in
auctions all use this method of selling real estate to the public. You can
often find real estate auctioneers listed in your local yellow pages. Like any
auction, the goal is to generate interest and competition among potential
purchasers in order to drive up the sales price. Often a minimum or reserve
price is set to protect the seller from giving the property away too cheaply.
These real estate auctions are promoted heavily in newspapers, on radio and
television, and on the Internet with sample prices that sound enticing. They
claim to have all types of properties and usually promote a few irresistible-
sounding properties — like 10 acres of pristine land for only $5,000. Of
course, who knows how far out into the boonies the property is located?
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Part I: Stacking Real Estate Up Against Other Investments
Our experience is that auctions are rarely great opportunities for investors,
because too many people compete for the unusual, quality property. Plus, the
reserve or minimum prices are set so close to the actual market value of the
property that the buyer essentially pays retail under the illusion that she’s
buying at wholesale. But some good opportunities do arise now and then, so
check out these auctions to see if you can find anything worth pursuing.
If you do find a property of interest in an auction, follow the same thorough
due diligence process that applies to foreclosures and REOs (see “Finding
Foreclosures and REOs” earlier in this chapter).
Unfortunately, proper due diligence isn’t always possible due to the short
time frame available before the sale or because the auctioneer doesn’t pro-
vide enough information. For example, the best way to minimize the possibil-
ity that the property contains some costly environmental hazards is to have
a professional firm prepare a Phase I environmental report (see Chapter 12).
But you’re unlikely to be able to afford one for every property that interests
you at an auction. This is just one example of the dangers in buying proper-
ties without a thorough and exhaustive due diligence investigation, so don’t
be rushed. Real estate is one investment that you can’t easily get out of if you
make a mistake. Remember — you don’t want any surprises!
If you’re the lucky buyer, you must immediately produce a certified funds
check for at least 10 percent of the purchase price. Your final closing date
usually falls within the next 30 days.
The Internet is the preferred method of promoting real estate auctions. As
with many Internet opportunities, great care should be taken to ensure that
you’re dealing with a reputable firm. Never even consider buying any real
estate sight unseen no matter how good the deal seems!
Chapter 4
Taking the Passive Approach
In This Chapter
▶ Researching real estate investment trusts (REITs)
▶ Considering tenants in common realty investments
▶ Exploring triple net properties
▶ Understanding tax lien certificate sales
▶ Looking at limited partnerships
M
any investors want the diversification and solid returns offered by
real estate but aren’t qualified for or interested in actively managing
their real estate holdings. These real estate investors often look for invest-
ment opportunities that require no management or even minimal interaction
with a property manager. Real estate investment trusts (REITs) are probably
the easiest to understand and access, but other avenues allow you to pas-
sively invest in real estate, including tenants in common, triple net proper-
ties, notes and trust deeds, tax lien certificate sales, and limited partnerships.
Current federal tax laws favor real estate investments in which the real estate
investors qualify as active investors, and this book focuses on real estate
investment strategies that qualify as active activities in order to garner the
full tax benefits. If you’re seeking a passive investment, though, this chapter
is for you.
Using Real Estate Investment Trusts
Real estate investment trusts (REITs) are for-profit companies that own and
generally operate different types of property, such as shopping centers,
apartments, offices, warehouses, hotels, and other rental buildings (see
Figure 4-1). These property-holding REITs are known as equity REITs. Some
REITs, known as mortgage REITs, focus on the financing end of the business;
they lend to real estate property owners and operators or provide credit indi-
rectly through buying loans (mortgage backed securities).
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Part I: Stacking Real Estate Up Against Other Investments
Figure 4-1:
Property
types
invested in
by REITs.
Industrial
3%
Mixed
3%
Shopping Centers
10%
Regional Mall
s
8%
Free Standing
3%
Apartments
14%
Manufactured Homes
1%
Diversified
7%
Lodging/Resorts
4%
Self Storage
8%
Health Care
11%
Specialt
y
8%
Hybrid REITs
1%
Mortgage REITs
8%
Office
11%
Source: National Association of Real Estate Investment Trusts.
Equity REIT managers typically identify and negotiate the purchase of prop-
erties that they believe are good investments and manage these properties
directly or through an affiliated advisory and management company, includ-
ing all tenant relations. Thus, REITs can be a good way to invest in real estate
for people who don’t want the hassles and headaches that come with directly
owning and managing rental property.
Distinguishing between public
and private REITs
We recommend that investors not be shy about asking for full disclosure of
the relationship between the REIT, its advisors, and the management com-
panies. REITs often involve conflicts of interest that aren’t clearly disclosed
or pay significant above-market fees that ultimately lower the cash flow and
return on investment available for distribution.
Public REITs are traded on the major stock exchanges and thus must meet
strict SEC reporting requirements:
✓ Liquidity: Public REITs trade every business day on a stock exchange and
thus offer investors the ability to buy and sell as they please. Of course, as
with other similarly liquid investments (like stock in companies in a vari-
ety of industries), liquidity can have its downside. More-liquid real estate
investments like REITs may inspire frequent trades caused by making
emotional decisions or trying to time market movements.
✓ Independent board of directors: A public company must have direc-
tors, the majority of whom are independent of its management.
Shareholders vote upon and elect these directors.
✓ Financial reporting: Public REITs, like other public companies, must file
comprehensive financial reports quarterly.
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Chapter 4: Taking the Passive Approach
We recommend that you stay away from private REITs unless you’re a sophis-
ticated, experienced real estate investor willing to do plenty of extra research
and digging. Because they’re not publicly traded, private REITs don’t have the
same disclosure requirements as public REITs. This difference means an
investor in a private REIT had better carefully scrutinize the prospectus and
realize that the private REIT has the ability to make changes that may not be
in the investor’s best interests but that reward the private REIT sponsors or
their affiliates.
Taking a look at performance
So what about performance? Over the long term, REITs have produced total
returns comparable to stocks in general. In fact, over the past 35 years, REIT
returns have actually been higher. In the context of an overall investment
portfolio, REITs add diversification because their values don’t always move
in tandem with other investments.
For investments that move perfectly in lock step, their beta or correlation
to the overall stock market is 1. For investments always moving in opposite
directions, the correlation is 0. Over the long term, the correlation between
stocks and REITs has been about 0.6 (which is about the level of correlation
between foreign stocks and U.S. stocks).
One final attribute of REITs we want to highlight is the fairly substantial divi-
dends that REITs usually pay. Because these dividends are generally fully tax-
able (and thus not subject to the lower stock dividend tax rate), you should
generally avoid holding REITs outside of retirement accounts if you’re in a
high tax bracket (for instance, during your working years).
In case you care, and you may well not, the reason for the high dividends is
the legal requirement in REIT charters that they have to distribute 95 percent
of their income. In other words, REITs can legally only retain a maximum of 5
percent of their net income; they must distribute everything else to the
shareholders.
Investing in REIT funds
You can research and purchase shares in individual REITs, which trade as
securities on the major stock exchanges. An even better approach is to buy a
mutual fund or exchange-traded fund that invests in a diversified mixture of
REITs. Some of the best REIT mutual funds charge 1 percent per year or less
in management fees. Vanguard’s REIT index fund charges just 0.20 percent per
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Part I: Stacking Real Estate Up Against Other Investments
year in fees and has produced average annual returns of 12.3 percent since
its inception in 1996. (An exchanged-traded version of this index fund offers
an even lower-cost approach to investing with a wafer thin 0.1 percent annual
operating fee.)
In addition to providing you with a diversified, low-hassle real estate invest-
ment, REITs offer an additional advantage that traditional rental real estate
doesn’t. You can easily invest in REITs through a retirement account such
as an IRA or Keogh. As with traditional real estate investments, you can even
buy REITs and mutual fund REITs with borrowed money (in nonretirement
accounts). You can buy with 50 percent down, known as buying on margin,
when you purchase such investments through a brokerage account.
Table 4-1 contains a short list of the best REIT mutual funds currently available.
Table 4-1 The Best REIT Mutual Funds
Fund Toll-Free Number Web Site
American Century
Real Estate
Investments
800-345-3533
www.americancentury.com
CGM Realty 800-345-4048
www.cgmfunds.com
Cohen & Steers
Realty Shares
800-437-9912
www.cohenandsteers.com
Fidelity Real Estate
Investment
800-544-8888
www.fidelity.com
SSgA Tuckerman
Active REIT
800-647-7327
www.ssga.com
Third Avenue Real
Estate Fund
800-443-1021
www.thirdavenuefunds.
com
TIAA-CREF Real
Estate
800-223-1200
www.tiaa-cref.org
T. Rowe Price Real
Estate
800-638-5660
www.troweprice.com
Vanguard REIT Index 800-662-7447
www.vanguard.com
If you really have your heart set on becoming the next Warren Buffett and
you enjoy the challenge of selecting your own stocks, you can research and
choose your own REITs to invest in. Both of the investment research publica-
tions Morningstar and Value Line, which can be found at many local libraries
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Chapter 4: Taking the Passive Approach
as well as online (www.morningstar.com and www.valueline.com), pro-
duce individual stock page summaries on various REITs. Forbes magazine also
writes articles about the better REITs (visit their Web site at www.forbes.
com for more information).
In addition to having a professional manager deciding what REITs to buy and
when, the mutual fund REITs listed in Table 4-1 also provide consolidated
financial reporting. If you purchase individual REITs, you have to deal with
tax statements for each and every REIT you’re invested in.
Tenants in Common
Tenants in common (TIC) real estate investments have been heavily promoted
as the common man’s opportunity to own a piece of institutional-grade, (com-
monly known as trophy) properties that the average investor could never
acquire on her own. Due to a March 2002 IRS real estate tax ruling, tenants in
common real estate ownership has been gaining momentum.
Tenants in common ownership is arranged by sponsors that form a TIC
investment group for each property; each individual investor actually
receives a title deed for an undivided fractional share in a large institutional-
grade property. The TIC sponsors either already have purchased or at least
control these properties. TIC sponsored properties available for investment
include regional shopping malls, large luxury apartment buildings, or even
class A (with the best-quality locations, construction, and finishes) high-rise
office buildings in major metropolitan areas.
These TIC investments do have some limitations: For instance, there are
often limits on the number of investors (usually 35, and married couples
count as a single investor) and their financial strength; each investor is
proportionately responsible for the debt on the property, if any; and each
owner must actually hold a specific fractional deeded interest in the prop-
erty. All owners must share and pay all profits and losses proportionately,
and the TIC sponsor can’t advance funds to cover any expenses. The IRS also
requires each owner to have a vote equal to his percentage of ownership.
Don’t feel too confident about your voting rights, because you probably own
only a small percentage (sometimes as little as 1 or 2 percent of the total prop-
erty); you may find that the majority make decisions about management and
leasing. Plus, the IRS requires unanimous approval of all co-owners to borrow
against the property or sell — which may or may not coincide with your goals
and needs.
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Part I: Stacking Real Estate Up Against Other Investments
Our advice is that although TICs provide some advantages for real estate inves-
tors seeking passive tax-sheltered income, new real estate investors and those
with modest assets who may need to liquidate or sell their interest should
avoid this investment for now because the current TIC offerings are typically
overpriced retail investments with extremely high sales commissions and
costs. We believe that this relatively new product will evolve and, with more
offerings from additional market players, the properties will become more
competitively priced and the commissions and costs will fall significantly.
Paying for 1031 availability and
“hassle free” management
These investment vehicles can be right for certain investors with significant
net worth and no desire to directly own real estate — as long as they fully
understand the benefits and drawbacks. The minimum investment for most
TICs is measured in the hundreds of thousands of dollars, although some TIC
sponsors offer fractionalized ownership for as little as $50,000.
Traditionally, owners with significant equity can use a tax-deferred exchange
(also known as a 1031 exchange) to either sell or exchange into a larger prop-
erty, or simply continue to hold and refinance the highly appreciated prop-
erty to generate cash for additional real estate investments, which also offer
additional tax benefits. But TIC candidates are usually real estate owners cur-
rently in or contemplating a tax-deferred exchange that are facing the strict
time limits and haven’t been able to find a suitable property on their own.
(See Chapter 18 for a discussion of the tax-deferred exchange.)
If you’re considering a TIC as an alternative for your tax-deferred exchange,
verify in advance with your tax advisor that your transaction qualifies. A tax-
deferred exchange is limited to like-kind property with specific rules about
how you hold title of both the relinquished and replacement properties. If the
property being sold is directly owned, the transaction most likely meets the
requirements and isn’t taxable at the time of sale as long as the TIC property
is a direct ownership of real estate and not a security. But many investors may
find that the property they’re selling is a partnership interest in real estate
and doesn’t qualify for the tax-deferred treatment because the two invest-
ments aren’t like-kind. Obtaining competent legal and tax advice in advance is
essential, or you may have a very unpleasant surprise when the IRS declares
that your transaction is fully taxable.
However, the TIC sponsors have targeted these owners of highly appreciated
properties who are considering a tax-deferred exchange but are at a stage in
their lives in which they’re not interested in expanding their real estate empire.
Or they may have used all of the tax benefits of depreciation (see Chapter 18)
and really should sell their property and simply pay the capital gains.
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Chapter 4: Taking the Passive Approach
A downside of these TIC investments is that they’re often extremely expen-
sive. Because the majority of the potential purchasers for these real estate
investments are coming out of a tax-deferred exchange, they’re subject to
tight time limits. The IRS requires 1031 exchanges to identify the replacement
property within 45 days of the close of escrow of the property being sold.
And the replacement property transaction must be completed within 180
days. Please see Chapter 18 for more details.
Thus, the syndicators of the tenants in common product are always stand-
ing by with a pending real estate acquisition for those buyers whose time
limits are running short and who need to identify and close on a property
within the time limits imposed by the IRS. If the owner is unable to meet the
deadlines, they lose all of the tax deferral benefits, so they’re often willing to
overpay. The TIC sponsors know that many real estate investors panic and
commit to real estate investments that aren’t prudent or suited to them just
to avoid paying the capital gains tax.
In exchange for this flexibility and readily available product, the syndicators
have prepurchased these properties and roll them over to the tenants in
common investors at a higher price. Further, the syndicators usually asso-
ciate with financial advisors who receive hefty sales commissions of 3 to 5
percent and even as high as 10 percent of the investors’ initial investment,
plus a spread to the TIC sponsor to cover their internal marketing and admin-
istration costs. Then many TIC sponsors have separate “advisory firms” that
are closely held by the principals of the sponsor, and they commonly charge
upfront, plus ongoing, consulting fees. Thus, the purchaser of a tenants in
common real estate investment is paying top dollar for the property and is
only receiving the benefit of as little as 90 percent of her gross investment
because of commissions and fees paid upfront.
The TIC sales pitch also places a heavy emphasis on the desirability of elimi-
nating the trials and tribulations often associated with an owner trying to
manage his own property. TIC sponsored properties are professionally man-
aged by the sponsor or a property manager of their choice.
Asking the right questions:
Are TICs for you?
Be aware that TIC sponsors often provide attractive teaser rates of return
that are guaranteed only for the first couple of years. For example, a review
of the private placement offering may indicate that investors will receive a 7
percent cash distribution per year for the first two years only. This rate may
potentially entice investors who have built up significant equity in their real
estate holdings but haven’t seen their cash flow increase as fast.
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Part I: Stacking Real Estate Up Against Other Investments
Also, like many other financial products, a lot of effort goes into the promotion
and sales of TICs, often through independent investment advisors, which
translates to a lot of overhead to cover. You typically get slick marketing mate-
rials and are referred to fancy Web sites or supposedly free seminars reminis-
cent of the late-night infomercial gurus. These promotional efforts are high on
fluff and scarce on details.
You need to determine whether TICs are right for you by asking your invest-
ment advisor and the TIC sponsor for written answers to some basic ques-
tions before sending them your money:
✓ Who’s receiving commissions and how much? The TIC sponsor
receives a commission or spread right off the top, plus the investment
advisors (broker) who refer their clients get a piece of the action, too.
✓ Was the offered property recently acquired and at what price? Many
TIC investors purchase the properties and then resell them within days
or months at full retail or top of the market pricing, so it may be informa-
tive to know how much the TIC sponsor has made on the investment in
addition to the commissions.
✓ How much of my net investment is actually invested in the property?
At the end of the day, after everyone has been paid, how much of my
investment actually is invested into the property?
✓ What’s the amount and timing of the cash distributions? If based on a
certain percentage rather than actual operating results, are the distribu-
tions guaranteed, and if so, for how long and by whom? Many TIC spon-
sors use an above-average cash distribution as a hook to entice new
investors, but property performance may not generate enough cash to
cover the distributions, and investors may actually be required to cover
operating losses. Where’s that fact in the fancy brochure?
✓ What are the charges for property and asset management? Most TIC
sponsors have affiliated property management firms that handle the
day-to-day management — but at fees toward the high end of reason-
able. Also, there may be another layer for an asset manager or advisory
firm that supervises the property management company, and they’re
also often controlled by or associated with the TIC sponsor. You have
no guarantee that the asset or property management is qualified or com-
petent, so be sure to ask questions about their experience and creden-
tials; excellent management is extremely important. Remember that this
is a passive investment, so you have little say in making any changes if
they don’t meet your expectations.
✓ How liquid is my investment, and does the sponsor offer a buyback
or loan program? Currently, there’s no viable secondary market for
TIC investments, so you’re at the mercy of the TIC sponsor or possibly
another investor who’d be willing to buy you out. Anyone buying a frac-
tional ownership is going to expect and receive a significant discount
from the actual asset value. Have you ever tried to sell a timeshare inter-
est at the price you paid originally from the developer?
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Chapter 4: Taking the Passive Approach
Of course, many investors are attracted to the fact that someone else (all
TIC sponsors claim to be experts) is tracking down the properties and doing
all of the due diligence, and you definitely pay a price for these benefits. So
follow the money and make sure you’re comfortable with this investment,
because it isn’t easy to sell should your needs change.
The evolving TIC industry is in its infancy and is trying to set standards that
should address some of the concerns about these investments and raise the
level of the sponsors. You can find more information on TICs at the Tenant-
In-Common Association Web site at www.ticassoc.org.
Triple Net Properties
Triple net property is a common term for a type of net lease where the tenant
pays some or all of the property operating and repair and maintenance
expenses in addition to the rent. Many investors are attracted to the minimal
property management and maintenance requirements of triple net properties
because the tenant is responsible for the majority of all operating costs and
maintenance.
Triple net properties are often promoted as another real estate option for
investors looking to avoid the headaches of day-to-day management. These
investments may seem like real estate investments, but they’re primarily an
investment in the net cash flow (after debt service) from a lease to a credit
tenant, and they’re promoted based on the cash-on-cash rate of return or
cap rate (see Chapter 12 for information on these measures of investment
return).
For years, these properties have been the favorites of real estate inves-
tors who like the steady income stream and safety usually associated with
bonds. But net leases come in all varieties, and though all net leases are often
referred to generically as triple net leases, the reality is that there is no stan-
dardization of terms or definitions. So the challenge is always to determine
exactly which responsibilities belong to the landlord and which are the ten-
ant’s, and it’s those vagaries that often make it difficult to precisely evaluate
these investments.
Thinking ahead about landlord/tenant
division of duties
There are several different types of triple net properties. All net leases have
some aspect of the tenant paying for operating expenses, taxes, insurance,
maintenance, repairs, and even capital improvements. These investments
(sometimes referred to as bond leases) include net leases where the total
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Part I: Stacking Real Estate Up Against Other Investments
responsibility rests with the tenant. In a bond lease, the tenant is fully
responsible for the repairs, maintenance, and operating expenses (including
taxes and insurance) of the entire property without any limitations.
The net net net leases (or NNN leases) are similar to the bond lease, with the
tenant being responsible for all operating and fixed costs of the property, but
often come with limitations on capital improvements or upgrades that the
landlord can pass on to the tenant.
Another type of net lease is the net net lease (or NN lease), which is an
investment where the tenant pays most operating expenses but the landlord
retains responsibility for the structural components such as the foundation,
bearing walls, and roof. Sometimes a net net lease also includes a property
where the owner is also responsible for major building systems such as
HVAC equipment, electrical, plumbing, and driveways and parking areas.
If you’re considering an investment in any type of net lease, you must carefully
review the lease to determine exactly who is responsible for all components of
the building. You should also be very specific on your requirements or expec-
tations about the quality of the maintenance of the property as well as the
details of the insurance coverage, including making sure you’re named on all
polices as an additional insured. If you’re a novice, be sure to use the services
of a real estate attorney or lease expert to prepare a lease abstract, which is a
summary of the pertinent information from the lease.
A triple net lease typically involves a fast-food franchise, restaurant chain,
local chain drugstore, or similar retail outlet. The owner buys the building,
which is built precisely to the tenant’s specifications, and the tenant then
enters a long-term fixed-rent lease in which she pays for almost everything,
including the property taxes, insurance, utilities, and most of the mainte-
nance. Many companies rely heavily on the sale/leaseback of their newly
built locations. The advantage to the tenant is that they free up capital to
expand and grow their primary business, which isn’t actually real estate.
Originally, these investments were offered by developers who worked exclu-
sively with such companies, but now many brokers specialize in the market-
ing and sale of triple net properties.
The owner should regularly inspect the property under any type of net lease
that isn’t a bond lease because she retains ultimate control — and thus the
liability — if the tenant fails to properly maintain the building. Robert has
seen a litany of litigation between the owner and tenant over issues of exactly
what type of net lease exists, with the key dispute being an interpretation of
who is responsible for the repair and maintenance of building components.
These lawsuits often result from third-party injuries, with the landlord and
the tenant each accusing the other of failing to properly inspect, maintain,
and/or repair the property.
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Chapter 4: Taking the Passive Approach
Minimizing the risks of triple
net investments
Lately, the returns available on these triple net properties have been low due
to the perception that they’re essentially a risk-free investment. However,
should the tenant find that the location isn’t profitable, you may find yourself
owning a customized taco stand that requires a lot of modifications to be a
viable location for another business.
Triple net real estate investments are suitable for some, but stay away from
them unless you’re really comfortable with the tenant and the location and are
willing to accept relatively low rates of return. Also, look closely at the rent
structure because most leases have many years of flat, fixed rental income
with an occasional upward adjustment that’s likely to be lower than the future
market rent. Triple nets may make some sense if you can consistently earn a
return that’s higher than a comparable bond investment. But you always run
a risk with any single-tenant investment property, and fast-food and drugstore
chains can (and do) go out of business. We advise investors interested in this
type of investment to consider the diversification and lower risk associated with
purchasing REITs (discussed earlier in this chapter) that hold triple net proper-
ties (among others) rather than a direct purchase of a triple net property.
Robert is aware of many triple net properties that probably seemed like great
deals at the time buyers purchased them with a national credit tenant (an
expanding company that has a very solid financial balance sheet) on a long-
term lease. What could go wrong? A lot. With leases as long as 50 years and
set rents that are modestly adjusted over time, you run a serious inflation risk
unless the rents can adjust to fair market rent at least every 5 to 10 years. The
more specialized the use of the building by the tenant, the more challenging
your life can be if the tenant vacates, so consider whether the tenant improve-
ments are suitable or can be modified at a reasonable cost to suit the needs of
a replacement tenant.
Notes and Trust Deeds
Although the vast majority of real estate loans for purchasing or renovating
properties comes from conventional lenders, some private sources of money
make loans backed by notes or trust deeds. Real estate investors have found
that they can benefit from the strong demand for real estate in their area by
acting as a lender. They purchase notes and trust deeds that are backed by
pledged real estate. Pledged real estate is the collateral or security interest
provided to the investors to protect them from nonpayment by giving them
the ability to foreclose on the real estate. Besides the interest earned on the
investment, the note or trust deed holder has the collateral of the underlying
real property if the borrower defaults on the loan.
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Part I: Stacking Real Estate Up Against Other Investments
Real estate investors who buy and sell trust deeds are also often interested
in making private hard money loans (loans on top of the first mortgage made
by a traditional lender) to property owners or other real estate investors.
These hard money loans are secured by the owner’s equity in the property
and offer potentially favorable returns for the lender willing to make loans
to borrowers that often have poor credit. Although your risk increases when
the borrower has credit issues, the terms can be quite attractive — typically
above-market interest rates ranging from 10 to 15 percent, plus loan fees of 3
to 5 points (a point is 1 percent of the loan amount and is essentially prepaid
interest), plus prepayment penalties that lock in the high interest rates or
require a hefty payment for the privilege of refinancing.
Your loan is secured by a mortgage or deed of trust against the property, so
it’s extremely important to be conservative with the loan-to-value ratio or the
amount of money you actually lend the borrower versus the fair market value
of the property. At times, borrowers damage or neglect the property if they
fall behind on the payments, so we advise real estate investors to limit their
exposure to no more than 50 to 60 percent of the value of the property.
Although making and purchasing real estate notes and trust deeds can be a
lucrative investment vehicle, acting as a real estate lender can be risky for the
novice. Properties with latent problems or unrecorded tax liens are just some
of the potential pitfalls. Should you decide that lending money on real estate
offers you the high returns you’re looking for without the headaches of owner-
ship, proceed with caution. Also be sure that you have an experienced real
estate advisor and/or your real estate attorney review the documents before
making an agreement or advancing any funds (see Chapter 6).
The safest approach to making secured loans on property is to thoroughly
evaluate the pledged collateral to protect your investment and determine the
fair market value if you had to foreclose. Never make a loan on a property
that you wouldn’t be willing to own if that becomes your best way to protect
your investment. Some lenders actually hope that the borrower does default
so they can obtain the property for a fraction of its market value.
However, don’t forget that you’re responsible for legal fees and foreclosure
costs in addition to the unpaid balance of your loan and accrued interest in
the event that the borrower defaults.
Tax Lien Certificate Sales
Real estate owners who fail to pay their property taxes in a timely manner
find that the local county files a lien on their property. A lien is any legal
claim or charge against real or personal property for the satisfaction of a
debt or duty that includes the right to take the property if the obligation isn’t
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Chapter 4: Taking the Passive Approach
discharged. The county ultimately sells the property in a tax lien certificate
sale auction to generate the funds necessary to satisfy the unpaid real estate
property taxes, along with the accrued penalties and fees.
But local municipalities don’t want to foreclose or wait for payment because
they need the funds today to pay the costs of government, so they auction off
these tax lien certificates to investors.
Tax lien certificates can be a good investment regardless of the economic
cycle, because some property owners will always be unable to pay their
property taxes. When you buy a real estate tax lien, you’re simply providing
the government entity with the funds for the delinquent taxes and buying the
rights to collect those taxes from the property owner (plus penalties and a
fixed rate of interest that can range from 12 to 24 percent per year).
The property owner can’t sell or pledge her real estate without paying the out-
standing tax liens, so over 90 percent of the tax lien certificates are redeemed
within 24 months (or the maximum allowable redemption period set by each
state or county). Look for tax lien certificates in certain types of real estate,
such as owner-occupied properties, because these tend to have nearly a 100
percent redemption rate. You may ultimately have to give the required legal
notices and foreclose on the underlying real estate to achieve your return of
capital and realize your return on investment, so always limit your purchase
of tax lien certificates to properties that you’re willing to own.
Tax lien certificates aren’t available in every state, and you don’t have any
way to control the timing of the redemption. Savvy real estate investors that
have done quite well with tax lien certificate sales generally buy multiple
liens to spread out their anticipated payoffs. Also, they read the fine print of
the government rules and regulations concerning these sales, because the
rules vary greatly from state to state — and each county within a state may
have different rules. Contact your county tax collector to see whether real
estate tax lien certificates are a viable investment alternative in your area.
You have to devote the time necessary to really find out about the underly-
ing properties even though finding information is difficult. The conventional
sources of local real estate knowledge — brokers and agents — don’t work in
this market because they offer no opportunities for them to earn commissions.
Limited Partnerships
Unlike a general partnership, in which every partner has full management
authority and accountability, a real estate limited partnership is an investment
program in which general partners manage property and accept unlimited
liability, and the limited partners don’t participate in management decisions
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Part I: Stacking Real Estate Up Against Other Investments
and their liability for losses is limited to their investment. A limited partner-
ship offers advantages to real estate investors who want to participate in the
market while limiting their day-to-day involvement and liability.
The disadvantage of limited partnerships is that limited partners don’t have
any authority, so limited partnerships are passive investments.
In a limited partnership, the general partner makes all the decisions of man-
agement and even decides when to sell the property. Upon disposition, many
limited partnerships provide for the general partner to receive a portion of
the appreciation (usually from 10 to 25 percent) right off the top — prior to
distributions to the limited partners who get a share of the remaining real-
ized appreciation based on their ownership percentage. This equity kicker
for the general partner is typically in addition to brokerage fees upon acqui-
sition and disposition, plus market rate or higher fees for property manage-
ment and asset management.
