Five Sound Reasons for Investing in Real Estate
As a Realtor®, I see dozens of properties every week touted as investment opportunities. However, because I also invest in real estate, I recognize that few of them would meet my rigorous standards of what qualifies as a good investment. Worse, the listing agent's claims are often not based on anything more than pie-in-the-sky guesswork!
Before taking on any investment opportunities, it's important to have a good idea of what kind of risks and rewards you're likely to realize, and to compare them to other opportunities.
In this article, I'll provide the five reasons to purchase real estate as an investment and offer a brief discussion of each.
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Quick Cash - Wholesaling and Flipping Real Estate
#1. Quick cash is one reason for investing in real estate.
It is quite possible to turn a fast profit on real estate, and there are several methods to make that quick dollar. However, it's not quite as easy as it looks.
New investors are sometimes told that they should start "wholesaling" real estate. Many go on to spend hundreds, even thousands, of dollars for programs that promise to teach them how to build wealth in just a few months. Trust me - save your money on these programs. One young woman I worked with followed the principles she learned only to get stuck paying $300 a month for a completely worthless piece of property that she couldn't sell if her life depended on it!
You can learn the basic principles from the book How to Buy Real Estate Without Cash or Credit, by Peter Finkl and Michael Conti. The book offers an excellent overview of the process and provides great tips for beginners, but does not promise that you'll be making ten grand per month your very first year. Instead, it explains how the process works, and after reading it, you will hopefully be wise enough to avoid venturing into the wholesaling category without first getting a few of these experiences under your belt! Wholesaling is rife with fraud and deception, and you don't want your first opportunity to leave you financially stranded!
How Wholesaling Real Estate Works
You've heard the principle "Buy low, sell high?" Property wholesalers set out to capitalize on this principle without actually buying the property. They typically enter a contract that contains a contingency to let them avoid purchasing if they don't locate a buyer or investor quickly enough. This contract says something along the lines of "I will purchase your property at this price only if I can locate another buyer-purchaser on or before this deadline date."
The legitimate wholesaler typically already has a likely buyer in mind and a reasonable expectation that his buyer will be interested. He understands that he can get the seller's agreement to sell for a price that's well below what the wholesaler's buyer will pay, and the wholesaler can pocket the difference, usually without risking more than a nominal earnest deposit that will be returned to him if the deal doesn't pan out.
Shady Wholesaling Practices
Although I have been practicing real estate since 2004, I have yet to meet a legitimate individual who engages profitably in wholesaling. They may create contingencies that a seller who has a competent agent will refuse to accept. For example, the one I mentioned above - to locate a buyer before a given deadline - may require the seller to stop showing or marketing his house for sale, eliminating all potential buyers who are working with a real estate agent.
I've seen shady operators who hide their true intention of finding a buyer only to walk away from the sale when they fail to locate one. This is a sure way to become known to local real estate agents, who will soon be reluctant to work with you!
I have seen wholesale companies that do legitimate resales after actually purchasing distressed properties. These companies are typically cash buyers who purchase far below market value and offer sellers a fast closing. The company then resells the property at or slightly below market value. They may or may not complete repairs to the property.
Finally, I've seen individuals who are not wholesalers turn a fast profit by making astute purchases that will resell quickly, which gets us back to the first of five reasons for investing in real estate: Quick profit.
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Flipping a Fast Profit
Robert Kiyosaki, author of Rich Dad, Poor Dad, says, "You don't make money when you sell real estate. You make money when you purchase it." Kiyosaki is a real estate mogul whose words ring true. If you are considering buying a property with the idea that you can turn it around for a quick buck, do the math first! If you cannot close on it today and find a buyer immediately who is willing to pay more for it than you did, you may be taking unnecessary risk. You must be able to buy sufficiently below market value that you can resell quickly at a discounted price and still make a profit after you pay for any repairs, sales commissions, and closing costs that will chip away at your net result.
