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"Make your profit when you buy." -- Real Estate Mantra
"Make your profit when you buy." -- Real Estate Mantra
Up to this point, we have focused on the preparation needed before investing. However, as we've discussed earlier in this guide, it's not enough simply to analyze deals. At some point, you will need to take the plunge and buy your first property. This chapter is going to focus on the best ways to find the best properties, negotiate the best deal, and make sure you get through closing in one piece.
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As the popular real estate quote at the start of this chapter states, you "make your profit when you buy." In most cases, you will not start your investing career by landing a big fat check; these checks come after you successfully implement your investment strategies. The profits you make, however, can be made or destroyed at the time of purchase . . . So what does it mean to "profit when you buy?"
To make your profit when you buy, you must purchase a property at a price that ensures you make your desired profits based upon your ability to execute your exit strategy. In other words, you need to buy smart. If you vastly overpay for a property, no amount of wishing, hoping, or improvement is going to make your investment worthwhile.
While you can't predict with 100% accuracy where the market is going to go, you can know where it's at today.
28 Cherry Street is currently listed at $145,000, and recent comparable sales show that the similar homes have sold for between $140,000 and $170,000. 28 Cherry Street, however, needs about $25,000 worth of work to be in nice condition. Therefore, if you pay $145,000 for it and put in $25,000, you'll be at $170,000, and that doesn't count all the closing costs, holding costs, selling costs, unforeseen overages, or other fees that you'll have to pay. You will be underwater (owe more than it's worth) on this property no matter how much work you do to it. However, if similar homes were valued at $225,000, you would find that you had, indeed, made your profit when you bought.
The same principle applies to rental investment properties. If all your monthly expenses (including taxes and insurance) on 28 Cherry Street were $1200 per month and the average rent received each month was $1100 per month, you would be losing money each month. However, if average rents were $2,000 per month and your total expenses were just $1100, you would be profitable from the day you bought it.
It's often said by experienced investors that appreciation is the "icing on the cake." In other words, don't count on the market swinging upward. You make your profit when when you purchase a property based on what it would be worth today, not what it might be worth someday. If an investment makes no sense without appreciation, don't invest in it. This is known as "speculating," and, while it may be profitable for some, is a risky venture for both inexperienced and experienced investor alike.
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Now that you understand why getting a great deal is important (to lock in your profits at the beginning), it's time to start looking for a property. Before you do, you need to define your selection criteria. This section will focus on what your criteria is, why it matters, and how to define it.
Imagine that you want to use a new recipe in making your dinner tonight. You take out a cookbook to find a recipe that looks good, discover a great baked chicken meal, and make your shopping list of ingredients in order to make the meal for your family. You head to the store and begin picking up the items on your list. Chicken, basil, olive oil, and other items begin to fill your cart. Suddenly, you see the spaghetti and remember another recipe that you once wanted to try with spaghetti. You begin to reach for the spaghetti, but then remember your shopping list. Spaghetti isn't on the list for tonight's dinner, so you put back the distraction and continue on your way home to make a perfect dinner for your family.
Real estate is no different. Your selection criteria list is just like your ingredient list in the example above. It is designed to keep you focused on shopping for the things you need and not waste money on other good looking things along the way. Real estate is an exciting field with a lot of different niches and strategies, so it is easy to get distracted by the next big thing or trend. Having a clearly defined selection criteria can help you stay focused, avoid "analysis paralysis," and keep you on track to buy a great investment property. By defining your criteria, you will be able to narrow down the choices in the market, and you will then eliminate the vast majority of deals that are only distractions. Instead, you'll focus on finding just the kind of deals that you are interested in buying.
In chapter 3, we looked at a number of different niches you could invest in, as well as multiple strategies you can use to invest. It's now time to choose the niche and strategy and come up with a list of criteria to narrow down your selection further.
There are a number of different items you will want to consider to add to your "criteria list." These could include:
No one can tell you exactly what your investment property criteria should or should not include. Some of it will come down to personal preference, such as, "I only want to buy in Seattle" or "I only want houses with basements," but most of your chosen criteria will revolve around the kind of investment you are getting into. For example, if you are looking to become a "buy and hold" investor of small multifamily units, your criteria is going to include small multifamily properties and will exclude old commercial buildings.
