Beware the money pit…
Risk vs. reward
Creating discipline for yourself
Pro forma budgets
Think like your potential buyer thinks
It ain’t that easy…
Buying foreclosures dos and don’ts
Make nice with the listing agent
A foreclosure example from Hell
Do you have the right temperament?
An instructive lesson…
I recently showed a foreclosed property in my area to a prospective buyer family. The husband and wife were quite enamored of the home – before they actually saw it in person. Then, when they got to actually go down into the basement, things, well, fell apart for them. There was a wet stain on the basement floor along one side of the foundation wall, where it met the floor. It was originally assumed that this water damage was due to poor drainage issues with the house at the exact point on the exterior side. However, upon closer inspection, this was definitely not the case.
Though poor drainage problems exist with many houses, and a good home inspector can help suss this problem out, as well as offer suggestions as to how best to fix the problem with some basic water damage repair suggestions, this particular home did not have this problem. Instead, it was clear that a water heating pipe directly above the wet area had been slowly leaking for some time. Our best guess: the house had developed a freeze-up due to being vacant in the middle of winter, and the caretaker had not been doing a very good job taking care of the property. We inspected the heating pipe, only to find a gaping hole in it right above the wet area on the basement floor below. Whatever water had been in the pipe had obviously drained out, since the heat was already off in the house.
Finding the mother lode
For any experienced property investor, this is liking striking gold. You can certainly use the property owner’s misfortune against them when it comes time to make a bid on the house. While the average homeowner buyer gets scared off by the prospect of a huge bill to pay to fix the problem, the experienced investor knows better: it’s simple math to guesstimate the repair costs of utilizing the services of any number of water restoration companies available in the area, bracket those costs by adding in an extra overage percentage, then taking that amount and deducting it from the amount you’d be offering for a purchase price. It also offers one the opportunity to ask for an even greater amount off what the asking price of the property may be at the time – in essence, it offers a property investor the ability to make a very sweet deal.
Different types of water damage
In the case of a plumbing leak, either while the house is occupied, or, as I described above, with a vacant home, when the water has been turned off, you won’t be able to get a good idea of any potential problem lurking in the house, especially if there is the presence of much older piping. In this case, you must plan for the worst – and expect the pipes to have burst or leaked at some point in the past. Sometimes you just won’t be “lucky” like the family in my example above, where a leak is obvious. Using “caveat emptor,” you’ll need to either plan on a rehab of all plumbing in the building. Or simply be prepared to walk away. However, as I mentioned before, be sure to utilize this fact against the seller in any negotiation to try and make a great deal.
Ground water issues
I have written in prior articles here about the potential problems associated with ground water infiltration into basements, as well as high water table issues. I have noted before that it’s imperative you use a licensed house inspector, or commercial building inspector. They can scope out any potential property investment problems associated with high water tables in the area, poorly graded building siting, underground streams and the ever-popular cracked foundations. I have previously written how “sometimes existing water or mold issues can be easily fixed. For example, an unmaintained building may have damaged or non-existent gutters and leaders. Hence, rainwater is dropped right next to foundations, and in heavy rains, there will usually be some form of basement seepage. This can then translate into standing basement water problems and/or mold growth – which of course, can spread. The solution – repair or replace existing gutters and leaders where needed, thereby stopping the problem from re-occurring.
In addition, make sure the area around the building is properly graded to allow for property rainwater to escape away from the foundation walls. Simply sealing foundation cracks is usually not enough. The perimeter grading is what is all-important. Your inspector will also be able to tell if any underground streams and/or a high water table will require you to install an interior French drain system in the basement, complete with sump pump and outflow pipe considerably far enough away from the building. Mitigating water problem costs known before you buy can easily be figured into your offer price on any potential acquisition.”
Using water restoration companies
Most water damage restoration companies will utilize an interior drain solution. There are basically two common ways to waterproof a house – one involves landscaping and the other installing an interior curtain drain (also known as a French drain). Landscaping is the more expensive solution, and can involve not just re-grading the entire perimeter of a house, but installing an exterior curtain drain at the same time around the perimeter. Naturally, you should look for simple solutions to a water problem first. For example, if gutters are broken or missing, or if downspouts are emptying directly onto the perimeter, rather than being led out many feet from the house, these can be inexpensively corrected.
