Mistake 1: Not Knowing the Four Principals
Friday, July 16
Your have probably heard that there are three principals to real estate investing (i.e. -- "Location, Location, Location"). If you have been involved in any decision regarding the purchase or sale of real estate, you must be aware of the importance that "location" has in these decisions.
These three real estate principals generally apply to people looking to purchase and occupy their own home (residential, owner-occupied homes). Buying your home is not real estate investing, but rather it's a necessity of life. Everyone has to live somewhere. That's why "location" is so important.
However, I found out the hard way that these three principals don't necessarily apply to investing in income producing and/or commercial properties.
If you want to invest in any type of income-producing property, then there are four real estate principals that must be followed:
(1) Location
(2) Demographics
(3) Timing
(4) Cash Flow
The term "Location" refers to a number of key factors related to the physical location of the subject property:
For example, residential properties should ideally be located in areas where there is easy access to all the basic necessities like electricity, telephone, clean water, gas, etc. Amenities like schools, hospitals, churches, grocery markets or shopping malls in the vicinity are a plus. This includes good roads and/or transportation to these amenities. And, make sure your property is not in a flood zone. You will find that these "location" factors are all interrelated and interdependent.
If you are buying the property for renting purposes, then you must also look into the demand of houses in that specific area. Some undesirable place / people in the neighborhood may also raise eyebrows. And, while it's good to have a residential property in the inner-city (not outer reaches), buying a house at an overly crowded road or congested shopping mall can backfire because of noise and all the hustle (a possible safety issue for kids).
On the other hand, commercial properties should be located at some swarming place for businesses. Transportation and parking facilities are other things to look at. If you already have some business in mind, you can see if the place attracts your potential customers (e.g. targeted age group or income class) for your business. Also make sure that you are not going for a place where plenty of other businesses are already offering the exact products or services. If the property needs lots of renovation before it can be utilized, then keep those expenditures in mind when settling on a price.
The surrounding crime rate is another important factor for both residential and commercial properties. Investors who are looking for long-term investment can earn huge profits by investing in some area going through major re-development or infrastructure programs. Buying a piece of property in this area when the work has just begun will be comparatively inexpensive, hence offering huge profit margins.
Apart from these basic "location" factors, you should consider your personal likes and dislikes about the neighborhood when finalizing a deal to invest in real estate.
The term "Demographics" refers to the demographic profile of the neighborhood and/or the surrounding area. You can easily get this information online from the Census data, or most school districts will post this data online, or you can simply ask a local real estate agent.
The key demographic information includes: population, number of housing units, owner-occupied housing units, renter-occupied housing units, vacant housing units, household size, household income, median age, gender, race and ethnicity. Demographics can tell you a lot about the neighborhood. Instead of looking at the "data" itself, I prefer to look at demographic "trends." For example, in th past 10 years, if the surrounding area is growing in population, vacancies are down, and median income is up, then this indicates that the area is desirable. Obviously, if the trends are all down, then this indicates that something may be happening that needs further investigation. Find out why before you buy.
The term "Timing" refers to market conditions when you purchase your property. Before you invest in real estate, take a moment to look at local market conditions. Is the local market experiencing a housing bubble, is it in a recession, or is it holding steady? Market timing can make you a lot of money in real estate, or it can leave you holding the bag. So, be sure you understand local market conditions before you buy. Obviously, it's better to buy at the end of a recession, before housing prices begin to rise. Needless to say, it is not good to buy during a housing bubble. More likely than not, you will lose. It's much better to simply wait for the market to adjust.
The term "Cash flow" refers to the amount of cash coming in relative to the amount going out. Cash flow is one of the most important considerations investors face when making real estate purchases, particularly now that so many markets across the country are struggling. While "appreciation" is often the most significant form of profit for real estate investors, cash flow is easier to determine and lower risk.
Although many elements combine to influence cash flow, one of the most important ones is the surrounding market. Areas with lower home prices are more likely to have positive cash flow. Remember, there are four possible financial benefits to investing in real estate:
(1) Appreciation (3) Tax Savings
(2) Positive Cash Flow (4) Mortgage Amortization
Many investors expect to get most of their return from appreciation. Consequently, they are willing to accept little or no cash flow or more commonly, negative cash flow. Tax savings were drastically curtailed by the Tax Reform Act of 1986.
Amortization (pay down) of the mortgage is a pittance in the early years of a loan.