A serious mistake novice investors commonly make is to underestimate their expenses and overestimate their profit. Most properties that can be obtained at prices well below market value are in need of work. The work may be as simple as cosmetic updates, or as complex as gutting the property and rebuilding its interior. Usually it's a mix of both, and investors may base their calculations on observable defects. For instance, the cost of replacing outdated light fixtures might be $1,000, but while the work is being done, the investor discovers that several of the light fixtures weren't updated when the rest of the electrical system was and are still wired with the property's original knob-and-tube wiring. This can easily double his cost for replacing those lights.
Wise investors do not over-prepare a property. The neighborhood and comparative sales will determine the property's likely resale value. Over-improvement is a sure way to lose money! I'll offer an example from one of my own early investments. My ex-husband and I purchased a turn-of-the-century house that needed some updates. We spent about $30,000 for the house, and it was located in an area where the most expensive homes of a similar size sold for about $45,000. We had $5,000 worth of necessary repairs to make. When he proposed to install granite countertops at a cost of almost $10,000, I vetoed the idea because we would have spent full market value prices and realized no profit if we sold it within a year or two. Instead, we rented it. He kept the house when we divorced a few year later, and decided to spend nearly $70,000 on upgrades. Fortunately, market values increased before he sold, but he still lost over $20,000!
Another thing new investors should learn about when attempting to flip property: laws that can affect flipping. During the housing bubble, prices escalated so quickly that some investors left serious defects in properties they resold. This led the Federal Housing Authority (FHA) to implement a delay before it would insure a loan for the resale of that property. If an investor is reselling in a market where FHA-insured loans are common, he or she would need to calculate the cost of holding onto the property for the minimum number of months - around three payments. Although the FHA's holding period has been suspended, investors should be aware of recent changes in lending practices or in local laws that could add to his costs.
The best way to hedge against risk if your investment goal is fast profit is to locate a knowledgeable Realtor® who is also an investor, and who is known for being reputable.
#2: Cash flow, or residual monthly income, is another terrific reason for investing in real estate.
Although I have nothing against flipping a property, I am not a skilled tradesman who can do the work, so the cost of labor and materials often makes it impractical for me to view real estate as a "quick cash" opportunity. For this reason, I like investments that provide me with residual monthly income - also known as rent!
Rental properties are the type of real estate investment I am most familiar with. I currently own four rental units, and they all provide me with cash flow. Meanwhile, I am building equity as incoming rents pay down the mortgage, and over a long enough period of time, their market values will increase. (Even though market corrections can temporarily drop property values, there is the universal truth that over time, prices go up.)
There are numerous types of properties that can generate good cash flow:
- Single family rentals
- Small multi-family rentals (duplexes, triplexes, and fourplexes)
- Apartment complexes
- Motels and hotels
- Other businesses
- Commercial rentals
Beginning investors would be wise to avoid large multi-unit complexes or businesses that they're not qualified to operate until they become qualified to operate them or until they locate someone they can pay to do it for them. Good property managers and business managers are worth what they earn - they pay for themselves with the mistakes inexperienced owners don't make!
When evaluating a property's cash flow, investors should perform a variety of calculations to determine both the ROI (return on investment) and the capitalization rate to determine a fair purchase price. These are important factors that should not be overlooked, but which can get tricky. A few things that must be taken into account to get the most accurate idea of whether a deal is really a deal include:
- Gross income vs. Net Income
- Terms of existing leases
- Rent rates (per sq. foot and/or per unit)
- Actual cost (per sq. foot and/or per unit)
- Costs of improvements to be made
- Cash investment required
- Financing terms
- Ongoing expenses and maintenance costs
- Management fees
- Whether additional streams of revenue can be developed
A tool such as this investment property analyzer can be helpful, but won't provide all the information necessary for more complex transactions. Again, a reputable real estate agent with sound expertise is invaluable before making this type of investment.
