Chapter 11

Investing in Real Estate

In This Chapter

Looking at the attractions and drawbacks of real estate investing

Understanding what it takes to become a successful property investor

Discovering simple and profitable ways to invest in real estate

Exploring some hands-on real estate investments

Avoiding bad real estate investments

If you’ve already bought your own home (and even if you haven’t), using real estate as an investment may interest you. Over the decades and generations, real estate investing, like the stock market and small-business investments, has generated tremendous wealth for participants. (See Chapter 2 for more on the rate of return from various investments.)

Real estate is like other types of ownership investments, such as stocks, where you have an ownership stake in an asset. Although you have the potential for significant profits, don’t forget that you also accept greater risk. Real estate isn’t a gravy train or a simple way to get wealthy. Like stocks, real estate goes through good and bad performance periods. Most people who make money investing in real estate do so because they invest and hold property over many years. The vast majority of people who don’t make money in real estate don’t because they make easily avoidable mistakes. In this chapter, I discuss how to make the best real estate investments and avoid the rest.

Discussing Real Estate Investment Attractions

Many people build their wealth by investing in real estate. Some people focus exclusively on property investments, but many others build their wealth through the companies that they started or through other avenues and then diversify into real estate investments. What do these wealthy folks know, and why do they choose to invest in real estate? In the following sections, I cover real estate’s attractions.

Real estate, like all investments, has its pros and cons. Investing in real estate is time-intensive, and it carries risks. Invest in real estate because you enjoy the challenge and because you want to diversify your portfolio. Real estate’s value doesn’t move in lockstep with other investments, such as stocks or small-business investments that you hold, so it’s a useful diversification tool.

Limited land

The supply of buildable, desirable land on this planet is limited. And because people are prone to reproduce, demand for land and housing continues to grow. Land and what you can do with it are what make real estate valuable. Cities and islands such as Hawaii, Hong Kong, San Francisco, Los Angeles, and New York City have the highest housing costs around because land is limited in these places.

Leverage

Real estate is different from most other investments because you can borrow 75 to 80 percent (or more) of the value of the property to buy it. Thus, you can use your down payment of 20 to 25 percent of the purchase price to buy, own, and control a much larger investment; this concept is called leverage. Of course, you hope that the value of your real estate goes up — if it does, you make money on your original dollars invested as well as on the money that you borrowed.

Here’s a quick example to illustrate. Suppose you purchase a rental property for $150,000 and make a $30,000 down payment (and borrow the other $120,000). Over the next three years, imagine that the property appreciates to $180,000. Thus, you have a profit (on paper at least) of $30,000 on an investment of just $30,000. In other words, you’ve made a 100 percent return on your investment. (Note that in this scenario, I ignore whether your expenses from the property exceed the rental income that you collect.)

Leverage is good for you if property prices appreciate, but leverage can also work against you. Say, for example, that your $150,000 property decreases in value to $120,000. Even though it has dropped only 20 percent in value, you actually lose (on paper) 100 percent of your original $30,000 investment. If you have an outstanding mortgage of $120,000 on this property and you need to sell, you actually have to pay money into the sale to cover selling costs — in addition to losing your entire original investment. Ouch!

Appreciation and income

Another reason that real estate is a popular investment is that you can make money from it in two major ways: through appreciation and from income. I explain both in the following list:

• Appreciation: You hope and expect that over the years, your real estate investments will appreciate in value. The appreciation of your properties compounds without tax (tax-deferred, actually) 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 property to avoid paying tax. (See the sidebar “Roll over those rental property profits” for details on tax-deferred exchanges of investment properties.)

  If you choose to simply take your profits and not roll them over, the federal tax rate on gains from property held more than one year — known as long-term capital gains — are taxed at no more than 20 percent. (Obamacare adds an additional 3.8 percent to that for high-income earners.) That’s beneficial when you consider that ordinary income can be taxed at rates approaching 40 percent. (Chapter 10 details the capital gains tax rules on the sale of a primary residence, which enable a single taxpayer to make up to $250,000 tax-free and a married couple up to $500,000 tax-free.)

• Income: You also hope and expect to make money from the ongoing business that you run: renting the property. You rent out investment property to make a profit based on the property’s rental income in excess of its expenses (mortgage, property taxes, insurance, maintenance, and so on). Unless you make a large down payment, your monthly operating profit is usually small (or nonexistent) in the early years of rental property ownership. Over time, your operating profit, which is subject to ordinary income tax, should rise as you increase your rental prices faster than your expenses. During soft periods in the local economy, however, rents may rise more slowly than your expenses (or rents may even fall).

Ability to add value

You, as a small investor, can’t add value to stocks by “fixing them up,” but you may have some good ideas about how to improve a property and make it more valuable. Perhaps you can fix up a property or develop it further and raise the rental income and resale value accordingly. Through legwork, persistence, and good negotiating skills, you may also be able to make money by purchasing a property below its fair market value.

