Getting Started in Real Estate Investing E-Book

Michael C. Thomsett

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: The Getting Started In Series
• Sprache: Englisch

Seitenzahl: 567

Veröffentlichungsjahr: 2009

Beschreibung

Real Estate A MUST-READ GUIDE TO REAL ESTATE INVESTING DURING TURBULENT TIMES GETTING STARTED IN REAL ESTATE INVESTING THIRD EDITION Given the current state of the economy, you might be asking yourself if right now is the right time to be investing in real estate. With the third edition of Getting Started in Real Estate Investing as your guide, you'll quickly discover how a combination of commitment and caution can help you make it in today's market. Designed for investors who want to get started in real estate, but don't know where to begin, this reliable resource will help you break into this fast-moving field and build equity the right way. Getting Started in Real Estate Investing, Third Edition addresses everything from selecting the right properties and becoming a landlord to using the proper tax strategies and finding the right professionals to work with. It also outlines issues you must be aware of in light of recent events, including the best ways to finance your real estate investments, considering the status of mortgage financing, and new requirements that may be thrown at borrowers. The new edition is updated to include information on: * Surviving in the post-bust housing market * Picking investments with the new credit realities * Looking ahead to future housing booms * Reading the emerging housing trends Written in a straightforward and accessible style--with a focus on residential and multifamily properties--Getting Started in Real Estate Investing, Third Edition also contains helpful information that will allow you to analyze your financial ability to buy and hold real estate as well as avoid potential pitfalls. In order to excel in real estate investing, you need to start by defining what you want to do and how much risk you can afford. But ultimately, success depends on making informed decisions about where and when to invest, and Getting Started in Real Estate Investing, Third Edition gives you the tools to achieve these goals--even under the most difficult market conditions.

Leseprobe

Table of Contents

Title Page

Copyright Page

About the Author

Introduction

Chapter 1 - Should You Be a Real Estate Investor?

Should You Buy Real Estate?