Although some limited partnerships are formed by general partners who treat
each partner as an equal, the majority is structured by general partners with
the perspective of “Heads: I win! Tails: You lose!” Some limited partnerships
are nothing more than a pure profit play for the general partner in which they
get their money upfront — often while the limited partners are held captive
and can only hope to see the return of their capital and some appreciation in
the distant future.
Limiting the scope of limited partnerships
Limited partnerships have been available for
many years. Prior to the extensive overhaul of
the federal taxation of real estate investments
in the 1980s, they were a common method of
real estate investing. Up until that time, all
losses from real estate were fully deductible,
and these loopholes created opportunities for
aggressive tax management to avoid legal tax
liabilities.
In 1986, Congress passed new tax regulations
that eliminated the favorable tax treatment of
most losses unless the real estate investor was
an active participant. To qualify as an active
participant, an individual must be involved in
direct management decisions of the property,
although the day-to-day rental activities of col-
lecting rent, overseeing repairs, and paying bills
can be delegated to a property manager.
Further, the federal tax code limits the deduct-
ibility of your passive losses against your
earned income (salary, dividends, and inter-
est) to a maximum of $25,000, as long as your
adjusted gross income doesn’t exceed $100,000.
The maximum $25,000 passive loss deduc-
tion phases out at a ratio of $1 for every $2 in
adjusted gross income between $100,000 and
$150,000. For real estate owners with adjusted
gross income exceeding $150,000, any passive
losses are carried forward to future years or
until the property is sold.
However, we discuss an extremely valuable
exception for real estate investors who qualify
as real estate professionals in Chapter 18.
Chapter 5
Fast Money: Small Down
Payments and Property Flips
In This Chapter
▶ Debunking no-money-down strategies
▶ Choosing the best fast-money strategy
▶ Uncovering those buy-and-flip properties
T
he only thing better for a small-time investor than getting rich is getting
rich quickly. Entire books have been written about hitting the real estate
big time with little money to invest through buying and flipping properties to
turn quick profits.
Does this scenario sound too good to be true? Of course it does! In some
cases, these strategies have proven profitable — but those success stories
are few and far between. That’s why we warn you about the realities and
truths of the get-rich-quick-and-with-little-money sales pitches in this chap-
ter, and we offer our best advice to guide you in case you choose to walk
these dangerous paths despite our persistent warnings!
Purchasing with No Money Down
If you’ve ever had insomnia and turned on the television in the middle of the
night, you’ve likely seen the late-night infomercial real estate gurus who claim
to possess the true secrets of buying real estate significantly below market
value — and they don’t even use their own money! They tell viewers that
anyone can buy real estate tomorrow using their no-money-down strategies.
And it gets even better — they tell you that you can actually receive money
from the seller to buy her property.
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Part I: Stacking Real Estate Up Against Other Investments
Although we do believe it’s possible to find a buyer who is so motivated that
she’ll actually pay you to take a property off her hands, the reality is that the
vast majority of such properties don’t prove to be profitable for you in the
long run. Ask yourself — why would anyone give away a property unless it
had some really serious problems?
Understanding why we recommend
skipping these investments
The concept of buying real estate without using any of your own money is
clearly dependent on finding an extremely motivated seller. A motivated seller
is one who faces circumstances that don’t allow him the flexibility to achieve
full market value for his property. For sure, a certain number of motivated sell-
ers exist in any market.
The late 2000s downturn in the real estate market may seem a perfect oppor-
tunity to explore the benefits of putting less money down to purchase a prop-
erty. The reality is that most lenders are no longer in the creative financing
business after being burned by the stated income or “no doc” and similar
subprime loans in which the buyers have no vested interest and were count-
ing on unsustainable appreciation to create equity.
There are also fewer sellers with significant equity in their properties so the
margin for seller financing is diminished. Low money down and/or install-
ment sales are much more likely and feasible when you have a seller with
plenty of equity. However, many of the most motivated current sellers are
owners of properties in which they owe as much or more than the property’s
current market value.
The stock market is a relatively liquid market where buyers and sellers can
enter or leave the market quickly with broad knowledge of current pricing.
In contrast, real estate assets are illiquid — it can take a relatively long time
The birth of the no-money-down movement
The popularity of no-money-down investing
peaked in the early-1980s when most real estate
loans were assumable — the buyer of the
property essentially took over or assumed the
payments on the current loan from the seller.
Properties weren’t appreciating that quickly in
that time frame, so many owners didn’t have
significant equity in their homes and were will-
ing to take small down payments or carry seller
financing as part of the transaction. The advent
of the due on sale clause in many mortgages
virtually eliminated the ability of buyers to
assume the sellers current loan.
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to enter or leave the real estate market. Real estate is also unique: A share
of your favorite stock always represents the same investment; not so with
real estate. This creates the opportunity to profit from pricing inefficiencies
between one property and another. Also, the ability to complete a real estate
transaction quickly provides an additional factor that can affect the price.
The following are examples of motivated sellers who may be willing to accept
a no-money-down offer:
✓ A seller who’s relocating and needs to sell in a hurry: An owner who’s
leaving the area may need to quickly sell his home so he can buy a
replacement home in his new location. In order to complete the sale in a
timely manner, he may be willing to lower the price to somewhat below
the full market value (the price he could have received if he were not in
such a hurry).
Finding a seller in a hurry is one of the most reliable ways to buy real
estate with little or no money down.
✓ A seller who’s desperate to sell and exasperated by the effort: The
owner of a property that has been vacant for an extended time period
or that requires extensive renovation may be desperate to sell. The
property may have a deadbeat tenant, or maybe it’s vacant after being
destroyed by the last tenant and the owner lacks the cash to make the
significant investment in repairs. This type of seller may be willing to
offer generous seller financing terms or even pay you to remove him
from his liability.
But even when sellers find themselves in such positions, who will stamp
“Desperate to Sell” on their forehead? Trying to determine a seller’s motiva-
tion always takes work. Check out Chapter 13 for more on the subject.
Although, clearly, such real estate owners exist, they’re not as common as
some of the real estate investment gurus would have you believe. There are
always anecdotal stories about an amazing success story, but there are many
more untold stories of cocky novice real estate investors who found out the
hard way that you get what you pay for.
Finding no-money-down opportunities
(if you insist)
No-money-down sellers are in greater abundance in a weak real estate market
(or buyer’s market) because sellers have fewer options. The target market for
no-money-down deals is a real estate market environment with highly moti-
vated sellers facing dire consequences (including foreclosure, which we dis-
cuss in Chapter 3) unless they dispose of their property. Usually, sellers that
need to sell quickly are in one of the following situations:
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Part I: Stacking Real Estate Up Against Other Investments
✓ A seller who has had some unfortunate circumstances such as an ill-
ness, a death in the family, a divorce, a job loss, or a significant loss
of income such that she can no longer afford to make the payments
and handle the ongoing expenses of the property — this situation is
often the one that leads to a no-money-down offer. Because of her com-
promised situation, such a property seller may not readily qualify for
new or additional loans that would allow her to handle the cash flow
dilemma she faces. Although home equity loans may be available in
these circumstances, the owner may be so financially overwhelmed that
she prefers to sell her property and downsize her financial obligations
to a more manageable level.
✓ A seller with significant equity but limited options to tap that equity is
likely to have cash flow problems, but the overall equity in the property
can allow her to act as a lender to you (see Chapter 8 for seller-financing
strategies).
The two most common good candidates (as opposed to the classic definition of
folks who would be flexible out of desperation) for no-money-down scenarios are
• Folks at or approaching retirement age who would prefer a steady
income stream to a lump sum.
• Individuals who inherited the property and are looking for monthly
income without the hassles of being a landlord.
In order to know whether the candidates you’re considering fall into one of
the preceding scenarios, you need to assess their motives. Chapter 13 helps
you do that.
Buying, Fixing, and Flipping
or Refinancing
In a solid real estate market, you often find properties appreciating at an
annual rate of 3 to 5 percent — a solid and sustainable rate of appreciation
that rewards investors with long-term investment horizons who take the buy-
and-hold approach with their real estate assets. This buy-and-hold strategy
works and should always be the foundation of your wealth-building.
But in some areas, the demand for housing has been so great that the limited
supply of new and existing properties available in the market is insufficient to
meet the demand. It’s in these markets of high demand and rapidly escalating
prices that real estate speculators with a buy-and-flip strategy appear.
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Chapter 5: Fast Money: Small Down Payments and Property Flips
There’s nothing wrong with the buy-and-flip strategy, but we prefer the more
conventional and lower-risk strategy of buy, fix, and hold.
The buy-and-flip strategy
The buy-and-flip strategy can also work with existing homes that the investor
can purchase from a motivated seller at a wholesale price that is below the
market value. The investor may not even have to close escrow before finding
a buyer willing to pay a retail price. There may be some minor cosmetic work
or simple improvements needed before reselling, but typically, buy-and-flip
investors really make their money when they buy at a discount and then
locate a buyer at full market value. This approach is risky, but it can also be
rewarding.
This high-risk strategy requires a rapidly rising real estate market with higher
than normal appreciation rates to allow for profits on short term investments.
Not only do you have to have excessive demand driving up the prices of real
estate, but you also have to cover all of the costs of real estate. With online
stock trading firms, you can buy shares of your favorite company in minutes
with relatively low transaction costs. But with real estate, the costs of buying,
holding, and selling a property are much higher and unknown, and generally
include
✓ Acquisition costs: Due diligence and inspection fees plus loan fees/costs
and points
✓ Transaction costs: Closing and escrow fees
✓ Repair or upgrade costs: Costs to renovate or fix property to make it
more desirable and generate the highest resale price (unless the prop-
erty is brand-new)
✓ Holding costs: Property taxes, insurance, and any negative cash flow
while the property sits vacant or if the rental income doesn’t cover the
carrying costs
✓ Sales costs: Commissions and title insurance from the sale of the property
Even during the weak real estate market in the late-2000s, you see late-night
infomercials promoting the flipping strategy, but they often cite examples
with just limited information. These ads feature an average Joe who invests
his excess income in a fixer-upper down the street — he pays $150,000 for it
and then sells it for $200,000 after replumbing the property and installing all
new flooring, window coverings, and appliances. The infomercials imply that
he just made a quick and effortless $50,000.
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But what they don’t say is that he has $3,000 in acquisition costs, $2,000 more
in transaction costs, $15,000 in repairs and upgrades, and $10,000 in sales
costs for a total of $30,000. That brings the theoretical profit down to $20,000
before factoring in holding costs. Even if everything works out well for Joe, his
property likely sits empty for at least six months while he renovates it, puts
it on the market, and shows it to prospective buyers. So by the time Joe has
completed this investment cycle, he’s quite possibly spent another $6,000 in
mortgage interest payments, plus $2,000 in property taxes and insurance. His
pre-tax profit is now $12,000 if everything goes well. But wait — there’s more.
Because he only held this investment for less than one year, he pays income
tax at his nominal ordinary earned income tax rate of, say, 30 percent, which
brings his amazing $50,000 profit down to a measly $8,400.
But what if there are some additional problems with the property when Joe
opens up the walls to replumb his new investment gem? Maybe there are
termites or roof leaks or problems with the foundation. What if the demand
for this property diminishes and he has to hold the property for 12 months?
(Some folks got burned in the late-2000s when the demand for housing sud-
denly evaporated.) Even in the best scenario, where Joe has accurately esti-
mated the repair and upgrade costs and there are no surprises, he finds that
just owning the property for six months longer than he expected doubles the
holding costs from $8,000 to $16,000, reducing the pre-tax profit to $4,000. By
the time he is done paying 30 percent of that in taxes, Joe has just $2,800 to
show for his efforts.
You may be located in a market that has experienced rapid housing price
increases, but be careful. If there is too much excess demand for new housing in
the area, real estate speculators — not long-term investors or homeowners —
can make up the majority of the purchasers. This tendency can be dangerous
when the majority of buyers in the market are looking for the quick profit rather
than a long-term, stable real estate investment. When enough of these specula-
tors head for the exits (as happened in some areas in the late-2000s real estate
market decline) and don’t return, prices can quickly turn tail. The speculators
are then forced to mitigate their losses by renting out their properties (some-
times for years) until the real estate market rebounds and they’re able to sell
the property to break even.
But we’re pragmatists — we know that lightning may strike and you may run
into a property that turns out to be a buy-and-flip candidate. So in Chapter
13, we detail how to keep this possibility open by using an assignment clause
when completing a purchase agreement. And we also cover possible tax draw-
backs of losing the advantages of lower capital gains taxes in Chapter 18.
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Chapter 5: Fast Money: Small Down Payments and Property Flips
The buy, fix, and refinance strategy
With the buy, fix, and refinance strategy, you invest in properties where value
can be added to the property through repairs, upgrades, and improvements
that take a distressed property and turn it into a solid and well-maintained
property. Over the years, with increased equity in the property and as long
as interest rates are attractive, you could refinance the property if you so
choose and use some of your equity towards other real estate investments.
We strongly prefer this method because it has proven throughout the years
to be the lowest risk, highest probability way to make money in real estate.
You can think of it as the tortoise in the old tortoise-and-the-hare story,
where the hare is the fast-money, high-risk, high-return strategy. The tortoise
may be slow and steady, but he ends up winning in the long run. As an exam-
ple, Robert is a conservative person by nature, yet he has acquired a signifi-
cant real estate portfolio by simply purchasing well-located-but-distressed
properties and renovating, filling them up, and then refinancing.
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Chapter 6
Building Your Team
In This Chapter
▶ Assembling your team first
▶ Hiring tax and financial advisors
▶ Seeking lending professionals
▶ Finding top real estate agents and brokers
▶ Adding appraisers and attorneys
T
here are some investments — called passive investments — where you
can simply turn your money over to professional money managers or
financial advisors who then act on your behalf and make the day-to-day
investment decisions, buying and selling investment assets within the portfo-
lio. Mutual funds are an example of this type of passive investment. You send
your money to your favorite mutual fund firm and periodically evaluate how
your fund’s managers are doing.
Investments in real estate that you’re directly involved in managing are the
norm, because passive investments in real estate aren’t readily available
(except for REITs and TICs, which we discuss in Chapter 4). And for most real
estate investors, real estate investing is hands-on and complicated enough
to require the services and knowledge of a team of professionals. Although
you may be skilled in your chosen field, it’s unlikely that you possess all of
the varied and detailed skills and knowledge necessary to initiate and close a
good real estate transaction.
Evaluate proposed real estate investments carefully and methodically before
you make the ultimate purchase decision. The uniqueness of each potential
real estate opportunity requires the investor to patiently critique the pend-
ing investment. You should understand the economic climate and potential
for growth, the current physical condition of the property, the tenants, and
the value of the property in the marketplace. Then you should ensure that
you’ve got a solid negotiating strategy to orchestrate a deal, that the financ-
ing comes through, and that the transfer of real estate is handled properly.
This requires a team approach.
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In this chapter, we discuss the different real estate professionals and service
providers that you should consider teaming up with as you search for real
estate investment opportunities and proceed with the purchase of property.
Knowing When to Establish Your Team
Some real estate investors make the mistake of looking for a property to buy
without spending enough time upfront thinking about and identifying the pros
whose help should be hired. We recommend that you have your team in place
before you begin your serious property searching, for two reasons:
✓ You can move quickly. The speed at which you can close a transaction is
an advantage in any type of market. In a soft or buyer’s market, some sell-
ers are desperate for cash and need to close quickly. In a rising or seller’s
market, sellers typically don’t tolerate having their property tied up in
a long escrow with a buyer who doesn’t understand the current market
conditions or how to properly evaluate the property. Sellers may be miss-
ing out on a better deal with a more qualified buyer. In a buyer’s market,
although less property may be selling overall, there is always demand for
the most appealing properties that are priced right and well located. These
properties often attract multiple offers, so being organized and efficient
can make the difference between securing and losing a desirable property.
✓ You can effectively research the property before making an offer.
Prudent investors conduct research and gather information before they
buy, so they know which property or properties are worthy of an offer.
Typically, the real estate industry describes due diligence as the period of
time after you place a property under contract (see Chapter 14). But you
really need to perform due diligence even before making an offer. You don’t
want to waste time or money on a property that can’t meet your goals.
Some real estate investors like to make an offer and get a property under
contract before they begin due diligence. We believe that this is a mis-
take and can lead to a reputation with sellers (and agents) that you’re
not a serious buyer (see the “Working with Real Estate Brokers and
Agents” section later in the chapter). We recommend only making offers
when you have done enough due diligence to feel comfortable that your
further, thorough review of the property interiors and books probably
won’t reveal any surprises that will lead to canceling the purchase.
The most effective research is done with the assistance of real estate
professionals to give you the advice and information you need to make an
intelligent decision. This pre-offer period is critical; it’s the one real oppor-
tunity for a prospective buyer to investigate a property while retaining the
ability to terminate the transaction without a significant monetary loss.
You may invest time and several hundred to several thousand dollars to
perform the necessary due diligence, but this is a small amount compared
to the potential losses from the purchase of a bad property. (We cover
this prepurchase research in Chapters 10 through 12.)
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Chapter 6: Building Your Team
Adding a Tax Advisor
A tax advisor may not be the first person that you think to consult before
making a real estate transaction. However, our experience is that a good tax
advisor can highlight potential benefits and pitfalls of different real estate
investment strategies. Of course, make sure that your tax person has expe-
rience with real estate investing and understands your needs and specific
goals in regard to your property investments. (We cover the ins and outs of
real estate accounting and taxation in Chapters 17 and 18.)
Although you may pick up a lot of information about real estate and discover
some of the advantages of property investing speaking with some tax people,
don’t rely on generic information (“investing in real estate offers a terrific tax
shelter,” for example). You need specific feedback and ideas from a tax expert
regarding your unique financial situation and which types of real estate invest-
ments work best for you.
Based on your age, income, and other important factors, the benefits you
seek from real estate may be entirely different from other investors. Many
real estate investors are looking for immediate cash flow from their proper-
ties. But others have sufficient income currently from other sources and
prefer to look at real estate as a wealth builder for their retirement years.
And almost all real estate investors are looking for tax benefits.
The role of your accountant is to evaluate and recommend investments and
tax strategies that maximize your financial position. Remember the old adage
that says, “It’s not what you make that matters but what you keep.”
A good tax advisor with property investment experience can tell you whether
your best real estate investment is the direct ownership of properties or per-
haps owning triple net leased properties with lower returns but fewer man-
agement headaches. An accountant can inform his clients as to whether they
can still meet the active participation required for certain tax benefits while
hiring a property management company to handle the bulk of the day-to-day
tenant/landlord issues.
You may also want to find out whether you qualify for the added tax benefits
that are available for some investors who qualify as real estate professionals.
Achieving such qualification isn’t easy, and the IRS may someday audit you.
Meet with your tax advisor and get to know the benefits and pitfalls of your
proposed real estate investments before you start making offers.
Finding a Financial Advisor
Over the years, Eric has written extensively about the financial planning pro-
fession and how individuals can best navigate important personal financial
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decisions with and without the help of such planners. In theory, everyone
entering into major investments like real estate should seek holistic financial
advice from a financial advisor who charges an hourly fee.
Avoiding financial conflicts of interest
Here are a couple of stories that highlight the
conflicts of interest you may be subjected to
when working with a financial advisor.
✓ While serving as an expert real estate wit-
ness, Robert had a case where a retired
couple was given some self-serving advice
by their financial planner. This couple
owned their principal residence plus three
other rental homes valued at $1 million. All of
their real estate was owned free and clear,
and the rentals were in great condition with
good long-term tenants. The properties pro-
vided a nice monthly income stream that
was mostly tax-free due to their deprecia-
tion deduction (see Chapter 18). Although
the real estate was clearly their largest
asset and completely debt-free, they also
had nearly $500,000 in liquid assets such as
stocks, bonds, and IRAs and seemed to be
fairly set. That was, until their new financial
advisor told them that their retirement was
at risk because they had too much invested
in real estate. The planner’s recommenda-
tion was to keep their own home as their
real estate investment, but sell the three
highly appreciated rental properties and
invest the proceeds in mutual funds and
other financial products from companies
affiliated with the planner.
The planner failed to disclose his relationship
with the sponsors of the new investments and
also failed to warn them about the significant
capital gains taxes that would be due upon
sale. By the time they met with their accoun-
tant, it was too late — two of the three rental
properties had been sold and over $200,000 in
taxes was due. The accountant advised the
couple to contact an attorney and file a law-
suit against the financial advisor. Although
the couple prevailed, they recovered only a
small portion of what they paid in taxes. Even
worse — they lost the benefits of cash flow
and appreciation on their real estate while
now owning fully taxable investments.
✓ In Eric’s previous work as an hourly-based
financial advisor, he often had clients
come to him who were disappointed with
the biased and confusing advice they got
from various so-called financial planners.
In one typical case, a widow had been told
by an advisor to sell her two investment
properties because he believed that the
stock market would produce better returns.
She set the wheels in motion to unload the
properties but put the brakes on at the last
minute after deciding she needed a second
opinion. She met with Eric. The first thing
that she noticed working with him was that
he was far more thorough in examining her
overall financial situation, including all of
her investments, insurance, and resources
for retirement. She also realized that she
was happy with her real estate holdings
and really didn’t have any motivation to sell
them. Furthermore, she found out from Eric
that over the long-term, the returns from
stocks and real estate were quite com-
parable. She thus decided to keep her life
simple and stable and hold onto her nicely
performing rental properties.
Don’t get us wrong, selling real estate can
make sense at times. However, you must ask
a lot of questions and run any proposed invest-
ment strategies by good independent advisors
before you make the decision to liquidate your
real estate and shift your investments to other
opportunities.
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Chapter 6: Building Your Team
In reality, many financial consultants sell investment and insurance products
that provide them with commissions or manage money for an ongoing per-
centage in stocks, bonds, mutual funds, and the like. Such salespeople and
money managers can’t provide objective, holistic advice, especially on real
estate transactions. When you buy property, you spend money these people
want to manage. Check out the “Avoiding financial conflicts of interest” side-
bar in this chapter for more information.
If you’ve worked with or can locate a financial advisor who sells her time and
nothing else, just as a good tax advisor does, consider hiring her. A true finan-
cial advisor can help you understand how real estate investment property
purchases fit with your overall financial situation and goals. (Chapter 1 dis-
cusses all the variables that affect the way your investments mesh with your
situation and goals.)
Lining Up a Lender or Mortgage Broker
Before looking at specific real estate opportunities, you need a budget. And
because your budget for real estate purchases is largely a function of how
much you can borrow (in addition to your cash available for a down pay-
ment), you need to determine the limits on your borrowing power. If you can’t
afford a property, it doesn’t matter what a great deal it is.
Postpone making an appointment to look at investment properties until after
you examine the loans available. You have two resources to consult:
✓ Lender is a generic term for any firm, public or private, that directly loan
you the cash you need to purchase your property. This type of lender is
often referred to as a direct lender. Most often, your list of possible lend-
ers includes banks, credit unions, and private lenders (including property
sellers). Lenders tend to specialize in certain types of loans.
✓ A mortgage broker is a service provider that presents your request for a
loan to a variety of different lenders in order to find the best financing for
your particular needs. Just like real estate or insurance brokers, a good
mortgage broker can be a real asset to your team (we cover mortgages
in detail in Chapter 8, along with the advantages and disadvantages to
working with mortgage brokers versus direct lenders in Chapter 9).
Protecting yourself by understanding
lending nuances
Lenders and mortgage brokers are in the business of making loans. That’s
how they make money. Their product is cash, and they make money by
renting it to people and businesses that pay them the money back plus
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interest, which is the cost of renting the money. Money is a commodity just
like anything else and its availability and pricing are subject to an assortment
of variables.
Lenders and mortgage brokers want to find you money for your next real estate
purchase, but they’re not objective advisors to provide counsel for how much
you should borrow. They’re trained to calculate the maximum that you may
borrow. Don’t confuse this figure with the amount that you can truly afford or
that fits best with your overall financial and personal situation. Because they
only are paid when they make loans, many borrowers have learned the hard
lesson that some lenders and mortgage brokers are willing to make any loan.
So why is getting a loan so difficult at times? Because lenders want to make
loans to those investors who are a good credit risk and who they think have
a high probability of repaying the loan in full plus the interest. This concern
became more pronounced in the late-2000s as real estate prices fell and
defaults and foreclosures escalated. The lender has costs of doing business
and needs to make a profit. Because the money they lend often belongs to
their depositors, lenders need to be careful and selective about the loans they
make. (See Chapter 9 for more information on the necessity of a good credit
rating when investing in real estate.)
On the upside, we’ve found that lenders can also serve a valuable role by pre-
venting you from making serious mistakes. Particularly in overheated seller’s
markets where prices are irrationally climbing with little fundamental eco-
nomic support, your lender and the required appraisal from a competent pro-
fessional appraiser can keep you from getting caught up in a buy-at-any-price
frenzy. (Of course, this isn’t always the case; look no further than the subprime
loan debacle that came to light in the late-2000s.) In these markets, lenders
tend to be a little more conservative, limiting loan amounts and requiring
larger down payments. These factors provide the lender with additional pro-
tection should market prices fall, but they’re also a signal that the lender feels
the loan exceeds the intrinsic value of the property that they’ll be stuck with if
you default. Smaller loan offers with higher down payments are a clue that you
may be paying more than a property is worth or buying at the market’s peak.
The lender requires collateral to protect them if the borrower doesn’t make
the debt service payments as required. Collateral is the real or personal
property that’s pledged to secure a loan or mortgage. If the debt isn’t paid as
agreed, the lender has the right to force the sale of the collateral to recover
the outstanding principal and interest on the loan. Typically, the property
being purchased is the pledged collateral for real estate loans or mortgages.
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Building relationships with lenders
Relationships with lenders can take time to build, so begin looking for lenders
that specialize in the types of properties within the geographic area that you
have targeted. They can help you understand your financial qualifications or
how much you can borrow before you begin your search for an investment
property. Although lenders only make money by making loans and some lend-
ers seem to be willing to lend money on any property at any price, the type of
lender you should associate with is one who understands real estate cycles
and your local real estate market. Not all lenders and mortgage brokers were
hit by the subprime lending mess, and it does matter that you develop a rela-
tionship with a lender that’s likely to be there when you want to acquire addi-
tional properties.
When you get together with your lender or mortgage broker, provide them
with your latest personal financial statement, which includes your income
and expenses as well as your assets and liabilities and net worth. The days of
“no documentation” or “stated income” loans are hopefully over.
Always be truthful with your lender. One way to sabotage a relationship with a
lender is to exaggerate or stretch the truth about your current financial situa-
tion or about the potential for your proposed property acquisition. Most lend-
ers require supporting documents for your income and assets and will obtain
a current credit report. When you don’t oversell yourself or your proposed
property, lenders are often more willing to work with you and even offer
better terms.
Working with Real Estate
Brokers and Agents
Your investment team should include a sharp and energetic real estate
broker or agent. All real estate brokers and agents are licensed by the state
in which they perform their services. A real estate broker is the highest level
of licensed real estate professional, and a licensed real estate sales agent is
qualified to handle real estate listings and transactions under the supervi-
sion of a broker. The vast majority of real estate licensees are sales agents.
Throughout this chapter, we refer to both real estate brokers and agents
simply as agents.
A real estate agent must have his license placed under a supervising broker
who’s ultimately responsible for the actions of the sales agent. Real estate
brokers often begin their careers as real estate agents, but it’s possible to
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meet the more stringent qualifications and immediately qualify as a broker.
Brokers and agents can perform the same functions; many real estate agents
actually have more practical experience and hands-on market knowledge
than the brokers they work for. Brokers that have many agents reporting to
them often spend most of their time educating, supervising, and reviewing
the transactions presented by their agents. So, if you have a problem with an
agent, contact the broker — the buck stops with her!
Generally, you deal with real estate agents, but the added experience and
dedication of a broker can be beneficial to you if you’re involved in larger and/
or more complicated transactions. Real estate agents are fine to handle the
majority of real estate transactions, including the typical purchase or sale of
an owner-occupied single-family home or condo. However, many owners of
investment real estate don’t want the disruption that can occur with openly
listing the property. The management company and employees begin to worry
about their jobs, and tenants become concerned that rents will be raised.
These problems can be avoided by quietly talking to one or two top brokers
in an area with the understanding that the potential transaction is to be kept
confidential. This leads to some great opportunities for the top brokers and
their clients.
Whether you use a broker or an agent, make sure that this person has a
solid track record with investment property transactions in your area. And
although having a real estate agent on your team is an excellent strategy that
gives you a competitive edge, don’t completely ignore the Multiple Listing
Service or in-house listings of brokers. Such sources often include properties
that other investors overlooked because they didn’t have the vision or the
right team members to see a potential opportunity.
Seeing the value of working with an agent
In many metropolitan areas, looking at the properties on a Multiple Listing
Service (MLS) or in the newspaper or online listings isn’t enough. The best
deals are often the ones that don’t make it into these sources. This is where
the insider information from real estate sales agents can make you the bride
and not the bridesmaid. (Of course, many brokers are themselves interested
in investing in income producing properties, and they have the first chance
at the best deals.)