Relative to investing in the stock market, tenacious and savvy real estate investors can more easily buy property below its fair market value. You can do the same in the stock market, but the legions of professional, full-time money managers who analyze stocks make finding bargains more difficult.

Ego gratification

Face it. Investing in real estate appeals to some investors because land and buildings are tangible. Although few admit it, some real estate investors get an ego rush from a tangible display of their wealth. You can drive past investment real estate and show it off to others.

In a New York Times article titled “What My Ego Wants, My Ego Gets,” Donald Trump publicly admitted what most everyone knew long ago: He holds his real estate investments partly for his ego. Trump confessed of his purchase of the famed Plaza Hotel in the Big Apple, “I realized it was 100 percent true — ego did play a large role in the Plaza purchase and is, in fact, a significant factor in all of my deals.”

Longer-term focus

One problem with investing in the securities markets, such as the stock market, is that prices are constantly changing. Television news programs, websites, smartphones, and other communication devices dutifully report the latest price quotes.

From my observations and work with individual investors, I’ve seen that the constant reports on price changes cause some investors to lose sight of the long term and the big picture. In the worst cases, large short-term drops, such as what happened during the 2008 financial crisis, lead investors to panic and sell at what end up being bargain prices. Or headlines about big increases pull investors in lemminglike fashion into an overheated and peaking market. Because all you need to do is click your computer mouse or dial a toll-free phone number to place your sell or buy order, some stock market investors fall prey to snap judgments.

While the real estate market is constantly changing, short-term, day-to-day, and week-to-week changes are invisible. Publications don’t report the value of your real estate holdings daily, weekly, or even monthly. These less-frequent publications are good because they encourage a longer-term focus. If prices do decline over months and years, you’re much less likely to sell in a panic with real estate. Preparing a property for sale and eventually getting it sold take a good deal of time, and this barrier to quickly selling helps keep your vision in focus.

Figuring Out Who Should Avoid Real Estate Investing

Real estate investing isn’t for everyone. Most people do better financially when they invest their ownership holdings in a diversified portfolio of stocks, such as through stock funds. Definitely shy away from real estate investments that involve managing property if you fall into either of the following categories:

• You’re time starved and anxious. Buying and owning investment property and being a landlord take a lot of time. If you fail to do your homework before purchasing real estate, you can end up overpaying — or buying a heap of trouble. You can hire a property manager to help with screening and finding good tenants and troubleshooting problems with the building you purchase, but this step costs money and still requires some time involvement. Also, remember that most tenants don’t care for a property the same way property owners do. If every little scratch or carpet stain sends your blood pressure skyward, avoid distressing yourself as a landlord.
• You’re not interested in real estate. Some people simply don’t feel comfortable and informed when it comes to investing in real estate. If you’ve had experience and success with other investments, such as stocks, stick with them and avoid real estate. Over long periods of time, both stocks and real estate provide comparable returns.

Examining Simple, Profitable Real Estate Investments

Investing in rental real estate that you’re responsible for can be a lot of work. Think about it this way: With rental properties, you have all the headaches of maintaining a property, including finding and dealing with tenants, without the benefits of living in and enjoying the property.

Unless you’re extraordinarily interested in and motivated to own investment real estate, start with and perhaps limit yourself to a couple of the much simpler yet still profitable methods I discuss in the following sections.

Finding a place to call home

During your adult life, you need to put a roof over your head. You may be able to sponge off your folks or some other relative or friend for a number of years to cut costs and save money. If you’re content with this arrangement, you can minimize your housing costs and save more for a down payment and possibly toward other goals. Go for it, if your friend or relative will!

But what if neither you nor your loved ones are up for the challenge of cohabitating? For the long term, because you need a place to live, why not own real estate instead of renting it? Real estate is the only investment that you can live in or rent to produce income. You can’t live in a stock, bond, or mutual fund! Unless you expect to move within the next few years or live in an area where owning costs much more than renting, buying a place probably makes good long-term financial sense. In the long term, owning usually costs less than renting, and it allows you to build equity in an asset. Read Chapter 10 to find out more about profiting from homeownership.

Trying out real estate investment trusts

Real estate investment trusts (REITs) are entities that generally invest in different types of property, such as shopping centers, apartments, and other rental buildings. For a fee, REIT managers identify and negotiate the purchase of properties that they believe are good investments, and then they manage these properties, including all tenant relations. Thus, REITs are a good way to invest in real estate if you don’t want the hassles and headaches that come with directly owning and managing rental property.

Surprisingly, most books that focus on real estate investing neglect REITs. Why? I’ve come to the conclusion that they overlook these entities for the following reasons:

• If you invest in real estate through REITs, you don’t need to read a long, complicated book on real estate investment. Therefore, books often focus on more complicated direct real estate investments (where you buy and own property yourself).
• Real estate brokers write many of these books. Not surprisingly, the real estate investment strategies touted in these books include and advocate the use of such brokers. You can buy REITs without real estate brokers.
• A certain snobbishness prevails among people who consider themselves to be “serious” real estate investors. These folks thumb their noses at the benefit of REITs in an investment portfolio. One real estate writer/investor went so far as to say that REITs aren’t “real” real estate investments.