By specifying ahead of time what criteria you are willing to look at, your search becomes much more manageable. In the same way, you are able to more effectively communicate your desires to others who may help you buy property. If you simply told people, "I am looking for real estate," the most likely response would be, "Good for you..." However, if you instead mentioned that you were looking to buy a small single family house in the Rockford neighborhood for under $150,000, you enable others to think of properties that might match that description and get you connected with the deal.
Perhaps the most important part of the criteria you put together is the financial component. If a deal doesn't make sense financially, it's not going to be a strong investment for you. In chapter 2, we looked at some of the basic math surrounding real estate investing, such as income, cash flow, and return on investment. However, generally speaking, a listing is not going to tell you the important information you want to know about the financials of a property. Yes, you can generally determine the amount of income the property makes, but you won't know immediately how much monthly cash flow the property produces, how overpriced the property is, or what you should offer. Additionally, it's not going to make sense to get out your spreadsheet and do a full property evaluation on every single deal you glance at. This is when "rules" come into play.
A "rule" is short for "rule of thumb." Rules can help give you a quick way to evaluate a property's financials on the fly. As with any "rule of thumb," using rules is not an exact science and should never be relied on entirely to decide if a property is a good investment. However, they can help you quickly filter a property and decide if it's worth further evaluation. Let's take a look at a few of these rules:
The 2% rule states that your monthly rent should be approximately 2% of the purchase price. In other words, a $100,000 home should rent for $2,000 per month; a $50,000 home should rent for $1,000 per month. This is a very conservative estimate that is very simplistic, but can help in deciding if a property warrants a deeper look. In most parts of the country, the 2% is very difficult to achieve, but the closer you can get to that, the better cash flow you'll receive.
Real World Example: An average three bedroom home rents for $800 per month in your neighborhood. According to the 2% rule - you should be looking to spend around $40,000 for that property ($800 / .02 = $40,000)
The 50% rule is a great rule-of-thumb that helps you to fairly accurately predict how much your expenses are going to cost you each month for a property. The 50% rule simply states that 50% of your income will be spent on expenses -- not including the mortgage payment. As mentioned above, most real estate listings will let you know what the monthly income of a property is. By dividing that number in half, you are able to easily see how much you'll have left to pay the monthly mortgage (principal and interest). Any income left over after the 50% of expenses and the mortgage payment are taken out is your cash flow. The 50% of expenses includes all expenses, including repairs, vacancies, utilities, taxes, insurance, management, turnover costs, and the occasional "big ticket" repairs that must be saved up for -- aka CapEx or Capital Expenses, like roofs, parking lots, furnaces.
Real World Example: An apartment building brings in $8,000 per month in income. Using the 50% rule, we are left with $4,000 to make the mortgage payment. If the monthly mortgage payment on the property was $3,500 per month, you can reasonably assume a monthly cashflow of $500 per month.
The 50% rule is especially helpful in teaching that expenses are almost always more than one might think. One common mistake that new investors make is underestimating how much the expenses are going to cost. The 50% rule helps to show that there are always costs that are unexpected, so plan for them.
The 70% rule is used by investors to quickly determine the maximum price one should pay for a property based on the after repair value (ARV). Though most often used by house flippers, the 70% rule can actually be used for any strategy when you want to find a good deal. The 70% rule says that you should only pay 70% of what the after repair value is, less the repair costs.
Real World Example: A home which, after being fixed up, should sell for approximately $200,000, needs approximately $35,000 worth of work. Using the 70% rule, a person should multiply $200,000 by 70% to get $140,000 - and then subtract the $35,000 in repairs. The most a person should pay for this property, therefore, should be $105,000.
Remember, a rule of thumb, like the ones above, is used only to quickly and efficiently screen a property and decide if it's worth further investigation. Never use a "rule of thumb" to decide exactly how much to pay or if you should invest or not. If a property passes the above rules (or gets close), it may be worth a more detailed analysis on paper or via a computer spreadsheet. Don't confuse a rule of thumb for a license to skip doing your homework.
NOTE: Check out the BiggerPockets 70% Rule Calculator to run 70% calculations on potential deals.
When you have your criteria set, it's time to start looking for your investment property. No doubt you've seen "For Sale" signs in front of homes, but there are many other ways to find investment properties. This section will explore various different ways that you can use to find properties -- the list is not exhaustive, but a good start for any new investor.