You want to be the first one contacted about the best properties coming
on the market rather than one of many when everyone knows about the
property from the MLS. The MLS is a service created and maintained by real
estate professionals per guidelines established by the National Association
of Realtors (NAR). This service gathers all of the local property listings into
a single place so that purchasers may review all available properties from
one source. The MLS also deals with commission splitting and other relations
between agents.
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For many years the MLS dominated the markets, but the Department of
Justice filed an antitrust lawsuit that was settled with NAR in 2008, agree-
ing that other listing services would be given access to the same listings.
Now there are several investment real estate listing services that are gaining
market share and offering instant access to an incredible database of infor-
mation on all types of properties from single-family homes and condos to
large commercial, industrial, and retail properties. Two of the most popular
listing services for investment properties are Loopnet (www.loopnet.com)
and CoStar (www.costar.com).
Understanding the implications of agency:
Who the agent is working for
When you deal with a real estate agent, you need to know who she repre-
sents. Real estate investors need to understand the concepts of dual agency
and single agency and the implications of each:
✓ Single agency: This is when an agent only represents the buyer or the
seller. The other party either represents herself or is represented by
an agent who doesn’t work for the same broker as the other agent. For
example, a buyer’s agent only has a fiduciary relationship with the buyer.
The buyer’s agent has a duty to promote the interests of the buyer and
keep all information confidential unless legally required to disclose.
The buyer’s interest should be first and foremost, and no information is
passed to the seller without your knowledge other than that information
that directly affects your ability to perform on the contract as written.
We strongly recommend that you work with an agent who operates as a
single agency representative. A lot of money is involved in income prop-
erty transactions, and you want to have someone looking out for your
interests whether you’re buying or selling an investment property.
✓ Dual agency: A situation in which the same individual agent represents
both the seller and the buyer or when two different agents represent-
ing the seller and buyer are from the same firm (with the same broker).
With any transaction, each agent involved owes a fiduciary duty of loy-
alty to each client he represents, but this is nearly impossible for one
agent who is representing both the buyer and seller in the same transac-
tion (and difficult as well if two agents work for the same broker).
Avoid the inherent conflict of interest found with dual agency and estab-
lish a relationship with a single agency agent who represents only your
interests. Dual agency makes it extremely challenging for one agent,
or two agents working for the same broker, to be loyal to clients with
opposing interests. For example, an agent may hear confidential infor-
mation from sellers about what their minimum acceptable price is, and
the same agent or another agent from the same firm hears from buyers
that they’re willing to pay more than what they first offered.
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Agents, and especially their brokers, prefer dual agency — they generate
more commissions by representing both sides of the transaction. That’s why
many agents start out showing their clients only properties that are listed by
their firms. However, this desire to capture a bigger share of the real estate
commission has led to some serious conflicts of interest. Now most states
either prohibit dual agency or at least require the agent to disclose the exact
nature of the agency relationship prior to commencing the representation of
a client by taking a listing, showing a property, or making an offer.
Getting a feel for compensation
Real estate agents are generally motivated to see the transaction go through
because they’re compensated when a sale is made. Compensation for agents
is typically calculated as a percentage of the sales price paid for a property. So
the agents actually have an interest in the property going for a higher price.
Commissions vary based on the property and the size of the transaction:
✓ Individual residential properties, such as single-family homes and
condos, have commissions of 5 to 6 percent of the sales price.
✓ Small multifamily and commercial properties are often in the 3 to 5 per-
cent range.
✓ Larger investment properties have commissions of 1 to 3 percent.
✓ Raw land (in its natural state with no grading, construction, or improve-
ments) is usually at 10 percent, unless the acreage is large. Subdivided
or finished developable lots in suburban areas typically draw a lower
commission.
These commissions are typically split between the firm listing the property
for sale and working with the seller and the agent representing the buyer.
The actual proportion of the split varies, with the listing agent sometimes
taking a smaller percentage than the buyer’s agent if the commissions aren’t
evenly split. The commission actually is paid to the broker, and the agent
receives his share based on his employment or commission agreement,
which also often calls for the agent to cover some of his own expenses and
overhead.
Real estate commissions can be a significant cost factor for real estate inves-
tors. Most listing agreements acknowledge that commissions aren’t fixed by
law and are negotiable. Traditionally, the seller “pays” the commission to the
real estate agents involved in the transaction, although because the buyer is
the one paying for the property, we say that both the buyer and seller ulti-
mately pay for the agent’s commissions.
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Real estate agents do add to the cost of purchasing property, but a good
agent, like a good property manager, can justify the cost of her services by
introducing you to properties that you would not otherwise have an opportu-
nity to purchase. A good agent earns her commissions other ways as well —
as a good negotiator and through her other marketplace knowledge.
Some real estate investors get a real estate license so that they can eliminate
paying at least one-half of the real estate commission to agents. And there are
times when you’ll be able to use your sale’s or broker’s license to effectively
reduce your transaction expenses and investment requirement by represent-
ing yourself in a transaction. This is particularly helpful when you’re looking
to sell a property in a strong seller’s market.
But as a licensee you need to be very careful to follow all real estate dis-
closure laws about your licensing status to all parties in the transaction.
Generally, a real estate agent is expected to have more knowledge in a real
estate transaction than others without such credentials. Thus, you must be
very careful when you act as an agent and a principal in a purchase or sale
transaction.
Although you may often have superior knowledge of market values and
opportunities in the marketplace, you need to make sure that you’re not self-
dealing or taking advantage of insider information that would have a material
impact on the value of the property. A real estate agent who buys properties
for the long-term for his own account is not likely to be challenged, but such
an individual that uses his knowledge to flip properties for a quick profit may
be subject to claims by the seller that he withheld information. For example,
you may find yourself named in a lawsuit if you bought a property at a low
price when you knew that a new road was going to be built that would greatly
enhance the property value in the next year or so.
Robert has seen many allegations against licensed real estate profession-
als who have been accused of self-dealing or failing to act properly in real
estate transactions when they buy the property for an entity that they have a
financial interest in or have a straw man or secret partner. This situation can
happen even if you disclose your real estate license status and your financial
interest in the buyer entity, but it is illegal and likely to be considered more
egregious if you conceal this information from the seller. Agents have also
been accused of illegal activity when they sell their own property (for exam-
ple, as a tenants in common or triple net investment opportunity) at a much
higher than market value.
One recent example from Robert’s litigation consulting practice involved a
real estate agent who advised an elderly owner to sell a residential rental
fourplex where the apartments were contiguous but each rental unit was on
a separate lot. The agent advised this unsophisticated owner to sell all four
units as a single property to a business associate of the agent. Then the new
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Part I: Stacking Real Estate Up Against Other Investments
owner turned around and within less than 12 months had sold each of the
four individual properties separately at a gross profit of over $1 million. The
agent clearly knew that real estate sold in smaller increments generates a
higher overall value. The aggrieved elderly owner filed suit against the agent.
Finding a good broker or agent
The key to finding a good broker or agent to assist you in the purchase of
investment real estate is to narrow the field down to those individuals who are
the best. Look for folks with the following qualifications:
✓ Full-time professional: Because the commissions earned on the sale of
a large income property can be so great, you’ll find that almost every
broker or agent will claim that she can represent you. But you want
to eliminate those brokers or agents who are greedy, incompetent, or
simply mediocre. Although many part-time real estate professionals sell
single-family homes and condos, you’ll quickly find that the most quali-
fied real estate investment property agents are full-time.
✓ Expert in the geographic market and specific property type: Find
someone who knows your market and the specific property type you’re
seeking. This knowledge is especially important if you don’t live nearby.
Avoid brokers who aren’t experts in your specific property type. For
example, don’t use a broker who specializes in single-family homes and
condominiums unless that’s your target market. Likewise, a commercial
property broker is unlikely to have the best investment opportunities
for your consideration with single-family investment property.
Some real estate investment books advise you to contact every broker or real
estate agent who targets your preferred geographic area. Although casting
a bigger net has some inherent attraction, our experience is that you should
only work with one broker or agent at a time in a given market area.
Real estate agents can be a key source for new investment opportunities and
general market information. This is where our advice about finding an experi-
enced agent who specializes in the types of properties you’re looking for and
knows the local market pays off. These agents know buyers and sellers and
also possess contacts for other services and products that you need as your
real estate investment portfolio expands.
After narrowing down the candidates, many standard screening techniques
can then be applied to pinpoint the top three that you should interview:
✓ Verify the professional’s license status: Most states have an online
broker and agent database, so this step is simple. Confirm that their real
estate license is current with no citations or disciplinary action for past
or pending violations. If you’re using a real estate agent, check both the
license status of the agent and her supervising broker. If the broker or
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Chapter 6: Building Your Team
agent has been disciplined by the state, inquire further to understand the
relevance to your transaction. A suspension or temporary revocation of a
license can be a serious issue — even if it was reinstated. The facts of the
case may be material to your choice of a real estate professional.
✓ Check references: Get the names and numbers for at least three clients
(in the geographical area where you’re seeking property) that the broker
or agent has worked with in the past year. Investment real estate trans-
actions tend to be fewer than owner-occupied property transactions, so
speaking with three or more clients from the last year maximizes your
chances of speaking with clients other than the agent’s all-time favorites.
Don’t just ask for the references; call them. And don’t just ask generic
questions about whether the client was happy with the broker or agent.
Dig deeper — find an agent who you can work with on investments that
are critical to your long-term wealth-building goals. Ask questions about
the types of properties and the geographic locations involved. Ask ques-
tions like, “Did the broker or agent assertively represent you and take
charge of the transaction or did you have to initiate conversations?”
Consider these traits when investigating potential brokers and agents as well:
✓ Willingness to communicate with you: The number one complaint
about real estate professionals is that they don’t keep their clients
informed during transactions. You’re looking for someone with experi-
ence who isn’t necessarily the top producer, because you want someone
who can take the time to communicate regularly with you.
✓ Interpersonal skills: A broker or agent needs to get along with you and
with a whole host of others involved in a typical real estate deal: other
agents, property sellers, inspectors, lenders, and so on. An agent needs
to know how to put your interests first without upsetting others.
✓ Negotiation skills: Putting a real estate deal together involves negotia-
tion, so you want a broker or agent with negotiating skills and lots of
experience in larger transactions. Is your agent going to exhaust all
avenues to get you the best deal possible? Most people don’t like the
sometimes-aggravating process of negotiation, so they hire someone
else to do it for them. Be sure to ask the agent’s former clients how the
agent negotiated for them.
✓ Reputation for honesty, integrity, and patience: When it comes to the
brokering of investment properties, the reputation of your representa-
tive can be critical. Brokers or agents with a track record of dealing
fairly with their clients and their peers can greatly assist in gaining the
cooperation of an adversarial seller. And gaining such cooperation is
often needed to close a complicated transaction. Some strife is almost
guaranteed when buying investment real estate — there are several
opportunities where the transaction can unravel and only the trust-
worthiness, perseverance, and patience of the real estate professionals
involved can keep the transaction on course.
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Making the most of your agent
To get the best deals, timing is critical. You want your broker or agent to
think of you first. To do this, you need to build a solid rapport with your
agent, which you can do by building a track record of not wasting the time
of your professional team. Because agents only get paid for deals they close,
they’re not interested in investing time and energy with numerous potential
buyers. They want serious buyers who will close the deal. Plus, if you garner
a reputation of tying up properties and then renegotiating the deal or cancel-
ing the escrow, you’ll find that your offers won’t be accepted in the future.
Sellers and their brokers don’t want to waste time with phantom buyers.
If you’re not interested in or not able to purchase a property at the time,
explain your situation and thank them for thinking of you. A handwritten thank
you note or simple gift also lets them know you appreciate their efforts — and
keeps you at the top of their lists for the next opportunity.
Considering an Appraiser
Many real estate investors know appraisers solely in the role of providing the
property valuation report required by lenders. And it’s generally in this role
that investors can find appraisers to be a source of aggravation rather than a
potential resource. However, an appraiser can be an effective team member
if your real estate investment strategy involves buying and selling properties
with somewhat-hidden opportunities to add value. Appraisers sometimes
possess insight into real estate opportunities that others miss.
Appraisers can help you by telling you the current value of a property, but
they bring real value as part of your real estate investment team by
✓ Providing insight into the factors that can lead to an increase in the
market value of a property.
✓ Assisting you in maximizing the return on your investment in upgrades
to distressed or fixer-upper properties.
✓ Giving you useful information on the demographics of the area and help-
ing to identify those properties that are distressed but have plenty of
upside potential (properties requiring work in good neighborhoods).
One of Robert’s partners, a highly successful real estate investor in foreclo-
sure properties, has even hired an appraiser as an in-house member of his
real estate investment team. Virtually every property that appears on the
weekly Notice of Default list from the title company is reviewed first by the
appraiser, who looks for properties that are located in the path of progress
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Chapter 6: Building Your Team
and with some real upside potential if brought to marketable condition physi-
cally and aesthetically. (For more on Notice of Default, see Chapter 3; for
information on getting in front of the path of progress, see Chapter 10.)
The appraiser is also able to assist in determining the as-is value and the cost
of making the necessary repairs and upgrades to the property. This informa-
tion helps the investor establish the maximum price she should pay for the
property, based on comparable sales in the market.
As many have learned from the debacles of the real estate collapse in the
early-1990s and the late-2000s subprime disaster, appraisals are often an art
and can be very subjective. You need to make sure you find an appraiser that
has a comprehensive education and training in proper appraisal techniques
and complies with USPAP (Uniform Standards of Professional Appraisal
Practice) set out by the Appraisal Foundation. The appraiser you use should
have extensive product knowledge of your target property type (residential,
commercial, and so on.) along with significant experience and market knowl-
edge in your area. Contact the local American Society of Appraisers and the
Appraisal Institute for referrals. Like many of the top professionals you seek
for your team, you should not simply look for the lowest price, because you
may end up with inferior value.
Finding an Attorney
You may think that adding an attorney to your real estate investment team
seems like an expensive luxury that you can’t afford. Indeed, you may be able
to purchase properties when you’re just starting out as a real estate inves-
tor without consulting an attorney, because buying a small rental property
is often not much different from purchasing your own home. The process is
relatively simple with preprinted forms that seem so easy to complete. And
you usually have an experienced real estate agent to guide you through the
process. (See Chapter 13 for information on locating forms.)
For simple transactions, the retention of an attorney is strictly a function of
whether attorneys are traditionally involved as the intermediary or closing
agent. If you live in an area where attorneys aren’t usually involved in real
estate transactions, an attorney may not be necessary. In some states, it’s
essential to have an attorney actually handle the transaction and closing.
But we strongly suggest that you consult with an experienced real estate attor-
ney as your investments increase in size and complexity. With more compli-
cated transactions, have the attorney review the documents — even in states
where the title or escrow company handles the paperwork and serves as the
independent intermediary or closing agent. A good real estate attorney can
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help you structure proposed transactions. Particularly if you’re looking into a
large transaction where you assume loans or you’re attempting to secure spe-
cial financing, a competent real estate attorney can be invaluable.
Robert’s late father, a real estate attorney, taught him early in his real estate
investment career that the best time to consult with an attorney is before
you finalize the proposed transaction. There is nothing your attorney can do
to avoid legal snafus and expensive litigation if he isn’t hired to draft, review,
and negotiate the terms of your proposed transaction in advance. Although
such a review may cost you some money up front, it’s definitely much more
economical than having to hire an attorney to get you out of a bind.
Seek an attorney who specializes in real estate purchasing and lease transac-
tions. Ideally, you’ll find one attorney or law firm that can assist you not only
with your transactions but also with the drafting and review of other docu-
ments as you operate the property. In particular, look for attorneys who have
specialized knowledge of tenant-landlord laws and the complicated issues sur-
rounding commercial leases.
Check references and find an attorney who has excellent communication
skills and can explain complicated legal terms and documents in terms you
understand. As with any professional, the old adage that “You get what you
pay for” holds true more often than not. So remember that the lower hourly
rate attorneys aren’t necessarily your better option, because more expen-
sive, yet more experienced, attorneys are your best bet when you’re invest-
ing in large real estate transactions.
Part II
How to Get the Money:
Raising Capital and
Financing
In this part . . .
I
n this important part, we detail the amount of money
you need to have in hand for various real estate invest-
ments, as well as where you can go to borrow the rest
(because few real estate investors buy property with 100
percent cash). In addition to discussing traditional lend-
ing sources, we also cover seller financing of properties.
Last but not least, we explain how to save money and get
the best loan for your situation.
Chapter 7
Sources of Capital
In This Chapter
▶ Moving beyond the no-money-down myth
▶ Knowing what you need to get going in real estate
▶ Locating cash
F
or many people, the trouble with real estate investing is that they lack the
access to cash for the down payment. The old adage that “it takes money
to make money” is generally true in our experience. Most real estate invest-
ing books make one of two assumptions. Some assume that you have plenty
of money and just need to figure out how to buy, add value to a property, and
then sell. Of course, it would be great if that were true, but not everyone is flush
with cash. The other common assumption is that you have no money and must
resort to scouring the real estate market in search of sellers so desperate to sell
that they or their lenders don’t require any down payment. We assume neither.
So how do you get started in real estate if you don’t want to own distressed
properties in the worst neighborhoods, and you don’t have a six-figure bal-
ance in your checking account to pay top dollar in the best neighborhoods?
You muster all the patience you can and embrace a long-term vision. You don’t
have to be wealthy or have great savings to begin making attractive real estate
investments. In this book, we present a wide range of investment options, so
there’s something for virtually everyone’s budget and personal situation. Our
method of building real estate wealth over time is to create investment returns
that are sustainable and provide generous returns on your investments.
Calculating the Costs of Admission
At some point in your life, you’ve surely had the experience of wanting to do
something and then realizing that you don’t have sufficient money to accom-
plish your goal. Perhaps it was as simple as lacking the pocket change to buy
a chocolate bar as a child. Or maybe it happened on a vacation when you ran
low on funds and tried to do business with a merchant who only took Visa
when you only carried American Express. No matter — the world of real estate
investing is no different. You can’t play if you can’t pay.
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Part II: How to Get the Money: Raising Capital and Financing
Forgetting the myth of no money down
The title of this chapter says it all: To invest in real estate, you need capital,
and likewise you need a source from which to gather said capital. On late-night
infomercials, at seminars, on audiotapes, and in books, you may hear many
self-appointed real estate experts tell you that you can invest in real estate with
literally no money. And if that’s not enticing enough, you may hear that you
can buy properties where the seller will put cash in your hands.
Have such no-money-down situations ever existed among the billions of com-
pleted real estate transactions in the history of the modern world? Why, yes
they have. Realistically, can you find such opportunities among the best real
estate investing options available to you? Why, no you can’t.
Think of the people you know who still haven’t found the perfect mate after
decades of searching. Mr. and Ms. Perfect don’t exist. Ditto the ideal real estate
investment. If you use our sensible criteria when seeking out properties that’ll
be good real estate investments and then add the requirement that you can
only make such investments with no money down, you’ll probably waste years
searching to no avail. We’ve never made a no-money-down real estate invest-
ment because the best properties simply aren’t available on that basis.
Our experience is that the no-money-down properties we have seen aren’t
properties we want to own. And if you receive cash out of escrow upon clos-
ing on a property, you’re either buying a severely distressed property that will
soon require major cash infusions or you’ve overleveraged the property. If it
sounds too good to be true, it is too good to be true! For a more complete dis-
cussion of no money down, please see Chapter 5.
Getting in the door with good credit
Don’t underestimate the importance of estab-
lishing good credit, because the best returns on
real estate rely upon the use of credit to obtain
the leverage of using OPM (other people’s
money). Lenders, property sellers, potential
partners, and so on all prefer to deal with you if
you’ve established a reputation for paying your
bills. Good to great credit is essential. Why pay
more for money when you can show the ability
to handle it properly and be rewarded with a
lower price?
Both of us began building our credit through
the responsible use of credit cards in our 20s
(paying monthly bills in full), and to this day, our
high FICO scores have allowed us to borrow
at favorable rates and terms and save tens of
thousands of dollars per year in financing costs.
And that difference will sometimes enable you
to make a deal work that otherwise won’t. We
cover the importance of good credit and ways
to remove unsightly blemishes on your credit
history that may keep you from getting solid
interest rates in Chapter 9.
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Chapter 7: Sources of Capital
Determining what you need to get started
Most of the time, real estate investors make a down payment and borrow the
majority of the money needed to complete a purchase. That is the conven-
tional way to purchase real estate investment properties and will be the most
successful method for you in the long run (as it has been for us).
In order to qualify for the most attractive financing, lenders typically require
that your down payment be at least 20 percent of the property’s purchase
price. The best investment property loans sometimes require 25 to 30 per-
cent down for the most favorable terms. Lenders tend to be more conserva-
tive and require larger down payments during periods of falling real estate
prices such as most areas experienced in the late-2000s.
For most residential investment properties, such as single-family homes,
attached housing such as condos and townhomes, and small apartment
buildings of up to four units, you can get access to the best financing terms
by making at least a 20 to 25 percent down payment. (Mortgages on non-
owner-occupied property tend to be
1
/4 to
1
/2 percent higher). You may be
able to make smaller down payments (as low as 10 percent or less), but you’ll
pay much higher interest rates and loan fees, including private mortgage
insurance. (We cover the topic of financing in Chapter 8.)
You won’t find such wonderful financing options for larger apartment build-
ings (five or more units), commercial real estate, and raw land. Compared
with residential properties of up to four units, such investment property gen-
erally requires more money down and/or higher interest rates and loan fees.
Please see Chapter 8 for more details.
Determining how much cash you need to close on a purchase is largely a
function of the estimated purchase price. Suppose you’re looking to buy
some modest residential housing for $100,000. For a 25 percent down pay-
ment you need $25,000, and adding in another 5 percent for closing costs
brings you to $30,000. If you have your heart set on buying a property that
costs three times as much ($300,000 sticker price), you need to triple these
amounts to a total of about $90,000 for the best financing options.
Rounding Up the Required
Cash by Saving
Most successful real estate investors that we know, including us, got started
building their real estate investment portfolio the old-fashioned way —
through saving money and then gradually buying properties over the years.
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Part II: How to Get the Money: Raising Capital and Financing
Many people have difficulty saving money because they don’t know how to
or are simply unwilling to limit their spending. Easy access to consumer debt
(through credit cards and auto loans) creates huge obstacles to saving more
and spending less.
Investing in real estate requires self-control, sacrifice, and discipline. Like
most good things in life, you must be patient and plan ahead to be able to
invest in real estate.
As young adults, some (but not most) people are good savers out of the gate.
Those who save regularly are often folks who acquired sound financial habits
from their parents. Other good savers have a high level of motivation to
accomplish goals such as retiring young, starting a business, buying a home,
having the flexibility to spend time with their kids, and so on. Achieving such
goals is much harder (if not impossible) when you’re living paycheck to pay-
check and worried about next month’s pile of bills.
If you’re not satisfied with how much of your monthly earnings you’re able to
save, you have two options (and you can take advantage of both):
✓ Boost your income: To increase your take-home pay, working more
may be a possibility, or you may be able to take a more lucrative career
path. Our main advice on this topic is to keep your priorities in order.
You shouldn’t put your personal health and relationships on the back
burner for a workaholic schedule. We also believe in investing in your
education. A solid education is the path to greater financial rewards and
leads to all of the great goals we discuss here. Education is key not only
for your chosen profession but also for real estate investing. Consider
getting a real estate license or learn to be an appraiser or property man-
ager — skills that not only help you with your property investing but
that also may allow you to take on part-time work to supplement your
income.
✓ Reduce your spending: For most people, this is the path to increased
savings. We have both routinely generated cash flow for investments
by living well beneath our means. Start by analyzing how much you
expend on different areas (for instance, food, clothing, insurance) each
month. After you’ve got the data, decide where and how you want to
cut back. Would you rather eat out less or have a maid come less often?
How about driving a less expensive (but not less safe) car versus taking
lower cost vacations? Although the possibilities to reduce your spend-
ing are many, you and only you can decide which options you’re willing
and able to implement. If you need more help with this vital financial
topic, consult the latest edition of Eric’s bestseller Personal Finance For
Dummies (Wiley).
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Chapter 7: Sources of Capital
Overcoming Down Payment Limitations
Most people, especially when they make their first real estate purchase, are
strapped for cash. If you don’t have 20-plus percent of the purchase price,
don’t panic and don’t get depressed — you can still own real estate. We’ve
got some solutions — you can either change your approach, allowing you
more time to save or lowering your entry fees, or you can seek other sources
of funding. In the following section, we lay out your options.
Changing your approach
Some ways you can alter your approach without having to find money else-
where are as follows:
✓ Seek low money down loans with private mortgage insurance: Some lend-
ers may offer you a mortgage even though you may be able to put down
only 10 percent of the purchase price. These lenders will likely require you
to purchase private mortgage insurance (PMI) for your loan. This insur-
ance generally costs several hundred dollars per year and protects the
lender if you default on your loan. (When you do have at least 20 percent
or higher equity in the property, you can generally eliminate the PMI.)
✓ Delay your gratification: If you don’t want the cost and strain of extra
fees and bad mortgage terms, postpone your purchase. Boost your sav-
ings rate. Examine your current spending habits and plan to build up a
nest egg to use to invest in your first rental. Often real estate investors
get started by actually buying a new home and simply keeping their old
home as a rental. For more information, see the section “Make saving a
habit” later in the chapter.
✓ Think smaller: Consider lower-priced properties. Smaller properties and
ones that need some work can help keep down the purchase price and
the required down payment. For example, a duplex where you live in
one unit and rent out the other is also a cost-effective way to get started.
✓ Turn to low entry cost options: For the ultimate in low entry costs, real
estate investment trusts (REITs) are best. These stock exchange traded
securities (which can also be bought through REIT-focused mutual
funds) can be bought into for several thousand dollars or less. REIT
mutual funds can often be purchased for $1000 or less inside retirement
accounts. (See Chapter 4 for more on investing in REITs.)
Lease options represent another low cost (although more complicated)
opportunity. With these, you begin by renting a property you may be
interested in purchasing down the road. In the interim, a portion of your
monthly rental payment goes toward the future purchase price. If you
can find a seller willing to provide financing, you can keep your down
payment to a minimum. Turn to Chapter 3 for more on lease options.
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Tapping into other common cash sources
Saving money from your monthly earnings will probably be the foundation
for your real estate investing program. However, you may have access to
other financial resources for down payments. Before we jump into these, we
offer a friendly little reminder: Monitor how much of your overall investment
portfolio you place into real estate and how diversified and appropriate your
holdings are given your overall goals. (Please see Chapter 1).
Dipping into your retirement savings
Some employers allow you to borrow against your retirement account bal-
ance, under the condition that you repay the loan within a set number of
years. Subject to eligibility requirements, first-time homebuyers can make
penalty-free withdrawals of up to $10,000 from IRA accounts. (Note: You
still must pay regular income tax on the withdrawal, which can significantly
reduce the cash available.)
Borrowing against home equity
Most real estate investors that we know began building their real estate
portfolio after they bought their own home. Conservatively tapping into
your home’s equity may be a good down payment source for your property
investments.
You can generally obtain mortgage money at a lower interest rate on your
home than you can on investment property. The smaller the risk to the lender,
the lower its required return — and thus, the better rates for you as the bor-
rower. Lenders view rental property as a higher risk proposition and for good
reason: They know that when finances go downhill and the going gets really
tough, people pay their home mortgage to avoid losing the roof over their
heads before they pay debts on a rental property.
Unless your current mortgage was locked in at lower rates than are available
today, we generally recommend refinancing the first loan and freeing up
equity that way versus taking out a home equity loan or line of credit.
A variation on the borrowing-against-home-equity idea uses the keep-your-
original-home-as-a-rental strategy. You build up significant equity in your
owner-occupied home and then need or want a new home. Refinance the
existing home (while you still live there, for the best owner-occupied rates)
and then convert it into a rental. Take the tax-free proceeds from the refi-
nance and use that as the down payment on your new owner-occupied home.
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Before you go running out to borrow to the maximum against your home, be
sure that you
✓ Can handle the larger payments: In the previous edition of this book,
we said,
“We don’t recommend borrowing more than the value of your home, as you
may be enticed to do with some of the loan programs that pitch borrowing
upwards of 125 percent of the value of your home. We hear these programs
being routinely touted as not only a way to free up equity and pay down
consumer debt, but also encouraging people to borrow in excess of the
current value of their home so they can invest in more real estate. This
excessive leveraging is dangerous and could come back to haunt you!”
We’re proud to have provided this sage advice before the real estate
crisis hit home in the late-2000s. Please see Chapter 1 for the big picture
on personal financial considerations.