Please. No, you can’t drive your friends by a REIT to show it off. But those who put their egos aside when making real estate investments are happy that they considered REITs and have enjoyed double-digit annualized gains over the decades.

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 that invests in a diversified mixture of REITs (see Chapter 8).

In addition to providing you with a diversified, low-hassle real estate investment, REITs offer an additional advantage that traditional rental real estate doesn’t: You can easily invest in REITs through a retirement account (for example, an IRA). As with traditional real estate investments, you can even buy REITs and mutual fund REITs with borrowed money. You can buy with 50 percent down, called buying on margin, when you purchase such investments through a non-retirement brokerage account.

Evaluating Direct Property Investments

Every year, Forbes magazine profiles the 400 wealthiest Americans, known as the Forbes 400. To get on the list, you must make the money through legitimate and legal channels (Forbes leaves out mobsters and drug kingpins). Numerous people made the most recent list primarily because of their real estate investments. For others on the list, real estate was an important secondary factor that contributed to their wealth.

Consider the case of Thomas Flatley, an Irish immigrant. He was practically broke when he came to the United States in 1950 at age 18. After dabbling in his own small business, he got into real estate development and accumulated thousands of apartments, more than a dozen hotels, and millions of square feet of office and retail space, growing his net worth to more than $1 billion.

If you think you’re cut out to be a landlord and are ready for the responsibility of buying, owning, and managing rental real estate, you have lots of direct real estate investment options from which to choose.

Before you begin this potentially treacherous journey through the process of real estate investing, read Chapter 10. Many concepts that you need to know to be a successful real estate investor are similar to those that you need when you buy a home. The rest of this chapter focuses on issues that are more unique to real estate investing.

Some investors prefer to buy properties, improve them, and then move on. Ideally, however, you should plan to make real estate investments that you hold until (and perhaps through) your retirement years. But what should you buy? The following is my take on various real estate investments.

Residential housing

Your best bet for real estate investing is to purchase residential property. People always need places to live. Residential housing is easier to understand, purchase, and manage than most other types of property, such as office and retail property. If you’re a homeowner, you already have experience locating, purchasing, and maintaining residential property.

The most common residential housing options are single-family homes, condominiums, and townhouses. You can also purchase multi-unit buildings. In addition to the considerations that I address in Chapter 10, from an investment and rental perspective, consider the following issues when you decide what type of property to buy:

• Tenants: Single-family homes with just one tenant (which could be a family, a couple, or a single person) are simpler to deal with than a multiunit apartment building that requires the management and maintenance of multiple renters and units.
• Maintenance: From the property owner’s perspective, condominiums are generally the lowest-maintenance properties because most condominium associations deal with issues such as roofing, gardening, and so on for the entire building. Note that as the owner, you’re still responsible for maintenance that’s needed inside your unit, such as servicing appliances, interior painting, and so on. Beware, though, that some condo complexes don’t allow rentals.

  With a single-family home or apartment building, you’re responsible for all the maintenance. Of course, you can hire someone to do the work, but you still have to find the contractors and coordinate, oversee, and pay for the work they do.

• Appreciation potential: Look for property where simple cosmetic and other fixes may allow you to increase rents and increase the market value of the property. Although condos may be easier on the unit owner to maintain, they tend to appreciate less than homes or apartment buildings, unless the condos are located in a desirable urban area.

  One way to add value to some larger properties is to “condo-ize” them. In some areas, if zoning allows, you can convert a single-family home or multi-unit apartment building into condominiums. Keep in mind, however, that this metamorphosis requires significant research, both on the zoning front as well as with estimating remodeling and construction costs.

• Cash flow: As I discuss in the “Estimating cash flow” section later in the chapter, your rental property brings in rental income that you hope covers and exceeds your expenses. The difference between the rental income that you collect and the expenses that you pay out is known as your cash flow. With all properties, as time goes on, generating a positive cash flow gets easier as you pay down your mortgage debt and (hopefully) increase your rents.

  Unless you can afford a large down payment of 25 percent or more (to help pay down your debt), the early years of rental property ownership may financially challenge you. Making a profit in the early years from the monthly cash flow of a single-family home may be hard because some properties sell at a premium price relative to the rent that they can command. Remember, you pay extra for the land, which you can’t rent. Also, the downside to having just one tenant is that when you have a vacancy, you have no rental income.

  Apartment buildings, particularly those with more units, can generally produce a small positive cash flow, even in the early years of rental ownership.