Installing a gravity-fed curtain drain system leading to a sump pit equipped with a sump pump inside the perimeter of the basement is the next best alternative for waterproofing. The main drawback: if the sump pump were to fail. That’s why, in a very flood-prone area, installing a secondary, battery run sump pump is always a good idea. Of course, if power were to go out for an extended period of time, you’re still going to have a problem. Unless you get a back-up generator to run during any power outage…mergency water problems with tenants
As a landlord, you’ll always be at the ready for burst pipes. These emergencies can be harrowing – but easily fixed. I have noted here that “any burst pipe will cause your tenant to call you – at any hour of the day or night…so you better have your emergency plumber (or two) lined up to call after you hang up with your frantic tenant. A plumber you can trust to get right out to your building and handle the bleeding, as it were, immediately. Sure, you’ll be paying double-rate for an emergency call – but think of the damage a burst pipe can do to your building. The worst-case scenario with a burst pipe, is when you don’t have a tenant in place to call you…Walking in on a flood as a property investor is one of the worst feelings you can have…So to hopefully avoid this, conduct regular inspections of your building(s), looking for potential water and or/pipe problems. Especially if you know you have any older, or rusting pipes. Maybe it would be best to replace them with pex (plastic) piping now to avoid any major problems later.
Do you have reliable tenants?
Beware the slow leak! This is the kind that your tenant never reports…the tenant with the long-term lease. The one who will “just live with” the minor annoyance of a small drip emanating from the base of the toilet, or under the kitchen sink, or behind the refrigerator. The leak you won’t notice until they move out, and you discover a warped floor, damaged carpet, or ceiling stains from above. Or worse – if you discover mold that’s been growing for quite a long time – requiring you to remove entire walls or ceilings, and completely replace them with new sheetrock, as well as painting them.
I have previously recommended that you train your tenants. And perform regular maintenance “visits” into your tenants’ units. Train them to call you immediately – if not sooner – when they discover the first drip out of anything in the unit Then call your trusty plumber to make the necessary repairs. You’ve budgeted for repairs and maintenance as part of your cash flow analysis – make sure you follow through and get your tenants to alert you to the smallest of problems as quickly as possible. In this way, you can avoid the much greater hassles in dealing with any growing water damage issues, and the overall monetary damage they can truly represent.
Photos courtesy of the-purest-of-treats.blogspot.com, mosbybuildingarts.com, home-dzine.co.za, brookfieldangler.com, quality1stbasementsystems.com, johnbatorplumbing.net, trexglobal.com
Considerations for the novice property investor…
I have written in prior articles here some suggestions for the novice investor looking how to flip a house and just breaking into the house flipping business. Unfortunately, there will certainly be a great deal of trial and error you’ll have to experience on your path to house flipping wisdom. But pay heed to some of these recommendations, and you should definitely cut down on beginner mistakes. I have noted in my article “The Art of The House Flip” (see http://investinginproperties.org/fixing/the-art-of-the-house-flip/) how at the start, you “should begin by knowing every fixer-upper that is on the market in your local area that you plan to do your property investing. That means not simply combing through Zillow or Trulia for all available houses on the market in your area. It means you must actually tour each and every one that is a viable candidate for your house flip dollars. Make sure you work with one local real estate agent exclusively. They can greatly aid you in setting up automatic searches on their local Multiple Listing Services (MLS) that will generate possible investment flips daily for you to explore.” I also had some good suggestions in that article about the possibility of flipping houses with no money down.
More cogent advice
But wait, there’s more…As part of your house flipping 101 primer, you’ll need to develop some major amounts of discipline. I mean, after all, you will be running your own business! Consider some more advice on this exact subject I have proffered in the same article, when I mentioned that you should certainly “pick a day of the week to be able to tour all the houses that just came on the market that week, that are in dire need of repair. It is these fixer-uppers, where you can invest renovation dollars to earn you profits that you’ll need to zero in on. If possible, and your work schedule allows it, be able to visit immediately new additions to the market that represent tremendous profit potential. Either they are undervalued, or need work that is modest, but will yield high returns for your investment money. Naturally, you also need to do your homework on what similar properties to the house you’re considering flipping are selling for of late (within the last 6 to 12 months only). This is known as knowing the “comps,” or comparable properties. As before, use your real estate agent to help guide you in your research here.”