✓ Understand the tax ramifications of all your alternatives: Borrowing
more against your home at what appears to be a slightly lower rate may
end up costing you more after taxes if some of the borrowing isn’t tax
deductible. Under current tax laws, interest paid on home mortgages
(first and second homes) of up to $1 million is tax deductible. You may
also deduct the interest on home equity loans of up to $100,000.
Be careful to understand the tax-deductibility issue when you refinance
a home mortgage and borrow more than you originally had outstanding
on the prior loan. If any of the extra amount borrowed isn’t used to buy,
build, or improve your primary or secondary residence, the deductibil-
ity of the interest on the excess amount borrowed is limited. Specifically,
you may not deduct the interest on the extra amount borrowed that
exceeds the $100,000 home equity limit.
✓ Fully comprehend the risks of losing your home to foreclosure: The
more you borrow against your home, the greater the risk that you may
lose the roof over your head to foreclosure should you not be able to
make your mortgage payments. That’s exactly what happened to too
many folks during the late-2000s real estate market decline.
Moving financial investments into property investments
As you gain more comfort and confidence as a real estate investor, you may
want to redirect some of your dollars from other investments like stocks,
bonds, and mutual funds into property. If you do, be mindful of the following:
✓ Diversification: Real estate is one of the prime investments (the others
being stocks and small business) for long-term appreciation potential.
Be sure that you understand your portfolio’s overall asset allocation and
risk when making changes. Please see Chapter 1 for more details.
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✓ Tax issues: If you’ve held other investments for more than one year, you
can take advantage of the low long-term capital gains tax rates if you
now want to sell. The maximum federal tax rate for so-called long-term
capital gains (investments sold for more than they were purchased for
after more than 12 months) is now just 15 percent. Investors in the two
lowest federal income tax brackets of 10 and 15 percent enjoy a 0 per-
cent long-term capital gains tax rate. Try to avoid selling appreciated
investments within the first year of ownership. Be sure to check on the
latest tax laws because there’s no guarantee these rates will continue in
the future.
Separating investments from cash value life insurance
You may own a cash value life insurance policy — one that combines a life
insurance death benefit with a savings type account in which some money
accumulates and on which interest is paid. In addition to being a costly cash
drain with its relatively high premiums, cash value life insurance investment
returns tend to be mediocre to dismal.
You’re best off separating your life insurance purchases from your investing. If
you need life insurance (because others are dependent on your income), buy
a term life policy, which is pure, unadulterated life insurance. But don’t cancel
your current cash value policies before replacing them with term if you do
indeed need life insurance protection.
Robert had a $500,000 whole life policy that he was sold when he was much
younger and more naive — and before he knew of Eric and his financial
advice! He ultimately decided to cash out the policy, the proceeds from
which he used to invest in an apartment deal. So rather than earning a
meager few percent per year in a cash value life policy, Robert has since
enjoyed double-digit annualized returns in a good real estate investment.
Capitalizing on advanced
funding strategies
Sophisticated investors who develop an extensive real estate investment
portfolio can employ more complicated strategies. In this section, we outline
those along with our advice for how to make them work.
Leveraging existing real estate investments
Over time, if the initial properties you buy do what they’re supposed to do,
they’ll appreciate in value. Thus, you may be able to take extra tax-free cash
from your successful investments to make more purchases. This tactic is
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called hypothecating your real estate. As we discuss in the section “Borrowing
against home equity” earlier in this chapter, many investors begin by employ-
ing this strategy with their owner-occupied home. They buy a home, it appre-
ciates over the years, and then they tap that equity to fund other real estate
purchases. By the same token, as you acquire more properties and they then
appreciate, you can tap their equity for other purchases.
As you build a real estate empire, you must exercise care not to overextend
yourself. The downside to continually pulling equity out of appreciated prop-
erties is that your fortunes may change. If the local real estate market or econ-
omy hit difficult times as happened in some areas in the late-2000s, you may
find yourself with vacancies and falling rents. In the worst cases, excessively
leveraged real estate investors have ended up losing some properties or even
bankrupt.
Bringing in partners or other investors
If smaller, lower-priced properties don’t satisfy your desires, you may be
able to find a partner. For example, find a duplex and get a partner where you
both initially occupy the property and make the payments, because duplexes
are typically more cost-effective per unit than unattached properties.
Especially to accomplish larger deals, you may need or want to invest with a
partner or other investors for the sake of diversification and risk reduction.
Bringing in a partner can also provide additional financial resources for down
payments and capital improvements as well as greater borrowing capability.
Partners can be either the best thing or the worst thing that ever happened
to you. Although the additional financial resources are essential when you’re
starting out in real estate, attempt to find partners with complementary skills
to really take advantage of the potential of real estate investment partnerships.
For example, Robert has focused on establishing partnerships where each
partner brings a needed skill to the table. One partnership consisted of a
top local real estate broker who identified properties along with a partner
who was a real estate lender and knew the ins and outs of lending. Robert’s
company provided the property and asset management to reposition the
property and create value. This team used their complementary skills to suc-
cessfully purchase, renovate, and later resell a 48-unit apartment building
while providing cash distributions to the partners during the holding period.
With the assistance of a good attorney, prepare a legal contract to specify
(among other issues) what happens if a partner wants out. A buy/sell agree-
ment makes a lot of sense because it outlines the terms and conditions in
advance for how partnership assets can be redistributed. With life events
(death, divorces, new marriages) constantly changing partnerships, having a
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buy/sell agreement in place at the time the partnership is initially established
prevents bickering down the road. Partnership disputes often enrich attor-
neys and accountants, rather than the partners or their intended beneficiaries.
Family members sometimes make good partners. Parents, grandparents,
and perhaps even siblings may have some extra cash they want to loan or
invest. But some families aren’t suited for partnering to buy and operate real
estate. Disputes over management style, cash distributions versus reinvest-
ing in the property, and how and when to sell are difficult in any partnership
but particularly in families where there may be different goals based on the
age or personal desires of the family members. If you already don’t get along
well at family gatherings, throw in a real estate partnership to really get the
fireworks going! To minimize the potential problems, we strongly suggest
documenting any real estate investment or lending relationship in writing
just as diligently as you would with a non–family member. When working
with family, you may be better off borrowing money with a promissory note,
a repayment plan, and interest payments. Check out Chapter 14 for more on
partnerships.
Seeking seller financing
You may be able to find some properties that your research suggests offer
potentially attractive investment returns and for which the seller may be will-
ing to extend financing. Some property owners or developers may finance
your purchase with as little as 10 percent or even less down. This method
can be an extremely beneficial way to buy real estate when your cash posi-
tion is limited. You can often set up the transaction as an installment sale so
that the seller has the added benefit of stretching the reporting of income
over a period of time and thus reducing her tax liability. You conserve your
cash; the seller reduces her taxable income.
The drawback with seller-financed properties is that you can’t be as picky
about what you get; a limited supply is available, and many properties
offered with seller financing need work or haven’t yet sold for other reasons.
Often these are reasons that only become apparent after you’re the owner!
Avoid properties that are distressed (have major problems and flaws). Don’t
get sucked in by great financing alone; only consider purchasing a property
with seller financing that you would be willing to buy conventionally. The
seller financing should just be an extra benefit, not the only benefit! Please see
Chapter 8 for details.
Taking on margin debt
In the section “Stocks, bonds, mutual funds, and other investments” earlier in
this chapter, we cover selling some of your non–real estate investments in
order to raise capital for property purchases. If you own stocks and other
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securities in a brokerage account, you can actually borrow funds against
those investments. For example, if you’re the proud owner of $100,000 worth
of so-called marginable securities in a brokerage account, you may be able to
borrow up to $50,000 at attractive interest rates, typically a little lower than
on fixed rate mortgages for a home.
In addition to providing you with a relatively low-cost source of funds, utiliz-
ing margin debt for real estate purchases also enables you to hold onto more
securities, which can better diversify your real estate holdings.
Be careful when using margin debt. Stocks, bonds, and other investments
can drop in value, sometimes sharply. When that happens as it did in 2008,
you may face what is known as a margin call, where you have to increase the
equity in your brokerage account, either by adding cash to it directly or by
selling some of your securities. Having to sell during tough times can force
you to liquidate shares at low prices. To add insult to injury, a significant
stock market decline like the ones that occurred in 2008 or in the early-1990s,
can coincide with a slumping real estate market.
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Chapter 8
Financing Your
Property Purchases
In This Chapter
▶ Understanding lender financing options
▶ Selecting the best mortgage for your situation
▶ Looking at home equity loans
▶ Seeking seller financing
▶ Knowing which mortgages to avoid
W
e know property investors who spent dozens to hundreds of hours
finding the best locations and properties only to have their deals
unravel when they were unable to gain approval for needed financing. You
can’t play if you can’t pay.
This chapter covers the financing options you should consider (and high-
lights those that you should avoid). We explain how to select the mortgage
that is most appropriate for the property you’re buying and your overall
personal and financial situation. In Chapter 9, we cover the actual process of
applying for and locking up the specific loan you want.
Taking a Look at Mortgage Options
Although you can find thousands of different types of mortgages (thanks to
all the various bells and whistles available), only two major categories of
mortgages exist: fixed interest rate and adjustable rate. Technically speaking,
some mortgages combine elements of both — they may remain fixed for a
number of years and then have a variable interest rate after that. This section
discusses these major loan types, what features they typically have, and how
you can intelligently compare them with each other and select the one that
best fits with your investment property purchases.
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Fixed-rate mortgages
Fixed-rate mortgages, which are typically for a 15- or 30-year term for single-
family properties, condos, and one- to four-unit apartments, have interest
rates that remain constant over the life of the loan. Because the interest rate
stays the same, your monthly mortgage payment stays the same.
Examining the pros and cons
For purposes of making future estimates of your property’s cash flow, fixed-
rate mortgages offer you certainty and some peace of mind because you
know precisely the size of your mortgage payment next month, next year,
and ten years from now. (Of course, the other costs of owning investment
property — such as property taxes, insurance, maintenance, and so on —
still escalate over the years.) But this piece of mind comes at a price:
✓ You generally pay a premium, in the form of a higher interest rate,
compared with loans that have an adjustable interest rate over time. If
you’re buying a property and planning to improve it and sell it within
five to ten years, you may be throwing money away by taking out a fixed-
rate loan to lock in an interest rate for decades.
✓ If, like most investment property buyers, you’re facing a tough time
generating a healthy positive cash flow in the early years of owning a
particular investment property, a fixed-rate mortgage is going to make it
even more financially challenging. An adjustable-rate mortgage, by con-
trast, can lower your property’s carrying costs in those early years. (We
discuss adjustable-rate mortgages in the next section.)
✓ Fixed-rate loans carry the risk that if interest rates fall significantly after
you obtain your mortgage and you’re unable to refinance, you’re stuck
with a relatively higher-cost mortgage. For example, you may be unable
to refinance if you lose your job, your employment income declines, the
value of your property decreases, or the property’s rental income slides.
Also remember that even if you’re able to refinance, you’ll probably
have to spend significant time and money to get it done.
Making a point of comparing fixed rates
In addition to the ongoing, constant interest rate charged on a fixed-rate
mortgage, lenders also typically levy an upfront fee, called points, which
can be considered prepaid interest. Points are generally a percentage of the
amount borrowed. To illustrate, 1.5 points are equal to 1.5 percent of the loan
amount. So, for example, on a $200,000 mortgage, 1.5 points translate into a
$3,000 upfront (also known as prepaid) interest. Points can add significantly
to the cost of borrowing money, particularly if you don’t plan to keep the
loan for long.
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Generally speaking, the more points you pay on a given loan, the lower the
ongoing interest rate the lender charges on that loan. That’s why you can’t
compare various lenders’ fixed-rate loans to one another unless you know the
exact points on each specific mortgage, in addition to that loan’s ongoing
interest rate.
The following are two approaches to dealing with points, given your financial
situation and investment goals:
✓ Minimize the points: When you’re running low on cash to close on a
mortgage, or if you don’t plan to hold the loan or property for long, you
probably want to keep your points (and other loan fees discussed in the
next section) to a minimum. You may want to take a higher interest rate
on your mortgage.
✓ Pay more points: If you’re more concerned with keeping your ongoing
costs low, plan to hold the property for many years, and aren’t cash con-
strained to close on the loan now, consider paying more points to lower
your interest rate. This is known as buying down the loan rate and can
be an excellent strategy to lower your overall costs of borrowing and
increase the property’s cash flow and equity buildup.
To make an easier apples-to-apples comparison of mortgages from different
lenders, get interest rate quotes at the same point level. For example, ask each
lender for the interest rate on a particular fixed-rate mortgage for which you
pay one point or two points, for example. You may also compare the annual
percentage rate (APR), which is a summary loan cost measure that includes all
of a loan’s fees and costs. However, please remember that the APR assumes
that you hold the mortgage for its entire term — such as 15 or 30 years. If you
end up keeping the loan for a shorter time period, either because you refi-
nance or pay off the mortgage early, the APR isn’t valid and accurate (unless
you recalculate based on the changed term and payoff).
Adjustable-rate mortgages (ARMs)
Adjustable-rate mortgages (ARMs) carry an interest rate that varies over time.
An ARM starts with a particular interest rate, usually a good deal lower than
the going rate on comparable length (15- or 30-year) fixed-rate mortgages,
and then you pay different rates for every year, possibly even every month,
during a 30-year mortgage. Because the interest rate on an ARM changes over
time, so too does the size of the loan’s monthly payment. ARMs are often
attractive for a number of reasons:
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✓ You can start paying your mortgage with a relatively low initial inter-
est rate compared with fixed-rate loans. Given the economics of a typi-
cal investment property purchase, ARMs better enable an investor to
achieve a positive cash flow in the early years of property ownership.
✓ Should interest rates decline, you can realize most, if not all, of the ben-
efits of lower rates without the cost and hassle of refinancing. With a
fixed-rate mortgage, the only way to benefit from an overall decline in
the market level of interest rates is to refinance.
ARMs come with many more features and options than do fixed-rate mort-
gages, including caps, indexes, margins, and adjustment periods. The follow-
ing sections help you to understand these important ARM features.
Start rate
The start rate on an ARM is the interest rate the mortgage begins with. Don’t
be fooled though: You don’t pay this tantalizingly low rate for too long. That
is why it’s often called a teaser rate. The start rate on most ARMs is set arti-
ficially low to entice you. In other words, even if the market level of interest
rates doesn’t change, your ARM is destined to increase as soon as the terms
of the loan allow (more on this topic in a minute). An increase of one or two
percentage points is common. The formula for determining the future inter-
est rates on an ARM and rate caps is far more important in determining what
a mortgage is going to cost you in the long run.
Future interest rate
The first important thing to ask a mortgage lender or broker about an ARM
you’re contemplating is the formula for determining the future interest rate
on your loan. ARMs are based on the following formula:
Future Interest Rate = Index + Margin
The index is a designated measure of the market interest rate that the lender
chooses to calculate the specific interest rate for your loan. Indexes are gen-
erally (but not always) widely quoted in the financial press. The margin is
the amount added to the index to determine the interest rate that you pay on
your mortgage.
For example, suppose that the loan you’re considering uses a one-year trea-
sury bill index, which is currently 4 percent, and the loan you’re considering
has a margin of 2.75 percent (also often referred to as 275 basis points; 100
basis points equals 1 percent). Thus, the following formula would drive the
rate of this mortgage:
One-Year Treasury Bill Rate (4 percent) + Margin (2.75 percent)
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Do the math and you get 6.75 percent. This figure is known as the fully
indexed rate (the rate the loan has after the initial rate expires and if the
index stays constant). If this loan starts out at just 4 percent, you know that
if the one-year Treasury bill index remains at the same level, your loan can
increase to 6.75 percent. If this index rises one percent to 5 percent during
the period that you’re covered by the ARM’s start rate, that means the loan’s
fully indexed rate goes to 7.75 percent (5.00 + 2.75), which is three percent
higher than the loan’s start rate.
Compare the fully indexed rate on an ARM you’re considering to the current
rate for a comparable term fixed-rate loan. You may see that the fixed-rate
loan is at about the same interest rate, which may lead you to reconsider your
choice of an ARM that carries the risk of rising to a higher future level.
Understanding ARM indexes
The different indexes used on ARMs vary mainly in how rapidly they respond
to changes in interest rates. If you select an adjustable-rate mortgage tied
to one of the faster-moving indexes, you take on more of a risk that the next
adjustment may reflect interest rate increases. When you take on more of the
risk that rates may increase, lenders cut you breaks in other ways, such as
through lower caps (the maximum rate increase possible over a given time
period; see “Future interest rate adjustments” later in the chapter), lower
margins or lower points.
Should you want the security of an ARM tied to a slower-moving index, you
pay for that security in one form or another, such as a higher start rate, caps,
margin, or points. You may also pay in other, less-obvious ways. A slower-
moving index, such as the 11th District Cost of Funds Index (COFI, discussed
later), lags behind general changes in market interest rates, so it continues
to rise after interest rates peak and goes down slower after rates have turned
down. The following list covers some of these indexes.
✓ Treasury bills (T-bills) are IOUs that the U.S. government issues. Most
ARMs are tied to the interest rate on 6-month or 12-month T-bills (also
referred to as the one-year constant maturity Treasury index). This is a
relatively rapidly moving index. Some investment property mortgages
are tied to the rate on ten-year Treasury Notes. Being a somewhat longer-
term bond, a ten-year index doesn’t generally move as rapidly as the
shorter-term indexes.
✓ Certificates of deposit (CDs) are interest-bearing bank deposits that lock
the depositor in at a set interest rate for a specific period of time. ARMs
are usually tied to the average interest rate that banks are paying on six-
month CDs. Like T-bills, CDs tend to respond quickly to changes in the
market’s level of interest rates.
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✓ London Interbank Offered Rate Index (LIBOR) is an average of the rate
of interest that major international banks charge each other to borrow
large sums of U.S. dollars, which is commonly referred to by real estate
lenders as an index for their adjustable loans. LIBOR tends to move and
adjust quite rapidly to changes in interest rates and is at times even
more volatile than the U.S. Treasury or CD index rates.
✓ Eleventh District Cost of Funds Index (COFI) is a relatively slow-moving
index. Adjustable-rate mortgages tied to the 11th District Cost of Funds
Index tend to start out at a higher interest rate. A slower-moving index
has the advantage of moving up less quickly when rates are on the rise.
On the other hand, you have to be patient to benefit from falling interest
rates.
In a relatively low-interest rate environment, such as in the early-2000s,
few lenders offer COFI loans. This illustrates the point that lenders don’t
always offer the same choice of indexes. Rather, each lender offers one
or typically no more than two indexes, and borrowers should specifically
look at the index as part of their overall decision on choosing a lender.
Future interest rate adjustments
After the initial interest rate ends, the interest rate on an ARM fluctuates
based on the loan formula. Typically, ARM interest rates change every 6 or
12 months, but some adjust every month. In advance of each adjustment, the
lender sends you a notice telling you your new rate. Be sure to check these
notices because on rare occasions, lenders make mistakes.
Almost all ARMs come with a rate cap, which limits the maximum rate change
(up or down) allowed at each adjustment. This limit is usually referred to as
the adjustment cap. On most loans that adjust every six months, the adjust-
ment cap is 1 percent; the interest rate charged on the mortgage can move
up or down no more than one percentage point in an adjustment period.
Loans that adjust more than once per year usually limit the maximum rate
change that’s allowed over the entire year as well — known as the annual
rate cap. On the vast majority of such loans, 2 percent is the annual rate cap.
Likewise, almost all ARMs come with lifetime caps, which represent the high-
est rate allowed over the entire life of the loan. Lifetime caps of 5 to 6 percent
higher than the initial start rate are common for adjustables.
Taking an ARM without rate caps is like heading out for a weeklong outdoor
trek without appropriate rain gear. When you consider an adjustable-rate
mortgage, you must identify the maximum payment that you can handle. If
you can’t handle the payment that comes with a 10 or 11 percent interest
rate, for example, don’t look at ARMs that may go that high. As you crunch
the numbers to see what your property’s cash flow looks like under different
circumstances (see Chapter 12), consider calculating how your mortgage
payment changes based on various higher interest rates.
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Avoiding negative amortization ARMs
As you make mortgage payments over time, the loan balance you still owe
is gradually reduced or amortized. Negative amortization (when your loan
balance increases) is the reverse of this process. Some ARMs allow nega-
tive amortization. How can your outstanding loan balance grow when you
continue to make mortgage payments? This phenomenon occurs when your
mortgage payment is less than it really should be.
Some loans cap the increase of your monthly payment amount but don’t cap
the interest rate. Thus, the size of your mortgage payment may not reflect all
the interest that you currently owe on your loan. So, rather than paying the
interest that you owe and paying off some of your loan balance (or principal)
every month, you end up paying off some, but not all, of the interest that you
owe. Thus, lenders add the extra, unpaid interest that you still owe to your
outstanding debt.
Negative amortization is similar to paying only the minimum payment that
your credit card bill requires. You continue to rack up finance charges (in
this case, greater interest) on the balance as long as you only make the arti-
ficially low payment. Taking a loan with negative amortization defeats the
whole purpose of borrowing an amount that fits your overall financial goals.
Avoid ARMs with negative amortization. The only way to know whether a
loan includes negative amortization is to explicitly ask. Some lenders and
mortgage brokers aren’t forthcoming about telling you. If you have trouble
finding lenders that will deal with your financial situation, make sure that
you’re especially careful — you find negative amortization more frequently
on loans that lenders consider risky.
Reviewing Other Common Fees
Whether the loan is fixed or adjustable, mortgage lenders typically assess
other upfront fees and charges. These ancillary fees can really amount
to quite a bundle with some lenders. Here’s our take on the typical extra
charges you’re likely to encounter and what’s reasonable and what’s not:
✓ Application fee: Most lenders charge several hundred dollars to work
with you to complete your paperwork and see it through their loan eval-
uation process. Should your loan be rejected, or if it’s approved and you
decide not to take it, the lender needs to cover its costs. Most lenders
credit or return this fee to you upon closing with their loan.
✓ Credit report charge: Most lenders charge you for the cost of obtaining
your credit report, which tells the lender whether you’ve repaid other
loans, including consumer debt (such as credit cards, auto loans, and
so on), on time. Your credit report should cost about $50 for each indi-
vidual or entity that will be a borrower.
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✓ Appraisal fee: The property for which you borrow money needs to
be valued. If you default on your mortgage, a lender doesn’t want to
get stuck with a property that’s worth less than you owe. The cost for
appraisal typically ranges from several hundred dollars for most resi-
dential properties to as much as $1,000 or more for larger investment
properties. (On particularly large properties, this fee can be more sig-
nificant — on a 30,000-square-foot office building, an appraisal may run
around $5,000; on a 300-plus-unit apartment building, it is more in the
$10,000 range.)
✓ Environmental assessment or phase I: Virtually all lenders making loans
on residential properties with five or more units or, especially, com-
mercial property, require a qualified engineering company to perform a
site assessment and overview of the entire area in which the property
is located to identify possible environmental issues. This type of report
is commonly referred to as a phase I environmental report, and the cost
directly correlates to the location, type of property, size, and even the
prior use of the property and the surrounding area. Phase I reports can
run from $300 to as much as tens of thousands of dollars. (We include
more details in Chapter 14.)
✓ Third-party physical inspection: Depending on the property being
financed, lenders often require third-party inspections by competent
professionals. For example, an inspection report from a licensed pest
control firm documenting the property condition and specifically the
presence of termites and/or wood-destroying organisms is required in
virtually all transactions, including single-family homes and commercial
properties. Again, the cost of these reports varies depending on the
property. (More details to come in Chapter 14.)
No-point mortgages aren’t no-brainers
Some property buyers are attracted to no-point
or zero-cost mortgages (which also some-
times have no other loan fees or costs either).
Remember that if a loan has no points, it’s sure
to have a higher interest rate. That’s not to say
that no-point loans are better or worse than
comparable loans from other lenders, but don’t
get duped into a loan because of a no-points
sales pitch. The lenders who heavily promote
these types of loans rarely have the best mort-
gage terms.
Consider a no-point/no-fee mortgage if you
can’t afford more out-of-pocket expenditures
now or if you think that you’ll only keep the loan
a few years. But if you’re that cash constrained,
you may want to consider whether you can
truly afford to buy investment property (see
Chapter 1).
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Request a detailing of other fees and charges in writing from all lenders that
you’re seriously considering. You need to know the total of all lender fees
so that you can accurately compare different lenders’ loans and determine
how much closing on your loan will cost you. For residential and commercial
income properties, the lender usually asks for a deposit that the lender uses
to cover the types of fees and charges outlined here.
To reduce the possibility of wasting your time and money applying for a mort-
gage that you may not qualify for, ask the lender for any reasons it may not
approve you. Disclose any problems on your credit report or with the prop-
erty. Don’t expect the lender to provide you with a list of credit or property
problems that may conceivably put the kibosh on a mortgage.
Making Some Mortgage Decisions
You can’t (or at least shouldn’t) spend months deciding which mortgage may
be right for your situation. So, in this section, we help you zero in on which
type is best for you.
Choosing between fixed and adjustable
Choosing between a fixed-rate or adjustable-rate loan is an important deci-
sion in the real estate investment process. Consider the advantages and dis-
advantages of each mortgage type and decide what’s best for your situation
prior to going out to refinance or purchase real estate. This section covers
the key factors to consider.
Your ability and desire to accept financial risk
How much risk can you handle in regard to the size of your property’s
monthly mortgage payment? If you can take the financial risks that come
with an ARM, you have a better chance of saving money and maximizing your
property’s cash flow with an adjustable-rate rather than a fixed-rate loan.
Your interest rate starts lower and stays lower with an ARM, if the overall
level of interest rates stays unchanged. Even if rates go up, they’ll likely
come back down over the life of your loan. If you can stick with your ARM for
better and for worse, you should come out ahead in the long run.
ARMs make more sense if you borrow less than you’re qualified for. If your
income (and applicable investment property cash flow) significantly exceeds
your spending, you may feel less anxiety about the fluctuating interest rate
on an ARM. If you do choose an adjustable loan, you may feel more financially
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secure if you have a hefty financial cushion (at least six months’ to as much as
a year’s worth of expenses reserved) that you can access if rates go up.
Some people take ARMs when they can’t really afford them. When rates rise,
property owners who can’t afford higher payments face a financial crisis. If
you don’t have emergency savings that you can tap into to make the higher
payments, how can you afford the monthly payments and the other expenses
of your property?
If you can’t afford the highest-allowed payment on an ARM, don’t take one.
You shouldn’t take the chance that the rate may not rise that high — it can,
and you can lose the property.
Ask your lender to calculate the highest possible monthly payment that your
loan allows. The number the lender comes up with is the payment that you
face if the interest rate on your loan goes to the highest level allowed, or the
lifetime cap. (For more on caps, see the “Future interest rate adjustments”
section earlier in the chapter.)
Don’t take an adjustable mortgage because the lower initial interest rate
allows you to afford the property that you want to buy (unless you’re abso-
lutely certain that your income and property cash flow will enable you to meet
future payment increases). Try setting your sights on a property that you can
afford to buy with a fixed-rate mortgage.
Length of time you expect to keep the mortgage
Saving interest on most ARMs is usually a certainty in the first two or three
years. An adjustable-rate mortgage starts at a lower interest rate than a fixed
one. But, if rates rise, you can end up repaying the savings that you achieve
in the early years of the mortgage.
If you aren’t going to keep your mortgage for more than five to seven years,
you pay more interest to carry a fixed-rate mortgage. A mortgage lender takes
extra risk in committing to a fixed-interest rate for 15 to 30 years. Lenders
don’t know what may happen in the intervening years, so they charge you a
premium in case interest rates move significantly higher in future years.
You may also consider a hybrid loan, which combines features of fixed- and
adjustable-rate mortgages. For example, the initial rate may hold constant
for three, five, seven, or ten years and then adjust once a year or every six
months thereafter. Such loans may make sense for you if you foresee a high
probability of keeping your loan seven to ten years or less but want some
stability in your future monthly payments. The longer the initial rate stays
locked in, the higher the interest rate. Don’t confuse these loans with the
often-unadvisable balloon mortgage (which we discuss in the “Mortgages
That Should Make You Think Twice” section later in the chapter).
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Selecting short-term or long-term
Most mortgage lenders offer you the option of 15-year or 30-year mortgages.
You can also find 20-year and 40-year options, but these are unusual. So how
do you decide whether a shorter- or longer-term mortgage is best for your
investment property purchase?
To afford the monthly payments and have a positive cash flow, many invest-
ment property buyers need to spread their mortgage loan payments over a
longer period of time, and a 30-year mortgage is the way to do it. A 15-year
mortgage has higher monthly payments because you pay it off quicker. At a
fixed-rate mortgage interest rate of 7 percent, for example, a 15-year mort-
gage comes with payments that are about 35 percent higher than those for a
30-year mortgage.
Locking yourself into higher monthly payments with a 15-year mortgage may
actually put you at greater financial risk. If your finances worsen or your prop-
erty declines in value, odds are you’ll have trouble qualifying for a refinance.