Unless you really want to minimize maintenance responsibilities, avoid condominium investments. Similarly, apartment building investments are best left to sophisticated investors who like a challenge and can manage more-complex properties. Single-family home investments are generally more straightforward for most people. Just make sure you run the numbers on your rental income and expenses to see whether you can afford the negative cash flow that often occurs in the early years of ownership (I show you how in the “Estimating cash flow” section later in this chapter). As I discuss in Chapter 12, do thorough inspections before you buy any rental property.

Land

If tenants are a hassle and maintaining a building is a never-ending pain, you can consider investing in land. To do so, you buy land in an area that will soon experience a building boom, hold on to it until prices soar, and then cash in.

Such an investment idea sounds good in theory. In practice, however, making the big bucks through land investments isn’t easy. Although land doesn’t require upkeep and tenants, it does require financial feeding. Here are some reasons investing in land can be problematic:

• Investing in land is a cash drain, and because it costs money to purchase land, you also have a mortgage payment to make. Mortgage lenders charge higher interest rates on loans to purchase land because they see it as a more speculative investment.
• You don’t get depreciation tax write-offs because land isn’t depreciable. You also have property tax payments to meet as well as other expenses. However, with land investments, you don’t receive income from the property to offset these expenses.
• If you decide that you someday want to develop the property, you’ll have to fork over a hefty chunk of money. Obtaining a loan for development is challenging and more expensive (because it’s riskier for the lender) than obtaining a loan for a developed property.
• Identifying many years in advance which communities will experience rapid population and job growth isn’t easy. Land in those areas that people believe will be the next hot spot already sells at a premium price. If property growth doesn’t meet expectations, appreciation will be low or nonexistent.

If you decide to invest in land, be sure that you

• Can afford it: Tally up the annual carrying costs so you can see what your cash drain may be. What are the financial consequences of this cash outflow? For example, will you be able to fund your tax-advantaged retirement accounts? If you can’t, count the lost tax benefits as another cost of owning land.
• Understand what further improvements the land needs: Running utility lines, building roads, landscaping, and so on all cost money. If you plan to develop and build on the land that you purchase, research what these things may cost. Remember that improvements almost always cost more than you expect.
• Know its zoning status: The value of land depends heavily 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. Also research the disposition of the planning department and nearby communities. Areas that are antigrowth and antidevelopment are less likely to be good places for you to invest in land, especially if you need permission to do the type of project that you have in mind. Beware that zoning can change for the worse — sometimes a zoning alteration can reduce what you can develop on a property and, consequently, the property’s value.
• Become familiar with the local economic and housing situations: In the best of all worlds, buy land in an area that’s home to rapidly expanding companies and that has a shortage of housing and developable land. I discuss how to research these issues in the upcoming section “Deciding Where and What to Buy.”

Commercial real estate

Ever thought about owning and renting out a small office building or strip mall? If you’re really motivated and willing to roll up your sleeves, you may want to consider commercial real estate investments. However, you’re generally better off not investing in such real estate because it’s much more complicated than investing in residential real estate. It’s also riskier from an investment and tenant-turnover perspective. When tenants move out, new tenants sometimes require extensive and costly improvements.

If you’re a knowledgeable real estate investor and you like a challenge, here are two good times to invest in commercial real estate:

• When your analysis of the local market suggests that it’s a good time to buy
• When you can use some of the space to run your own small business

Just as owning your home is generally more cost-effective than renting 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.

So how do you evaluate the state of your local commercial real estate market? Examine the supply-and-demand statistics over recent years. Determine how much space is available for rent and how that number has changed over time. Also discover the vacancy rate, and find out how it has changed in recent years. Finally, investigate the rental rates, usually quoted as a price per square foot. See the next section to find out how to gather this kind of information.

Here’s one sign that purchasing a commercial property in a particular area is not wise: The supply of available space in the market has increased faster than demand, leading to falling rental rates and higher vacancies. A slowing local economy and an increasing 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.

Deciding Where and What to Buy

If you’re going to invest in real estate, you can do tons of research to decide where and what to buy. Keep in mind, though, that as in other aspects of life, you can spend the rest of your days looking for the perfect real estate investment, never find it, never invest, and miss out on lots of opportunities, profit, and even fun. In the following sections, I explain what to look for in a community and area that you seek to invest in.

I’m not suggesting that you need to conduct a nationwide search for the best areas. In fact, investing in real estate closer to home is best because you’re probably more familiar with the area, allowing you to have an easier time researching and managing the properties.

Considering economic issues

People need places to live, but an area doesn’t generally attract homebuyers if jobs don’t exist there. Ideally, look to invest in real estate in communities that maintain diverse job bases. If the local economy relies heavily on jobs in a small number of industries, that dependence increases the risk of your real estate investments. The U.S. Bureau of Labor Statistics compiles this type of data for metropolitan areas and counties. Visit www.bls.gov for more information.

Also, consider an area’s likelihood of appreciation or depreciation. Determine which industries are more heavily represented in the local economy. If most of the jobs come from slow-growing or shrinking employment sectors, 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 stand a greater chance of faster price appreciation.