Pitfalls abound though…
I have also outlined in another article here some of the major pitfalls to be aware of when just getting your feet wet in house flipping. In a separate piece here (you can see the whole article at: http://investinginproperties.org/locating-property/beware-biggest-house-flipping-danger/) I have warned that “from the outset, you’ll need to create a pro forma budget for your real estate investing project. This is the easy part. Acquisition costs, tentative rehab costs, and carrying costs until you sell it need to tallied up. Be sure to be conservative in all areas, and don’t forget to add 10% as an overage factor when investing in real estate. Then, figure on a realistic market value for the property once it’s all fixed up to determine your net income projection.”
When the model for flipping houses doesn’t work…
I have also warned in here about some other major pitfalls that could befall you when investing in house flipping. I have ticked off many possible roadblocks to the novice property investor who’s trying to understand how to flip a house. However, I wanted to note here that one danger in particular should be evaluated prior to getting your feet wet. I’m speaking of the area you choose to do your house flipping business.
I have noted before that location is critical to the success of your house flipping projects. However, this assumed your area met other criteria to be successful. I should note that an aspect as serious as the crime rate should not be the main determinant of your selection of an area…Many geographical regions are in the process of gentrification, and prior poor crime statistics for an area do not necessarily indicate future problems. Rather, you should take in demographic data as a whole for any area you’re considering acquiring a flipping project. If a new access ramp to a nearby highway is about to be built, or if a new local mall is about to be constructed, then indeed, the area may be about to make some major improvements, and be a great indicator of a place to purchase a fixer-upper to rehab and then place on the market soon thereafter.
Be wary of this scenario…
However, there is a model for house flipping that simply does not make financial sense. This occurs when the geographic area you’re considering buying into has low absolute market valuations for houses while at the same time labor costs remain high relative to more affluent areas nearby. Let me give an example. Let’s say the area you want to invest in has an average home sale price in the hundred to hundred and fifty thousand dollar range. Meanwhile a very affluent town thirty miles away has an average sales price in the four hundred to five hundred thousand dollar range. If your budget will only allow you to purchase in the lower price range town, fine. However, if labor costs are roughly the same between the two areas, beware! A hundred thousand dollar renovation project doubles the cost of a hundred thousand dollar acquisition. But after the renovation, you probably will not be able to recoup such a high renovation cost – plus profit – when it comes time to place it on the market. But if you buy a four hundred thousand dollar home, the hundred thousand dollar renovation only represents a twenty percent increase in the valuation – not fifty percent! The flipping houses model needs to keep consistency between areas. Otherwise, you’ll be stuck “over-improving” a property – and most probably, will have to take a loss on it in order to sell it.
Length of time on the market
Also consider the average length of time on the market for homes in the area you’re considering buying into. This is critical. You can get this information from Zillow, Trulia, Realtor.com or your local Realtor…for any given zip code. If you find an area that has an increasing average length of time on the market, be very wary of investing there. In addition, if the area has an average length of time that’s got an average over one hundred eighty days, also be extremely concerned. Your model is based on moving your product quickly – your newly renovated house. If you get stuck in an area where there are too few buyers looking, you’ll then be stuck holding your property for a long time. The longer you hold it, the more your carrying costs will eat into any potential profit when you do sell.
Photos courtesy of askmen.com, cbsnews.com, metrosdrealty.com, foreclosuredatabank.com, barnettassociates.net, fixandflipnetwork.com, gumtree.com
Using simple math to locate the best properties
You think you found an excellent potential rental property to acquire. Now it’s time to crunch your numbers to determine how much you should offer for it. If your return on investment (ROI) looks good on paper, then by all means move ahead and place an offer. (You can also use a basic investment property ROI calculator. The one I supply on this site is quite excellent.) You’ll find with experience, you’ll be making many offers every week in order to arrive at one good deal. By determining your property ROI on each potential investment property acquisition, you’ll find that you’ll be able to compare it with other properties, as well as other assets too.
What’s the ROI of my investment property?