You may be able to refinance your way out of the predicament, but you can’t
count on it.
Don’t consider a 15-year mortgage unless you’re sure that you can afford
the higher payments that come with it. Even if you can afford these higher
payments, taking the 15-year option isn’t necessarily better. You may be
able to find better uses for the money. If you can earn a higher rate of return
investing your extra cash versus paying the interest on your mortgage, for
instance, you may come out ahead investing your money rather than paying
down your mortgage faster. Some real estate investors, including Robert, are
attracted to 15-year mortgages to get their loans paid off by retirement age.
If you decide on a 30-year mortgage, you still maintain the flexibility to pay
the mortgage off faster if you choose to. You can choose to make larger-than-
necessary payments and create your own 15-year mortgage. However, you can
fall back to making only the payments required on your 30-year schedule when
the need arises. The only situation in which you can’t pay off your 30-year mort-
gage faster is if the loan has a prepayment penalty (a penalty for paying off your
loan before you’re supposed to), which we dislike. Normally, prepayment penal-
ties don’t apply if you pay off a loan because you sell the property, but when
you refinance a loan with prepayment penalties, you have to pay the penalty.
Borrowing Against Home Equity
Home equity loans (or a derivative called a HELOC — home equity line of
credit) enable you to borrow against the equity in your home. Because such
loans are in addition to the mortgage that you already have (known as the
first mortgage), home equity loans are also known as second mortgages.
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A home equity loan may provide a relatively low-cost source of funds for an
investment property purchase, especially if you’re seeking money for just
a few years. You can refinance your first mortgage and pull cash out for an
investment property purchase, but we don’t advise doing that if your first
mortgage is at a lower interest rate than you can obtain on a refinance.
Home equity loans generally have higher interest rates than comparable first
mortgages because they’re riskier to a lender. The reason: In the event that
you default on the first mortgage or file for bankruptcy protection, the first
mortgage lender gets first claim on your home.
Interest paid of up to $1 million on home mortgages for primary or second-
ary residences is tax deductible (on loans taken out after October 13, 1987).
The tax deduction for home equity loans is limited to the interest paid on up
to $100,000 of home equity debt. See Chapter 7 for a discussion of borrowing
against home equity in the context of finding down payment money.
Getting a Seller-Financed Loan
Not every seller needs or even wants to receive all cash as payment for
his property, so you may be able to finance part or even all of an investment
property purchase thanks to the property seller’s financing. The use of seller
financing is the cornerstone of most no-money-down strategies.
Seller financing is a transaction in which the seller accepts anything less than
all cash at closing. One form of an all-cash transaction to the seller is the buyer
literally paying all cash, but typically it’s a transaction in which the buyer uses
a conventional loan (money to purchase the property from a lender other than
the seller) so that the seller effectively receives all cash at closing.
Some sellers are financially well off enough that they don’t need all of the
sales proceeds immediately for their next purchase or are buying a property
for less money — or maybe not buying a replacement property at all — and
prefer to receive payments over time. They may be looking for the payments
to replace their income in retirement or they may prefer to receive the funds
over time so they can reduce their taxable income.
Any seller with equity can offer seller financing, but usually private individuals
are the best sources. The best candidates for seller financing are sellers with
significant equity or, best of all, folks who own their property free-and-clear
(without any debt on the property at all). Many seniors have owned their
properties for years and may be more willing to extend a loan.
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Sometimes sellers offer this option, but in other cases, you need to pop
the question. We can think of two good reasons to ask for the seller to help
finance an investment property purchase:
✓ Better terms: Mortgage lenders, which are typically banks or large
monolithic financial institutions, aren’t the most flexible businesses in
the world. You may well be able to obtain a lower interest rate, lower
or waived fees, and more flexible repayment conditions from a prop-
erty seller. There are also many expenses with conventional loans that
a property seller may not require: loan points, origination fees, and an
appraisal. Some sellers may not even require a loan application or credit
report, but they’d be wise to go through due diligence (including a per-
sonal financial statement) on the buyer.
✓ Loan approval: Perhaps you’ve had prior financial problems that have
caused mortgage lenders to routinely deny your mortgage application.
Some property sellers may be more flexible, especially in a slow real
estate market or with a property that’s challenging to sell. A seller can
also make a decision in a few days, whereas a conventional lender often
takes weeks.
Be careful when considering a property where a seller is offering financing as
part of the deal; this act may be a sign of a hard-to-sell property. Investigate
how long the property has been on the market and what specific flaws and
problems it may have.
Some of the reasons why sellers may offer their own financing are listed below:
✓ They’re attracted to the potential returns of being a mortgage lender.
This reason shouldn’t concern the buyer as long as the terms of the
seller financing are reasonable and avoid the issues raised earlier in the
chapter about balloon payment or interest-only loans.
✓ The seller has significant equity. This situation creates another win-win
opportunity for both the buyer and seller to use seller financing.
✓ The current financing has prepayment issues. This road can be a prob-
lem for the buyer; if the underlying financing has a due-on-sale clause
and the lender becomes aware of the sale, it can demand the full pay-
ment of the outstanding loan balance on short notice.
✓ They’re seeking a price that exceeds the normal conventional loan
parameters, or the property doesn’t qualify for a conventional loan for
some reason. Examples of qualification issues include a cracked slab,
environmental issues, improvements done without permits, and so on.
This scenario is risky for the buyer and may be an indication that they’re
over-reaching or pursuing a property that’s not a good investment.
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Be sure that your seller financing agreement is nonrecourse (as discussed
later in the chapter) and doesn’t contain a due-on-sale clause prohibiting you
from selling the property without paying off the loan in full. If the seller
requires a due-on-sale clause, you have to pay off the full balance owed to the
seller when you sell the property. Most sellers wisely ask for the due-on-sale
clause so that the property can’t be sold to another owner.
Mortgages That Should Make
You Think Twice
You may come across other loans such as balloon loans and interest-only
mortgages. We also want you to know the potential risks associated with
recourse loans. The following section presents our thoughts on these options.
Balloon loans
One type of loan that is sometimes confused with a hybrid loan is a balloon
loan. Balloon loans start off just like traditional fixed-rate mortgages. You
make level payments based on a long-term payment schedule, over 15 or 30
years, for example. But at a predetermined time, usually three to ten years
after the loan’s inception, the remaining loan balance becomes fully due.
Balloon loans may save you money because they have a lower interest rate
than a longer-term fixed-rate mortgage. Sometimes, balloon loans may be
the only option for the buyer (or so the buyer thinks). Buyers are more com-
monly backed into these loans during periods of high interest rates. When a
buyer can’t afford the payments on a conventional mortgage and really wants
a particular property, a seller may offer a balloon loan.
Balloon loans are dangerous for the simple reason that your financial situa-
tion can change, and you may not be able to refinance when your balloon
loan is due. What if you lose your job or your income drops? What if the value
of your property drops and the appraisal comes in too low to qualify you for
a new loan? What if interest rates rise and you can’t qualify at the higher rate
on a new loan? We recommend balloon loans only when the following condi-
tions apply:
✓ Such a loan is your sole financing option.
✓ You’ve really done your homework to exhaust other financing options.
✓ You’re certain that you can refinance when the balloon comes due.
If you take a balloon loan, get one with as much time as possible, preferably
seven to ten years, before it becomes due.
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Interest-only loans
In the early years of such mortgages, your monthly mortgage payment is
used only to pay interest that is owed. Although this helps to keep your pay-
ments relatively low (because no money is going toward repaying principal),
the downside is that you’re not making any headway to pay down your loan
balance.
Usually, after a preset time period, such as five or seven years, your mort-
gage payment jumps substantially so that you can begin to pay down or
amortize your loan balance. Our experience and observation has been that
many people don’t really understand or investigate how this increased pay-
ment affects them, which is why we’ve long advised against taking these
types of loans.
The main attraction that we see for interest-only mortgages for investment
property purchases is that the low initial payments help you achieve more
positive cash flow early on. Our concern, however, is seeing some property
buyers attracted to interest-only loans to afford purchasing high-cost prop-
erty that is difficult to realize positive cash flow from.
If the only way for you to invest in an income property is to use an interest-
only loan, perhaps you shouldn’t invest. Investing in rental real estate is risky,
and you can lose your entire investment if the market turns and you don’t
have the staying power to ride through the real estate cycles.
If you consider an interest-only mortgage, be sure that you understand
upfront exactly how high your payment will be after the loan moves out of
the interest-only payment phase. And be sure that you’ve surveyed the mort-
gage marketplace and understand how the terms and conditions of interest-
only loans stack up versus other types of mortgages.
Recourse financing
The goal of most real estate investors is to accumulate wealth over time
while not taking any unreasonable risks. That’s why we discourage using
interest-only loans or loans with balloon payments. But there is another
factor to explore before agreeing to any loan: Is the loan nonrecourse or
recourse?
✓ Nonrecourse financing: In the event you fail to fulfill the terms of your
loan, this type of loan limits the lender to only foreclosing on the under-
lying property. Foreclosure is the full and complete satisfaction of the
loan, and the lender can’t seek a deficiency judgment or go after your
other assets.
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✓ Recourse loans: These loans lower the lender’s risk because they offer
additional protection. The lender has the legal right to seek a deficiency
judgment against you personally or pursue other assets to cover any
shortfall should the property value not fully cover the lender’s outstand-
ing debt balance. Remember that after a loan is in default, the interest
penalties and legal fees can add up quickly. If you’re already in default
on the loan for your rental property, the last challenge you need is to
have a lender looking to take your home or other viable rental proper-
ties to satisfy their deficiency judgment.
As long as you’re not too aggressive and don’t overleverage your rental
properties, real estate investing can be relatively safe, and the chances are
you won’t be faced with losing your property by defaulting on your loan. But
there are limits to your ability to control all of the diverse factors that can
affect your property. For example, your cash flow will definitely suffer if the
major employer in your area suddenly leaves.
Nonrecourse financing has more stringent qualification standards, such as
higher debt coverage ratios (see Chapter 6), and generally results in a lower
loan amount. But just as with borrowers who utilize interest-only loans so
that they can borrow as much money as possible, the closer you live to the
edge, the more likely you’ll regret it.
Many of the loans you consider will be nonrecourse, but if you’re seeking
financing for an unstabilized property (a property whose cash flow is uncer-
tain due to vacancy or unusually high expenses) or a property requiring
major renovation, you may find that lenders are willing to provide the funds
you need only with a full recourse loan.
Typically you’re evaluating different loan proposals with either full recourse
or full nonrecourse financing. But lenders can also offer a partial recourse
loan. A partial recourse loan allows the lender to seek a deficiency judgment up
to a certain limit if you default. Again, there may be great real estate invest-
ment options where such a loan makes sense, but be very careful before
agreeing to such terms, and include the consequences to your overall financial
status in a worst-case scenario in your overall analysis.
No matter what type of loan you use, we strongly recommend that you only
use nonrecourse financing. You’ll sleep better at night!
Chapter 9
Securing the Best Mortgage Terms
In This Chapter
▶ Understanding the best ways to shop for mortgages
▶ Solving common loan problems
I
n Chapter 8, we discuss how to choose among the many loan options
available to select the one that best suits your personal and financial situ-
ation. In the process of delving into the different types of real estate invest-
ment financing, you may have already begun the process of speaking with
different lenders and surfing Web sites.
In this chapter, we provide our top tips and advice for shopping for and ulti-
mately securing the best financing that you can for your real estate invest-
ment purchases and refinances. We also cover common loan problems that
may derail your plans.
Shopping for Mortgages
Financing costs of your real estate investment purchases are generally the
single biggest expense by far, so it pays to shop around and know how to
unearth the best deals. You may find that many, many lenders would love to
have your business, especially if you have a strong credit rating. Although
having numerous lenders competing for your business can save you money,
it can also make mortgage shopping and selection difficult. This section
should help you simplify matters.
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Relying on referrals
Many sources of real estate advice simply tell you to get referrals in your quest
to find the best mortgage lenders. Sounds simple and straightforward — but
it’s not. For instance, loans for commercial investment properties and residen-
tial rental properties with five or more units have different lender underwriting
requirements and terms compared with residential one- to four-unit loans (see
Chapter 2 for explanations of these types of investments).
Good referrals can be a useful tool for locating the best lenders. Here are a few
sources we recommend:
✓ Start with a bank or credit union that you have a relationship with cur-
rently and then seek referrals from it if it’s not interested in making the
specific loan you have in mind.
✓ Collect referrals from people who you know and trust and who have
demonstrated some ability to select good service providers. Start with
the best professional service providers (tax advisors, lawyers, financial
planners, real estate agents, and so on) you know and respect, and ask
them for their recommendations.
✓ Contact associations of real estate investors, especially those in your
state. (You can find a comprehensive list organized by state at the Web
site www.realestateassociations.com.) Networking with local
investors is a great way to learn about the local real estate market and
to benefit from other people’s experiences.
Don’t take anyone’s referrals as gospel. Always be wary of business people
who refer you to folks who have referred business to them over the years.
Whenever you get a recommendation, ask the person doing the referring why
they’re making the referral and what they like and don’t like about the service
provider.
Mulling over mortgage brokers
You don’t need to use a mortgage broker unless you’re trying to get a loan for
a property that has some challenges or you as the buyer have less than stellar
credit or want to put the minimum down. Thus, we recommend going directly
to lenders for simple deals (a relatively small price tag, a property that’s in
good condition and enjoys a good location, and so on) and using mortgage
brokers for bigger, more complicated, or more difficult deals.
But many property buyers get a headache trying to shop among the enor-
mous universe of mortgages and lenders. Check out the following sections
when deciding on whether you want to use a broker.
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Counting a broker’s contributions
A good mortgage broker can make the following contributions to your real
estate investing team:
✓ Advice: If you’re like most people, you may have a difficult time decid-
ing which type of mortgage is best for your situation. A good mortgage
broker can take the time to listen to your financial and personal situa-
tion and goals and offer suggestions for specific loans that match your
situation. Brokers do work on commission, which unfortunately can
temper the objectivity of their advice, so tread carefully. Don’t blindly
accept a mortgage broker’s advice, which may be nothing more than a
commission-driven sales pitch masquerading as counsel.
✓ Shopping: Even after you figure out the specific type of mortgage that
you want, dozens (if not hundreds) of lenders may offer that type of
loan. (You’ll find fewer lender options for five-plus-unit residential prop-
erties and commercial properties.)
Thoroughly shopping among the options to find the best mortgage
takes time and knowledge you may well lack. A good mortgage broker
can probably save you time and money by shopping for your best deal.
Brokers can be especially helpful if you have a less than pristine credit
report or you want to buy property with a low down payment — like 10
percent of the value of a property. Purchasing a multifamily residential
property with five or more units or a commercial, industrial, or retail
property is difficult with less than a 20- to 30-percent down payment.)
Be careful, when selecting a broker, because the worst among them get
in the habit of repeatedly using the same lenders — perhaps because of
the lofty commissions those lenders pay out. (More on understanding
mortgage broker’s commissions in the “Keeping up with commissions
and other contingencies” section.)
✓ Paperwork and presentation: An organized and detail-oriented mort-
gage broker can assist you with completing the morass of forms most
lenders demand. Mortgage brokers can assist you with preparing your
loan package so that you put your best foot forward with lenders.
Have your personal financial statement prepared in advance so that it
can be easily updated. Each time you seek a loan for an investment
property, you have to provide a current financial statement to the
broker (and, actually, all potential loan sources).
✓ Closing the deal: After you sign a purchase agreement to buy a real
estate investment property, you still have a lot to do before you’re the
proud new property owner (see Chapter 14 for all the details). A compe-
tent mortgage broker makes sure that you meet the important deadlines
for closing the deal.
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Keeping up with commissions and other contingencies
A mortgage broker typically gets paid a percentage, usually between 0.5 to 1
percent, of the loan amount. This commission is completely negotiable, espe-
cially on larger loans that are more lucrative. (In case you’re interested, the
commission on larger deals — say, on a loan of $25 million or more — is 0.25
to 0.5 percent.)
Be sure to ask what the commission is on every alternative loan that a broker
pitches. Some brokers may be indignant that you ask — that’s their problem.
You have every right to ask; after all, it’s your money.
Even if you plan to shop on your own, talking to a mortgage broker may be
worthwhile. At the very least, you can compare what you find with what bro-
kers say they can get for you. Again, be careful. Some brokers tell you what
you want to hear — that is, that they can beat your best find — and then
aren’t able to deliver when the time comes. Some mortgage brokers promise
fantastic terms to get you in the door; then, when you’re just about ready to
close on your loan, they come up with a last minute problem with your credit
report, appraisal or some other issue that prevents them from delivering on
the loan as quoted. This bait-and-switch tactic often works because most
borrowers have some blemish or negative on their loan application or credit
report. So make sure you find a mortgage broker who doesn’t overpromise
and underdeliver.
If your loan broker quotes you a really good deal, make sure you ask who the
lender is. Most brokers refuse to reveal this information until you pay the
necessary fee to cover the appraisal, credit report, and required environmen-
tal reports. But after taking care of those fees, you can check with the lender
to verify the interest rate, the points, the amortization term, and the prepay-
ment penalties (if any) that the broker quotes you, and make sure that you’re
eligible for the loan.
Web surfing for mortgages
You can shop for just about anything and everything online, so why should
mortgages be any different? Mortgage Web sites often claim that they save
you lots of time and money.
In our experience, the Internet is better used for mortgage research than for
securing a specific mortgage. That’s not to say that some sites can’t provide
competitive loans in a timely fashion. However, we’ve seen some property
purchases fall apart because the buyers relied upon a Web site that failed to
deliver a loan in time.
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Here’s a short list of some of our favorite mortgage related Web sites that
you may find helpful:
✓ HSH Associates: The folks at HSH Associates (www.hsh.com) publish
mortgage information for most metropolitan areas. For $20, you can
receive a list of dozens of lenders’ rate quotes, but you need to be a real
data junkie to wade through all the numbers on the multipage report
that features lots of abbreviations in small print.
✓ Government-related sites: The Web sites of the U.S. Department of
Housing and Urban Development (www.hud.gov) and the Veterans
Administration (www.va.gov) provide information on government loan
programs and feature foreclosed homes for sale.
Fannie Mae, which stands for the Federal National Mortgage
Association (www.fanniemae.com), and Freddie Mac, which is the
Federal Home Loan Mortgage Corporation (www.freddiemac.com),
have worked over the years with the federal government to support
the mortgage marketplace.
✓ Mortgage Bankers Association: The trade association for mortgage
lenders, the Mortgage Bankers Association (www.mbaa.org), has arti-
cles and data on the mortgage marketplace. Its Web resources page also
includes links to state and local mortgage banker associations.
This group is an excellent source of information on loans for residential
properties with five or more units and commercial, industrial, and retail
properties.
✓ E-LOAN: One of the first major online lenders, E-LOAN has stood the
test of time and continues to offer competitive loans (www.eloan.com).
This well-organized site can give you a quick overview of competitive
mortgage pricing. Of course, you’re under no obligation to use one of its
mortgages just because you survey the options available.
✓ Journalistic sites: Numerous Web sites feature news and information
about the real estate markets around the country. Several journalistic
sites worth perusing include www.realtytimes.com, www.deadline
news.com, www.inman.com, and www.erictyson.com.
✓ Legal research sites: Legal issues certainly raise their ugly heads on
many a real estate deal. The Web site of self-help legal publisher Nolo
Press (www.nolo.com) offers some free resources as well as details on
all of the company’s legal books.
Cornell Law School’s Legal Information Institute (www.law.cornell.
edu/topics/mortgages.html) includes legal information on mort-
gages, including hard-to-find links to federal- and state-specific statutes.
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Solving Potential Loan Predicaments
In Chapter 8, we discuss the different types of mortgages and how to select
the one that best fits your situation. But remember that just because you
want a particular mortgage doesn’t mean that you’re going to get approved
for it.
The best defense against loan rejection is avoiding it in the first place. To head
off potential rejection, disclose anything that may cause a problem before you
apply for the loan. For example, if you already know that your credit report
indicates some late payments from when you were out of the country for an
extended period or your family was in turmoil over a medical problem, write a
letter to your lender that explains this situation. Or perhaps you’re self-
employed and your income from two years ago on your tax return was artifi-
cially much lower due to a special tax write-off. If that’s the case, explain that
in writing to the lender.
Lenders who understand investment property
Al, an investor Robert knows, had an interest-
ing experience when a lender initially indicated
that he had insufficient income to support the
purchase of four brand-new rental condos
he was buying. (This situation is also a real-
world example of a potential quick buy-and-flip
scenario — the properties in question appreci-
ated about 12 percent from a purchase agree-
ment in six months.)
The lender had trouble understanding a basic
concept of real estate ownership — it offers the
benefits of depreciation to shelter other income
for real estate professionals. So much of Al’s
income was sheltered through real estate hold-
ings that his tax returns showed only about 20
percent of his actual income, which wasn’t
sufficient to qualify for the loan. Al had to actu-
ally educate the loan underwriters by showing
them the various real-estate limited-liability
corporation tax returns with the significant
amounts of depreciation and how they flowed
through to his personal tax return.
Real estate investors need to be aware that
when they’re looking to purchase additional
real estate, they need to work with a lender
that understands that depreciation is a noncash
item that allows real estate investors to actually
keep more of their income. Al asked the mort-
gage broker who was a better risk — someone
who makes $100,000 and has no tax benefits
from depreciation and thus pays 40 percent in
taxes with a net income of $60,000, or someone
who makes several hundred thousand dollars
but only reports $50,000 and thus pays taxes at
a lower rate. Remember the old adage, “It’s not
what you make but what you keep that really
counts.”
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Chapter 9: Securing the Best Mortgage Terms
Even if you’re the ideal mortgage borrower in the eyes of every lender, you
may encounter financing problems with some properties. And of course, not
all real estate buyers have a perfect credit history, lots of spare cash, and no
debt. If you’re one of those borrowers who must jump through more hoops
than others to get a loan, don’t give up hope. Few borrowers are perfect from
a lender’s perspective, and many problems aren’t that difficult to fix.
Polishing your credit report
Late payments, missed payments, or debts that you never bothered to pay
can tarnish your credit report and squelch a lender’s desire to offer you a
mortgage loan. If you’ve been turned down for a loan because of your less-
than-stellar credit history, request a free copy of your credit report from the
lender that turned you down.
Getting a report before you even apply for a loan is advisable and no longer
costs you any money. Once a year, you’re entitled to obtain a free copy of
your credit report from each of the three credit bureaus. The contact informa-
tion for the credit bureaus is
✓ Equifax: 800-685-1111; www.equifax.com
✓ Experian: 888-397-3742; www.experian.com
✓ Transunion: 800-916-8800; www.transunion.com
If problems are accurately documented on your credit report, try to explain
them to your lender. Getting the bum’s rush? Call other lenders and tell them
your credit problems up front and see whether you can find one willing to
offer you a loan. Mortgage brokers may also be able to help you shop for
lenders in these cases.
Sometimes you may feel that you’re not in control when you apply for a loan.
In reality, you can fix a number of credit problems yourself. And you can often
explain those that you can’t fix. Some lenders are more lenient and flexible
than others. Just because one mortgage lender rejects your loan application
doesn’t mean that all the others will.
As for erroneous information listed on your credit report, get on the phone
to the credit bureaus. If specific creditors are the culprits, call them too.
They’re required to submit any new information or correct any errors at
once. Keep notes from your conversations and make sure that you put your
case in writing and add your comments to your credit report. If the customer
service representatives you talk with are no help, send a letter to the presi-
dent of each company. Getting mistakes cleaned up on your credit report can
take the tenacity of a bulldog — be persistent.
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Another common credit problem is having too much consumer debt at the
time you apply for a mortgage. The more credit card, auto loan, and other
consumer debt you rack up, the less mortgage you qualify for. If you’re
turned down for the mortgage, consider it a wake-up call to get rid of this
high-cost debt. Hang on to the dream of buying real estate and plug away at
paying off your debts before you make another foray into real estate. (See
Chapter 8 for more information.)
Conquering insufficient income
If you’re self-employed or have changed jobs, your income may not resemble
your past income, or more importantly, your income may not be what a mort-
gage lender likes to see in respect to the amount that you want to borrow. A
simple (although not always feasible) way around this problem is to make a
larger down payment.
If you can’t make a large down payment, another option is to get a cosigner
for the loan — your relatives may be willing. As long as they aren’t overex-
tended themselves, they may be able to help you qualify for a larger loan
than you can get on your own. As with partnerships, make sure that you put
your agreement in writing so that no misunderstandings occur.
Dealing with low property appraisals
Even if you have sufficient income, a clean credit report, and an adequate
down payment, the lender may turn down your loan if the appraisal of the
property that you want to buy comes in too low. This is a relatively rare situ-
ation that happens more in rapidly appreciating markets; it’s unusual for a
property not to appraise for what a buyer agrees to pay.
With the decline in real estate values in the late-2000s, many sellers are still
unrealistic about the value of their property and need a reality check.
Assuming that you still like the property, use the low appraisal to renegotiate
a lower price from the seller.
You may be the owner of a property in need of refinancing because the loan is
coming due or the terms are unfavorable and the appraisal is too low. In this
case you obviously need to follow a different path. If you have the cash avail-
able, you can simply put more money down to get the loan balance to a level
for which you qualify. If you don’t have the cash, you may need to forgo the
refinance until you save more money or until the property value rises.
Part III
Finding
and Evaluating
Properties
In this part . . .
H
ere’s where the rubber hits the road. In this part,
we discuss what, where, and how to buy a rental
property. We cover the vital topic of how to value and
evaluate real estate investment properties using a variety
of financial tools and techniques. And, if you want the low-
down and advice for negotiating contracts, performing
inspections, and closing of your purchase, this is the part
for you.
Chapter 10
Location, Location, Value
In This Chapter
▶ Choosing your investment area
▶ Looking at what makes a good investment location
▶ Discovering what’s in your own backyard
▶ Contrasting neighborhoods
▶ Getting to know seller’s markets and buyer’s markets
A
s the most well-known saying in real estate goes, “The three most
important factors to success in real estate are location, location, and
location!” There is a strong correlation between the location of your real
estate investments and your financial success. And we firmly agree that the
location of your real estate investment is critical in determining your success
as a real estate investor. But we prefer the phrase coined by Eric: “Location,
location, value.” This revised adage clearly emphasizes location but also
stresses the importance of finding good value for your investment dollar.
Merely owning real estate isn’t the key to success in real estate investing;
acquiring and owning the right real estate at the right price is how to build
wealth! As you gain experience in real estate, you’ll develop your own strat-
egy, but to make any strategy succeed, you need to do your homework and
diligently and fairly evaluate both the positive and negative aspects of your
proposed real estate investment. That’s where we come in.
In this chapter, we cover important aspects of regional and local demograph-
ics, how to analyze the economy, and which factors are most important
to real estate investing. We also discuss barriers to entry and the supply/
demand equation. Then we show you where to find this information and how
to interpret the numbers to determine your local areas with the most poten-
tial. Finally, we discuss real estate cycles and timing.
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Deciding Where to Invest
If you’re going to invest in real estate, you need to decide on a location. Most
real estate investors initially — and wisely — look in their local communities.
We give you the tools to evaluate properties anywhere, but you have an
inherent advantage if you begin your search close to home. Unless you really
know another real estate market and regularly find yourself there for other
reasons anyway, we recommend that you stay close to home with your real
estate investments — no more than one to two hours by your favorite mode
of transportation.
Robert has had success with a real estate investment strategy that limits his
potential markets to cities where he had personal management experience
when he worked for a large national real estate firm. He also limits himself to
areas that are no farther than a one-hour, nonstop flight on Southwest
Airlines.
Although we strongly advise that you cut your teeth on an income property
or two in your local market, establish parameters that meet your specific
needs. For example, maybe you have family responsibilities that limit the
amount of time you can devote to overseeing and managing your real estate
investments. The one-hour-flight rule that Robert uses would likely be too
taxing in that situation, and could be replaced by something like a 30-minute-
drive rule.
Although virtually everyone lives in an area with opportunities for real estate
investing, not everyone lives in an area where the prospects are good for
real estate in general. That’s why it’s important to broaden your geographic
investment horizon as long as you don’t compromise your ability to effec-
tively manage and control your property.
Even if you decide to invest in real estate in your own locale, you still need
to do tons of research to decide where and what to buy — extremely impor-
tant decisions with long-term consequences. In the pages that follow, we
explain what to look for in a region, a community, and even a neighborhood
before you make that investment decision. Keep in mind, though, that you
can spend the rest of your life looking for the perfect real estate investment,
never find it, never invest, and miss out on lots of opportunities, profit, and
even fun.
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The dangers of investing out of your area
In many regions of the country, real estate
prices escalated in the early- to mid-2000s to
the point that it was difficult for entry-level real
estate investors to buy. If you lived in such an
area, it was tempting to go far afield in search
of reasonably priced property. Recently, the
decline in prices in some areas is equally entic-
ing, but you need to exercise caution.
