CHAPTER
14

Investing in Real Estate

In This Chapter

• Should you invest in real estate?
• Real estate agents and how to work with them
• How to treat your primary residence as an investment
• Calculating whether the investment can be profitable

Once upon a time I was a real estate broker, and my territory was one of the wealthiest neighborhoods in Chicago. Who bought those ultraluxury homes? Generally, people who had made their money themselves. These homes were often sold for cash, to people who had started and sold a successful business or invented something astounding; personal injury lawyers who had settled a big case; and people who had invested in real estate. (This was some time ago, so I’d probably add in tech millionaires who cashed stock options, nowadays.)

Some began by buying, living in, and selling their homes at a profit. Some invested in apartments, office buildings, or occasionally land and were able to generate a combination of rents and gains at sale. But be warned: investing in real estate is far more difficult and requires far more time and attention than most other investments. Despite what get-rich-quick seminars would have you believe, real estate investment can be just as risky, if not more so, than investing in securities.

Buying a Home as an Investment

In this chapter, I’m going to briefly consider your home as an investment. Chapter 16 covers your home purchase as a goal—as an end to your investing program, rather than as part of a wealth-building program.

Your Primary Residence

Let’s say you need a place to live, but you want to use your home as a stepping stone to all your future, improved homes. You’re going to treat a home purchase and ultimate sale a little differently than if you just want a nice place to settle into for the rest of your life, or at least the foreseeable future.

Most people’s first home is not their dream home. What you buy for investment needs to be someone else’s dream home, not necessarily yours (because you’re going to be moving on, right?). Figure out your target price range—how much of a mortgage you can get (or less) and how much of a down payment you’ve saved. As long as you live in the property, you will probably be able to get an owner-occupied mortgage rate. Financing strictly investment properties often requires a higher down payment and different financing. No matter how much a lender might be willing to loan you, think carefully about what you can actually afford in the context of your own lifestyle. You might not want to borrow the maximum.

Your first step is to understand the market. Choose the area you would like to purchase in, and start going to open houses. Be sure you see not only properties in your price range, but cheaper ones. The owners of lower-priced homes may be your future buyers and will want something better than they have now. Or you might find a good deal. Also see more expensive properties, so you can begin to understand what kind of amenities and finishes make the difference.

You should look critically at purchasing condominiums and townhouses. Depending on where you live (center of a big city, for example), they may be the principal type of affordable housing available. However, because they are part of a larger complex whose value is well established, it will be hard for you to sell this type of property for much more than the average sale price, unless you find a wreck or a distress sale and intend to improve it while living in it.

Be particularly careful to understand why the unit is distressed (developer problems? estate sale? big assessment coming up?) and how condo rules might affect anything you contemplate doing to the unit. Don’t buy a condo without studying a copy of the declaration and rules, and find out whether the assessments or homeowner’s fee has gone up dramatically, or whether a special assessment is contemplated or planned. None of these things will necessarily kill your purchase, but you should be able to scope out what your ownership costs might be. No surprises.

You should also understand the history of sales in the building. Have they sold steadily? Have sellers had their unit on the market for years? How much did prices drop in a downturn, and have they recovered? One advantage of condo buying is that you will be able to assess the price track record better than a more unique single property.

When you buy a single-family or small multi-unit (more about that in “Small Multi-Unit Properties,” later in this chapter), you’re more likely to have more freedom in selling or renting, but check with the local government of the area to understand if there are regulations or requirements for single-family rental.

Buy the Worst House on the Best Block

Once you’ve scoped out what’s available in your price range, the price range just below yours, and the price range just above yours, you want to narrow it down to which are the worst homes on the block.

Are you saying to yourself, I saw this adorable place. Sure, the neighborhood is a little dicey, but I can get so much more for my money? Wrong, wrong, wrong. You’re thinking like a homeowner, not an investor—a homeowner who is going to live in that place a long, long time waiting for the neighborhood to catch up with what you paid.

You want to do the exact opposite. You want the tiny house, the ugly house, the neglected house, the 1950s house in a sea of vintage homes, the old home in a sea of new ones. This strategy has several advantages:

• Your new neighbors will be thrilled to see you. They’ll welcome with open arms someone who’s going to improve the eyesore.
• Your upside potential future sales price will be higher because the neighborhood pricing will support it.
• Future buyers who would like to live in the neighborhood but can’t quite afford it will be interested. Some will move into the neighborhood just for schools, proximity to transportation, or safety (three factors you should consider when purchasing).