Real Estate as a Growth Fund

The Real Estate Cycle

Real Estate Rules of Thumb

Real Estate Investment Performance

Your Home as an Investment

Expanding Your Portfolio

Chapter 2 - How to Choose Property

Conditions in Your Local Market

Profitability and Cash Flow

Factors Adding to Value

Rental Trends

Making Your Money Go Further

Questions to Ask

Chapter 3 - Financing Your Investment

The Supply and Demand of Money

Types of Loans

Fixed-Rate and Adjustable-Rate Loans

Adjustable-Rate Mortgages

Creative Financing

Calculating the Down Payment

Qualifying for the Loan

Borrowing to Invest

Refinancing

Chapter 4 - The Cost of Borrowing

The Real Cost of Real Estate

The Significance of Interest

How Interest Is Computed

Using Amortization Tables

Reducing Your Interest Cost

Arguments Against Acceleration

Accepting Two Loans

Conclusion

Chapter 5 - Tax Benefits of Real Estate

Deducting Expenses

An Overview of Tax Strategy

Real Estate Losses and Your Taxes

How to Calculate Depreciation

Calculating the Basis

When You Sell Investment Property

Annual Tax Benefits of Real Estate

Deferral Rules

Converting between Residence and Investment Property

Chapter 6 - Setting Up Your Books

Using Professional Help

Design Suggestions

Multiple Properties

Chapter 7 - Managing Your Investment

When to Buy

When to Sell

When to Wait

Neighborhood Conditions Affecting Value

Property Conditions That Affect Value

The Danger of Overimprovement

Managing in a Buyer’s Market

Hazard Insurance

Types of Hazard Insurance

Chapter 8 - Analyzing the Market

Three Distinct Real Estate Markets

Popular Methods for Setting Value

Determining Market Value

Analysis of Cash Flow

Calculating Return and Yield

Profit upon Sale

Chapter 9 - Analyzing Your Financial Capability

The Meaning of Financial Capability

Cash Flow

Understanding Vacancy Risk

Negative Cash Flow and Your Personal Budget

Chapter 10 - Working with Professionals

Financial Advisers

Tax Professionals

Real Estate Agents

The Real Estate Contract

Inspectors

Appraisers

The Attorney or Escrow Agent

Chapter 11 - Becoming a Landlord

Tenants and the Law

Demographics of Tenants

The Landlord’s Dilemma

The Statement of Condition

Deposit Policies

The Rental Agreement

Property Management Firms

Chapter 12 - The Fixer-Upper Market

Types of Fixer-Uppers

Locating Bargain Properties

The Cash Flow Risk

Living in the Fixer-Upper

Limitations for Real Estate Dealers

Converting to Rental

Chapter 13 - The Property-Flipping Market

The Real Estate Bubble: Comparing Speculation to the Buy-and-Hold Strategy

Markets for Property Flipping: Entry and Exit Strategies

Lease Options

The Flip-Rental Conversion

Chapter 14 - Passive Investments

Passive Loss Limitations

Partnership Investments

The Structure of the Program

Selling Partnership Units

The Real Estate Investment Trust

Exchange-Traded Funds for Real Estate

Investing in Mortgages

Chapter 15 - Other Ways to Invest

Multifamily Residential Property

Commercial and Industrial Property

Raw Land

Chapter 16 - Setting Your Investment Goals

Real Estate and the Long Term

Real Estate and Retirement Planning

Developing Investor Vision

Appendix

Glossary

Index

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Copyright © 2009 by Michael C. Thomsett. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Thomsett, Michael C.

p. cm.—(The getting started in series)

Includes bibliographical references and index.

eISBN : 978-0-470-48018-2

1. Real estate investment. 2. Real estate investment—United States.

I. Thomsett, Jean F., 1947- II. Title.

HD1382.5.T564 2009

332.63’24—dc22

2009004116

About the Author

Michael C. Thomsett is a long-time real estate investor, with experience both as a landlord and in the fixer-upper market. He began writing full time in 1984, and has since published more than 70 books and 500 magazine articles. Among his books are several in the Wiley Getting Started In Series.

Thomsett’s real estate books include three editions of Getting Started In Real Estate Investing, which has been a successful and best-selling book since 1994. The current edition is completely updated based on the dramatic changes in both the real estate and credit markets in recent years. Other books in the same series include Thomsett’s Getting Started In Options, which came out in its eighth edition in 2009 and has sold more than 250,000 copies. He also wrote Getting Started In Property Flipping and Getting Started In Rental Income, as well as many other books in the same series.

Today, he lives near Nashville, Tennessee, and continues writing full time. The author’s web site is www.MichaelThomsett.com.

Introduction

The Allure of Property

Why is real estate so universally popular as an investment? There are several reasons, and before considering real estate as a possibility for yourself, you may want to review the answers to this important question. You will see that, with its different investment advantages considered together, real estate is difficult to match by other investments.

However, even with real estate’s long-term advantages, you have to be cautious when committing money to a real estate program. As a general rule, real estate takes time to appreciate, and getting money out is not always easy. All markets are cyclical, and real estate is no exception. When you consider the extended downward cycle in real estate in most areas from 2006 into 2008, you quickly realize that real estate requires a commitment in both time and money.

All real estate is local. Even while the extended downward cycle prevailed on average from 2006 until 2008, there were a few areas where prices held up and even increased. Seattle, Washington, and Portland, Oregon, were among the best markets during these generally difficult times. So when you judge your local market, you need to study local conditions rather than regional or national averages. Real estate is an incredible investment, as long as local conditions are at the best point in the cycle. This is true because of five specific attributes.

First, it is one of the few finite investments. There is only so much real estate to go around, and when it is used up, prices have to increase. With a limited amount of space, the land available for development of housing, office, commercial, industrial, recreational, government, and lodging purposes is also limited. Not all land is appropriate for development. When the land is too steep, too wet, or in protected areas, it has to be eliminated as potential development land. When all of the topographically prohibitive land is removed from consideration, and when government-owned conservation lands are removed, there is only a relatively small amount of land remaining. Even beyond that, of the available land, not all of it can be developed because of zoning restrictions or the simple fact that the current owner does not want to sell. In comparison to the finite nature of real estate, corporations and most mutual funds can issue more shares if the demand from investors is strong enough. In theory, there is no limit to the number of investors in popular stock market issues.