Regardless of whether prices are up or down,
there always seem to be a proliferation of
seminars that promise real estate investment
opportunities in other areas of the country. In
California and other areas (where even with
the recent price adjustments many proper-
ties are still relatively high-priced), seminar
sponsors target owners and wannabe real
estate investors, touting the great investments
that can be found in other, often unnamed,
parts of the country. They claim that you can
buy rental real estate for a fraction of your
local prices and achieve high returns on your
investment. They even provide pictures of these
properties — but there are always tiny little
disclaimers somewhere on the page!
We strongly advise against investing blindly
in areas that you don’t know personally. And
never consider these investments unless you
have the proper local contacts such as a great
property manager, contractors and suppliers,
and competent legal and accounting advice. In
the greater Las Vegas area alone, an estimated
40,000 non-owner occupied rental homes are
primarily owned by out-of-state real estate
speculators that bought new homes as invest-
ments to flip but got stuck with them when the
market turned.
Robert routinely serves as an expert witness
and recently had a case where an out-of-state
owner saw a great investment opportunity for
an upscale four-bedroom executive home. Even
though he worked over 3,000 miles away, what
could go wrong with such a beautiful rental in a
dynamic and prosperous suburb of San Diego?
It looked like a good investment in a great
neighborhood, and the property manager found
a respectable renter in just a few days.
Unfortunately, what seemed so good sud-
denly turned south when the initial check for
the security deposit and first month’s rent was
returned, marked “account closed.” Later that
week, the owner got a long-distance call from
a disgruntled neighbor complaining about the
barking dog and that many more people were
occupying the home than just one family. Six
months later, after paying hefty legal bills for
the eviction plus making several cross-country
airline flights, the owner finally regained pos-
session of his now-trashed executive home.
Aside from the lost rent for six months, the
damage to the home was in excess of $50,000.
In the subsequent lawsuit against the broker,
it came out that the broker had recommended
an unlicensed property manager who never did
any screening of the tenant.
One experience like this, and you may stick to
money market accounts. So when you read
about great real estate opportunities in faraway
places, remember that it’s better to be safe than
sorry. Our experience indicates that if it sounds
too good to be true, it is too good to be true! Risk
and return are truly related. It’s better to have
a more solid and easy-to-manage property in
your own community than to try and hit a home
run in a different time zone.
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Understanding the Goal: Finding
Properties Where You Can Add Value
So you’re looking for properties that allow you to lower the cap rate, which
is essentially lowering the required rate of return. You want to buy when
you determine that the property has a strong likelihood of producing future
increases in NOI and cash flow. So you should look for properties where your
analysis shows that the income for the property can be increased or the
expenses reduced.
However, certain clues indicate whether a property really has rents that are
below market. Properties with no vacancies and a waiting list are prime can-
didates. Other telltale signs are properties that have low turnover and then
have multiple applicants for those rare vacancies. Economics 101 says that if
demand exceeds supply, the price is too low.
Some owners actually market their real estate investment properties at a
below-market price. These are motivated sellers, probably with a variety of
personal reasons for their need to sell more quickly and cheaply than they
would if they had more time and patience. Health reasons, family dissolu-
tions, financial issues, and so on are all likely reasons that a seller will agree
to a quick sale at a below-market price.
However, some sellers don’t achieve the top value in the market for other
reasons. For example, some owners despise the whole process of selling their
rental properties so much that they knowingly underprice the property to
ensure a quick and clean transaction and retain the ability to reject any and
all contingencies that a buyer would typically require in a market deal. The
elimination of hassling and haggling is paramount to these sellers; they just
want to get the sale done, so they’re willing to give the buyer such a good
deal that the buyer takes the property essentially as is.
Some sellers are truly ignorant of the actual market value of the property
they’re selling. There really is no excuse (save laziness) for a seller in a
major metropolitan area to not know the true value of the property he owns,
because there are many real estate professionals who can inexpensively
assist sellers in determining the estimated value of their property. Simply
ask a real estate broker for a comparative market analysis (CMA) or hire an
appraiser, and you’ll get a detailed report determining the current as-is value
of the investment property.
The most common question Robert hears from real estate investors is “How
do I find these underpriced properties?” Our experience indicates that under-
priced investment properties typically have older owners with no mortgage
who have exhausted the possibility of taking depreciation deductions on their
tax returns.
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Chapter 10: Location, Location, Value
Look for properties where you can increase value. These value-added prop-
erties are properties that allow you to either increase the NOI or decrease
the rate and thus create value. As we point out in the “Income capitalization
approach” section earlier in this chapter the value of a property is increased
with an increase in NOI or a decrease in the capitalization rate. The capital-
ization rate is directly correlated to the anticipated risk of the investment, so
stabilizing properties through long-term leases and more financially viable
tenants can reduce risk and lead to a lower cap rate.
A simple example of how to increase the value of a building is to find a residen-
tial rental property in a high demand area where all rental rates are the same
for similar floor plans. In reality, the rents should reflect the fact that, say, not
all two-bedroom units have the same location benefits. For example, a unit
overlooking the pool is often more desirable than a unit on the main street, so
raising the rents for the more desirable units increases rental income.
Evaluating a Region: The Big Picture
Though we advise you to think local, any decision about where to invest
should start with an evaluation of the overall economic viability and trends of
the surrounding region. If the region isn’t economically sound, the likelihood
for successful real estate investments within that area is diminished.
Understand how to evaluate important economic data so that you can invest
in the areas that are poised for growth.
We define a region as a concentrated population base (rather than an entire
state or section of the country). Data for any larger geographic area would
be difficult to use for the types of real estate investments you’ll be making.
For example, data for the state of Texas isn’t as important as vital economic
trends for your proposed investment in the Houston area.
Gathering and analyzing the relevant economic data has never been easier,
thanks to the Internet. The most important data for population growth, job
growth, and economic trends is available online, and there are numerous
entities tracking this information. From the federal government, to state
and local governments, to universities and business groups, information on
regional economic trends is readily available.
In addition to the academic and governmental agencies that provide broader
economic indicators, several private firms specialize in providing specific data
on occupancy, availability, and rental rates for different types of real estate for
many of the major cities throughout the country. These services offer limited
information to non-subscribers. For example, two of our favorites with a
national perspective are the CoStar Group (www.costar.com) and Real
Estate Research Corporation (www.rerc.com). There are many smaller firms
that specialize in specific geographic areas, like MarketPointe Realty Advisors,
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Part III: Finding and Evaluating Properties
which focuses on Southern California (www.marketpointe.com). Check with
real estate investment professionals that hold the Certified Commercial
Investment Member (CCIM) designation in your area, because they have
access to the excellent CCIM Institute’s Site to Do Business (STDB).
You can find the vital economic data you need for your evaluation through
your local economic development department, chamber of commerce, or
public library. Real estate lenders often have in-house economists that collect
information concerning areas where they lend money, and these folks are
often the first to detect weaknesses in the market. So if your lender isn’t par-
ticularly enamored about the location for your proposed real estate invest-
ment, it probably knows something that you should heed. Also, contact a
professional appraiser in your area, because they routinely collect this infor-
mation for their appraisals.
These sources collect, record, analyze, and report information accord-
ing to specific geographic boundaries as established by the federal gov-
ernment. The U.S. government divides urbanized areas of the country
into Standardized Metropolitan Statistical Areas (SMSA). SMSA’s are large
areas that consist of one or more major cities. For example, the entire San
Francisco Bay Area, the combined areas of Dallas and Fort Worth, Greater
Los Angeles, and Greater New York City are each a single SMSA.
If your proposed investment isn’t in an area tracked as part of an SMSA, much
of the same information is available, but you have to do a little more digging.
You’re looking for more than just numbers. Attitude and leadership are impor-
tant as well. Many neighboring cities are working together with regional plan-
ning boards and economic development agencies. Their goal is job creation,
and they possess great powers to make important economic decisions regard-
ing regional airports, mass transportation, and the reuse of surplus military
installations. Clearly, such regional governance can have a major impact for
better or worse on your real estate investments.
You’re looking for a region or area that is growing and has a diverse eco-
nomic base with strong employment prospects. In the following sections,
we cover some of the more significant factors that can impact real estate
demand and values.
Population growth
Population growth is one of the cornerstones upon which demand for real
estate is based. An area with a steady growth in population soon needs more
residential and commercial rental properties. More people mean more
demand for housing, retail shopping, and offices and service providers. In
other words, people use real estate, so the demand for real estate is enhanced
as the population increases.
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Increases or decreases in population are the result of three activities: births,
mortality, and people moving into or out of the area. In most areas, births
exceed deaths, and thus most areas experience moderate growth. So the real
impact comes from a dynamic and mobile society. We’ve seen tremendous
shifts in population from northern states to the more temperate climates of
the Sunbelt. Immigration has also been a major factor in many parts of the
country.
How does population growth affect your real estate decisions? Simply put,
economists find that a new household is needed for every increase in popula-
tion of three persons. Of course, these numbers can vary based on average
household size. So if you’re considering investments in rental homes or small
apartment buildings in a certain area, the overall net population growth can
be a factor in determining current and future demand for rental housing.
But knowing the increase in population for the entire SMSA or region isn’t
enough because population growth isn’t evenly spread and can vary. As you
get down to the next level in your research (see the “Investigating Your Local
Real Estate Market” section later in the chapter), you need to determine
the communities and even neighborhoods where the increased population
will want to live, work, and shop. Real estate developers, and their lenders,
look closely at net population growth in specific submarkets to forecast the
demand for their proposed developments.
Job growth and income levels
Job growth is another fundamental element in determining demand for real
estate. Economists generally predict that a new household is needed for
every 1.5 jobs created. So if a new employer moves into the area and brings
150 new jobs, the local real estate housing market will need approximately
100 new dwelling units. Of course, these new jobs also positively impact the
demand for commercial, industrial, and retail properties.
The U.S. Bureau of Labor Statistics compiles job growth and other economic
data by SMSA as well as by county. This info is available at the Bureau’s Web
site (www.bls.gov). Other great sources for economic data are local colleges
and universities and good local libraries.
But you need more information about the types of jobs before you can esti-
mate their effect on the demand for each type of real estate. Although job
growth is critical, so are the following factors:
✓ Income levels: Without stable, well-paying jobs, an area can stagnate.
Even with positive growth in population and jobs, a lack of income can
stifle the demand for additional residential and commercial properties.
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✓ Level of employment diversification: If the local economy is heavily
reliant on jobs in a small number of industries, that dependence
increases the risk of your real estate investments. Some areas of the
country have plenty of jobs, but they’re lower- rather than higher-paying
jobs. Ideally, look to invest in real estate in communities that maintain
diverse job bases.
✓ Industries represented: Consider which industries are more heavily
represented in the local economy. If most of the jobs come from slow-
growing or shrinking employment sectors, such as farming, small retail,
shoe and apparel manufacturing, and government, real estate prices are
unlikely to rise quickly in the years ahead. On the other hand, areas with
a greater preponderance of high-growth industries, such as technology,
generally stand a greater chance of faster price appreciation.
✓ Types of jobs: The specific types of jobs available can be important
depending on the target market for your income property. If you’re
buying a class A office building in an urban area, look for statistics on
current and future employment levels for professional employment.
For example, owning an office building across the street from the new
regional courthouse gives you a real advantage in attracting law firms
and legal support firms. Of course, you also want to make sure that the
area boasts a good mix of nearby retail and food services to complement
and support the tenants in your building.
In addition to job growth, other good signs to look for include the following:
✓ Stable-to-increasing wages: The demand for real estate clearly cor-
relates to income levels, so local jobs with strong underlying demand
are key. With many jobs being outsourced to other parts of the country
and world, it’s important that the local jobs aren’t only secure but also
unlikely to see an erosion in purchasing power.
✓ A recession-resistant employment base: Traditionally, jobs that enjoy
stability are in the fields of education, government, and health care.
Even areas renowned for strong demand and limited supply of real
estate can slow down if the economy is hit hard, as shown by the col-
lapse of some technology firms in the early-2000s.
✓ Employment that’s highly unlikely to be outsourced: Jobs can flow to
another area of the country or overseas to the latest low-cost manufac-
turing base.
✓ Declining unemployment: Examine how the jobless rate has changed
in recent years. You wouldn’t want to invest your entire savings into a
rental property located adjacent to the large typewriter factory!
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Chapter 10: Location, Location, Value
Investigating Your Local
Real Estate Market
Although everything starts at the regional level, you need to fine-tune your
perspective and look at your local real estate market, too. All of the same
types of economic data that you collect on a regional basis are important in
evaluating your local real estate market.
With real estate investing, deciding where to invest is frequently more impor-
tant than choosing the specific rental property. You can have a rental prop-
erty that meets the needs of the market, but if it’s located in a declining area
where the demand is weak or an area with overbuilding and an excess of avail-
able properties, your investment won’t perform financially. (These are the
properties that perform the worst over time but are typically the types of
properties highly touted by the infomercial gurus who love to brag about how
much real estate they control but rarely tell you about their long-term invest-
ment returns.)
Likewise, you need to determine the areas that may be too richly priced,
because your cash flow and future appreciation will be hurt if you overpay
for a property. Often properties in the best neighborhoods in town are so
overpriced that there is little appreciation potential and thus we advise you
to seek other properties unless you’re content with low returns similar to
investing in safe and low yielding bonds.
The problem with forecasting the future
No one can precisely predict the future. And
with due respect to our friendly economists,
forecasts of population and job growth can
go awry. For example, the impact of 9/11 was
widely predicted to present a crushing blow
to local economies that relied heavily on tour-
ism. A significant decrease in tourism would
then ripple through the economy and result in
heavy job losses and lead to lower real estate
demand.
There was a short-term impact, and some
people were adversely affected. However,
Robert figured that everyone needs a vacation,
and if folks can’t feel safe traveling abroad,
then they’re going to travel domestically. So
he invested in Las Vegas apartments in 2002
at a time when the major hotels were still lim-
iting their employees to part-time work in an
effort to stem losses. Within three years, most
tourism-dependent cities saw a record number
of visitors — Americans fundamentally shifted
their travel patterns and habits to travel domes-
tically, where they felt safe.
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In many local real estate markets, the demand for real estate is impacted
more by the regional economy than by the local economy. For example,
bedroom communities have high demand for rental homes and apartments
even though they may only have service sector jobs in the immediate area,
because the higher income professional and manufacturing jobs are concen-
trated in other areas of the region.
In the sections that follow, we help you research quantitative issues to con-
sider when deciding where to invest in real estate. But you also must consider
other factors, for instance, the weather or recreation and entertainment
options — all key factors in the livability or quality of life for citizens. All of
these criteria contribute to the overall desirability of a local market area and
should be important considerations for the real estate investor. And don’t
underestimate the image or reputation of an area.
Supply and demand
The supply and demand for real estate in a given market has a direct impact
on the financial performance of your income property. And although we
firmly believe that the overall economic prospects for a region or community
are vital, you must also find supply and demand information about the spe-
cific type of real estate that you plan to purchase.
Obviously, the best environment for investing in real estate is one with
strong demand and limited supply. When the demand exceeds supply, short-
ages of available real estate push up prices.
Both sides of the equation — supply and demand — have indicators that you
should evaluate in forming your consensus about the strength of the local
real estate market. In the sections that follow, we take a close look at each
indicator in detail. Supply-side indicators include building permits, the rate at
which new properties have been rented or absorbed into the market, and the
availability of alternatives for similar real estate. Demand indicators include
occupancy and rent levels.
The overall relationship between supply and demand determines the market
conditions for real estate. For example, a large number of pending or recently
issued building permits, weak absorption or rental of new properties, and
an excess of income property listings that have been on the market for an
extended time are all indicators that the supply of a specific product type is
greater than the demand. Such market conditions soon result in lower occu-
pancy, lower rents, and often rental concessions like free rent or lower rental
rates early in the lease, which mean lower cash flow and smaller appreciation
potential. These aren’t the markets you should be seeking.
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When the demand for real estate is high, there are few vacancies and,
property owners raise rents and eliminate or minimize any concessions.
In commercial properties, landlords cut back on the tenant improvement
(TI) allowance and require the tenants to take the space as-is and make any
upgrades or changes to the space at their own expense.
Building permits and absorption
Building permits are often the first tangible step outlining the intent of a
developer to build new real estate projects. Therefore, knowing about the
issuance of building permits is an essential leading indicator to future supply
of real estate.
The trend in the number of building permits tells you how the supply of real
estate properties may soon change. A long and sustained rise in permits over
several years can indicate that the supply of new property may dampen future
price appreciation. Many areas experienced enormous increases in new build-
ing during the late-1980s, right before prices peaked due to excess inventory.
Conversely, new building dried up in many areas in the late-1970s and early-
1980s as onerous interest rates strangled builders and developers. In the
early-2000s, despite the record low-interest-rate environment, most parts of
the country weren’t overbuilding, but by the late-2000s, there was neverthe-
less an excess of supply. Though building levels were in equilibrium with
demand, the problem was that the demand was artificially inflated. This infla-
tion was the result of governmental pressure to increase home ownership by
offering creative financing to individuals who were unqualified to borrow such
large amounts, as well as speculation by some real estate investors. The crazy
and irresponsible speculation was particularly pronounced in certain Sunbelt
areas like Las Vegas, Phoenix, and many parts of Florida.
Absorption, the rate at which new buildings are rented and occupied, can be
useful to determine the potential for the market to become saturated, or over-
supplied with certain types of real estate. A healthy real estate market is one
in which the available new properties have rented in a relatively short period
of time — typically measured in months. Absorption is measured in housing
units for residential properties and in square footage for all commercial types
of properties.
Absorption can be either a positive or negative number and is usually
tracked on a quarterly and annual basis:
✓ Positive absorption: More space is rented or occupied by owners/
users during the measured time period than was built or taken out of
the rental housing supply by demolition or even conversion to owner-
occupied condominiums.
✓ Negative absorption: The new supply of a given type of real estate is
being built faster than users can or want to use it.
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You can obtain information on building permits from your local planning or
building department. Absorption statistics aren’t as easy to find, but absorp-
tion is tracked by local real estate appraisers and real estate brokers. For
example, professional real estate brokers holding the CCIM (Certified
Commercial Investment Member) designation specialize in the sale of income
properties and often have that information. See Chapter 6 for many other rea-
sons to have an appraiser on your real estate team.
Building permits and absorption are property-type specific, and an oversupply
in industrial properties generally has no bearing on other types of commercial
income properties such as retail or office. The only exception is when the use
of a property can be changed. For example, many industrial properties have
been upgraded to add office space for manufacturing firms so they can have
their administrative functions and operations in the same facility. This type of
hybrid usage is more difficult to track — but extremely important to note if it’s
occurring in your proposed investment market.
Another noteworthy trend for residential real estate investors is that new
construction favors single-family homes rather than multifamily apartments.
This discrepancy can have a significant impact on your decision whether to
invest in single-family rental properties or multifamily properties, because
multifamily properties benefit from the reduced competition. There are sev-
eral reasons for this phenomenon, and we discuss some of them in the sec-
tion “Considering barriers to entry” later in this chapter.
Availability of alternatives — renting versus buying
When the cost of buying is relatively low compared with the cost of renting,
more renters can afford to purchase, thus increasing the number of home
sales and lowering demand for rentals. A key indicator you can use to gauge
the market is the number of property listings:
✓ Increase in property listings: Increasing numbers of property listings
or a significant increase in the time the average property is unsold is an
indication of future trouble for real estate price appreciation. However,
as property prices reach high levels, some investors decide that they
can make more money cashing in and investing elsewhere. When the
market is flooded with listings, prospective buyers can be choosier,
exerting downward pressure on prices.
✓ Decrease in property listings: A sign of a healthy real estate market
is a decreasing and low level of property listings, which indicates that
the demand from buyers meets or exceeds the supply of property for
sale from sellers. At high prices (relative to the cost of renting), more
prospective buyers elect to rent, and the number of sales relative to
listings drops.
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Occupancy levels
Before you invest your hard earned money, determine the current occupancy
levels for your proposed type of income property.
The market occupancy rate is another way to gauge the supply and demand
for a given property type in the local market. The market occupancy rate for
a particular type of property is the percentage of that type of property avail-
able for occupancy that’s currently rented. For example, you may find data
telling you that there are 2,312 total residential rental units in apartment
buildings in a local market, and the occupancy rate is 97 percent (or 2,242
are occupied), which would mean that 3 percent (or approximately 70) of the
units are vacant. For commercial, industrial, and retail properties, the occu-
pancy level is calculated based on square footage.
With commercial, industrial, and retail properties, determining the occu-
pancy levels is relatively easy. A quick look at the directory or a walkthrough
of the property can give you a lot of information.
The true occupancy rate is actually much more difficult to determine with
apartment buildings. With apartments, the vacancies aren’t as obvious, and
obtaining accurate information can be challenging — most professionally man-
aged properties don’t advertise their occupancy levels or volunteer this info
(nor do they post tenant directories anymore due to safety and privacy con-
cerns). But fear not, we have some suggestions:
✓ Trade organizations and industry service providers: Some of these
groups track this data. For example, the local affiliates of the National
Apartment Association (www.naahq.org) and the Building Owners and
Managers Association (www.boma.org) often publish vacancy and rent
surveys for apartments and office buildings, respectively.
✓ The do-it-yourself approach: You can contact owners of comparable
properties and offer to collect this data and give them a copy of the
results.
After you acquire the info, here’s how to use it:
✓ Low vacancy rates: When combined with a low number of building per-
mits, low vacancy rates generally foretell future real estate price appre-
ciation. If you find minimal vacancy in your market, it’s a landlord’s
market with higher demand from tenants for existing units, which is a
good sign for real estate owners. And good for real estate investors, if
the market prices remain reasonable.
✓ High vacancy rates: High rates indicate an excess supply of real estate,
which may put downward pressure on rental rates as many landlords
compete to attract tenants.
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Concessions, which typically include free rent, often indicate weakness in the
rental market. However, some types of real estate and rental markets almost
always have concessions, no matter how strong the rental market. This prac-
tice is very common in larger professionally managed apartment communities
where a prospective tenant’s first question when calling to inquire about a
potential rental unit is inevitably “What’s your special?” Apartments in
Phoenix and many other areas of the Sunbelt may be able to raise their rents
and maintain occupancies at or above 95 percent, but they can’t eliminate the
rental concessions or their rental traffic will simply evaporate. In commercial
properties, the TI or tenant improvement allowance is similar, with many mar-
kets requiring certain levels of dollars per square foot in custom build-outs or
upgrades when the rental rate is actually less negotiable. (Check out Chapter
12 for more information on concessions.)
Rental levels
The trend in rent levels, or rental rates, that renters are willing and able to pay
over the years also gives a good indication as to the supply/demand relation-
ship for income properties. When the demand for real estate just keeps up
with the supply of housing and the local economy continues to grow, rents
generally increase. This increase is a positive sign for continued real estate
price appreciation.
Of course, you need to be careful to make sure that you’re getting the true
and complete story on rents. Owners and their property managers are very
smooth and savvy and don’t allow their quoted rental rates to fall when the
market shows some signs of softening. This strategy is logical because other
tenants may have recently leased at a higher rate and would be upset to see
the new tenants getting a better deal. So owners and property managers offer
concessions or other perks to make sure that they’re competitive in the cur-
rent market while maintaining the perception of stable rents.
As a prospective rental property owner competing against these owners, you
need to evaluate the current rent levels on a level playing field, so you want to
calculate the effective rental rate. For example, if you see a comparable rental
property available at $1,200 per month, but the owner is offering a concession
of one month free rent on a 12-month lease, the effective rent is really $1,100
per month (the $1,200 loss spread out over the rest of the year).
An advantage of investing in commercial real estate is that there are few gov-
ernmental regulations and controls, and the relationship between tenants and
landlords is essentially a free market. However, residential rent control or rent
stabilization (local laws regulating how much rents may increase) is an issue
in some cities and towns. Investing in markets with rent control, or even with
a pro-tenant environment where a landlord has difficulty terminating a lease,
may not provide adequate returns on investment, and appreciation will be
more limited. Although occupancy levels are usually strong in such areas,
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your overall cash flow may be threatened because the property’s expenses
may rise faster than you can legally raise the rents. In these communities,
landlords who invest in major upgrades or capital improvements to a rental
unit may not be able to raise rents or recover their costs because any rent
increases must be approved by the local rent control board. Then, even if
allowed at all, the approved capital improvements are amortized or spread
over many years. Don’t put your real estate future in the hands of others!
Path of progress
Buying real estate in up-and-coming areas with new development or renovated
properties not only greatly enhances the ease of finding and keeping good ten-
ants but also leads to higher occupancy, lower turnover, and higher rates of
appreciation.
In virtually all major cities, some areas are experiencing new construction
and growth — and have the reputation of being the area to live in. But by the
time most folks feel this way, you’ve lost an opportunity to get in when prices
have more appreciation potential. So, here are a few indicators to use to stay
ahead of the game:
✓ Follow the retailers: You can often take a clue about where you should
invest by looking for major retailers who do extensive research before
making a decision to open in a given neighborhood. For instance, maybe
a new Costco or Sam’s Club is anchoring the new shopping center.
✓ Follow the highways: One of the best and most obvious indicators of
where new development is headed is transportation. But make sure that
the roads or mass transit projects actually get built. With so many fund-
ing and environmental challenges today, it can be extremely risky to
invest in real estate based on proposed transportation projects. But after
they’re built, you’re sure to find real estate investment opportunities.
But the path of progress isn’t limited to new development. Many cities have
areas that have seen better days and local leaders are doing their best to
revitalize these tired and even blighted sections of town. A key component
can be redevelopment districts that are formed with the property tax rev-
enues being diverted to a special redevelopment agency that promotes new
projects through a streamlined approval process and financial assistance.
Often, the traditional downtown areas are being redeveloped with many
incentives for developers and owners willing to be among the first ones in.
Although redevelopment areas can be great opportunities, significant risk is
associated with investing in areas that are dynamic and changing. Like trans-
portation projects, sometimes the best intentions of local leaders and redevel-
opment agencies can hit a snag.
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Considering barriers to entry
Investing in real estate in an area that has strong demand and limited supply
is likely to enhance your profitably. One of the trends to follow is the creation
of more roadblocks to new development and thus severe limitations on the
construction of additional buildings to meet even the increasing demands for
real estate from natural population growth.
For example, maybe your chosen area has inhabitants with strong anti-
apartment sentiments or concerns about the environment. If you currently
own or quickly invest in existing apartments in such areas, these factors
can actually work to your benefit, because they make the addition of more
housing units (competition) difficult.
Stepping in the path of progress
One of Robert’s best real estate investments
was a 30,000-square-foot, two-story medi-
cal center complex on three acres in Santee,
California, a suburban bedroom community
of San Diego. The building had been a hub of
activity before the large medical group that
occupied the property disbanded. The building
was foreclosed on by the lender and was virtu-
ally vacant for several years, because the area
didn’t easily attract new tenants due to the lack
of nearby sit-down restaurants and shopping.
However, Robert found out that major redevel-
opment was planned around the new trolley and
transportation center located within a half mile.
Besides a multiscreen cinema as the anchor
tenant, the brand-new center would include
everything from clothing stores to bookstores,
plus several new restaurants. Robert was con-
fident that the new center would be a catalyst
for the entire area, so he quickly purchased the
rundown and neglected two-building center for
less than the assessed value on the property tax
rolls. His investment plans included significant
renovation — including complete exterior
painting, parking lot repairs, installation of a
large monument sign for tenant promotion, plus
cleaning and upgrading the vacant suites. He
also renamed the complex Santee Professional
Center to improve its image, build identity in the
community, and attract nonmedical tenants.
Lest you think that Robert made the perfect
investment that had no snags, soon after his
purchase the national cinema chain filed bank-
ruptcy and the developer halted plans. But a
new developer came in and signed the national
department store Target as the anchor tenant,
and within 18 months, they had built and fully
leased the new 500,000-square-foot shop-
ping center. Now there are several other new
office buildings completed or planned, as well
as major upgrades to the other buildings in the
area. The Santee Professional Center has been
running at high occupancy and was recently
appraised at nearly three times the acquisition
price!
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We suggest that you look for markets where natural and even man-made barri-
ers to entry exist.
The popular board game Monopoly taught most people from an early age
about the importance of location and barriers to entry. When you control the
playing field and prime properties, you dramatically improve your odds of
successfully building wealth. In the following sections, we cover some of the
more prominent factors that limit the supply of real estate and enhance cash
flow and future appreciation for those who already own existing properties.
But, in the long term, the lack of buildable land in an area can prove a prob-
lem. Real estate prices that are too high may cause employers and employees
to relocate to less expensive areas. If you want to invest in real estate in an
area with little buildable land and sky-high prices, run the numbers to see
whether the deal makes economic sense. (We explain how to do this in
Chapters 11 and 12.)