Understand the Real Estate Business

During your travels in open-house land, you’re going to meet a lot of real estate brokers. It can be a great way to find someone to work with, guide you through all the listings for sale, and help you with the contract, finding a lender, and suggesting inspectors and repair people. Do you need one?

It depends. I’d never sell a house without an agent. I wouldn’t want to be available at all hours to answer calls (they aren’t either, but more than I would care to be), or make appointments with potential buyers. I don’t have an ability to prequalify a buyer, and I simply don’t have the connections to arrange the closing, deal with sometimes hostile negotiations face to face, or promote the property to other agents. In my view, they earn their commission.

Real estate agents tend to fall into three types:

The professional who understands her segment of the market She has the contacts and the understanding of value and financing to help you out. Be aware that if she specializes in high-end homes, or starter bungalows, she’s probably not going to know much about properties at the other end of the price spectrum, and probably not much about small multi-units or investment properties. She may have an assistant, and if you’re small potatoes, that’s who you’ll probably be working with. She’s out trying to get more lucrative listings. Real estate agents live in the moment for short turnarounds, so you’re not going to get her excited by the promise that one day you’ll be a seller.

The socialite Real estate is filled with part-timers and, often, wives of rich and influential men. These people cycle through the job very quickly when they find out how much work it really is. They may turn out to be quite good—or they may know absolutely nothing about property. True story: an agent and I were once standing in the basement of a home with a client, looking at a furnace. The client asked what kind of heat the house had. A blue flame was clearly visible through the door of the furnace. The agent said, “Really, I have no idea—oil, I think.” She was right about one thing: she had no idea.

The newbie Don’t immediately select an agent just because he or she has total sales in the millions or is the top seller in their office. The agent may have a turn-and-burn policy, and if you don’t quickly generate a sale, they could lose interest or hand you off to an assistant. People cycle through the profession rather quickly, but if you find a hungry newbie who behaves professionally (follows up, keeps in touch, shows you what’s out there, and gives you honest advice), you might be working with someone who will put much more time and effort into you than a more experienced agent. You’re more valuable to this new agent.

Get an Inspection

Unless you’re extremely well versed in housing construction and know what can go wrong, get a qualified home inspector to go over your proposed purchase, and make sure your offer has an escape clause in case the inspection goes poorly. This is less necessary in a condo, where common elements are common problems, but you should thoroughly test appliances and plumbing, look under sinks and at walls and ceilings for signs of leakage, and so on.

Just because the inspector finds things wrong (and they almost always do), it doesn’t mean that you should discard the property. Just be aware of what a repair might cost. The agent and the seller might not like it, but you can go back with a contractor for an estimate. If they won’t let you do that, be very wary. You can sometimes negotiate for a higher price and cash back at closing, which may allow you to finance the repair. Just be aware that that will increase your mortgage and closing costs based on the higher purchase price.

On the other hand, even the best inspector misses some things. You need to have at least a small emergency reserve to cover things like the bottom dropping out of the water heater, or a sewer line that hasn’t been rodded out in a while.

Be Canny with Improvements

Improvements that you make when you’re an investor planning to sell may be different than what you’d do if you planned to live there for 30 years.

Since you’ve done your homework on what buyers expect in properties at the level you hope to sell this one, you’ll know whether granite counters, custom cabinets, tile, oak floors, or highly upgraded bathrooms are expected or not. If you’re still friendly with the agent after the sale, ask for suggestions on what would improve the property. What would she like to see done if she were to re-list it? Agents know what sells: when I sold my dad’s house, mine made a terrific suggestion for flooring that was quite inexpensive. Just about every person who viewed the property commented on the beauty of the flooring.

Don’t fail to research what permits might be required in your jurisdiction for specific home improvements. Mess up and you could find your job shut down, yourself slapped with some big fines, and even your eventual sale halted. It’s just not worth trying to sneak by. Put it in your budget.

Keep the place neat and clean (and get the pets out).

If you’re going to be an owner-occupant who wants to sell the place eventually, learn to be spic-and-span and super neat. Buyers hate clutter—the less you have, the more they can picture their own things in the space. However, totally empty rooms read smaller, because there’s nothing to scale the eye against.

Most Realtors will advise you not to be home when prospective buyers are viewing the property because there’s too much chance they’ll ask you something or you’ll blurt out something that will turn them off.

What About Staging?