Second, real estate has a track record that can only encourage investors. Real estate investments have gained in value in the past partly because of the limited amount of real estate and partly because of other factors, such as tax benefits. The historical record for real estate, like all markets, has had ups and downs. But over time, real estate has kept pace with inflation and has usually exceeded the Consumer Price Index (CPI) growth rate. The real estate cycle is highly predictable, following patterns based on normal supply and demand and varying regionally but in the same manner for each cycle. This is not true of the other popular investment, the stock market, in which investing may often be compared to a blindfolded roller coaster ride—more exciting and potentially more profitable, but not always as stable.

Third, real estate investors enjoy exceptional federal income tax benefits. These benefits are unlike those available for any other investment. The 1997 Taxpayer Relief Act dramatically improved the tax benefits of owning your own home by eliminating the tax on profits for the first $500,000 when primary residences are sold. This may not directly benefit investors, but many possible strategies will evolve from this new law and will be explained later in this book. For investors, too, tax benefits are significant. You are allowed to deduct all of the necessary expenses connected with owning rental property, such as for repairs, cleaning, accounting, interest, property taxes, and others. You can also write off the cost of buildings and other improvements over a period of years. The tax laws also provide exceptions for real estate investors to claim losses that would otherwise not be deductible.

Fourth, real estate is an investment you can see. There is something satisfying and reassuring about owning an intrinsic property. This gives you the opportunity to care for the investment and keep its value up by direct actions you take right in your own community. Even by testifying before your elected officials in decisions affecting your property value, you are directly involved in protecting your investment and in influencing its future market value. In comparison, investing in stocks directly or through mutual funds yields an account statement and perhaps a certificate, but you never get to see your money at work like you do with real estate. In the stock market, you own part of an intangible whole and never directly own an actual piece of a company’s real assets.

Fifth, real estate is considered one of the basic necessities. People need shelter, and housing provides them with that. Even commercial, industrial, and other types of property all relate to demand for those uses, based on local population. So investing in real estate means you are investing in the value of your own community. As a responsible investor, you are a participant in planning to maintain your town’s way of life while also putting your capital to work.

The primary emphasis of this book is on investments in residential property, mostly houses or limited multifamily properties (e.g., duplexes or triplexes). Most people start out with these fairly modest and affordable properties because they can be easily rented out so that rent income can be used to make mortgage payments and to pay for maintenance and utilities. As a general rule, more complex real estate investments in commercial or industrial properties require more money and higher risks. Many real estate investors move into the nonresidential areas later on but start out by acting as landlords in residential markets.

As a real estate investor, the best starting point is to identify conditions affecting value in your city or county and to estimate where the real estate cycle is at the moment. Of course, you want to buy at the price bottom and not at the top. But identifying these precise times in the cycle is not as easy as it is in hindsight, so you will also need to develop keen analytical resources. This book helps you identify those sources and the experts you will need to include as part of your investment “team” of advisers.

As a starting point, take three initial steps:

1. Become familiar with local conditions and economic influences (e.g., employment or rental unit supply and demand) to define your local real estate cycle.

2. Gather the information you need to make an informed decision, remembering that smart investing requires analysis and strong data.

3. Set goals for yourself and develop a series of logical investing rules, including identification of various kinds of risks and the level of risk you are willing and able to assume (i.e., your “risk tolerance”), and resolve to limit your investments to those levels.

This book is designed with you in mind. A starting assumption is that you are going to need guidelines to accomplish these three steps and to move into the specific steps you need to become a successful real estate investor. This includes numerous resources, both online and through various professionals; forms and worksheets; and guidance in preparing and documenting your taxes and keeping your books.

In the coming chapters, you are going to find easily referenced and organized information. Each chapter focuses on a specific issue of real estate investing and includes many useful tools: illustrations, examples, forms, charts, and definitions in the margins as each term first appears in the text. This format is designed to help you move through the discussion so that you do not have to backtrack to find important supplementary material. All of the definitions are also repeated in the glossary at the end of the book.

In Chapter 1, the first important question is asked: “Should you be a real estate investor?” This is an essential starting point because (1) not everyone wants the same thing from a real estate investment, and (2) some people are simply not suited for real estate, based on personal goals, temperament, or income.

