Real estate investors can be broken into three categories: landlords, flippers, and speculators. Which do you want to be? In my opinion you should plan to be a landlord. Yes, many of my fellow BPers are going to take umbrage with that statement. Yes, it’s horribly biased. Yes, it’s self serving. However, before y’all bust out the pitchforks, let’s take a glance at my reasons.
I’m going to start off by examining my investor categories.
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A speculator is anyone who banks on appreciation when evaluating an “investment.” Even if you take into account other considerations, ask yourself this: Would you be in the deal without a future price jump? If the answer is no, you’re a speculator.
You’ll notice above that I put “investment” in quotations. That because speculators aren’t investors. In the purest form of speculation – you buy a property and cough up money every month to cover it’s expenses. Your “plan” is that one day the price will go up and you’ll strike Texas Tea.
Paying a small amount over and over again with the hope of a big pay day. Does that sound familiar?
Yep, speculators are gamblers in a different guise. Can you make money doing this? Of course! But to do better than blind luck you need inside information that isn’t priced into the market.
To avoid the speculation trap, evaluate your investments assuming no appreciation. If anything, plan for a drop in price to help temper your investment risk.
Increasing the value of a property through hard work is not speculating. It’s sweat equity. Both a flipper and a landlord can create sweat equity as we’ll see…now.
A flipper is all about sweat equity. It’s the most labor intensive of the real estate investment approaches. Like every investors, they put in long hours finding a property to buy. Unlike other investors, once they own the asset a flipper has to keep working hard. Overseeing contractors, managing expenses, and forcing deadlines takes time. Not to mention selling the property when it’s done.
As Glenn Schworm points out, Time is always working against a flipper. Debtees aren’t charities. Whether it’s a bank, hard money lender, the US government, or the county treasurer – you owe them money for every day you own the property.
Another factor a flipper should be aware of is the property itself. I’ve been involved in gobs of rehabs and I can say one thing for certain: there will be surprises. You could spend month’s doing your due diligence (losing the deal in the process) and something will still catch you off guard. These “unexpected gifts” aren’t always negative, but 90% of the time they are.
As a flipper you are still at the mercy of the housing market. Did the prices in your area drop 10% since you bought the property? Tough, put that sucker on the market because Time is so close you can smell the garlic on his breath.
A landlord is also known as a buy and hold investor. Guess what they do? While they’re holding the property, they rent it out and create a monthly cash flow. This creates an asset which pays them to hold it.
One great thing about being a landlord is the tax benefits. Not only do you get a lower capital gains rate if you own the property for over a year, but you can take full advantage of depreciation. Tax depreciation is essentially the government giving you a loan with 0% interest. It’s one of the few times the friendly version of Uncle Sam comes around to dinner. When no one is looking he slips a few bucks in your pocket and whispers “pay me back when you can” (ie, when you sell.)
So far, this post has been lacking in graphs. Let’s rectify that shall we?
This chart shows historical rental rates vs home prices. I find it compelling for two reasons:
- Home prices are astronomically more volatile then rent prices. Looking for nice steady returns? Landlord it up.
- Now is the best time to buy rentals in the last 15 years.
You’ll notice how prior to 1999 home prices stayed in line with rental prices? It confuses me to no end that real estate analysts expect the market to “rebound” in the next few years. Rebound to what? Artificially inflated prices? I’ve seen no compelling data that the housing market will surge. I believe people claiming the contrary are succumbing to wishful thinking.
That said, I pray I’m wrong. I own real estate and am not opposed to making money.
Plan to be a Landlord
Now’s where you’re going to catch me out. I’ve been very careful to say you should plan to be a landlord. I’m not arguing you should become a landlord. It’s not for everyone. Even if you hire a property manager, you’ll manage some aspects of the day to day operations: maintenance, accounting, etc. Across my real estate holdings I employ 5 or 6 full time staff (depending on how you count). When tax time came, I still poured over general ledgers to make sure the depreciation and expenses were spot on. It’s a straightforward way to protect your investment.
However, you should plan to be a landlord – even if you hope to flip the home. Crunch the numbers as though you were going to own the property for 5 years. Is there enough cash flow to make this worth your while? Yes, this requires even more legwork: you must understand the market rent and develop a relationship with a good property manager.
If the investment makes sense as a rental, proceed as planned. Buy the property and fix it up as needed. When the work is done, you’re presented with two options: sell the home or rent it out. Remember, it’s much easier to rent a home than sell it.
Why is this an effective strategy? It shrinks time down into a cuddly teddy bear. He’s not so scary. Worst case scenario you rent the home for a while, earning money while you wait for good selling market conditions.
For tax purposes, consider owning the property for at least a year to take advantage of the long term capital gains rate. If you do a like-kind exchange you won’t pay those taxes right away, but Uncle Sam will want pound of flesh one day.
Wrap It Up
Plan to be a landlord. Buy property expecting to own it for a long time. Bide your time and sell it when the market is in your favor.
Do keep in mind, real estate is still a form of investing. All investing carries risks. Leave yourself as much wiggle room as possible so you don’t implode if it goes pear shaped.
Photo: URBAN ARTefakte (Archiv…