Finally, check out the unemployment situation and examine how the jobless rate has changed in recent years. Good signs to look for are declining unemployment and increasing job growth. The Bureau of Labor Statistics also tracks this data.

Taking a look at the real estate market

The price of real estate, like the price of anything else, is driven by supply and demand. The smaller the supply and the greater the demand, the higher prices climb. An abundance of land and available credit, however, inevitably lead to overbuilding. When the supply of anything expands at a much faster rate than demand, prices usually fall.

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 me to invest in real estate in the San Francisco Bay Area decades ago. 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. 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 protect the land from development or because the land is impossible to develop. Of the land available for development, nearly all of it in San Francisco and the vast majority of it in nearby counties had been developed.

In the long term, the lack of buildable land in an area can be a problem. 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. (I explain how to do this later in this chapter.)

In addition to buildable land, consider these other important real estate market indicators to get a sense of the health, or lack thereof, of a particular market:

• Building permits: 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.
• Vacancy rates: If few rentals are vacant, you can assume that the area has more competition and demand for existing units, which bodes well for future real estate price appreciation. Conversely, high vacancy rates indicate an excess supply of real estate, which may put downward pressure on rental rates as many landlords compete to attract tenants.
• Listings of property for sale and number of sales: Just as the construction of many new buildings is bad for future real estate price appreciation, increasing numbers of property listings are also an indication of potential future trouble. 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. At high prices (relative to the cost of renting), more prospective buyers elect to rent, and the number of sales relative to listings drops.

  A sign of a healthy real estate market is a decreasing and relatively low level of property listings, indicating that the demand from buyers meets or exceeds the supply of property for sale from sellers. When the cost of buying is relatively low compared with the cost of renting, more renters can afford and choose to purchase, thus increasing the number of sales.

• Rents: The trend in rental rates that renters are willing and able to pay over the years gives a good indication of the demand for housing. When the demand for housing 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. Beware of buying rental property subject to rent control; the property’s expenses may rise faster than you can raise the rents.

Examining property valuation and financial projections

How do you know what a property is really worth? Some say it’s worth what a ready, willing, and financially able buyer is willing to pay. But some buyers pay more than what a property is truly worth. And sometimes buyers who are patient, do their homework, and bargain hard are able to buy property for less than its fair market value.

Crunching some numbers to figure what revenue and expenses a rental property may have is one of the most important exercises that you can go through when determining a property’s worth and making an offer. In the sections that follow, I walk you through these important calculations.

Estimating cash flow

Cash flow is the money that a property brings in minus what goes out for its expenses. If you pay so much for a property that its expenses (including the mortgage payment and property taxes) consistently exceed its income, you have a money drain on your hands. Maybe you have the financial reserves to withstand the temporary drain for the first few years, but you need to know upfront what you’re getting yourself into.

Here are two big mistakes that novice rental property investors make:

• They fail to realize all the costs associated with investment property. In the worst cases, some investors end up in personal bankruptcy from the drain of negative cash flow (expenses exceeding income). In other cases, negative cash flow hampers investors’ ability to accomplish important financial goals.
• They believe the financial statements that sellers and their real estate agents prepare. Just as an employer views a résumé with some skepticism, you should always view such financial statements as advertisements rather than sources of objective information. In some cases, sellers and agents fib or spin things in the most favorable way. In most cases, these statements contain lots of projections and best-case scenarios.

For property that you’re considering purchasing, ask for a copy of Schedule E (Supplemental Income and Losses) from the property seller’s federal income tax return. When most people complete their tax returns, in order to minimize their income taxes, they try to minimize their revenue and maximize their expenses — the opposite of what they and their agents normally do on the statements they sometimes compile to hype the property sale. Confidentiality and privacy aren’t an issue when you ask for Schedule E because you’re asking only for this one schedule and not the person’s entire income tax return. (If the seller owns more than one rental property for which financial data is compiled on Schedule E, he can simply black out this other information if he doesn’t want you to see it.)

You should prepare financial statements based on facts and a realistic assessment of a property (see Figures 11-1, 11-2, and 11-3). There’s a time and a place for unbridled optimism and positive thinking, such as when you’re lost in a major snowstorm. But deciding whether to buy a rental property isn’t a life-or-death situation. Take your time, and make the decision with your eyes and ears open and with a healthy degree of skepticism.

The monthly rental-property financial statement that you prepare in Figures 11-1 through 11-3 is for the present. Over time, you hope and expect that your rental income will increase faster than the property’s expenses, thus increasing the cash flow. If you want, you can use this financial statement for future years’ projections as well.

Valuing property

Estimating a property’s cash flow is an important first step to figuring a property’s value. But on its own, a building’s cash flow doesn’t provide enough information to intelligently decide whether to buy a particular real estate investment. Just because a property has a positive cash flow doesn’t mean you should buy it. In areas where investors expect to earn lower rates of appreciation, real estate generally sells for less and may have better cash flow.