In big cities you can hire professionals for a consultation on how to make the home look more attractive. Often they are decorators, but what you want is someone who can help you make dramatic but inexpensive improvements—select paint colors, rearrange furniture, distribute candles, flowers, or potpourri about the house, and so on. They’ll help you get rid of clutter you don’t notice. These people can literally make a $10,000 difference in the selling price, and speed up a sale.

If you can’t find someone, bring in a couple of real estate agents and ask them to be brutally honest. Here’s where you absolutely want the top sellers with experience—they know what sells. Agents won’t charge you for this because they’re hoping to get the listing, and to be fair you should at least consider them when you do sell.

Let’s say you want to sell in 3 years. Do the structural repairs first, then the exterior, and finally the freshening up of the interior so that everything will look new to the buyer and you haven’t had 3 years to beat it up.

What’s a Good Profit?

I don’t know your local area, but I can say with certainty that your profit won’t be as much as you hoped and as much as those real estate seminars would like you to believe. Some areas are so up-and-coming that in a few years your sale price can double. Not as likely anymore, but it still happens.

I’d feel pretty darn good about a purchase if I got my down payment back plus double the cost of what I’d put in for repairs. You got the tax deduction for owning the place and lived there for all that time. Of course, some sellers do far better, but you’re probably going to need to do it a few times before you can spot the perfect house needing the most cost-effective repairs.

Other Considerations

While you can probably get a better return from buying owner-occupied housing, improving it, and selling it, you’re going to be putting a lot more time into this type of investment than you would simply going online and trading mutual funds.

It can be hard to raise enough money to handle the down payment and the needed repair costs. Most people tend to buy the most expensive house their down payment funds will get them, and neglect to keep a reserve for repairs and upgrades. You may be able to get a construction loan, which will temporarily loan you money at a fairly high (often variable) interest rate with a balloon payment at the end of the (short) term. Then you have the house reappraised at its now higher worth and refinance the mortgage, paying off the construction loan. If you do this, the carrying costs of the loan need to be accounted for and figured into your sale price and profit analysis.

You may be wrong in your estimate of what your house can sell for, and your improvements and hard work may not return what you hoped. Bigger risk, bigger rewards, remember? You can control some of the risks because the investment is being run by you, not some far-off CEO or the government of Krakistan. At the same time, it’s you who must make the choices, do the work, and live with the consequences. Or hopefully, reap the profits. What might they be?

Let’s say you purchase the home for $250,000, putting 10 percent down and allowing $5,000 for closing costs and moving your stuff, putting down deposits on utilities, and so on. You plan on putting $35,000 into repairs, but you end up spending $50,000 instead. Three years later you sell it for $350,000. How much have you made? We’re going to confine our first look to the cash gain or loss and leave the tax factors for your accountant to advise on (and you should have that conversation if you’re seriously evaluating a potential investment).

Your total investment:

$25,000 down payment

$5,000 closing costs

$50,000 repairs

$38,670 in mortgage payments ($225,000 at 4 percent interest)

$118,670 = your total cash cost

What did you make?

$350,000 sale price

–$118,670 your cost for home purchase and upgrade

–$35,000 closing costs, transfer taxes, and real estate agent commission

–$212,622 mortgage payoff

–$16,292 = loss

Not exactly get rich quick, right? But wait, you’ve lived there for 3 years—3 years you would have been paying rent somewhere else. You also got a tax deduction for the interest you paid on the mortgage (and it’s mostly interest in the first few years.) You’ll walk out of the closing with about $102,378—which will give you a start on a much bigger purchase. Fiddle with the numbers a bit—sell for more, put less into repairs, sell it yourself without an agent (good luck) and the returns can come out quite differently—in either direction.

Is this type of investing worth doing? For some people, yes. Personally, I’ve never had the time or courage to make it work, but I see people who do. Often, they are people who are full-time real estate agents who see tons of property, can judge value, and have a flexible work schedule that allows them to meet the plumber when he calls asking where you want the bathtub that was just delivered to your front porch. One agent I know had set herself a goal of purchasing a property a year, renting it, and selling it when the appreciation allowed a profit and she could upgrade to a better property. She managed 10 in 10 years. Not all of them were profitable, but once the portfolio grew large enough she had enough portfolio diversification to absorb losses. And a tidy retirement income base.

Purchasing Small Multi-Unit Properties

People who buy small multi-units (four apartments or less) with the intention of living in one while renting the other(s) have a somewhat different orientation. The worth of these properties is based more on rent collected than the renovate-and-sell model.