First, start with the rent roll…Let’s examine the income side of the equation, namely, the rent roll. If the rental property you’re considering making an offer on is already fully rented out, then you obviously won’t have to impute a projected amount for any existing vacancy. However, make sure you’ve confirmed the actual rent roll by asking to see copies of the seller’s leases with his tenants. In addition, check to see that they are indeed current market rents. You don’t want to have a seller’s friends or family receiving some lesser rent as a break for their relationship with him. Be sure the gross monthly rent is an actual rent, and not a made-up one, designed to help the seller increase the price for his property. If you feel an actual rent is way under market value, then you can adjust your numbers accordingly, as long as there are no long term leases associated with the property that are currently in place.
Part of your due diligence is to check on what constitutes market rent for each of the units in the building. For example, try checking out ads for other, similar units currently being offered for rent in your area, as well as visiting some of them to make sure they are similar to the property you’re considering making an offer on. Ads can be located in your local papers, Craigslist, or other online classifieds for your area. Also check with local real estate agencies to see what they have listed for current rentals.
Sites like Trulia, Zillow or Realtor.com can also provide you with this invaluable information. You can also obtain prices of actual rentals – what the units actually rented out for, through the same sites and/or your local realty agency. Most multifamily or apartment unit rentals tend to rent for the same amount, or slightly less than their advertised rents. However, in the case of single family home rentals, be sure to check for their actual rental price, since they may have a much larger disparity between advertised and actual rents. Also, if you feel you can make some modest renovations and repairs to bring the units in the building more in line with current market rents, then figure on the higher rent roll as well.
The expense side
When you’ve got your rent roll numbers down, you can next concentrate on the expense side of your pro forma income statement. From the top, you’ll state your total estimated gross monthly income. On the other side of the ledger, you start subtracting all your monthly costs. These include your fixed costs like property insurance, taxes, any property management fee, homeowners association fees, and other maintenance items that you are responsible for. This may include landscaping, snowplowing, or, in some cases, heat or water charges. As with the rent roll, be sure to ascertain the exact expense figures. Double check the seller’s numbers by asking for proof of all his prior expenses. Then, pore over them again as a means of double-checking his numbers.
Don’t forget your vacancy rate
It is critical to never forget to include a rate for vacancies in your particular area. When a tenant’s lease ends, and you begin looking for another replacement tenant, you’re going to have a vacancy. Maybe it’ll only be a couple weeks…Most usually it will be at least a month. In a good area where there are many tenants available (as in an urban area), a standard vacancy rate would be 7%. In a more rural area, where tenants are harder to come by, you may want to bump up this figure. Either way, you’re going to have some vacancy when a tenant leaves, and you need to build this number into your calculations to show an accurate picture of cash flow over the life time of your ownership of the particular investment property you’re analyzing.
Mortgage costs to be added in…
You’ll also need to add in your total monthly mortgage amount, assuming you’re not paying all cash for the rental property. Consider the fact that property investors are charged higher interest rates than homeowners…usually about one to one and a half percent higher on average. Also, expect to make a higher down payment than a conventional home loan. Thus, instead of twenty percent down for a conventional home loan, non-owner occupied rental property can start at twenty-five to thirty percent down in most cases. (With poor credit, it can go up to forty or fifty percent down, depending upon the lending institution and their lending standards.) You’ll then need to subtract your mortgage payment based on what you intend to offer on the property to determine your net cash flow per month. Naturally, if you’re paying all cash, there would be no mortgage payment figure to subtract. The greater the positive cash flow it shows on paper, the more attractive the property will be to make a bid on.
Figuring your return on investment
Now, to determine your return on investment (ROI), you’ll need to divide the annual positive cash flow amount by the expected total amount you’ll be putting into the property when you buy it. This will include your down payment (or, the total amount if you’re paying all cash) plus all closing costs on the purchase. This ROI is also sometimes referred to as your “cash on cash” return on the investment property. It will enable you to compare buying this particular asset with other types – whether they be another property you’re interested in, or other investment choices like REITs, stocks, bonds, etc. Of course, this simple analysis does not take into account the other benefits of property ownership, like market appreciation, tax benefits that include the ability to depreciate your asset, and the overall barrier against inflation that property usually confers on investors.