In the stock market, you have more clues about a specific security’s worth. Most companies’ stocks trade on a daily basis, so you at least have a recent sales price to start with. Of course, just because a stock recently traded at $20 per share doesn’t mean that it’s worth $20 per share. Investors may be overly optimistic or pessimistic.

Just as you should evaluate a stock versus other comparable stocks, so, too, should you compare the asking price of a property with the prices of comparable real estate. But what if all real estate is overvalued? Such a comparison doesn’t reveal the state of inflated prices. So in addition to comparing a real estate investment property to comparable properties, you need to perform some local area evaluations of whether prices from a historic perspective appear too high, too low, or just right. To answer this last question, see Chapter 10.

Here are the pros and cons of the different approaches you can use to value property:

• Appraisers: The biggest advantage of hiring an appraiser is that she values property for a living. An appraisal also gives you some hard numbers to use for negotiating with a seller. Hire a full-time appraiser who has experience valuing the type of property that you’re considering. Ask her for examples of a dozen similar properties in the area that she has appraised in the past three months.

  The drawback of appraisers is that they cost money. A small home may cost several hundred dollars to appraise, and a larger multi-unit building may cost $1,000 or more. The danger is that you can spend money on an appraisal for a building that you don’t end up buying.

• Real estate agents: If you work with a good real estate agent (I discuss how to find one in Chapter 12), ask him to draw up a list of comparable properties and help you estimate the value of the property that you’re considering buying. The advantage of having your agent help with this analysis is that you don’t pay extra for this service.

  The drawback of asking an agent what to pay for a property is that his commission depends on your buying a property and on the amount that you pay for that property. The more you’re willing to pay for a property, the more likely the deal is completed, and the more the agent makes on commission.

• Do-it-yourself: If you’re comfortable with numbers and analysis, you can try to estimate the value of a property yourself. The hard part is identifying comparable properties. Finding identical properties is usually impossible, so you need to find similar properties and then make adjustments to their selling prices so you can do an apples-to-apples comparison.

  Among the factors that should influence your analysis of comparable properties are the date each property sold; the quality of the location; the lot size; the building age and condition; the number of units; the number of rooms, bedrooms, and bathrooms; the number of garages and fireplaces; and the size of the yard. A real estate agent can provide this information, or you can track it down for properties that you’ve seen or that you know have recently sold.

  Through a series of price adjustments, you can then compare the value of your target property to others that have recently sold. For example, if a similar property sold six months ago for $250,000 but prices overall have decreased 3 percent in the last six months, subtract 3 percent from the sales price. Ultimately, you have to attach a value or price to each difference between comparable properties and the one that you’re considering buying.

These approaches for valuing property aren’t mutually exclusive. Obtain the numbers and analysis that an appraiser or real estate agent puts together.

Discovering the information you need

When you evaluate properties, you need to put on your detective hat. If you’re creative and inquisitive, you soon realize that this isn’t a hard game to play. You can collect useful information about a property and the area in which it’s located in many ways.

Begin your inquiries with the real estate agent who listed the property for sale. One thing that most agents love to do is talk and schmooze. Try to understand why the seller is selling. This knowledge helps you negotiate an offer that’s appealing to the seller.

As for specifics on the property’s financial situation, ask the sellers for specific independent documents, including Schedule E from their tax return. (See the earlier section “Estimating cash flow” for more information.) Hire inspectors to investigate the property’s physical condition (I advise you on hiring inspectors in Chapter 12).

Local government organizations can be treasure troves of information about their communities. Check out the other recommended sources in Chapter 10 as well as those that I suggest earlier in this chapter.

Digging for a Good Deal

Everyone likes to get a deal or feel like they bought something at a relatively low price. How else can you explain the American retail practice of sales? Merchandise is first overpriced, and what doesn’t sell quickly enough is then marked down to create the illusion that you’re getting a bargain! Some real estate sellers and agents do the same thing. They list property for sale at an inflated price and then mark it down after they realize that no one will pay their asking price. “A $30,000 price reduction!” the new listing screams. Of course, such reductions aren’t a deal.

It’s possible to get a good buy on a problem property that provides a discount larger than the cost of fixing the property. However, these opportunities are hard to find, and sellers of such properties are often unwilling to sell at a discount that’s big enough to leave you much room for profit. If you don’t know how to thoroughly and correctly evaluate the property’s problems, you can end up overpaying.

Scores of books claim to have the real estate investment strategy that can beat the system. Often these promoters claim that you can become a multimillionaire through investing in distressed properties. A common suggested strategy is to purchase property that a seller has defaulted on or is about to default on. Or how about buying a property in someone’s estate through probate court? Maybe you’d like to try your hand at investing in a property that has been condemned or has toxic-waste contamination!