Some guides will advise you to "work only with motivated sellers" and to make offers that are 30-50% below market value. I disagree completely!
1. If you offend a seller with an absurdly low offer, they're likely to slam the door on the deal. You'll end up having to spend ridiculous amounts of time looking at properties in order to find one that has a seller who has enough equity and a big enough need to sell before you'll get a response. It just does not happen very often, and the great deals you passed up because of this "technique" will have been snapped up by someone else. Instead, look for properties that are already priced at maybe 15% below market value and work at knocking it down another 5-8%. (For the record, I personally never use percentages of purchase price as a basis for determining my offer. I use actual dollars for my calculations and save the percentages for my ROI and cap rate evaluations.)
2. "We buy ugly houses" signs is the preferred method for investors who seek such distressed sellers. While these investors advertise that they create a "win-win-win" for themselves, the seller, and the second buyer, this is rarely true. What they do instead is take extreme advantage of sellers who are at a low point and who must sell even though they'd prefer not to. I've never heard someone say they were satisfied with their contacts with a wholesaler, but I've heard many complaints.
How to Become Wealthy - Build Net Worth
#3: Property values increase over time, so investing can produce a high degree of net worth later on and make savvy investors wealthy.
This principle is a powerful generator of wealth! When combined with properties that also provide positive cash flow, the results can be extremely rewarding. Here is a glimpse of an amateur investment - a property I purchased some years ago to live in, but transformed into my first investment property:
Purchase price: $97,000 (I bought the property with a zero down loan and paid about $2,500 in closing costs. Payments were around $724 per month (principle, interest, taxes, and insurance).
I lived in the property for two years, paying a bit extra toward the loan each month. I rented it out when I moved out of state. My renters paid $750 a month, a little below market value, but it stayed rented steadily for three years. I was responsible for all the maintenance costs, since I wasn't charging quite enough rent to cover possible maintenance. So in essence, my renters paid for 36 of my house payments, and an extra $936 besides. During that time, I had about about $2,500 worth of repairs, so the property really didn't cash flow very well. I actually lost money in this respect.
However, when I decided to sell, the market had increased nicely. This was at the very beginning of the housing bubble, so I don't encourage new investors to think every property will have this kind of growth in just five years, but I was able to resell the property for $127,000, which paid off the mortgage, the real estate agent's commission, closing costs, and a couple thousand dollars in buyer closing costs. After all expenses, the title company mailed a check for $36,000.
As I mentioned above, the principle of making money when you purchase the property, not when you sell it, still applies.
That might sound crazy, because if you purchase today for $100,000 and sell it later for $125,000, it appears to be profitable, right? Not necessarily!
Many factors can affect how much growth a property can achieve:
- Market conditions
- The economy
- Other investment options that could have provided more return on your investment
- Laws and developments that can affect values (such as the city deciding to build a toxic waste dump across the street!)
- Inflation rates
- Obsolescense - building trends can make today's attractive property look dismal in tomorrow's buyer's eyes. One example of this would be a home with small bedrooms, for instance. Today's families need room for computers, game systems, and devices that didn't take up space twenty years ago.
For these reasons, it's important to find a property that you can obtain at a fair price, that requires as little upkeep as possible, and that's not in an area where major neighborhood changes are expected in the next few years.
It's impossible to predict what will happen beyond a few years, but if you purchase properties that are in stable areas or you obtain distressed properties in areas showing signs of revitalization, you can maximize your property's growth potential.
Better yet, if you purchase a property that's likely to build your wealth, and you can generate cash flow from it, you'll double up on the benefits of investing.
An Important Side Note: Obstacles to Investing
Although this video was produced in Australia for Australian investors, the principles are valid everywhere. This 25-minute seminar presentation is chock full of wisdom as it presents the seven obstacles that prevent investors from becoming successful with real estate.
Understanding these principles will give you a framework to consider the three investment reasons already mentioned, and it will help you understand the value of the last two reasons for investing in real estate.