Environmental issues
Individuals and organizations concerned about the environment aren’t a new
trend. Environmental issues are now a key factor in the potential develop-
ment of real estate projects in just about every area of the country.
Those concerned about the environment are expressing their disapproval
of new and proposed projects with more authority and success because fed-
eral and state laws require excruciating investigative reports on all aspects
of proposed land development. It’s extremely difficult in most urban areas
to find land suitable for development that doesn’t have some limitations or
require remediation, such as the relocation or preservation of endangered
species or plants. (Remediation can also include the cleanup and removal of
contaminants.)
Many of these laws or guidelines find universal support — no one wants to
live in a concrete world or destroy our beautiful countryside. And nearly
everyone wants clean air, clean water, and the highest quality of living
possible.
But preserving and protecting our environment comes at a cost: A large por-
tion of potential developable land is being taken out of production or even
consideration for use. The land that isn’t available for development is being
broadened and now includes much of the government-owned lands and virtu-
ally all land that can be classified as a hillside, wetland, or vernal pool (sea-
sonal or temporary wetland). In many areas, additional swaths of public and
private land are being designated and set aside by governmental agencies to
protect endangered plants and wildlife.
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These man-made decisions to preserve land, combined with other factors,
can lead to a shortage of buildable land.
Shortage of buildable land
Economics 101 teaches that strong demand and a limited supply lead to
rationing through higher pricing. Well, that is exactly what’s happening
over the decades in many of America’s major metropolitan areas as people
exhaust the supply of buildable land (notwithstanding the general decline in
real estate prices in the late-2000s).
Upward pressure on real estate prices tends to be greatest in areas with little
buildable land. This characteristic was one of the things that attracted Eric
to invest in real estate in the San Francisco Bay Area when he moved there
in the mid-1980s. If you look at a map of this area, you can see that the city
of San Francisco and the communities to the south are on a peninsula. The
ocean, bay inlets, and mountains bound the rest of the Bay Area. More than
80 percent of the land in the greater Bay Area isn’t available for development
because state and federal government parks, preserves, and other areas pro-
tect the land from development, or the land is impossible to develop. Of the
land available for development in San Francisco and the vast majority of it in
nearby counties, virtually all of it had already been developed.
CANES: Citizens Against Nearly Everything
Many cities are now putting more authority into the hands of local and even
neighborhood planning boards that exercise their influence and control over
proposed new developments. Although many of the representatives on these
local planning boards are just interested in maintaining the aesthetics or
compatibility of proposed developments with the existing land uses, some
are motivated by another agenda.
The term CANES — Citizens Against Nearly Everything — was coined by then-
San Diego Padres President Larry Lucchino, whom Robert interviewed on his
weekly radio show many times while the baseball team proposed and fought
for the development of a new ballpark. Various groups claiming to represent
taxpayers, citizens, and environmentalists objected at every opportunity.
Ultimately, after years of delays and dozens of lawsuits, the ballpark finally
opened in downtown San Diego.
This trend isn’t unique to San Diego. Across the country, those opposed to
growth seek to avoid increased traffic, congestion, and overcrowding of their
schools and parks. In many communities and neighborhoods, homeowners
are expressing their disapproval of new multifamily development. (If you
want a big turnout at city hall, just announce that 300 new low-income apart-
ments are being built across the street from the new for-sale housing tract.)
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Such resistance to new development or even redevelopment isn’t new. But it
does seem to be a trend that should be considered by even a real estate inves-
tor with a duplex or a couple of rental homes. Unbridled growth isn’t the
answer (nor are stagnation and decline), but our point is that you need to
evaluate the impact of such attitudes on your income properties. Barriers to
entry are a reality that you shouldn’t overlook.
For example, increased demand in a community opposed to growth results in
higher prices, so investing in these areas certainly enhances your prospects
for appreciation. However, well-planned or smart growth can also lead to a
higher quality of living and greater long-term returns on your investment.
Condo conversion and construction defect lawsuits
Carefully evaluate the impact of the condominium market in your area
because it can have a material effect on the overall supply of rental housing.
Apartments converted to condos often result in fewer rental units because
condo conversion units are typically purchased by owner-occupants that find
such housing to be a financially viable entry-level opportunity. But the reverse
trend is also a concern because many areas have a significant number of failed
condo conversion projects where only a portion of the units are sold; the
remaining units are in foreclosure or bankruptcy and are being sold in bulk to
owners who rent them until the market improves. New condominiums are
often purchased by investors to use as rentals that will compete for tenants.
Some of these projects were financially unsuccessful and are in the hands of
court-appointed receivers or lenders. These are supply and demand factors
that can affect your real estate market and should be part of your real estate
strategy.
Many apartment buildings in urban areas were originally built as condomini-
ums, but market weakness or the threat of construction defect legislation
(discussed later in this section) led to a business decision by the developers
to operate these condos as rental units. There isn’t much controversy about
the ultimate conversion of these rental condos to owner-occupied units; it’s
just a function of market timing, with most remaining as rentals in the current
market environment.
However, a dilemma faced by many cities is the excessive number of conver-
sion projects of apartment rental communities into condominiums. On one
hand, the severe shortage of affordable entry-level housing in many cities
made the conversion of apartments to condominiums an excellent opportu-
nity for first-time home buyers. The concern was that conversion of apart-
ments to owner-occupied condos reduced the supply of rentals.
How are condo conversions typically handled? The most common game plan
for a conversion of an existing apartment community to a condominium proj-
ect almost always consists of extensive exterior renovation, including painting,
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landscaping, and other cosmetic items. Occasionally, local ordinances require
some structural repairs or upgrades, but the exterior work is primarily limited
to the cosmetic issues. In other words, rarely do developers spend a lot of
money on a new roof!
The unit interiors also receive a complete overhaul and upgrade — new floor-
ing, window treatments, new and often upgraded appliances, and solid coun-
tertops and other decorative touches to really make the unit shine. These
converted condos can be quite attractive as reasonably priced investments
that look great and are well located, many times in areas where new devel-
opment is difficult because the area is completely built-out and the cost to
acquire the land would be prohibitive. But you need to look deeper than the
smoke and mirrors that create the attractive façade of quality construction.
The problem is that in most cases, the existing building systems, such as the
roof, plumbing, electrical, and HVAC, haven’t been upgraded or replaced. So
you may have a brand-new interior that looks sharp, but the major structural
systems are quite old. Also, properties built under the code requirements in
effect at the time of original construction usually have lower standards for
weatherproofing, insulation, and noise reduction. If you buy one of these con-
verted apartments as a rental property, you may not know that your tenants
can hear everything (and we mean everything) that goes on in the adjacent
unit. That is, until they call to complain!
This conversion of apartments to condominiums can impact the rental
market in one of two ways.
✓ Some of the condos are purchased by individuals that intend to live
there personally. In this case, that reduces the rental housing stock,
which means less competition for apartments.
Further, a good balance of owner-occupied housing units (with their
inherent increased pride of ownership) can be healthy for the overall
rental market. We strongly advise real estate investors to purchase
rental homes in areas that are predominantly owner-occupied.
✓ Other converted condos aren’t owner occupied, with many investors
snapping up the reasonably priced units, speculating that they’ll enjoy
good returns. These units will be rented out, so there is no reduction in
the rental housing stock.
In the long run, we believe that investing in condominiums that began life as
apartments isn’t wise. In the early years, when the appliances and surface
interior and exterior cosmetic finishes are relatively new, not much can go
wrong. But after the true age of the building begins to show through increased
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repairs and maintenance, the volunteer association board of directors will
face a real challenge. Will it be willing and able to dramatically increase the
monthly assessments to cover the increased costs and to accrue the funds
necessary to handle major capital items? Robert has managed associations for
30+ years, and his experience is that the assessments stay artificially low and
the property condition declines over time. You don’t want to own a unit in an
association with major physical problems and no reserves.
The construction of new, attached, for-sale housing (or condominiums) has
been severely restricted since the 1990s in many parts of the country due
to construction defect lawsuits. The building industry claims that such law-
suits are unnecessary and extremely wasteful, and the attorneys represent-
ing homeowners insist that litigation would be unwarranted if the builders
simply didn’t build such shoddy and poorly constructed housing units. At the
end of the day, the reality is that construction defect lawsuits are reducing
the number of attached housing projects that are being built, because insur-
ance is virtually nonexistent for developers and subcontractors.
Government’s effect on real estate
This country offers many examples of the importance of state and local gov-
ernment on prospects for prosperity. The following are key governmental
and quasi-governmental factors to consider when researching a prospective
community in which to invest:
✓ Tax considerations: For decades, California had an unbeatable combina-
tion of great weather and job growth that attracted millions from around
the world. In the early-2000s, California suffered from a declining economy
and what some real estate investors and business owners felt was exces-
sive government regulation and taxation. After the recall of Governor Gray
Davis in 2003 and the election of Arnold Schwarzenegger, there was a lot
of reason for “Kali-fornians” to be optimistic. Unfortunately, the last few
years have seen increasing tension between political factions and an ever-
increasing litany of pro-tenant, anti-investment, job-killing legislation poli-
cies that offset many of the natural attributes of California and are being
exploited by other western states.
California real estate investors and others with means are establishing
legal residency in Nevada, Texas, Washington, Florida, and other states
without state income taxes in increasing numbers. It can make a signifi-
cant improvement in a person’s overall income tax liability, and it may
not even be that much of a sacrifice. For example, a California real estate
syndicator that attended one of Robert’s property management courses
found that living on the east side of beautiful Lake Tahoe (in the state of
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Nevada) was just as nice as the west (or California) side, where the top
income tax rate can add up to another 10 percent in addition to the fed-
eral income tax.
You should also have a detailed understanding of the property taxation
system and appeals process. Be sure to determine whether a proposed
income property acquisition is in a special assessment district where
additional taxes are assessed against properties. Such special assess-
ment districts may offer some advantages like better schools, parks, and
fire and police services and may be well worth the additional annual
investment. But you should know in advance how much the additional
costs will be, how long you’ll be required to participate, and exactly
what you’re getting in return so that you can properly evaluate whether
you’ll be able to generate a commensurate increase in your rental
income.
✓ Economic development incentives: The economic development groups
for many of these states are advertising in business publications and
major newspapers and aggressively encouraging employers to relocate
with incredible real estate incentives such as virtually free land or lower
property and/or income taxation. Besides lucrative offers of real estate
and tax incentives, as the global economy becomes ever more competi-
tive, businesses are being lured to locations that can reduce their costs
of labor, energy, and transportation.
✓ Community’s reputation: Your local chamber of commerce, tourism
bureau, and city hall all work very hard to establish the right reputa-
tion and attract the top employers. These organizations can have a real
impact on the market environment for businesses and thus create more
jobs in the long run, which leads to increased population and higher
demand for all types of real estate.
✓ Business-friendly environment: You can’t underestimate the impor-
tance of a probusiness attitude among state, regional, and local gov-
ernments to help create a vibrant economy where your real estate
investments can prosper.
Comparing Neighborhoods
The reputation of particular neighborhoods can be based on many factors.
Certain key or essential elements differentiate the neighborhoods with good
reputations and positive trends from the areas that are stagnant or trending
the wrong direction.
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Schools
If you don’t have school-age children, you may not initially be concerned
about the reputation and test scores of the local schools. Think again.
Whether you’re investing in residential or commercial income properties,
schools matter. The demand for residential and commercial property (and the
subsequent value of the property) is highly correlated to the quality of local
schools.
Ask any real estate agent about the impact of schools on the demand and
sales price for a home in a great school district. Likewise, employers use the
quality of local schools in recruiting their key personnel — and sometimes
even relocate company facilities to be near areas known for their schools.
The Internet can be a very useful tool in determining the quality of local
schools. Most school districts have Web sites that include information on
the test scores of their students for mandatory state and federal testing.
Unfortunately, many people make snap judgments about school quality
without doing their homework. Visit the schools and don’t blindly rely on
test scores. Talk to parents and teachers, and discover what goes on at the
school.
Crime rates
Crime can have a significant and sobering effect on the demand and desir-
ability of all types of income properties. No one wants to live in a high crime
area, and commercial tenants and their customers neither work at nor
patronize unsafe businesses. No areas are going to be crime-free, but you
don’t want to find out after the close of escrow that you have purchased a
rental property that is claimed by rival gangs. Before you make your invest-
ment decision, consult these sources:
✓ Local law enforcement: Contact local law enforcement and obtain the
latest and historical crime statistics.
✓ Local newspapers: Newspapers often have a police-blotter section that
provides information on major and even petty crimes in the community.
✓ Sexual-offender databases: Laws require certain convicted sexual
offenders to register with local law enforcement. These databases
allow you to identify the general locations of convicted sex offenders
who have committed sexual offenses against minors and violent sexual
offenses against anyone.
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These databases aren’t foolproof. The states haven’t been consistent
in their efforts to maintain and make them available. Also, persons
required to register don’t always follow the requirements, but at least
you can find out about the known ones.
Be sure to advise your tenants to check the database; this information is
dynamic, and everyone needs to make their own decision about the
safety of his or her family. You should always disclose any known regis-
tered individuals in the neighborhood (but that doesn’t mean that you
need to do the research).
Pride of ownership
Pride of ownership is an intangible attitude that has tangible results. Pride of
ownership also has no economic boundaries — even modest-income areas
can really look sharp. Look for rental properties in neighborhoods that reflect
pride of ownership — well-kept and litter-free grounds, trimmed plants, beau-
tiful flowers, fresh paint, and so on. This curb appeal helps you attract and
retain your tenants.
Although everyone may have a different perception of exactly what consti-
tutes a well-maintained property, pride of ownership is readily apparent, and
the effort made by business owners and homeowners to keep their proper-
ties looking sharp is important to real estate values.
You may find that some of the more aesthetically pleasing areas look that
way for a reason. Homeowner’s associations and business parks typically
have a board of directors and architectural review committees that routinely
inspect the properties under their jurisdiction, as well as review and restrict
improvements to meet certain standards.
Other areas may have informal committees of neighbors who band together
to keep their properties in tiptop condition. This tendency is also true of mul-
tifamily residential and commercial properties, and these properties usually
must also submit to local laws and regulations enforced by the building or
code enforcement departments.
You can control the appearance, condition, and maintenance of your own
property, but your options are limited if the properties surrounding it fall
into disrepair. Your purchase of a fixer-upper and the investment of time,
money, and sweat equity won’t be rewarded financially if the surrounding
properties are in a state of disrepair and have owners that don’t really care.
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Property values, occupancy, and rental rates all sag when property owners no
longer take pride in their property. Avoid declining neighborhoods that dis-
play the red flags of dispirited owners — poorly kept properties, junk-filled
vacant lots, inoperative cars in the parking lot or street, graffiti, vandalism,
and deferred maintenance. Neighborhood deterioration is a blight that
spreads from one property to another.
Role play: What attracts
you to the property?
One of the best ways to evaluate the prospects for a particular neighbor-
hood is to play the role of a residential tenant looking for the best place to
call home. Go back in time to when you made the decision to live in your
neighborhood. What were the primary criteria you used to make that deter-
mination? You’re probably typical of many of your potential tenants. They
prefer rental properties in close proximity to various amenities, all of which
can be captured in a property knowledge sheet.
Property knowledge sheets
One of the best ways to have the answers to the questions that may be raised
by your rental prospect is to prepare a property knowledge sheet for each
of your rental property locations. A property knowledge sheet contains all the
basic information about your rental property, such as the size and type of the
rental unit and the unit number (for multiple-unit properties), plus the age,
type of construction, and other important details about the unit.
A thorough property knowledge sheet also contains important information
about the local neighborhood and general area. Like the chamber of com-
merce or visitor’s information bureau, you want to be able to answer ques-
tions about the area. Rental prospects are generally interested in knowing
about employment centers, transportation, local schools, child-care, places of
worship, shopping, and medical facilities. You can really make a positive
impression on your rental prospect if you can tell them where the nearest dry
cleaner or Thai restaurant is located.
With all this vital information from your property knowledge sheet at your
fingertips, you can be ready to answer your rental prospect’s questions. The
more you know about your property, the easier it is for you to offer impor-
tant reasons for a prospect to select your rental over the competition.
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Property knowledge sheets can definitely give you the edge over your compe-
tition. Because you’re often competing with large multifamily rental proper-
ties, you need to be prepared to answer important questions about the area.
Often, immediately knowing a detail such as whether a certain child-care
center is in your area can make the difference between success and failure.
Check out Figure 10-1 for an example of a property knowledge sheet.
Figure 10-1:
Property
knowledge
sheet.
Property Knowledge Sheet
Property Information
Rental address ________________________Unit # ______ City ________________ Zip code ________
Office hours (if any) _____________ Square footage of unit(s) ___________________________________
Unit mix—Studios ____ 1 Bedroom ____ 2 Bedroom/1 Bath ____ 2Bedroom/2 Bath ____ Other _______
Rent—Studios _____ 1 Bedroom _____ 2 Bedroom/1 Bath _____ 2Bedroom/2 Bath _____ Other _______
Application fee __________ Security deposit _______________ Concessions ________________________
Age of rental ___________ Type of construction _______________ Parking ________________________
Recreational facilities _________________________ Laundry ________________ Pets _______________
Storage _______________________ Utilities (who pays?) ___________________ AC/Heat ____________
Appliances ____________________________________________ Floor coverings ____________________
Special features/comments _________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
Community Information
School district ___________________ Grade school _______________ Jr. high _____________________
High school _____________________ Jr. college __________________College _____________________
Trade school ____________________ Pre-school (s) ____________________________________________
Childcare _______________________ Places of worship ________________________________________
Police station ____________________ Fire station _________________ Ambulance __________________
Electric _____________ Natural gas _____________ Telephone _______________ Cable _____________
Water ______________ Sewer __________________ Library _____________ Post office _____________
Hospital ________________________ Pharmacy ___________________ Vet ________________________
Other medical facilities ____________________________________________________________________
Nearby employment centers ________________________________________________________________
Transportation ___________________________________________________________________________
Groceries ________________________Other shopping __________________________________________
Local services ____________________________________________________________________________
Restaurants ______________________________________________________________________________
Comments _______________________________________________________________________________
_________________________________________________________________________________________
Rental Market Information
Rental competitors/rental rates/concessions ___________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
Our competitive advantages ________________________________________________________________
_________________________________________________________________________________________
Our disadvantages ________________________________________________________________________
_________________________________________________________________________________________
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Commercial property considerations
Looking at a property from a tenant’s perspective is also useful if you’re
investing in commercial properties. Remember that your commercial tenants
are in business to make money — and their location is often a key factor.
Have you ever seen a small retail center that includes several vacant suites
with butcher paper in the windows? That is the universal sign that a property
is in financial trouble and in need of proactive ownership, management, and
leasing — or the spiral toward foreclosure will continue.
Right down the street from a failing property, you may find another retail
property with long-term leases and a waiting list, because successful retail-
ers almost always flock together. That explains the success of many regional
shopping malls that command high rents. Sometimes, just getting the right
anchor or primary tenant in a commercial, industrial, or retail income prop-
erty is all it takes to start the chain reaction toward the dream for any land-
lord — high occupancy, high rents, and low turnover!
Finding well-situated properties is easier when you’re considering investing
in an area where you’ve lived your entire life, but not as easy for investing in
other locales. Nonetheless, every area has potential if you know what you’re
looking for and are willing to take the time to do the research.
Mastering Seller’s Markets
and Buyer’s Markets
Some real estate investors make the mistake of not continuing to research
the economics of their real estate markets after they’ve made their invest-
ments. Even if you plan to buy and hold, you need to pay attention to the
market conditions. As we have seen, the criteria we advise you to consider in
making decisions about which markets are the best for investing are dynamic
and can fluctuate.
Savvy real estate investors monitor their markets and look for the telltale
signs of real estate cycles. These cycles present opportunities for expanding
your real estate portfolio or repositioning from weaker markets to stronger
markets because not all areas experience peaks and troughs at the same
time. That is why you need to know and track the timing of seller’s and buy-
er’s markets.
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Understanding real estate cycles
We believe that real estate is cyclical and that successful real estate inves-
tors always remain aware of the real estate cycles in their areas. First, we
need to define what we mean by seller’s or buyer’s market:
✓ A buyer’s market occurs when current property owners are unable to
sell their properties quickly and must be more flexible on the price and
terms. This is a great opportunity to seek seller financing.
✓ A seller’s market is almost like the classic definition of inflation — “too
much money chasing too few goods.” In this case, the goods are real
estate properties, which are in high demand. When sellers are receiving
multiple offers within 24 to 48 hours of a listing or you see properties
selling for more than the asking price, you’re in a strong seller’s market.
Real estate traditionally experiences cycles as the demand for real estate
leads to a shortage of supply and higher rents and appreciation. That leads
to the building of additional properties, which, along with changes in demand
due to economic cycles, usually results in overbuilding and a decline in rents
and property valuation.
However, not everyone agrees that real estate cycles are relevant to residen-
tial real estate investors. Some of the real estate infomercial gurus claim that
real estate investing in homes and apartments is recession-proof because
people always need a place to live. Although that is partly true, we think that
the economic base of the community where you invest does have a direct
impact on all aspects of your operations — occupancy, turnover, rental rates,
and even quality of tenant.
For example, when times are tough, residential tenants are the first to impro-
vise, with some finding that “doubling up” or even taking in roommates is
palatable if it results in lower costs for housing. Some renters are even willing
to move back in with Mom and Dad or another relative when their personal
budgets don’t allow them to have their own rental unit.
Robert has managed all types of income properties throughout the western
states and has observed a broad cross-section of economic activity. He has
seen how real estate cycles may be similar in a particular region but often
vary from region to region. For example, when some areas of the country
were setting records for rents in the mid-’80s, landlords couldn’t give away
their apartments in Texas. Even venerable California was a miserable place
to own real estate in the early-’90s. In the late-2000s, areas where real estate
speculation and condo converters went crazy have suffered.
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Can real estate investors who track these real estate cycles make investment
decisions based on this information? Absolutely. That is where most success-
ful and knowledgeable real estate investors see potential for increasing their
real estate investment returns by timing the real estate market.
Timing the real estate market
Although the length and depth of the real estate cycles vary, there are clear
highs and lows that real estate investors need to consider.
In some real estate markets, the double-digit appreciation over the first
half of this decade brought record prices for homes and income proper-
ties. In the mid-2000s, the most common question for Robert on his live
Southern California NBC call-in feature was “Should I buy income properties
in Southern California at these seemingly high price levels, or should I invest
elsewhere?” These callers didn’t want to miss out on what they thought was
almost guaranteed price appreciation. But what goes up must come down, so
when the market corrected in the late-2000s with significant price declines in
most areas of the country, the question Robert hears is “When will we reach
the bottom of the market?”
No one-size-fits-all answer solves this critical question. A key factor is the
investment horizon, or planned holding period for a particular investor and
that specific investment. If the holding period is long enough, even purchas-
ing income properties in today’s overpriced markets will probably look good
15 to 20 years from now.
The alternatives are to identify those markets with excellent economic fun-
damentals where prices have remained low and invest there. The concept is
similar to the “buy low, sell high” truism for stocks, except you sell in over-
priced markets and reinvest in the lower priced markets. Such markets do
exist, but the question is whether the properties in the lower priced markets
are going to provide the same or better investment returns in the long run
versus alternative markets.
Unlike the stock market, real estate transactions entail significant transaction
costs (as a percentage of the market value of the property). That’s why selling
and buying property too frequently undermines your returns.
It’s our contention that even in the few markets where such “bargains” exist,
they aren’t really great opportunities. We are reminded of the business con-
cept that in the long run you usually get what you pay for! There is so much
more than just the projected rent and the selling price. Without going into
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a detailed analysis of property condition, expenses, and other invaluable
criteria, you should simply consider whether these areas pass muster after
performing the economic analysis described earlier. Probably not.
Carleton Sheets, plus many other well-known infomercial gurus, have tra-
ditionally advised their followers that you should seek income properties
where the projected gross monthly income is at least 1 percent of the pur-
chase price. This strategy would mean that if you acquire a rental property
with a projected monthly income of $2,000, your acquisition costs should
not exceed $200,000. The advice is sound, but there are fewer and fewer
markets where such properties exist. You may remember from your reading
on investments that risk and return are generally related. That is, the lower
the risk you take, the lower your expected return. (That is why short-term
government-backed bonds and federally insured money market accounts
offer nominal rates of interest or return on investment, and investments with
higher risk, such as real estate, demand higher rates of return.)
So the real question is, what are the risk-adjusted returns like for investing in
these areas of the country with record high prices versus the risk-adjusted
returns available in other, lower-priced real estate markets? You may find
a rural property where the monthly rent exceeds 1 percent of the purchase
price, but what about rent growth and appreciation? At the end of the day,
you may find that your lower priced market with all of those “bargains” pro-
vided you with minimal cash flow and marginal appreciation.
Knowing when to sell and when to buy real estate is easier said than done.
But if you follow the fundamentals of economic analysis, and remember that
“location, location, value” is the key to successful real estate investing, you
can do well.
Chapter 11
Understanding Leases and
Property Valuation
In This Chapter
▶ Looking at leases and their terms
▶ Comprehending valuation
▶ Developing value benchmarks
L
ocation, as discussed in Chapter 10, is an important consideration when
looking to invest in income property. But what you pay for the property
and the cash flow it generates make a significant difference in the success of
your investment. Leases generate the income stream you should base your
real estate investment strategy on. All the quantitative analysis we guide you
through in Chapter 12 is for naught if you don’t have a handle on the leases.
Therefore, in this chapter, you start your research, analysis, and evaluation
of specific properties by analyzing the leases.
We then introduce you to the concepts behind evaluating potential invest-
ment properties and explain the key principles behind property valuation
that you need to be familiar with. We also provide you with a few quantitative
tools you can use to size up prospective properties and determine whether
you should move on to other properties or investigate further.
The Importance of Evaluating a Lease
A lease is a contractual obligation between a lessor (landlord) and a lessee
(tenant) to transfer the right to exclusive possession and use of certain real
property for a defined time period for an agreed consideration (money). A
verbal lease can be enforceable, but it’s much better to have a written lease
that defines the rights and responsibilities of the landlord and the tenant.
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Owning a nice rental property with attractive and well-maintained buildings
may give you a sense of pride of ownership, but what you’re really investing in
are the leases. Successful real estate investors know that an excellent opportu-
nity is to find properties with leases that offer upside potential in the form of
higher income and/or stability of tenancy.
Regardless of the type of property you’re considering as an investment, make
sure that the seller provides all of the leases. And don’t accept just the first
page or a summary of the salient points of the lease — insist on the full and
complete lease document along with any addendums or written modifica-
tions with the seller’s written certification that the document is accurate and
valid. (Verbal modifications to the written lease aren’t generally enforceable.)
Have your real estate legal advisor review the leases as well (see Chapter 6).
Existing leases almost always run with the property upon transfer of ownership
and thus are enforceable. The new owner of the property can’t simply renegoti-
ate or void the current leases he doesn’t like. Because you’re legally obligated
for all terms and conditions of current leases if you buy a property, be sure
that you thoroughly understand all aspects of the property’s current leases.
You may find that you’re presented with the opportunity to purchase proper-
ties with leases that are detriments to the property and actually bring down
its current and future value. For example, the leases may be so far above the
current market conditions that you should discount the likelihood that the
leases will be in place and enforceable in the future.
Other common problems with leases include
✓ The leases are preprinted boilerplate forms (as opposed to a custom-
ized lease tailored to the specific tenant-landlord agreement) that may
or may not comply with current laws or issues relevant for the specific
tenant.
✓ The charges for late payments, returned checks, or other administrative
fees may not be clearly defined or may be unenforceable.
✓ The rules and regulations may not be comprehensive or enforceable.
✓ There is no rent escalation clause, which spells out future rent increases,
or it isn’t clearly defined.
We’re not saying to bypass purchasing any properties with leases with these
problems. Just be aware and factor the effect, if any, into your purchasing
decision, or just simply note that you need to change the onerous terms
upon renewal.
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Reviewing a Lease: What to Look For
A seller should be honest and disclose all material facts about the property
he’s selling, but most states don’t have the same written disclosure require-
ments that are mandated for residential transactions. So even though your
broker or sales agent and other members of your due diligence investigation
team (see Chapter 6) may be assisting you with inspecting the property and
reviewing the books provided during the transaction, remember that at the
end of the day, you need to be the one who cares the most about your best
interests.
Note the expiration dates of the leases, because any lease that’s about to
expire should be evaluated based on current market conditions. Future
leases may not be at the same rent level, plus you must consider the conces-
sions or tenant improvements necessary to get the lease renewed:
✓ Residential lease renewals may require a monetary concession or pos-
sibly a perk for the tenants, such as cleaning their carpets or installing
microwaves or ceiling fans.
✓ Commercial lease renewals can require significant tenant improvements
or rent concessions.
Factor these costs into your analysis because renewing a tenant, even with the
associated costs, is typically much more cost effective than losing the tenant.