In this scenario, the main obstacle is coming up with the higher down payment for what is nearly always a more expensive property than a comparable single-family home. As long as you will live there and the building is four units or smaller, you should qualify for owner-occupied lending rates, and the lender will take into account the actual rents as income on the rental unit(s) when figuring out if you will qualify for a higher mortgage. Depending on the property and the neighborhood, you may qualify for a low down payment FHA loan, or be required to come up with 10 percent or 20 percent for a down payment.

The second obstacle is actually finding a property. Some neighborhoods are filled with these properties—they were particularly popular with immigrants and people who had large families or expected their children to move upstairs when they married. Other neighborhoods and suburbs have practically none. Especially in older properties, these units can be spacious and quite nice—they were built to be owner and family occupied.

The idea in investing in one of these properties is that you live in one, getting help with paying the mortgage by applying rent from the other units, and over time you increase rents until the tenants are buying the building for you. If your plan is ultimately to move into a single-family home, you can rent the unit you now have, providing more income; sell the property with increased value based on now higher rents; or borrow against the property for whatever amount the increased rents will support, and add another property.

The main pitfall with this strategy is that the tenants can drive you crazy. A small property will probably need to be self-managed (so you need at least rudimentary fix-it skills) because it’s too small to support professional management fees. Also, maintenance and repair costs may be higher on a bigger property. Multi-units can experience market reverses also, and rents can deteriorate. Major, unexpected repairs can gobble up all your projected profits. The fewer the units, the more a vacancy will hurt your income.

The main advantage is the flexibility. You can live there, you can increase income, and you can sell it at a profit. There’s not as much pressure to move in a hurry, and no restrictions on renting it. There’s some economy of scale over renting a single-family home, and even if one stays vacant for a few months, the other unit(s) will still be paying rent and covering some of the costs—less risk of vacancy or destruction than renting single-family properties.

In the early years, you’ll be lucky if the property pays the mortgage (figure your unit in at a reasonable market rent) and covers repair costs. These properties are usually priced at break-even or a little less (figuring you should also count your tax deductions). But as the years go on, they can be very profitable.

Apartment Buildings, Offices, and Other Real Estate Investments

Larger apartment buildings are a whole different ballgame. You need different kinds of financing and a much bigger down payment. A lender will evaluate their worth based on the property’s balance sheet, carefully evaluating costs and rent collected. Special care needs to be taken to ensure that the current owner isn’t providing a statement based on a lot of deferred maintenance, or that the cost of those basic repairs is factored into your purchase offer. This is really beyond the scope of beginning investing, and I suggest you either get your toes wet with smaller properties to gain experience, or get a reliable partner who can help you learn the ropes while investing with you.

The one purchase that many beginners make, or find themselves inheriting, is vacant land. You might have the luck to buy a great piece of land in the path of development, but these opportunities have become far fewer in recent years as city sprawl has diminished. In the meantime, land produces no income and requires you to pay taxes. Unless you plan to build on it in the near future, or use it for some profitable purpose, it’s a liability, not an asset.

I’ve seen a fair amount of clients who have inherited farm land, often rented. It can be quite hard for the city-dwelling heir to evaluate and manage the investment. If you find yourself in this situation, get an appraisal. County extension services can tell you what the estimated price per acre for the county is, but a professional on the spot can do a better job of evaluating the value based on both the land and the rents collected (if it’s being farmed by someone).

If you inherited the property free and clear (without any loans), you’ll have to take into account the appreciation potential and the collected rents. Is it a worthwhile investment? Well, compare it to a decent dividend-paying stock—are you making at least 2 percent on rents for the total worth of the property? Does it have steady value or solid appreciation value? Whenever you keep your money in one investment, you give up the opportunity to invest in another. Be sure holding the farm is actually a decent investment, and don’t retain it only because of childhood memories or loyalties to a deceased family member.

Investing in real estate can bring you good returns—if you learn how to manage costs and use a sharp pencil when figuring income and outgo. Be prepared to put far more time and hands-on labor into this type of investment, and be sure you have the personality to cope with contractors, tenants, and house hunters.

The Least You Need to Know

• Work with a real estate agent who’s right for your needs.
• Treat your primary residence as your first real estate investment.
• Choose the most cost-effective improvements that will help you sell at a profit.
• Get an inspection to protect yourself.
• Consider small rental properties as an alternative to renovating and selling.