For example, you may be interested in developing a long-term investing plan over an entire lifetime involving wealth-building through real estate, or you may only want to hold properties for a few years hoping for rapid price appreciation. The difference between long-term investing and speculation requires entirely different approaches to how you buy and sell and which properties you pick. Some people want to convert their current home to a rental property and then move to a larger or newer home, a step many people take when the market is slow but rental demand remains high.

This book is designed primarily for investors who want to get started in one of the various investment formats but are not sure how to begin or to break into the market modestly and build equity in one or more rental properties over time. The important point is that, as with all investments, you need to define what you want to do and how much risk you can afford, and then look for good matches in the current market. Success always depends on making informed decisions about where and when to invest.

Chapter 1

Should You Be a Real Estate Investor?

Headline: “The big run-up in real estate values is now over.” This headline could easily have appeared in any U.S. newspaper in 2006, 2007, or 2008. But, looking back over time, the same pronouncements were made at various times in the 1970s, 1980s, and 1990s. Real estate values change every few years, and the cycles are continuous. The big difference in the cycle that began a downward spiral in 2006 was that additional economic conditions aggravated the situation. These included liberal credit, widespread speculation, and predatory lending practices. Making matters worse, big financial institutions jumped into the speculative trend, investing billions of dollars in mortgages through formalized programs.

You have probably seen and heard the bad news for yourself. Foreclosures are up, housing prices are falling, and the number of homes on the market is higher than ever before. Adding to the problem are “experts” on television financial programs, some announcing that the housing crisis will last another two to three years. In fact, however, no one can really illustrate the market cycles that way, and financial news programs thrive on bad news. Unfortunately, this only makes things worse because audiences become increasingly afraid when they hear the endless streams of negative forecasts.

Key Point

Endlessly hearing bad news affects investors and adds to their apprehension. Remember, however, that when things sound the gloomiest, it is the best time to buy.

The downtrends always end, and the market always turns upward. But, knowing how long it will take can be very difficult because so many factors influence the timing of every cycle. Wherever the market is at this moment, it will be at a different place next year; and, in the future, the pattern will be repeated.

The uptrend cycle is also interesting. Once real estate cycles turn around, the same doom-and-gloom experts will tell you that you have missed the boat and that you should have bought last year. These experts fail to realize that, with real estate, even when you have missed the latest boat, there will be as many “boats” coming in the future as you have missed in the past—if not more. Real estate is not a one-time opportunity, as it is made to sound on financial programs. Many factors—shifts in the job market, population growth and migration trends, regional desirability, and economic factors like interest rates—all mean that real estate opportunities occur not just once, but repeatedly and in very predictable cycles.

The many advantages of owning real estate are difficult to beat with other forms of investment. Real estate comes with the usual investment risks, but some very special risks related to real estate should also be kept in mind when you compare it to alternatives. With real estate, you gain tax advantages and direct control over the asset, and attain the ability to borrow money to purchase a property without being taxed on the money borrowed. (In fact, by refinancing, it is possible to keep your capital working while you still own the property.) In exchange for these advantages, you need to buy an expensive property, place yourself in debt, and in most cases, be unable to get your cash out through a quick sale. You also cannot sell part of your investment as you could stocks or shares of a mutual fund.

Real estate provides you with a combination of benefits and control. You can influence the value of a property with landscaping, roofing, a new coat of paint, and interior design, for example. When you buy stock in a corporation, it does not give you the right to go to corporate headquarters and sit in on management meetings, and you cannot own the specific assets represented by your shares. Stock ownership gives you a portion of ownership in an intangible unity called “equity,” which collectively owns the company and appoints executives and managers. This is an important distinction.

real estate

land and all permanent improvements on it, including buildings.

One of the risks that many first-time real estate owners do not consider is that if you become a landlord, you will have to interact with tenants. This means that they may call you in the middle of dinner or while you are trying to watch the game on Sunday. These problems keep many would-be investors out of the business entirely. But, with careful screening of applicants and by the proper use of a telephone answering machine, you can achieve a relatively comfortable balance, while still acting as a responsible and fair landlord. All you really want as a landlord is a tenant who will pay the rent on time and do a reasonable job of caring for your property.

rights

intangible assets added onto real estate, which have value not because of the land itself but because of the advantages these rights provide.