An example of a cash return ROI
As an example of the cash on cash return method, consider you want to acquire an investment piece of real estate for $500,000. Assume the property will throw off a conservative positive cash flow of $15,000 annually. If you put 30% down on the property, and therefore invested $150,000 of your own money, the return on investment would be 10% ($15,000/150,000). ROI’s above eight percent would make for excellent investment property returns these days…
Unless you’re specifically trying to offset other income by buying negative cash flow property (where the aim is to use investment property as a tax shelter), you shouldn’t be considering wasting your time on investment properties with cash on cash returns below five percent. There’s simply too many things that can go wrong for you to accept a smaller ROI investment property. Always remember to analyze your numbers conservatively, and definitely stay above this five percent ROI level. This simple method will then hold you in good stead as you move forward in making new property acquisitions.
Photos courtesy of jackphanginvestment.com, scottyancey.com, empirepropertyinvestors.com, auction.com, sixi.be, vestahawaiipropertymanagement.com, aspectestateagents.com.au, sumobob.com
High risk property investing…
If you’re into high-risk property investing techniques that may return higher yields than the more traditional forms of property investing, then by all means consider investing in abandoned property. Since these are typically houses that have fallen into disarray due to owner neglect and ensuing abandonment over a lengthy period of time, they will not be on the market for sale. So your real estate agent will not be able to help you out in your searching. In fact, locating a potential money-making abandoned property will eat up much of your valuable time, since you’ll have to do all the search work yourself. However, if you happen to pass by areas with what look to be abandoned houses, then by all means try using these techniques to scope them out further to see if they can be potential cash cows.
Spotting an abandoned house
First, when you spot an abandoned house, simply walk up to the front door and see if there is in fact anyone living there. You’d be surprised how many neglected houses look abandoned – but are not! If you’ve made several attempts at knocking on the front door at different times of the day on several occasions, and still no one answers, it’s a good bet the house is abandoned. Next, you’ll want to run a simple search using your county’s public property assessors web site and find out who the owner is, as well as their legal address. You can then proceed to contact them through mail, or by looking up their phone number online using a reverse address listing.
Contacting an abandoned property owner
When contacting these owners, be straightforward, no-nonsense, and respectful. Clearly, they either are in the process of being foreclosed upon, or have some dire reason they have left their house in such disarray. So they may not be in the most pleasant of moods when you’re successful in reaching them. Just be prepared, and you’ll be fine. While being humble and respectful, simply offer them a way to get out of their financial bind. Remember – you’re their savior – the solution to their financial problems. If they have a mortgage, offer to pay it off as the sales price for the house. If they have an assumable mortgage, ask if you can take it over. On the other hand, if they own the house free and clear, and are wasting money on paying taxes and insurance on the property, ask for them to hold the paper on your offer. Depending on how dire their circumstances, they may be able to finance the full amount of your offer – or at least, a very large percentage. In addition, they may be very lax in asking for credit reports from you, making it easy to qualify for their owner-financed loan. You could have a tremendous opportunity.
Bracketing your potential expenses
Keep in mind, like investing in foreclosures, the house is probably going to be in just as rough shape inside as it is outside. So you’ll need to bracket your fix up costs to anticipate the absolute worst when trying to either flip the property, or rent it out. Also consider, if you’re going to rent it out, there are a number of government grants you can investigate, that are specifically related to multifamily renovating, such as the Rental Rehab Program. With this particular program, the government will require you to install section 8 tenants after renovations are completed, but it could be an excellent way to create a very positive cash flow on a currently-abandoned property.
Working with difficult locations
Your other main concern, besides locating and proper numbers crunching, will be location. Usually, most abandoned properties tend to be in poorer, more crime-riddled areas of metropolitan areas. However, if you also look at up-and-coming lower income areas that are in the process of gentrification of late, you may be able to spot several abandoned properties worthy of further inquiry with their owners. It’s worth a shot.
Always be on the lookout
Abandoned properties, whether they be abandoned properties in CT, NY CA…you name the state…are certainly worth investigating. Just keep your laptop or pen and paper handy to write down their addresses as you pass by them when driving. It’s a good idea to take photos of these houses from the street for easier reference back to them later, as you cull through the most viable ones for investment. In addition, be wary of going inside any abandoned property without permission. Abandoned property law still considers it trespassing if you don’t have the express OK from the owner to go inside.
photos courtesy of buildingmoxie.com, nakedphilly.com, holidayapartments101.com, easyinsure.ca, shouldersofgiantmidgets.blogspot.com, barnettassociates.net
The cap rate demystified…
When evaluating several properties to purchase, whether you’re investing in rental property or commercial real estate, experienced property investors use a cap rate formula to help crunch their numbers. Ultimately, the cap rate (more formally known as the capitalization rate) aids the investor in analyzing what property makes the best deal. It is used simply as an indicator – a directional arrow – as to which property SHOULD offer the best yields, and throw off the most profit for you in the future. However, a controversy has brewed of late about how much investors should rely on the cap rate.
