CHAPTER 1
Basic Finance for the Investor
While there are certainly plenty of real estate books on the market that specialize in real estate investment, those same books fall short when it comes to one of the most important aspects of real estate investing: financing.
Buying real estate as an investment can bring great rewards. Holding real estate and watching its value rise over the long term is a nice way to retirement for many people.
One of the advantages of real estate can also be a disadvantage, however. Itâs not a liquid asset. You canât get your money out of it as easily as you can get money out of an ATM. If itâs a stinker, you have to sell it, and that takes time and it takes money.
You canât just change your mind because of a heavy dose of buyerâs remorse, take your receipt for your investment condo back to the store, and get your money back after saying something like, âWell, it was the wrong size, and my aunt gave me one for Christmas.â
Real estate investment needs commitment. You need to decide that itâs right for you before you get involved.
There are two different types of investors: those who buy and hold, and those who buy and sell quickly, a process that is often called flipping. Flippers attempt to find bargains, fix them up, then sell them for a profit. And these two types of investors are not exclusive; you can both be a flipper and hold for the long term.
Flipping brings a whole new element to real estate investing compared to simply holding onto property for a long period of time, then either selling it when you think youâve made enough money or keeping it and passing it down to your grateful heirs.
Flipping requires more than just buying; it requires you to know how to make repairs on a home and evaluate how much of a return in the form of increased value those repairs would generate. Or maybe the issue isnât just increased value but simply making the place livable.
Flipping requires different financing strategies from those used for long-term investments. Any real estate investment book you read concentrates more on either finding, fixing, and flipping real estate or finding and keeping real estate while paying little attention to the financial aspectâperhaps one of the most critical pieces of the real estate investment puzzle.
Getting the wrong financial package can wipe out your profits, hold you back from selling because of lack of equity, or perhaps require you to sell for more than the market will bear because of the bad loan you got when you bought the property in the first place.
If youâre a flipper, financing is critical. If youâre long term, financing is also critical, but at least in long-term deals you can always refinance the property down the road if you made a bad loan choice in the beginning. Weâll discuss refinancing investment properties in detail in Chapter 4.
But then again, because youâre reading this book, you wonât be making those mistakes, now will you?
One advantage that a long-term investor has is the ability to buy in other markets.
Letâs say, for instance, that your local real estate market is humming right along. You know that you can find a property, fix it up, and sell it for a profit. Or maybe your market is really moving and you can find a piece of property that takes absolutely no work (or very little), and because of the real estate demand in your area, you know you can make another 10 percent on your investment.
You know you can do this because you know your market. You know the neighborhoods. You know the contractors who work on your properties, or if you do most of the rehab yourself, you can drive to the job site every day.
Thatâs not true if youâre buying in Texas and you live in California. Yes, you can fly in and look at properties, but if you want to fix and flip, youâve got a brand-new problem. How do you find someone you trust to be the contractor while youâre a couple of time zones away? How do you monitor the contractorâs progress?
How do you pay the workers, and how do you make sure theyâre not sitting around drinking beer all day long while youâre frantically trying to get your contractor to return your voicemails?
The truth is, you canât. If youâre a flipper, then a long-distance rehab project may not be for you. In fact, if you were planning on making $20,000 on a nice little flip, then all the labor, plane fare, and headaches wonât be worth it at the end.
Yes, you can be a long-distance flipper if the properties youâre buying donât need any work and you think you can sell them quickly and for a profit. Yet, youâre not local. Youâre not the only real estate investor, and there will be local professional investors who can sniff out a flip a lot more quickly than you can simply by being where the property is. By the time youâve found a potential investment, gotten on the plane, and rented a car to look at your potential investment, if it was such a good deal, itâs probably been snatched up while you were checking your bags.
I will note that sometimes faraway investors can have the upper hand when theyâre in a part of the country that is doing better economically than the locale they want to invest in.
For instance, a town may have experienced some huge layoffs as a result of downsizing, creating a significant economic hit. If you are living in an area that is not depressed, you may have more disposable income and be able to buy a house for less than market value.
But even then, as a flipper, if you invest in a depressed area, who are you going to sell toâanother flipper? If the local economy youâre buying into is in the middle of some major economic upheaval, then home buyers arenât exactly going to be lining up along the street waiting to bite on that âbargainâ house you found. Many of the people in the town where you found your bargain have, unfortunately, been laid off.
