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Real Estate 301 The Investment Property

Posted on January 29, 2011

This is where things become really interesting. Real estate investing can be very rewarding and is something for which I have a real passion. Many people claim to be experts in the field, selling complicated financial techniques and creative purchasing strategies, but the truth is, focusing on some basic investment principles can make any person successful in real estate.

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For the purpose of this lesson, we will discuss two types of real estate investments: undervalued properties and rental properties. Foreclosures, developments, resales and commercial properties will be discussed in detail in subsequent articles.

Buying Under Value

This type of real estate acquisition is a very easy concept to understand yet difficult to practice in reality. The basic idea here is that if you buy a house for $90,000, and it's valued at $100,000, your net worth, and thus your access to capital, instantly increases by $10,000. Pretty simple, eh? The trick however is knowing how to locate these undervalued properties. The first way is plain luck. Sometimes you will be simply presented with good deals. I have had many good deals put in front of me; some which I have pursued and others which I have declined. The secret I suppose is to first make people aware that you are interested in buying undervalued properties. A good way to start is to call local real estate brokers and let them know what you are trying to do. Tell them that you are looking to purchase a property with a list price less than the "appraised" value. They will likely have several properties that meet this criteria. There are many different reasons why a seller may unload his or her property for less than what it is worth., and you never know until you ask. Divorce, job loss, financial stress, moving and foreclosure are just some of the reasons why people sometimes need to sell their home quickly, and cheaply. Remember, this is business. Its nothing personal. If someone offers you an undervalued home, that is essentially the same as offering you cash. Would you turn down free money?Didn't think so.

Now, of course this works very well in theory and may not always be a good decision in reality. For example, if I am offered the deal above, the one for which I can increase my net worth by $10,000, I may be inclined to reject the offer if,

a) the market is on a decline my $10,000 profit may disappear very quickly.

b) flipping the property may take an additional investment or require me to hold on for a longer period than desired.

c) the property provides a net-loss in rental revenue and would thus deplete my potential profits over time.

My advice: When considering buying an undervalued property, make sure to analyze all the facts. What is the total cost (purchase price, lawyer fees, closing costs, appraisal costs, etc.) in acquiring the asset? Next, calculate the estimated costs associated with carrying the property (mortgage costs, property taxes, repairs and maintenance, personal costs, etc.). And finally, determine at what price (minus seller closing costs of course), and at what date, you could resell your property. If this number results in a profit, then you have a good investment.

Rental Properties

Another misconception about real estate investing is that being a landlord, or owning rental properties more specifically, is as an easy way to make money. Like almost everything in real estate, owning a rental property can be an excellent investment, or an absolute nightmare. Although nothing can ever be certain, there are several ways in which to increase your chances of making your rental investment a success.

  1. Look for positive cash flow For me, this is the most important aspect of investing in a rental property. The basic principle behind income generating (profit) properties is to have the rental revenue completely cover your operating costs (mortgage payments, property taxes, insurance, maintenance and repairs, advertising,etc.). Through this, your investment, or the amount you pay out of pocket for the property (ie: the down payment and closing costs) generates a return equal to the net (revenue minus costs) income generated from the rental.
  2. Choose your tenants wisely Being a landlord can prove to be very problematic if you do not do your homework and unfortunately, it is difficult and sometimes impossible to know ahead of time if the people you choose will be good tenants, ie:pay their rent and respect your property. Verifying rental references is a great place to begin. Be aware that many prospecting tenants attempt to use fake or personal friends to act as previous landlords. Don't be fooled by this. Make sure the reference is an actual landlord and did in fact rent their property to the applicants. Second, demand, not ask for, a credit check. If they won'tallow you to check their credit yourself then have them purchase a copy of their report from Equifax or TransUnion. This should be non-negotiable.Thirdly check their employment history. Similar to that of their references, verify that their employment history is real and be certain to ask for pay stubs or proof of income. Any good tenant will have no problem providing this information.
  3. Rent-to-Ownis a Good Option - Entering into a rent-to-own agreement with your tenants can be a very beneficial arrangement. In this type of contract, the tenant will sign a standard rental lease however they will have an option to purchase the property at a specified price and date in the future. I have personally done this and find it a very lucrative way of investing in rental properties. Generally, a portion of the monthly rent will be credited towards the purchase price as a down payment, if and when,the tenants decide to buy the property.I have always made the future purchase price market value, subject to up to three independent appraisals. The beauty of this arrangement is that you often receive slightly higher rents than usual, you tend to have better and more responsible tenants (as they plan one day to own the house), you receive market value for your home in the future and if they don't buy, the portion of the monthly rent being saved for their deposit, remains in your own pocket. As a landlord, there are very few drawbacks to this type of arrangement.
  4. Keep things simple There is little sense in spending at the top of your budget when it comes to furnishings or redesigning a rental property. Although a more attractive place can attract higher than average rents, the amount invested does not increase the rental income proportionally. Having said that, it is also not very wise to rent properties that need substantial work or that would attract less than average quality tenants. Paint and cleaning supplies can go a long way in making a property attractive, and do not require you spend a fortune.
  5. Be Your Own Property Manager: If possible, try to always manage and maintain your own properties. This is not because I see no value in property management companies, but rather because no one will ever care about your property as much as you do. As a landlord, you are guaranteed to run into problems at one point or another, and it makes it much easier to handle the situation if you live close by. However, if you are forced to seek the services of a property manager or a general contractor, make sure you use someone who has been in business for a while and has substantial references in the community.

My advice: For new investors, choose properties that require little renovations and are well-maintained. Buy in good areas of town whenever possible in order to attract better quality tenants. Income generating properties should be your main focus until you gain a broader knowledge of more complex real estate investments.

Avoid Speculation

Investing in real estate based on speculation is the quickest way to lose all of your money. I have seen this too many times to count and often results from inexperienced investors trying to get rich too fast. Many realtors have Ph.D's in speculation sales insisting that "You should buy now because prices are going to go up." Are they sure? Is that a guarantee? Investing in a property with the expectation that it will increase in value is nothing more than a gamble. Yes, real estate increases in value over time, but that is only over the long-term.

Novice investors should acquire properties based on real facts and numbers, not on market expectations. Allow me to explain using a couple of examples.

Example 1. You purchase a residential home for $100,000, appraised at $100,000, and generate a net income of $250.00 per month.

Example 2. You purchase a commercial lot for $100,000, appraised at $100,000, with the anticipation that you can resell it for double after one year.

Suppose for a moment that one year after purchasing the properties mentioned above, the real estate market is in recession and prices are 15% lower than before. In example 1, although your property is now valued at $85,000, you have been covering your expenses for one year and have generated a profit of $3.000. Likely you would continue to rent the property as you would not be in a situation where you we're forced to sell. In example 2, your property is also now valued at $85,000. The difference here being that not only have you been covering your expenses out of pocket for the entire year, but you are now in a position where you must decide either to sell it at a loss, or continue paying out of pocket in hopes that one day the property will in fact increase in value.

Although the above example is a very basic scenario, it does paint a picture of how dangerous investments can be when based on speculation. Unless you have deep pockets, and can afford to cover your expenses at all times, I would strongly recommend sticking to more secure, income-producing investments.

My advice: Investing based on market fluctuations is dangerous and should be only considered if you are a seasoned investor. Leave this type of investment alone until you have enough experience, and capital, to take on riskier ventures.

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Notes

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Posted in Home Improvement Post Date 09/30/2016


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