Looking beyond the potential problems of dealing with tenants, the potential gains from investing in real estate make it worth a serious look. Let us begin by establishing a few important distinctions. Real estate is land plus permanent improvements, which most often means buildings. You may also become involved in the rights attached to the ownership of real estate, broadly called real property. Also be aware of the important difference between the full value or price of real estate, as opposed to equity, which is the portion you own after deducting debt. Equity is the purchase price (or current value of the property) minus all outstanding debt balances.

real property

real estate plus the rights attached to it, such as leases, easements, and estates.

Should You Buy Real Estate?

The pros and cons of owning real estate help you not only to understand the breadth of this market, but also to decide whether the market is appropriate for you. A checklist of points to consider:

Positive Attributes of Real Estate

1. Direct control: It is up to you, the owner, to maintain and improve your real estate investment. You do not have this kind of control in any other type of investment.

2. Monthly income: Rent income pays all or most of your mortgage. This means that tenants pay your debt and that, as market values increase, you benefit.

3. Tax benefits: Real estate is the only investment in which you are allowed to deduct annual losses. You are allowed to deduct property depreciation, as well as interest, taxes, utilities, insurance, and maintenance expenses.

4. Historical returns: Although real estate cycles can last a while and markets can be tough, historically, returns from real estate have been better than in any other market.

5. Insurance: Real estate is one of the few investments that yields monthly cash and is insured. Through your casualty insurance plan, you are protected against fire, liability, and other losses.

Key Point

Check positive and negative attributes of any investment to identify risks and rewards of the decision.

Negative Attributes of Real Estate

1. Landlord issues: When you work with tenants, you are likely to experience some problems. Tenants can be demanding and, in some cases, they may even do damage to your property. Some investors are well-suited to take on this risk, but others are not. It is wise to know in advance how you feel about working with tenants. It also is imperative to check references carefully to make sure you get the best possible tenants.

2. Cash problems: Whether or not you have tenants who pay their rent, you have to pay your mortgage every month, as well as insurance, taxes, and utilities. So, extended vacancies or, even worse, having tenants who do not pay rent on time will negatively affect your cash situation. If your personal budget is not strong enough to carry you through a vacancy period, you could face problems with your investment.

3. Market conditions beyond your control: Cycles vary not only by duration, but from one region to another. These factors are unpredictable. So, as a real estate investor, you have to be willing to go along for the ride, no matter how long it takes or how many twists and turns are going to be involved.

4. Financing restrictions: As a homeowner, getting financing is relatively easy compared to getting investment property financing. You may be required to make a larger down payment and pay higher interest, as well as other loan fees. You may also be limited in the number of investment properties you will be allowed to finance. Lenders are going to be concerned about your personal financial strength and ability to continue mortgage payments, even if you have vacancies in your investment properties. In addition, to succeed as a real estate investor, you are going to need exceptionally strong personal credit.

equity

the portion of real estate you own. In the case of property bought for $100,000 with a $58,000 mortgage owing, the equity is the difference, or $42,000.

Real Estate as a Growth Fund

speculator

an investor who buys property with the goal of earning the greatest possible profit in the shortest possible time.

Some investors buy real estate for the long-term appreciation and tax advantages it provides. In comparison, the speculator is an investor who attempts to make the greatest possible profit in the shortest possible time and is willing to take higher risks than long-term investors because short-term profits will be much higher. Speculators often are accused of being opportunists in the market, but that characterization is not always accurate. The speculator is simply taking a different approach to investing. The same distinctions can be seen in the stock market. Some investors buy long-term growth stocks, whereas others try to guess where short-term price run-ups will occur. In all such instances, speculators chase after higher profits, but they also assume considerably higher risks. With that in mind, some long-term investors believe that speculators often do not achieve as much in the long run because real estate, by its nature, is a long-term investment. Both approaches have their good and bad features. Consider the following examples, which compare two investors who each have $50,000 to invest.

Key Point

Decide ahead of time if you want to get into the market as a long-term investor or a short-term speculator. This will affect how you invest.