I do not agree with the notion that you should accept negative cash flow because appreciation will more than pay you back. But that is why most investors do accept negative cash flow.
In fact, owning rental property almost invariably has the exact opposite effect on your cash flow. It takes your current annual cash flow and confiscates part of it to feed the rental property. Negative-cash-flow properties are called "alligators" because you have to feed them constantly or else they will eat you alive.
Only if you buy on a bargain basis or increase the value of the propertysignificantly can you get positive cash flow from a rental property. Can that be done? Absolutely. Is it easy money? No. Is it passive income in the sit-in-a-hammock sense of that word? Hell, no! You will earn every penny of it. If you do not want to work hard and take risks, get out of real estate altogether before you get badly burned.
My Dad always told me that the secret to investing in real estate is to make your profit when you purchase the property. The only way you can do that is to buy the property below market value.
How are you going to do that?
Perhaps you have looked at 6 (maybe 10 deals) and you are finding it nearly impossible to make them cash flow based on collecting a reasonable rent and getting 30 year fixed rate financing.
Take a deep breath. This is one of the most common problems for real estate investors and what I believe to be one of the things that discourage many people away from starting a lucrative real estate investing business. There is hope though. Read on.
First, unless you happen to be lucky enough to live in or near a city that has a low income area where you can still buy "rental houses" where the values are about 100 times the monthly rent, you need to realize that finding these deals is like the Easter Egg hunts you had as a kid. You've got to look at a lot of deals to find that special one that will work for you and produce positive cash flow every month.
How many will you need to look at? It can vary, but I do not think that looking at 50 is out of the range of possibility.
Are you kidding? So, I need to look at 50 houses to find one that will work? Yes, you might need to look at 50 houses, making better distinctions about what might work and what will not work to find a good deal.
You may also find that putting out marketing to find motivated sellers makes finding these types of houses easier rather than just looking at houses that are for sale by owner or listed with a real estate agent.
Buying houses at a discount and/or with good terms can significantly improve your ability to make a house cash flow, especially if the interest rate on the terms you can get from a seller is much better than the current rate you could get from a bank or lender.
What if you have some houses that are very close, but none that will have positive cash flow? First, keep looking. Second, there are some ways to ethically increase the amount a tenant pays you in rent which could make a negative cash flow house a positive cash flow house.
For example, if instead of just renting the house, you sell the house on a rent-to-own, you can get payments that are on par with what your actual mortgage, taxes and insurance expenses are because they need to be able to pay your actual mortgage, taxes and insurance payments to afford that house.
When you interview your potential buyer, you explain that market rent is $1,000 (or whatever it is), but that if they have $10,000 to put down toward purchasing the house, their mortgage payment with taxes and insurance would be $1,400 (or whatever it is).
You tell them they need to pay the $1,400, but that you will credit the $400 above market rent toward the purchase of the house when they do go out and get their own loan and buy the house from you. In the meantime, they rent with the payment that resembles your mortgage payment and monthly expenses - thereby producing positive cash flow.
This next investment strategy is my favorite: buy duplexes. For example, you can buy a duplex for about the same price as a single family home. The difference is that now you have two renters paying you market price for your property. If you buy the duplex right, you should be able to pay the mortgage with the rents from one side of the duplex. The other side of the duplex pays for all other expenses. That's a great way to produce positive cash flow from day one.
For example, I recently purchased a newly constructed duplex for $200,000, which was located in a very nice subdivision. With 20% down, the mortgage payment on $160,000 loan was about $1,000. So, I rented each side of the duplex for $1,100 / month - giving me $2,200 / month of income. My taxes, insurance and miscellaneous expenses equaled about $800.00 / month. My total expenses were $1,800 / month, and with $2,200 in income, that's $400 / month in positive cash flow.
The bottom-line is: you need to look at a lot of deals to find one that will cash flow. Take your time, do your homework, and make your profit when you purchase your property. Don't put all your eggs in the "appreciation" basket.
Comments
Don Konipol Reply
almost 2 years ago
Negative cash flow (alligators) cause more bankruptcy and foreclosures in real estate investments than all other reasons combined
Luis P Reyes Reply
almost 2 years ago
Good information. May be a little self serving as I offer market research services but I would disagree that market data, census data can be easily obtained especially if minimum is 50 properties. You have to be able to trust the information especially if coming from a broker and ZIP Code or Census tract data may not be sufficient in more complex areas or in this complex market. As other post mentioned beginners especially are going for leftovers so they need to be extra careful and as you say do their homework.