In some cases, the strategies that these real estate gurus advocate involve taking advantage of people’s lack of knowledge. For example, some people don’t know that they can protect the equity in their home through filing for personal bankruptcy. If you can find a seller in such dire financial straits and desperate for cash, you may get a bargain buy on the home. (You may struggle with the moral issues of buying property cheaply this way, however.)

Other methods of finding discounted property take lots of time and digging. Some involve cold-calling property owners to see whether they’re interested in selling. This method is a little bit like trying to fill a job opening by interviewing people you run into on a street corner. Although you may eventually find a good candidate this way, if you factor in the value of your time, the deal seems like less of a bargain.

Without making things complicated or too risky, you can use some of the following time-tested and proven ways to buy real estate at a discount to its fair market value:

• Find a motivated seller. Be patient and look at lots of properties, and sooner or later you’ll come across one that someone needs to sell (and these aren’t necessarily the ones advertised as having motivated sellers). Perhaps the seller has bought another property and needs the money to close on the recent purchase. Having access to sufficient financing can help secure such deals.
• Buy unwanted properties with fixable flaws. The easiest problems to correct are cosmetic. Some sellers and their agents are lazy and don’t even bother to clean a property. One single-family home that I bought had probably three years’ worth of cobwebs and dust accumulated. It seemed like a dungeon at night because half the light bulbs were burned out.

  Painting; tearing up old, ugly carpeting; refinishing hardwood floors; and putting new plantings in a yard are relatively easy jobs. They make the property worth more and make renters willing to pay higher rent. Of course, these tasks take money and time, and many buyers aren’t interested in dealing with problems. If you have an eye for improving property and are willing to invest the time that coordinating the fix-up work requires, go for it! Just make sure you hire someone to conduct a thorough property inspection before you buy. (See Chapter 12 for details.)

  Be sure to factor in the loss of rental income if you can’t fully rent the property during the fix-up period. Some investors have gone belly up from the double cash drain of fix-up expenses and lost rents.

• Buy when the real estate market is depressed. When the economy takes a few knocks and investors rush for the exits (as in the late 2000s downturn), it’s time to go shopping! Buy real estate when prices and investor interest are down. Interest rates are usually lower then too. During times of depressed markets, obtaining properties that produce a positive cash flow (even in the early years) is easier. In Chapter 10, I explain how to spot a depressed market.
• Check for zoning opportunities. Sometimes you can make more productive use of a property. For example, you can legally convert some multi-unit apartment buildings into condominiums. Some single-family residences may include a rental unit if local zoning allows for it. A good real estate agent, contractor, and the local planning office in the town or city where you’re looking at the property can help you identify properties that you can convert. However, if you’re not a proponent of development, you probably won’t like this strategy.

If you buy good real estate and hold it for the long term, you can earn a healthy return from your investment. Over the long haul, having bought a property at a discount becomes an insignificant issue. You make money from your real estate investments as the market appreciates and as a result of your ability to manage your property well. So don’t obsess over buying property at a discount and don’t wait for the perfect deal, because it won’t always come along.

Recognizing Inferior Real Estate “Investments”

Some supposedly “simple” ways to invest in real estate rarely make sense because they’re near-certain money losers. In this section, I discuss real estate investments that you should generally (but not always) avoid.

Avoiding ticking time shares

Time shares are near-certain money losers. With a time share, you buy a week or two of ownership or usage of a particular unit, usually a condominium, in a resort location. If you pay $8,000 for a week of “ownership,” you would pay the equivalent of more than $400,000 a year for the whole unit ($8,000/week × 52 weeks). However, a comparable unit nearby may sell for only $150,000. The extra markup pays the salespeople’s commissions, administrative expenses, and profits for the time-share development company. (This little analysis also ignores the not-so-inconsequential ongoing time-share maintenance fees.)

People usually get hoodwinked into buying a time share when they’re enjoying a vacation someplace. Vacationers are easy prey for salespeople who, often using high-pressure sales tactics, want to sell them a souvenir of the trip. The cheese in the mousetrap is an offer of something free (for example, a free night’s stay in a unit) for sitting through a sales presentation.

If you can’t live without a time share, consider buying a used one. Many previous buyers, who almost always have lost much of their original investment, try to dump their time shares. (This fact tells you that time shares are a crummy investment.) You may be able to buy a time share from an existing owner at a fair price, but why commit yourself to taking a vacation in the same location and building at the same time each year? Many time shares let you trade your weeks; however, doing so is a hassle, and you’re limited by what time slots you can trade for, which are typically dates that other people don’t want.

Staying away from limited partnerships

In Chapter 2, I give you good reasons to avoid limited partnerships. High sales commissions and ongoing management fees burden limited partnerships sold through stockbrokers and financial planners who work on commission. Quality real estate investment trusts (REITs), which I discuss earlier in this chapter, are infinitely better alternatives. REITs, unlike limited partnerships, are also completely liquid.