Being a long-distance flipper, then, is a challenge. You donât know the area as well as the locals do, you canât monitor your project efficiently, and itâs hard to find buyers in a depressed market.
On the other hand, such opportunities bode well for long-term investors. If you see that a certain area outside where you live is going through some difficult times, you can find a bargain house and hold onto it, waiting to sell until the economy recovers.
I own a home in Austin, Texas, that I bought in the late 1990s. The seller was an investor from California who had bought the house some 10 years earlierâright in the middle of the S&L debacle. Combine that crisis with an oil and gas industry that was suffering through perhaps one of its most trying times, and you can see why real estate in Texas was depressed.
The investor bought in 1988 during an economic downturn in Texas and sold 10 years later, doubling his money, after the economy recovered. He was long term.
Not just that, but the property I bought was listed as a âfixer-upperâ that needed some âtender loving care,â meaning that it had its challenges. In fact, the California owner had never lived in the property but had rented it to various people for the entire decade.
When I bought the house, it needed some work. The carpet was old, the tile in the kitchen area was coming up, and the entire house needed some significant updatingâSignificant with a capital S.
My wife and I had been looking in that particular part of Austin for nearly a year, trying to find the perfect deal. We had seen so many similar houses that we knew immediately that the property was a steal. The property had been listed, and within 24 hours of its original listing, it had had three offersâall from locals.
We not only offered the asking price but also bumped it up by a few thousand dollars (because we knew we had found a bargain) and won the bid. We bought the home, completely remodeled it, and turned it into a very nice piece of property. We still own the home today, and the property has appreciated nearly fourfold since we bought it. And I doubt that we will ever sell it. Okay, we will, but not for a long, long time. I know the area, and itâs a keeper.
Sometimes people get into real estate investments by accident. For instance, you find a house you really, really want to move into, but your current property isnât selling for what youâd like to sell it for, so you keep it and rent it out.
Or perhaps you inherited a property from a relative and decide to keep it long term and not sell right away.
Occasionally life simply causes you to get into real estate when you had no initial motivation to do so. Youâd never thought of it, and now youâre in it. And you find out you like it!
The Pros and Cons of Being a Landlord
First and foremost, the landlord owns the property and collects (hopefully) the rent each month. The landlord is also at the bidding of her tenants when it comes to repairs and maintenance of the property.
This doesnât mean day-to-day maintenance. A landlord may not be responsible for a clogged sink, but he might be responsible if the clogged sink is due to tree roots from outside the house invading the outdoor plumbing.
Typically, if something goes wrong, you as the landlord have got to fix it. If itâs an emergency situation or something that makes the property uninhabitable or dangerous, not only may the terms of the rental agreement require you to fix it, but local or state laws may also require that you fix it.
Think fallen tree limbs knocking down power lines or a flood from a broken pipe. Or suppose thereâs no heat in the winter or cool air in the summer because of a poor heating or cooling system.
This means that youâve got to have some money handy, or at a minimum a few credit cards or trade lines opened up at Loweâs or Home Depot. When your tenants squawk, youâll need to have whatever theyâre squawking about fixed, and pronto.
Being a landlord also means collecting rents on time; after all, if one of the reasons you want to buy investment property is to have the tenants pay your mortgage for you, then it stands to reason that youâll want to be paid on a regular basis.
Thatâs also one of the advantages of holding: having someone else pay your mortgage for you while your asset appreciates in value. Letâs look at an example of how that works.
You want to buy a duplex for $200,000, and you put 20 percent down. You finance the property at 6.50 percent for 30 years, so the monthly payments you make to the mortgage company come in at around $1,250 per month, including taxes and insurance.
Rents in that neighborhood go for about $900 per month per unit, so your duplex brings in about $550 per month over and above your payments. Thatâs not counting regular maintenance, but youâre still ahead.
Now letâs also assume that property in that area is appreciating at a rate of about 5 percent per year.
After five years, youâve made just over $33,000 in additional income. Your tenants have paid for your investment by more than making your payments each month. Your property has also appreciated to $255,250.
The total value of your holdings = $40,000 down payment + $55,250 appreciation + $33,000 income. Thatâs a $128,250 equity position, or a gain of $88,250. Plus, if you invested that $33...