What is a cap rate exactly?
A simple cap rate definition would be that the real estate cap rate is a calculation that measures the annual rate of return for any given investment property, or set of investment properties. The cap rate for any geographical area will differ, with the general axiom that the more in demand the area is, the greater the cap rate will be. These hotter markets tend to offer yields with cap rates around ten percent or more. However, low demand areas may throw off cap rates as low as four percent.
How to calculate cap rate
I have previously written about how to calculate the cap rate here. I have noted that the calculation for the CAP rate is easy; simply follow this order: ascertain the annual rent roll from a given investment property (making sure to double check and confirm any seller-given figures). If there are vacant property investor units in the building, you’ll need to ascribe a correct market rent for each unit. Make sure you check out several Realtor’s estimates, Craigslist listings, and have actually visited like units in other buildings to help determine accurate rent roll pro forma numbers. Then add up all the expenses associated with the building, on an annualized basis.
I had also mentioned that you should not forget a vacancy amount (usually between five to ten percent of total rent roll), as well as maintenance, taxes, insurance, electric, heating, and any other utilities the tenant will not be paying directly for. Of course, unless you’re paying all cash for the property, you’ll need to add in your mortgage payment on an annualized basis as well. Once you subtract the total expenses from the pro forma total income, you’ll have your (hopefully) positive cash flow number. This, of course, is your net income.
Cap rate calculation
Now simply divide the net income figure by the amount the seller is asking for the property. (As an example, if a property that throws off $50,000 in net income has an asking price of $500,000, then the CAP rate would be $50,000/$500,000, or 10%.) To reiterate, the greater in demand the area, the greater the CAP rate should be. In addition, you need to set minimum standards for yourself. Some investors won’t buy anything with a CAP rate below 5%. That’s up to you. But be sure to use the CAP rate to help you back into the highest amount you would offer for a property. The CAP rate can represent your rate of return on any given investment property.
At the beginning of your investment property search, a novice may initially want to use pen and paper, however, there are many real estate investment calculator programs readily available online to do the calculations for you. Simply plug in your specific numbers to software programs that act as a cap rate calculator…one of them is right here in the Tools section – and let them do all the numbers crunching for you…
Here’s the crux of the cap rate controversy…
Some real estate investment pros believe the cap rate to be too short-sighted…like looking at a landscape with a telescope. One such critic of cap rates is W. Grayson Powell, a broker and managing partner with Coldwell Banker Sun Coast Partners. In an article he wrote last year ( “Property Investment Cap Rates Aren’t Always Accurate, “ Wilmington Biz.com, September 1, 2014), Mr. Powell noted that “cap rates are solely based on property income performance for the current year. Cap rates don’t take into consideration factors that may affect property values five years or 10 years down the road. Because cap rates only deal with what a property is producing now, it’s a very shortsighted and narrow view of property value and should not be the number on which you ultimately base your purchase price.”
Like buying a used car?
He goes on to compare cap rate analysis with your decision-making process when buying a used car. He adds that “cap rates on income properties are often like the list price of a used car. They can be an indicator of the estimated value of the property and give you a starting point for your search, but there is more information and more work to be done before choosing a property and making an offer.” Mr. Powell then notes that “there are many factors to consider when determining and fine-tuning property valuations. Here are a few of them:
- How good are the existing leases? A reputable grocery store with a 20-year lease is low risk; but a restaurant that’s empty most of the time with one year left on its lease is much riskier.
- Is there a good tenant mix and do they effectively serve the needs and interests of the surrounding community? The demographics of a community can change, and the types of tenants must evolve to match the needs and demands of the people in the area.
- What is the age and condition of the property? How soon will you have to pay for upgrades and repairs?
- What is the current housing market and financial environment like? Are rental rates rising or falling?
- What are the current interest rates and what are they expected to be in the coming months?
- Are operating and management expenses rising or falling? Here’s a hint – they’re usually rising.
- What are the historical occupancy, retention and vacancy rates for the property over the last 10 years to 15 years?