Even experienced real estate investors will catch a few tips they haven't thought about before.
What is OPM? Why, "other people's money," of course! Which brings us to the fourth reason investors turn to real estate:
#4: To leverage their time and money.
Let's pretend that you have $100,000 cash in your savings account, and you want to put it to work for you instead of earning a measly few percent interest. You could purchase a single property, or you could use it to purchase several properties that other people would ultimately pay for. Let's take a look:
Leverage Explained in a Nutshell
Ok, I admit, I'm not the greatest artist. You can see how the same $100,000 can be used to purchase one home for cash, owe nothing more, and rent it out for its market value of $1,000 per month.
To leverage your investment, however, you might purchase two similar properties in the same price range, putting part of your investment as down payment for each one and getting a loan. (This is using the bank's money... OPM!) Then you rent those houses for their market value of $1,000 each. After paying your loan each month using your renters' money, you'd have $1,200 instead of $1,000.
In both scenarios, you've invested the same $100,000, but leveraging your funds provides you with more cash flow and a greater opportunity for long-term wealth.
You leverage your time when you invest in real estate, too. If you work at a job that pays $100,000 per year, and you put in 40 hours per week at your job, you'd be able to leverage your time by investing in a cash flow property. Perhaps you buy a fixer-upper, spend a hundred hours fixing it up, and resell it for a $45,000 net profit. You have leveraged your time very fruitfully compared to what you earn in your day job.
#5: Investment real estate provides generous tax deductions.
By now you've seen that there are a variety of sensible reasons to invest in real estate. You've probably also heard that mortgage interest can be deducted from your income tax. When it comes to investment property, the deductions are considered a bit differently. In fact, newcomers to real estate investing may feel overwhelmed at learning about the various deductions available:
- Simple depreciation
- Amortized depreciation
- Advertising expenses
- Mileage expenses
- Repairs and maintenance
- Legal fees
A competent accountant can be helpful in determining what you can and cannot deduct. You may be surprised to learn that a property that provides positive cash flow and doesn't cost any significant out-of-pocket expenses can still be viewed as a loss on your income tax!
My four rental units made a $6,000 difference on my family's last income tax return!
Because I am not an accountant and I don't keep fully up to date on changes in tax laws, I won't try to explain the various deductions here. Instead, I'll refer you to a tax specialist - preferably one who can assist you with tax planning.
Detailed Overview of Costs Associated with Buying
How to Invest in Real Estate
You can see that the reasons for investing in real estate are terrific, and they often support each other. The next question for would-be investors to ask is, "How do I begin?"
You may already own a property that you live in, or one that you have inherited. If you do have an asset to start with, I'd recommend that you start with an idea of what you'd like to achieve with it.
If you're starting from scratch, I'd encourage you to read up a bit first. The books I have chosen for this page include two books that I have read and that helped me get my own start, and one that comes highly recommended for avoiding speculative investing - something that is about as likely to make you wealthy as playing the slot machines in Vegas! Don't gamble your investment! I have seen people over-leverage, speculate, and plan ineffectively. I promise it is not a pretty picture. I encourage you to learn from others' mistakes before making your own!
Finally, talk to a qualified Realtor®. Many real estate agents who sincerely want to do a great job for their buyers just aren't familiar with these concepts, so make sure you find one that has personal experience working with investors and invest themselves. You'll need to be prepared to put down around 10% of the purchase price, sometimes even 20%, in order to make your first purchase.
Commercial Realtors® are well-acquainted with these principles, but are likely representing industry sector properties like strip malls, retail sites, and other businesses - property types that are much riskier for a novice. I'd encourage you to get familiar with them if you are interested in operating a business or want to invest in commercial properties instead of managing individual tenants. Investment properties listed with commercial agents also typically require a 10-20% down payment, but may have more options for owner financing. Again, inquire about what makes your chosen agent capable of being your best choice of a representative.
Many happy returns, both in your satisfaction and financial results!