The MLS, short for the Multiple Listing Service, is a collection of properties for sale by different real estate brokers across the country. When you search a site like Realtor.com or Redfin.com, you are actually searching the MLS. This information is widely distributed for the most eyes to see.
While quickly fading from use, the classified section of your local newspaper is a good place to look for homes that are "For Sale by Owner." Oftentimes, real estate agents will also put their listings in the newspaper, so it can be a bit challenging to determine what is listed on the MLS and what is not.
Some homes are simply sold the old fashion way - by word of mouth. By letting everyone know that you are in the market to buy (and defining your criteria, as discussed above), you place yourself in the best position to find deals via word of mouth. You can do this directly with peers, at your local real estate club, or in the BiggerPockets Marketplace
Craigslist.org is a free online classifieds website that is currently the #51 most popular website in the world. Millions of people use Craigslist.org to buy, sell, trade, or give away almost anything you can imagine -- including real estate.
Outbound marketing is when you go out and bring sellers to you. This can involve advertising, direct mail, or a number of other marketing techniques. Marketing is such an important topic that we have dedicated an entire chapter, chapter 7, to it.
Loopnet.com is the web's largest marketplace for commercial properties. From small multifamily properties to apartment complexes, shopping malls, fast food restaurants, and more, Loopnet.com is the place to search for publicly listed commercial properties for sale.
When you buy a property, you don't simply write a check to the seller and get the keys. The process of buying and selling real estate is a complex and often lengthy venture that has many moving parts. This section is going to walk you through the steps, from beginning to end.
Step One: You decide on your investment strategy/niche (see chapter 3 .)
Step Two: You define your selection criteria (see earlier in this chapter.)
Step Three: You decide upon the method of financing the deal. This means you will have a clear plan of how you are going to purchase the property. If you are planning on using a bank loan, you will want to be "pre-approved." If you plan on, instead, using all cash, you will want to have that money liquid and ready to be used (see chapter 6 ).
Step Four: You begin looking on the MLS, commercial search sites like Loopnet.com, the newspaper classifieds, direct mail, yard signs, and all other avenues to find properties for sale. You probably will connect with a real estate agent at this point, as they are generally "free" for the buyer (they are typically paid out of the seller's closing costs). If you are dealing directly with homes that are not listed on the MLS, you probably will not use a real estate agent but instead will just contact the sellers themselves.
Step Five: You run each property through a list of criteria "filters" to quickly screen out the duds. These filters are based on the criteria you set as well as the rules we discussed earlier in this chapter.
Step Six: You make an offer on the property (or properties) that you want to pursue. You may offer less than what you are actually willing to spend, or you may offer your bottom line. Typically, an offer is made using a "Purchase and Sale Agreement," which your real estate agent will most likely do for you. If you are not buying a property from the MLS and do not use an agent, you can usually get a fill-in-the-blank purchase and sale agreement online at a paper supply store, from an attorney, or free from a local Title and Escrow company. We strongly recommend that any agreement you use be reviewed by your real estate attorney, however.
Step Seven: You negotiate the deal with the seller and, if possible, come to a mutually accepted agreement on price and terms. For a great article on negotiation, see Seven Tips for Better Negotiations.
Step Eight: You perform your "due diligence," which includes any inspections of the property. The property details are then handed over to either a Title or Escrow company or a local attorney (depending on your state). During this time, you will also submit needed paperwork for your financing,begin lining up contractors (if work is needed), check on the validity of the financials given about the property, and prepare for closing in handling whatever other issues come up. This process can take anywhere from several days to several months or more, depending on the situation. Bank financing is generally the reason this process takes longer, so if you are using all cash, closings can be much quicker.
Step Nine: You sign papers at the Title and Escrow or attorney's office. Later that day (or within several days, depending on your location), the paperwork will be recorded, and you'll be the new owner.
By the end of this chapter, you should understand the importance of having a clearly defined set of criteria before starting your investment shopping, and these criteria should include both personal and financial requirements. This well-defined criteria list will help narrow down your choices and help weed out the bad properties, giving you the best chance for a solid profitable investment that best meets your needs. You should also have a clear basic understanding of how the buying process works, from the first thought to getting keys in hand.
In the next chapter, we are going to dive deeper into the world of real estate financing and look at 12 different methods you can use to finance your next investment.
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Photos: Vagabond Shutterbug, steakpinball, Alex E. Proimos, Thomas Leuthard.
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