- What are the tax implications of buying a particular property?”
Finally, he goes on to recommend “analyzing the cap rates and the values of each individual tenant, rather than looking at the property as a single entity. This provides a better picture of the actual risks that exist within a given property.”
The fallacy of his argument
My opinion is that, while all of his assertions are correct, he loses sight of the main reason why a property investor uses the cap rate: namely, to analyze what the investor should be offering to pay for any given investment property. Obviously, this will be highly subjective from investor to investor. However, keep in mind that, when a piece of investment real estate goes on the market for sale, the asking price of that investment property is pegged to a point in time. It’s not the asking price ten years from now. And the asking price usually bears some relationship to the prior year’s income performance of the property….and not to the performance in ten years.
And this is the main fallacy with Mr. Powell’s argument. I think it’s absolutely fair to consider a property’s short term performance utilizing the cap rate in so doing – because the cap rate will reflect the underlying value of the property today – when the asking price is set. After all, the asking price is not set some time down the road. As I mentioned earlier, you’ll be taking into account vacancy rates for the area when you figure your cap rate. And you’ll also be analyzing the future revenue potential of a property based on your expectations of what renovations will be needed to bring in current market rents, or how the rental market in general will perform down the road as well.
photos courtesy of hudsoncreg.com, joelane.com, denalipm.com, sanpedrosquareproperties.com, sultharproperties.com, usnews.com, mortgage.lovetoknow.com, whatsthepointofaventura.com
The allure of the “steal”
Bidding at real estate auctions always attracts a certain segment of property investors. Whether it’s government auctions (gov auctions), foreclosure auctions or seized property auctions, certain types of investors are attracted to them. Call it the art of the steal…And there are a number of very large property auction companies that cater to, and aid in, the selling of distressed properties to investors. Some of the top auction houses include REDC (which is now known as Now Auction.com), Parrott Auctions.com, and Williams Auction.com.
Over time, I’ve developed a theory that auctions are alluring to two basic subsets of the real estate investor: the hardened, experienced pro, and the novice looking for the “steal” of a deal. It’s easy to spot the pro in the room – they’re the ones with the steely gaze, and the dispassionate air of someone who just doesn’t give a damn whether they acquire a property or not. They’re also the ones who have done their homework: they know exactly which properties they will be bidding on, what the market value of each property is now, and after they improve it, and have an exact “upset” price written down for each of those properties. That’s the price that over which, they simply stop bidding and let someone less experienced take their lumps on by overbidding and ultimately purchasing. They also are quite skilled at estimating their renovation costs.
The novice, on the other hand, is someone drawn by the extreme allure of making a steal of a deal. Usually, they have not done their homework, crunched the numbers, researched the area where the property sits, and think that, in absolute numbers, a low price equals a steal. Boy, they couldn’t be more wrong. And they traditionally last about, oh, one auction. Then they get burned financially, and leave the next auction for the pros – and for more novices to take their place.
An instructive tale of woe
For an illustration of the large downsides of auction buying for the novice, let me provide a highly entertaining example of a recent exchange I had with such a novice auction investor. As a real estate broker, I had gotten a call from a novice buyer who had purchased a small three bedroom single family house at auction a year earlier. He had done nothing with it – yet – and wanted to, as he put it, “unload it quickly.” And he wanted my estimate of its current market value.
Since he lived hundreds of miles away from the property, I asked him for a key to gain access. He said he did not have one. I asked if his tenant had it. He said he did not have a tenant. Upon further questioning, I figured out that he was not being very forthcoming (I assume out of sheer sheepishness for buying this turkey of a property), and that he had never even seen the property in person. Yikes. I was dealing with a definite novice auction buyer. One who had not done any research whatsoever as to the market, current condition of the property, or what the value would be if he improved it. I performed my normal regimen of research, and saw that he had purchased the property at auction for the very modest sum of $2,100. I’m sure he thought he could make a killing on it. Ugh…
Will the fun ever end?
I went over to the house, which was situated on a small, but secluded lot, far away from the center of town in which it was located. I was able to make it through the first line of overgrown grasses and shrubs to the front porch. As I peered in, I saw the place was utterly trashed as, alas, many foreclosures and county-owned properties can be. Prior owners just feel the need to “get back” at the big bad lender who held their mortgage, and who forced them out. It’s a simple reality in the property investing business, and we tend to get inured to the sight. But in addition to the house being in such a sorry state, it also had a tremendous amount of wood rot visible to the naked eye, and I felt unsafe even being on the front porch. In a way, I was glad he hadn’t sent me a key. (Yes, the front door was locked.)