Comprehending a residential lease
The analysis of current leases for residential properties is usually fairly
straightforward, but that doesn’t mean you shouldn’t do your homework!
Review each and every residential lease to make sure that no hidden sur-
prises are awaiting you, such as future free rent, limits to rent increases, or
promises of new carpet or other expensive upgrades. Some sneaky sellers of
residential properties know that some buyers don’t thoroughly review each
lease, so they load the leases with future rent concessions in exchange for
higher rents up front, which they use to make the property’s financial state-
ments look more desirable. The net effective rent is what you’re looking for
to make your payments. An above-market lease isn’t really above market if
you’re giving away free rent or promising to replace the carpet upon lease
renewal.
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Making sense of a commercial lease
Commercial leases are much more complicated than residential ones. Thus,
the commercial real estate investor must have a thorough understanding of
the contractual obligations and duties of the lessor (landlord) and lessee
(tenant).
The analysis of commercial leases is typically called lease abstraction. A
lease abstract is a written summary of all the significant terms and conditions
contained in the lease and is much more than a rent roll. Although a good
rent roll covers the lease basics — rent, square footage, length of lease, and
renewal date or options — a good abstract covers other key tenant issues
such as signage, rights of expansion and contraction, and even restrictions
or limitations on leasing to other tenants that offer similar products and ser-
vices. Have written lease abstracts prepared for any commercial property
you’re considering to ensure that you understand all the terms.
When obtaining financing for commercial properties, lenders typically
require a certified or signed rent roll along with a written lease abstract for
each tenant. However, because the income of the property is critical to the
owner’s ability to make the debt service obligations, most lenders don’t
simply rely on the buyer’s numbers but independently derive their own
income projections based on information they require the purchaser to
obtain from the tenants. This information includes
✓ Lease estoppel: A lease estoppel certificate is a legal document completed
by the tenant that outlines the basic terms of his lease agreement and
certifies that the lease is valid without any breaches by either the tenant
or the landlord at the time it’s executed. These estoppel certificates also
benefit the purchaser of the property; you should seriously consider
requiring estoppels from all tenants when you purchase a commercial
building — regardless of the requirements of any lender.
Although tenant or lease estoppel certificates are rarely required by lend-
ers or purchasers for residential transactions, there is a strong argument
that the benefits of the estoppel certificate also apply in the residential
setting. Residential tenants are more likely to dispute the amount of the
security deposit or claim that they were entitled to unwritten promises by
the previous owner — free rent, new carpet, or waived late charges.
✓ Financial statements: The rent provided in the lease is a concern, but
the amount you actually collect determines the profitability of your real
estate investment. Because of this, many leases require the commercial
tenant to periodically provide (or present upon request) a recent financial
statement.
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Chapter 11: Understanding Leases and Property Valuation
✓ Recent sales info: Most retail leases have provisions for percentage
rents, in which the tenant pays a base rent plus additional rent based
on a percentage of sales. The percentage rent is often on a sliding scale:
The percentage paid by the tenant increases as its sales increase. Be
sure that you receive and review recent sales information and ensure
that the tenant is current on its percentage rent payments.
Reviewing the financial strength or sales figures for your commercial and
retail tenants can be an excellent indicator of the future results of your prop-
erty. Many of your best tenants in the future will be your small tenants that
have successful businesses and need to expand. Also, look at the personal
guarantees provided to see whether they’re backed by sufficient resources.
The compatibility of the tenant mix is also important.
One of the best ways to make money in real estate is to find commercial leases
where the person in charge of the property isn’t collecting the proper rent due
under the terms of the lease. For example, you may find that the rent roll from
the seller of a property you’re considering for purchase hasn’t implemented
rent increases when due. Even more common is the failure of landlords and
their property managers to correctly calculate and collect the common area
maintenance charges or ancillary fees and reimbursements due from the tenant
(see Chapter 12). Of course, you may also find that the landlords are actually
overcharging the tenants, and thus you never want to purchase a property
relying on phantom income that you don’t have the legal right to collect.
Understanding the Economic Principles
of Property Valuation
Knowing certain economic principles can be useful when seeking to evalu-
ate the current and future value of potential real estate investments. In this
section, we supply you with some background information to help you deter-
mine which properties are likely to have strong demand.
Have you ever traveled to a foreign country and observed miles of beautiful
coastline that you know would be worth a fortune at home? A few years ago,
Robert returned from Costa Rica, where he saw dozens of faded “For Sale”
signs on mile after mile of unimproved oceanfront property with spectacular
water views. Local folks told him that these properties rarely sell and are
available at low prices. The weather is humid but not much different than
similar weather along the Florida coast, where property is expensive. So what
are the factors behind such wide disparities in pricing and value?
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Well, you need to consider several important economic principles when
evaluating the potential value of a property. The basis of value for any piece
of real estate is grounded in the following four concepts:
✓ Demand: The need or desire for possession or ownership backed by the
financial means to satisfy that need.
✓ Utility: The property’s ability to satisfy its intended purpose. For exam-
ple, a very inaccessible location isn’t suitable for a retail property.
✓ Scarcity: Similar properties are finite, and substitution doesn’t indicate
that other properties can meet the same needs. Substitution is the idea
that an investor won’t pay more for a property than the price of another,
similar property.
✓ Transferability: The relative ease with which ownership rights are trans-
ferred from one owner to another.
In the earlier example, the oceanfront land in Costa Rica wasn’t in high
demand, was relatively inaccessible (the closet major airport was in the
capital city of San Jose — nearly 100 miles away), the availability of so many
similar properties made the scarcity a nonissue, and the complications of
the government requirements for foreign ownership may limit the ability to
transfer the property to non–Costa Ricans.
An understanding of the current value and future potential of real estate
investments is based on these four concepts. But three other important eco-
nomic principles can affect the value of real estate now and in the future:
✓ Regression: A property’s value is negatively impacted by surrounding
properties that are inferior, of lower value, or in worse condition. In
other words, don’t buy the best property in a bad neighborhood.
✓ Progression: A property’s value is positively impacted by surround-
ing properties that are superior, in better condition, and have a higher
value.
This concept is one of the most important for the real estate investor
looking for long-term success. Seek a well-built but neglected and
poorly maintained property located in a good neighborhood. You then
add significant value by repositioning the property up to the level of
the surrounding properties through proper maintenance, repairs, and
upgrades.
✓ Conformity: Property values are optimized when a property generally
conforms to the surrounding properties, and negatively impacted when
it doesn’t. Higher or optimized value through conformity is what you’re
seeking when you purchase the distressed property and renovate it to
enhance its appearance and utility. This is also the economic principle
that cautions against overimproving the property.
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Determining highest and best use
All of these economic principles are based on the premise that the maximum
value of real estate is achieved when a property is being utilized in its highest
and best use. Highest and best use is the fundamental concept that there is
one single use that results in the maximum profitability by the best and most
efficient use of the property. (This concept focuses solely on financial issues.
For example, it says nothing about the impact that a significant, dense prop-
erty development has on traffic and the local environment.)
The highest and best use of a specific property doesn’t remain constant over
time. Zoning of a property can eliminate certain possible uses of a property
at the time of evaluation. However, particularly for properties in the path
of progress, time can create new opportunities. For example, agricultural
land in the middle of a rapidly expanding commercial and resort area isn’t
the highest and best use (financially speaking) of the property. (Check out
Chapter 10 for more on zoning issues.)
This was the case for the strawberry fields that bordered the west side of
Disneyland in Anaheim for several decades. The long-time owner of the prop-
erty wasn’t interested in selling at any price, so the property wasn’t utilized
to its highest and best use. However, after the owner passed away, his heirs
quickly sold the property, and the Disney resort developed the property.
Comparing fair market value
and investment value
When discussing real estate values, most people immediately think of fair
market value — basically, the price that the buyer and seller can agree to
for a real estate transaction. Determining the fair market value of real estate
often seems like an elusive concept much like the old adage “Beauty is in the
eye of the beholder.”
A bit more specifically, the fair market value is the most likely price a buyer
is willing to pay and a seller is willing to accept for a property at a given time.
This definition is based on three assumptions:
✓ The market for similar real estate is open and competitive.
✓ The buyer and seller are both motivated, acting prudently and with
knowledge.
✓ The buyer and seller aren’t under any undue influence or affected by
unusual circumstances.
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However, real estate investors encounter another type of value — investment
value. Although the market value is the value of a property to a typical inves-
tor, investment value is its value to a specific investor based on his particular
requirements, such as the cost of capital, tax rate, or personal goals.
Someday, you may find yourself competing against another buyer for a prime
investment property only to be surprised that she seems willing to pay much
more. If you’ve carefully analyzed the property, and the seller provided the
same information about the property to all potential purchasers, the other
buyer is likely basing her offer on the property’s investment value to her.
Maybe the other buyer needs a replacement property for a 1031 exchange
and has the strong motivation of potentially losing the deferral of significant
capital gains unless she buys property of equal or greater value within cer-
tain defined time periods (see Chapter 18). Such buyers are often willing to
pay a premium for a property to avoid losing the tax deferral benefits avail-
able under federal and many state tax codes.
You don’t want to get into a bidding war for a property and overpay, so
remember that market value and investment value are two different concepts.
Investment value can be higher or lower than market value. For example, an
investor who can’t use the tax benefits of depreciation would be willing to pay
less for a property that would generate large annual depreciation than would
an investor that has other passive income and can use the deferral of taxation
to reduce his current income tax obligations.
Reviewing the Sources of
Property-Valuing Information
As a prospective buyer, you may find that quite a few folks have an idea of
what a piece of property is worth:
✓ Professional appraisers: Owners and lenders hire these property valu-
ation specialists to formulate the value of a property at a given point in
time. Sellers rarely consult appraisers unless the sale is the result of liti-
gation or probate, or a government entity is the buyer or seller.
✓ Brokers and agents: A Competitive Market Analysis (CMA) or a Broker
Price Opinion (BPO-V) is an estimate of market value that is gener-
ally available from brokers or agents active in the local area where the
property is located. Some lenders also use the term Broker Opinion of
Value (BOV). Because brokers and agents routinely track the listing and
sale of comparable properties, they offer this information to owners
with the goal of getting a listing on the property. Their valuation may be
fair and reasonable; however, a buyer should remember that the real
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estate agent isn’t a disinterested third party, but rather only paid if he’s
involved in a sales transaction — and then he’s compensated more for a
higher sales price.
✓ Sellers: Many sellers also do their own informal or anecdotal research
by obtaining information about recent sales of properties they know in
the area. Ultimately, the seller must make the final critical decision as
to the asking price for a property. Because the valuation of real estate
has many variables, inefficiencies in the pricing of income properties
are common.
As a prospective buyer, the values these folks come up with are merely start-
ing points for your analysis. Much more research is required. We spend the
balance of this chapter, and Chapter 12, helping you do your research.
Many real estate investors find that becoming real estate appraisers can be
helpful to their success in investing in real estate. You may want to get a certi-
fication in real estate appraisal while making your real estate investments.
Another benefit of this choice is that you qualify for the favorable tax treat-
ments offered to real estate professionals (as described further in Chapter 18).
Or you may just want to have a better understanding of the techniques used
by appraisers for evaluating your own properties. For more information on
professional appraisers and their education and training, please refer to www.
appraisalfoundation.org or www.appraisalinstitute.org.
Establishing Value Benchmarks
The proper analysis of real estate requires due diligence and research,
which starts with evaluating the existing leases (see the “The Importance
of Evaluating a Lease” section earlier in this chapter) and continues with
crunching the numbers (see Chapter 12). However, almost more than any
other investment, the real estate industry has relied for years on value
benchmarks to set prices and evaluate potential purchases.
One of the reasons value benchmarks are so widely used is that they can
easily be calculated by using basic information available on a property.
Virtually all properties you encounter for sale include this information in the
listing brochures or offering packages provided by sellers or their brokers or
sales agents.
These value benchmarks are general guidelines only, and they can be mislead-
ing, especially to the novice real estate investor. When you first hear them,
they sound impressive, but they’re only quick and simple indicators of value.
Don’t make investment decisions without calculating the Net Operating Income
(NOI) (which we cover in detail in Chapter 10). The measures in this section
shouldn’t be the sole basis for the purchase of income-producing real estate.
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Some professional appraisers may perform these calculations as a verifica-
tion test to ensure that their results are in the ballpark and even include
them in their appraisal. However, these numbers aren’t as accurate at indi-
cating value as the traditional methods of appraising the value of real estate
(the cost approach, market approach, and income capitalization approach
discussed in Chapter 12). Neither are they formally recognized and man-
dated by the professional appraisal institutes or federal lending guidelines as
approved methods of appraising real estate.
In the following sections, we cover the standard value benchmarks that apply
to all types of real estate, as well as some that are unique to a specific sector.
Gross rent/income multiplier
Two important value benchmarks include
✓ Gross Rent Multiplier (GRM): GRM is most commonly used for resi-
dential income properties, such as single-family rental homes and small
apartment buildings, because virtually all of their income is in the form
of rent payments from tenants.
✓ Gross Income Multiplier (GIM): GIM includes rent plus all other sources
of income and therefore is more widely used to quickly evaluate com-
mercial or industrial real estate investments.
The monthly rent or income is used in some areas of the country, but typi-
cally the GRM and GIM are calculated by using annual numbers. Both the
GRM and GIM are calculated by dividing the proposed acquisition price by
the annual rent or total income. For example, the GRM for a rental home that
can be acquired for $100,000 with a monthly rent of $750 ($9,000 annualized):
GRM =
Proposed acquisition price
Annual rent
=
$100,000
=
11.1
$9,000
Likewise, an industrial building that sells for $250,000 with an annual gross
income of $20,000 has a GIM of 12.5.
These formulas require little information and are a simple way to quickly com-
pare similar properties. Savvy real estate investors glance at the GRM or GIM
on a listing sheet and may either eliminate some properties from or earmark
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Chapter 11: Understanding Leases and Property Valuation
them for further consideration, but they don’t write an offer to purchase just
because the ratio seems attractive. Experienced investors know that much
more analysis is needed because these formulas don’t consider future appre-
ciation, financial leverage, the risk of the investment, or operating expenses.
They focus on gross income only, which can be deceptive.
Here’s how relying on these formulas can be tricky: If the GRM and GIM ratios
seem high, you need to check further to see whether the price is too high —
in which case you should pass on this property. Or maybe the rents are below
market value and the price is reasonable. Conversely, you may see a low GRM
and think that you found your next investment prospect only to discover that
the property is really overpriced because the seller has projected unrealistic
rents based on seasonal rentals for dilapidated furnished studio apartments in
a beach community.
Because both GRM and GIM only consider the income side of the investment,
these formulas don’t differentiate between the operating and capital expense
levels of each property. The income is important, but what you’re left with
after paying the expenses makes your mortgage payment and provides
you with cash flow. As we discuss in Chapter 12, the operating and capital
expense levels can make a tremendous difference in the overall cash flow and
the value of the property.
For example, compare two small apartment communities — both available
for $1 million and each with an annual gross income of $100,000. On each,
the GRM is 10. But which is the better investment? The GRM doesn’t give any
indication, but further analysis gives you the answer because expenses for
each property probably differ.
One apartment building is over 40 years old and has only month-to-month
rental agreements with a high turnover of tenants. The property has interior
hallways, is poorly maintained, and has an elevator that has never been mod-
ernized. This property suffers from above-average annual operating expenses
of $85,000. The other potential investment is also an older property but
caters to seniors on long-term leases who rarely move and do little damage.
The building is a two-story, garden-style walk-up with annual expenses of
$45,000. Clearly, assuming you use the same financing for each property, the
second property (with $40,000 less in expenses) should result in greater cash
flow to the owner.
Price per unit and square foot
For apartment investors, the asking price per unit can provide a general feel
for the reasonableness of the seller’s pricing. Price per unit is calculated by
simply dividing the asking price by the number of units. For example, a six-
unit building priced at $240,000 works out to $40,000 per unit.
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Like the GRM calculation, the price per unit does have its limitations. The cal-
culation doesn’t account for the location or age of the property, the quality
of construction or amenities, or the unit size and condition. You should only
use it as a quick indicator of relative value when comparing similar proper-
ties in the same market area.
The price per square foot is a widely used yet simple calculation most often
associated with commercial, industrial, and retail properties (and sometimes
used for residential properties). To find this number, take the asking or sales
price of a property and divide it by the square footage of the buildings. It’s
only a ballpark gauge of relative value and can be limited because it doesn’t
factor in the location or quality of the improvements or other important
issues like the parking ratio or the occupancy level and rent collections.
For example, a 5,000-square-foot building going for $250,000 may seem
like a good value at $50 per square foot in your market until you find that
it hasn’t been occupied for years and is in a distressed area of town. Or a
10,000-square-foot building for $1.25 million may seem overpriced at $125
per square foot until you discover that the U.S. Postal Service just signed
a 20-year net lease at full market rent with generous annual cost-of-living
increases.
Replacement cost
Replacement cost is another factor that real estate investors should consider
prior to making a real estate investment. The replacement cost is the current
cost to construct a comparable property that serves the same purpose or
function as the original property. The calculation of replacement cost is usu-
ally done by comparing the price per square foot to an estimate of the cost
per square foot to build a similar new property, including the cost of the land.
If you buy an investment property below its replacement cost, you can gen-
erally know that a prudent builder probably won’t construct a similar new
product. This fact minimizes the chance that overbuilding will result in excess
supply. It isn’t until resale value (minus depreciation) of existing properties
equals the cost to construct new properties that a builder will find it finan-
cially feasible to build an additional product.
Especially when considering investing in a real estate market that seems
overpriced, avoid buying investment properties where the cost for new con-
struction is equal to or lower than the replacement cost of a similar building.
When prices rise to the point that it’s more economical to build a new prod-
uct rather than buy existing investment properties, builders know that they
can build an additional product and sell it at a profit. And you then have addi-
tional properties to compete with.
Chapter 12
Valuing Property through
Number Crunching
In This Chapter
▶ Getting a return on your investment
▶ Understanding the mysteries of Net Operating Income
▶ Delving into cash flow
▶ Looking at three basic approaches to valuation
▶ Determining what you should pay for a property
W
ith the help of your real estate team, you need to narrow your real
estate investment opportunities down to just those properties that
seem to have the best chance to produce financially in the long run. In
Chapter 11, we cover the basics of property valuation and provide you with
the information you need to examine the leases of prospective properties.
In this chapter, we get down to the business of running the numbers. We
cover the essential elements of understanding and arriving at a property’s
income and expenses and Net Operating Income — and we explain what that
is! We then take these important numbers a step further and show you the
best valuation tools traditionally used by appraisers and commonly used by
lenders to determine what a property is worth.
But after you’ve done all of your research and analysis, the reality is that
you still need to establish whether a proposed property has the potential to
be a good investment opportunity. Overpaying for a good property isn’t any
better than getting a deal on a bad property. Neither will meet your goals. So
we close the chapter by putting it all together to help you decide how much
you should consider paying.
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Understanding the Importance
of Return on Investment
The purchase of an investment property is really the purchase of a future
income stream or cash flow. Although pride of ownership or the satisfaction of
being the owner of a rental property may be an important issue for some
people, most real estate investors focus primarily on the investment returns
that they can generate from a given property.
Four elements determine the return you see on your investment:
✓ Net cash flow: Net cash flow is money generated by the property
after deducting all costs and debt service from the income. See the
“Calculating Cash Flow” section later in this chapter.
✓ Tax benefits of depreciation: Many investors are able to use these tax
benefits to shelter other sources of income (we cover this subject in
Chapter 18).
✓ Buildup of equity: If you acquired the property with debt, the equity
buildup from paying down the debt over time is a factor.
✓ Appreciation: True wealth is created through appreciation (buying prop-
erty and selling it years later for much more than you paid). Significant
estates and generational wealth are created through appreciation.
The key to generating a profitable real estate portfolio is finding and purchas-
ing properties that exhibit the potential for high occupancy and growth in
income while keeping expenses and turnover reasonable. Success in real
estate investing depends on purchasing a property for the right price so that
you have the ability to use your management skills to increase the value over
time. Don’t base your investment decision on emotions. Falling in love with a
property can lead to overpaying.
You also need to determine what work needs to be done to the property to
correct any deferred maintenance or functional obsolescence. Even if you
simply hold the property and look for cash flow and appreciation, you want
to be able to evaluate the holding costs during your ownership period.
Then you need to determine the future value of the property to calculate the
likely disposition price and determine your return on investment.
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Chapter 12: Valuing Property through Number Crunching
Figuring Net Operating Income
Knowledgeable real estate investors begin a serious analysis of a potential
property acquisition by deriving the projected Net Operating Income, com-
monly abbreviated as NOI. We find it surprising how many real estate inves-
tors don’t make the effort to calculate the NOI before buying a property.
Instead, the quick-and-easy nature of the benchmarks we cover in the previ-
ous chapter seduces unwitting investors into a false sense of security.
The calculation of Net Operating Income is simply
NOI = Income – Expenses
NOI is the most critical factor in determining the potential for return on your
investment in real estate. Determining the NOI of a property is one of the fun-
damental building blocks to analyzing real estate investments. Any decision —
to buy, hold, or sell — should only be made after a careful analysis of the
actual current and projected future NOI for a given real estate investment.
Arriving at a reasonable estimate for future NOI is the key to determining the
value parameters for your real estate investment. We recommend that you
value a property based on the projected NOI for the next year, or preferably
next few years.
The current NOI is fairly easy to obtain and is often provided by the seller
(although in the rest of this section, we explain common problems with this
seller-provided data). Deriving the projected NOI is a more time-consuming
and in-depth process. The forecasting of a property’s NOI is more of an art
than a science. Many times, the estimation of NOI is based on a number of
assumptions or projections about future events that are anything but certain.
Will your tenants renew their leases (and at what rates)? Will the tenants
make their rent payments and other contractual requirements as agreed in
their leases? Will expenses stay within the expected range, or will there be
significant world or local events that lead to a spike in costs (like the avail-
ability and cost of property insurance after the 9/11 terrorist attacks or a sig-
nificant increase in the price of oil)?
Whether you receive current or projected NOI estimates from a seller, be care-
ful to verify the numbers. Some sellers, and many real estate brokers and
agents, prefer to provide a pro forma NOI (a projection of future financial per-
formance of the property) that uses higher rents and lower expenses. These
fictitious numbers are based on the theory that the new owner will raise the
rents to market level and simultaneously lower the costs of operating the
property. These assumptions are rarely valid. Unless the property has leases
that renew at higher rates or below-market leases that are expiring while the
demand is high, you seldom find a professionally managed property with
below-market rents. If it were that easy to increase income, wouldn’t the cur-
rent owner do it? Expenses are also unlikely to decrease significantly.
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Part III: Finding and Evaluating Properties
Have you ever seen a projection from a seller, her broker, or her sales agent
that projects a lower NOI for an investment property on the market? They act
as if the only way for NOI to go is up. Although you want to invest in proper-
ties where that is the likely result, the reality is that real estate is a cyclical
business, and supply and demand factors have a major impact.
“Garbage in, garbage out” holds true for your projections of your future NOI.
Therefore, make a careful and detailed analysis of the property you’re consid-
ering. Real estate investing isn’t something you should do by the seat of your
pants. Develop your own operating pro forma prior to purchasing any prop-
erty. And any evaluation or projection of the income stream for a property
should begin with an analysis of each lease or rental agreement (which we
cover in Chapter 11).
Evaluating income: Moving from
fiction to useful figures
To evaluate the income side of your budget, we advise that you painstakingly
record and verify all income by using a zero-based budget concept. A zero-
based budget is where you start with a blank piece of paper (or spreadsheet, if
you enjoy computer software) and individually, tenant by tenant, create the
projected rents and income stream for the property. (A similar zero-based
budget concept is useful for determining your likely or expected expenses and
is discussed in further detail later in the chapter.)
Sellers may provide or be asked to sign a certified rent roll or similar docu-
ment verifying the accuracy of the tenants and rents listed. Although this doc-
ument may be a great exhibit in your lawsuit against the seller for fraud, we
advise that you use this document cautiously and only as a tool in developing
your own independent analysis of the current and future rent payments due
under the terms of the existing leases. Don’t just gather static data and num-
bers on your current tenants; you must be able to interpret the data. Evaluate
the strength of each tenant. The lease may give you the legal right to future
rent payments; however, a tenant who is unable or unwilling to meet his lease
obligations won’t be good for your rental collections.
You want a property that has tenants who not only have the current financial
strength to meet their obligations under the lease but who will also enhance
or increase your income in future years. For example, you may determine
that one of your commercial office building tenants will be looking to expand
and will probably replace a tenant that is barely surviving and unlikely to
renew their lease.
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Chapter 12: Valuing Property through Number Crunching
It’s truly amazing how little some commercial landlords know about the
needs of their current tenants. Be sure to actually talk to your prospective
tenants (in addition to getting the estoppel certificates discussed in Chapter
11). Tenants are the key to your future success, and you want to make sure
that you can provide the proper environment so their businesses can grow
and prosper while you benefit from their rental payments, which ultimately
pay for the building you plan to own free-and-clear in the future.
But the income side of the equation involves more than just estimating rents.
The typical income and expense statements for reporting in real estate include
standard terminology that all real estate investors should know:
✓ Gross potential income or GPI is the maximum gross income that would
be generated from the rent if the property were at 100 percent occu-
pancy and all money owed were collected in full. (This is sometimes
referred to as gross possible income.)
✓ Effective gross income or EGI is essentially the money that is actually
collected. EGI is calculated by taking the GPI and then subtracting the
vacancies, concessions, delinquencies, and collection losses and then
adding the other income from late charges, returned checks, and all
other secondary sources.
In the sections that follow, we provide the details on what to subtract and
add to work your way from GPI to EGI.
Accounting for vacancies
The real estate investment community seems to be locked on using 5 percent
as the vacancy factor; brokers and even lenders typically use a 5 percent
vacancy factor without any regard for the actual market conditions. This
number may or may not be the right number to use; we advise that you care-
fully determine the most accurate estimate of future vacancy rather than use
a standard figure such as 5 percent.
The issue of vacancies is particularly applicable to many new real estate inves-
tors who begin either by retaining their current homes as investment proper-
ties when they move up to larger homes or by purchasing rental properties as
investments. Novice investors often simply compare the monthly rental rate
that they plan on charging to the monthly costs for paying the mortgage and
any other recurring expenses (property taxes, utilities, homeowner’s dues,
and so on). This practice can be dangerous if you don’t have sufficient cash
reserves for the unexpected — like being unable to find or retain tenants or
having to evict a tenant who stops paying.
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If you have a single-family rental home, the property is either occupied or
vacant. With the average length of residential tenancies in many parts of the
country at less than one year, using a 0 percent vacancy factor is unrealistic.
Our suggestion for your pro forma for a single-family rental home is to antici-
pate a loss of income equivalent to one month per every 12 months, which
reflects an 8.3 percent vacancy rate. This rate may represent a vacancy, a
delinquency, or a concession (see the following sections), but our experience
indicates that, one way or another, you’re likely to lose at least one month’s
income every year, and you should allow for this prospect in preparing your
pro forma to determine the potential income before making your investment
decision.
Calculating concessions
A concession is any benefit or deal-sweetener offered by the landlord to
entice the tenant to enter into a lease or rental agreement. Concessions
can be anything of value that motivates the tenant, but most commonly
include free or reduced rent or additional features (a ceiling fan, microwave,
upgraded finishes, extra parking, and so on). In many areas, concessions are
a significant factor in estimating future income. Remember that a concession
of one month’s free rent is essentially an 8.3 percent discount of the annual
rent. A free month’s rent for a simple residential tenancy with a monthly rent
of $1,000 means that you’ll only collect $11,000 in the first year, or an effec-
tive rental rate of $916.66, or a concession rate of 8.3 percent. This swing is a
significant factor when added to your expected vacancy rate and allowance
for collection loss (see the next section).
Deducting delinquencies and collection losses
The industry standard for collection loss (rent or other charges that the land-
lord must write off as uncollectible) is typically 0.5 percent of rental income.
This is another number that seems to be acceptable as a general rule; how-
ever, savvy real estate investors make their own analyses of the actual col-
lection loss they may experience based on the strength of the tenant, the
strength and depth of the local job market, the average turnover of the area
overall, the amount of security deposit they hold, and the nature of local
tenant/landlord laws. For example, collection losses for residential proper-
ties in the Las Vegas area often exceed 2 to 4 percent, and the continued
advent of pro-tenant legislation in California and other major metropolitan
areas foretells increased losses to landlords because of the inability to evict
nonpaying or disruptive tenants. In a weak economic environment, collection
loss can be even more significant, and prudent landlords take steps to make
sure that they have financially sound tenants who can pay rent. The competi-
tion for these qualified tenants means that you may have to lower the rent or
offer concessions, which are better options than trying to get top dollar from
an unqualified tenant.
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