Ignoring hucksters and scams

Real estate investors with lofty expectations for high returns become bait for various hucksters who promise these investors great riches. It’s bad enough when the deck is stacked against you. Even worse is putting your money into scams.

In the following sections, I provide some examples of hucksters and scams that could severely hamper your financial success. Take heed, my friend.

If an investment “opportunity” sounds too good to be true, it is. If you want to invest in real estate, avoid the hucksters and scams and instead invest directly in properties that you can control or invest through reputable REITs (or REIT mutual funds), which I discuss earlier in this chapter.

Don’t believe the hucksters

Cable television infomercials (and now websites) bring investors a never-ending stream of real estate hucksters. The faces and names change over the years, but the pitch is the same. If you’re a cable television viewer, you’ve likely seen the chirpy Dean Graziosi and his lengthy real estate infomercials on various cable television channels, including CNBC. Graziosi claims that he can teach you to make great riches investing in real estate without putting up any of your own money.

Graziosi has been selling advice since 1999. He started with advice about inspecting a car with his CarPro VHS tapes. However, Graziosi didn’t have the expertise — he interviewed an experienced auto mechanic. He then pitched a program on television called Motor Millions, which he claimed could help folks break into the billion-dollar used car market and make an easy profit to “make your dreams a reality.” Graziosi has been selling his book Profit from Real Estate Right Now! The Proven No Money Down System for Today’s Market. Over the years, Graziosi has written and promoted other real estate books with similar content.

If the descriptions of these programs and books aren’t enough to make you run in the other direction, Graziosi also appears to have no training or educational background to qualify him for his self-anointed real-estate guru status. In his books and through interviews, Graziosi says that he “chose” not to go to college and got started in the working world by joining his father in his small car business. That business, according to Graziosi, subsequently failed.

In the mid-2000s, Graziosi began flogging various real estate programs to the public. The books, audio tapes, and DVDs I’ve reviewed are filled with excessive motivational nonsense wherein Graziosi preaches about the importance of having the right mindset and attitude to succeed as a real estate investor. He provides little in the way of details and how-to information. It turns out that there’s a good reason for this lack of information (besides his lack of training and experience). After customers buy a book or DVD set directly from his company, his salespeople use high-pressure tactics to sell personal real estate coaching services for thousands of dollars.

Graziosi’s lack of experience and lack of common sense are exposed many times in his publications. Consider the following:

• In Profit from Real Estate Right Now! he claims that when he saw a real estate agent putting up a for sale sign on a $525,000 house across the street from a home he already owned, he did a quick walk-through of the property and immediately wrote a near full-price purchase offer. In that offer, he claimed to buy the home as-is without having it professionally inspected. This tactic is dangerous for anyone who isn’t a contractor and an expert on all the operating systems of a home. Graziosi clearly lacks this expertise; his not telling the reader the importance of doing such an inspection is a horrible oversight.
• Recent years have shown that Graziosi changes his stripes and story. In the mid-2000s, he encouraged taking out risky mortgages and layering on heavy debts. The real estate market slide in the late 2000s exposed the dangers in that short-sighted approach.

  Now that real estate prices have corrected significantly in most parts of the country, Graziosi is claiming that his system enables novice investors to take advantage of low prices and depressed market conditions. Graziosi suggests that people buy foreclosures (for no money down, of course) and then rent out the property. He also claims that by getting such good deals when you buy foreclosed property, you can refinance and pull lots of cash out of your property and buy more. If you believe this idea is simplistic and naïve, go to the head of the class! Most foreclosures happen in highly depressed areas where decent renters are hard to come by. And it’s wishful thinking to expect that you’ll get such a steal on a property that you can turn around and find a lender willing to do a refinancing that enables you to pull out cash.

Stand strong against the scams

In addition to hucksters, the real estate field has outright scams you should be on guard against. Here are just a few examples:

• First Pension was an outfit run by loan broker William Cooper, who bilked investors out of more than $100 million. First Pension was sold as a limited partnership that invested in mortgages. Using a Ponzi-type scheme, Cooper used the money from new investors to pay dividends to earlier investors.
• New York attorney Alan Harris defrauded real estate investors (including actress Shirley Jones) out of millions of dollars when he pocketed money that was set aside for property investments. The lure: Harris promised investors far higher yields than they could get elsewhere.
• Stephen Murphy, a real estate investor who claimed to make a fortune by buying foreclosed commercial real estate, wrote and self-published a book to share his techniques with the public. Murphy’s organization called the people who bought his book and pitched them into collaborating with him on property purchases that supposedly would return upwards of 100 percent or more per year. However, Murphy had other ideas, and he siphoned off nearly two-thirds of the money for himself and for promotion of his books! He even hoodwinked Donald Trump into writing praise for his book and work.
• Time shares, a truly terrible investment that I discuss earlier in this chapter, have also been subject to bankruptcy and fraud problems.