I quickly saw that the property in its current condition would have to be sold for its land value only. Unfortunately, that would not be much more than what the novice paid for the property. Further, I told him I did not want to represent him (liability problems galore there – especially if a potential buyer falls through the floor), and of course, there was little money to be made in the simple brokering of any deal. To make matters worse, I felt the renovation costs to bring the house up to rentable, or market value for-sale condition, would far outstrip the amount he could get for the property when he sold it. My recommendation: best to get out now, list it on Craigslist, and try to get out for close to what you paid for it. He of course has already been paying carrying costs like taxes and insurance on it for over a year already.
Are real estate auctions investing for you?
This little tale of woe should be heeded by any property investor considering jumping in as a novice to the property auction bidding process. If at all possible, and if it interests you and you have the right temperament, go in and watch the pros, and how they conduct themselves at auction. Ask them how they do it – every experienced auction property investor has their own unique “system.” Learn from them before diving headfirst into the auction waters. You’ll save yourself the grief of someday calling a Realtor saying you’ve got this piece of property you bought, sight unseen, that you need to unload…quickly.
photos courtesy of roarlocal.com, giyum.com, mcginnisauctions.com, houstonauctioncompany.com, howtobuyusarealestate.com, realtor.org
Property risk definition
Any novice property investor is prone to make rookie mistakes when investing in property– and being unaware of the basic pitfalls that investment property can present is chief among them. After all, investing in real estate is a time consuming, largely capital-intensive way of making money. In addition, even if you are choosing to own shares in real estate funds like Real Estate Investment Trusts (REITs), the basic underlying problems remain. Here are some of the key risks involved in any real estate investment – be they investing in houses, commercial real estate, foreign investments or time shares for that matter.
Some sage property investment advice
Novice investors should be wary of any real estate project that involves negative cash flows. Second homes and land speculation are prime examples, however even simple “fixer-uppers” can become disastrous for throwing off large sums of negative cash flow (also known as “negative gearing”). Unless you’ve had experience with land development, steer clear of this form of property investment. In general, be as conservative as possible when numbers crunching for fixer-uppers. Obtain several contractor estimates for the scope of work to be done prior to even making an offer on a rehab project. Without a doubt, investing in negative cash flow real estate should be attempted only by those with deep pockets, looking to shelter other forms of income from the tax man. The losses thrown off by negative cash flows will aid in reducing the bite of their overall tax bill. So, in effect, negative gearing makes sense for them…but not so for the novice investor actively looking for profits from the outset.
What is investment property?
Investment property is any real estate designed to earn a profit for the investor. And this means it can be located anywhere in the world. However, if you’re considering foreign property investment, think again. The novice property investor should be aware that buying foreign real estate is fraught with inherent risks. (Are you an expert in the politics of the country involved? Are they stable? How many trips abroad are you considering making to watch over your property? And what are the costs involved with those trips? Who do you call when a problem arises with the property in an emergency? Other major risks that can be found in in foreign real estate buys include fluctuating currencies, different real estate laws by country, as well as the singular lack of real estate protections afforded property here in the U.S. compared with other countries. These are all concerns – and inherent risks – only the well-experienced should address. In addition, I have always advocated buying close to home. You know your home area better than any other, and you won’t be considered an absentee owner. Too many tenants like to take advantage of the property and its landlord when they know the owner lives far away…
Owning property – sort of…the risks of time shares
Another important risky real estate area are time shares. They represent some of the highest levels of property investment risk. Time shares are very risky because it’s difficult to predict what, if any, value will accrue over time, the longer you hold onto them. They are very sensitive to market fluctuations, and can drop in value quite suddenly as well. In addition, time shares are very hard to predict with any degree of certainty their future positive cash flows based on prior years performance levels. Finally, these time shares can be difficult to sell when you need to, which can create an ugly financial situation for you when you are most exposed.
photos courtesy of kristinandcory.com, wilmothpropertyservices.com, sellworldmarktimeshares.com, foreclosure-support.com