Example

Karen invested $50,000 as a down payment on a $160,000 triplex. Her rents more than covered her mortgage payment, and she held onto the property for eight years. At the end of eight years, she sold the property for $235,000, realizing a capital gain of $75,000. During the holding period, she enjoyed positive cash flow and tax benefits and, upon sale, she earned a profit on the investment. Mortgage payments and other expenses were covered by rent receipts.

Example

Adam paid cash for a run-down house in need of many repairs, mostly cosmetic. He landscaped the yard, painted inside and out, repaired the broken windows, and upgraded the plumbing and electrical systems. The total of his purchase price and repairs came to about $50,000. He sold the house about eight months after he bought it and, after closing costs, netted $60,000. He made a net profit of $10,000 (before taxes) in less than one year.

A comparison between these two examples is more complicated than it seems at first glance because the two people may be paying different tax rates and because there is no way to know what future appreciation may occur on the fixed-up house, nor what rental receipts could be earned by turning it into a rental unit. However, the illustrations demonstrate two different approaches. The first is the long-term strategy, aimed at achieving positive cashflow, tax benefits, and capital appreciation. This example is not unusual, but it is ideal. The second example demonstrates how short-term strategies may work. The risk here is that the cosmetic repairs may not add enough value to the property to make it worthwhile in such a short period of time but, again, the example is not untypical. These outcomes do occur if the speculator understands the market and knows good value when it presents itself.

The speculator made $10,000 on a fast turnaround of the property, which is a better annual rate than the long-term appreciation approach. However, the speculator gained no tax benefits or positive cash flow during the holding period. As you can see, the decision to be a long-term investor or a speculator depends on your tax circumstances, your ability to manage market risks, and even your personal temperament.

Speculators share a good part of the blame for the national bubble that began to appear in 2006. By buying properties and quickly selling them to other speculators, a process known as property flipping (see Chapter 13), speculators rapidly drove up prices. In some markets, notably places like Miami-Dade, speculation in the so-called pre-construction market was so severe that the county ended up with a nine-year supply of condo units. Even so, construction and speculation continued. Eventually, the market ran out of new speculators, and it was impossible to sell all of those units. This is what invariably occurs when speculation runs wild.

preconstruction market

a market for property that has not yet been built, popular among speculators during bubbles, when prices are rising rapidly.

Key Point

Watch what is going on in your area. If much building is taking place but there appears to be little or no demand, you may be in the middle of a bubble.

Combined with predatory lending practices that infected the markets at the same time, the real estate bubble was exceptionally severe. The lenders who made borrowing too easy, often giving loans to people they knew could not afford them, aggravated the situation as long as prices were rising. Speculation and predatory lending were a dangerous and destructive combination.

predatory lending

the practice of granting loans to borrowers despite knowing they cannot afford payments; or performing little or no credit verification to close such loans; or actively pursuing current borrowers to encourage them to refinance existing loans with excessive loan fees or high interest rates.

The riskless transaction that lenders and mortgage brokers go through when placing mortgage loans has been and is one of the most destructive forces in the real estate market—and will probably continue to be in the future. It is riskless for lenders because, as soon as loans are underwritten, these loans are sold to agencies that package them in pools and sell them. These pools operate like mutual funds in that they are made up of numerous mortgages. So, for the lender or mortgage broker, there is no real concern about whether a borrower is financially qualified, or even whether the borrower can afford mortgage payments. Money is made by placing loans in secondary market agencies, which create pools and then sell them to investors.

Key Point

A riskless transaction always damages the market because it creates artificial economics. Anyone who watched real estate from 2006 to 2008 knows how much damage riskless transactions create.

A responsible way to get into real estate investing is to be realistic about what you can afford. Every investment contains risks; in the past—especially during price run-up bubbles—many people naively believed that no actual risk was involved. Many speculators lost significant capital because they bought property at the worst possible time-when prices were at their highest and just before the bubble burst.

A realistic approach to real estate investing should include a test of how well real estate matches your risk tolerance and personal goals. Additionally, ask yourself how real estate investments are likely to compare to non-real estate investments such as the stock market.

In the stock market, certain stocks are referred to as growth stocks. Generally, this means that the stock’s value is expected to increase over time. If you buy shares today and the estimate of future price growth is right, your investment will steadily grow in value over many years. You will not be concerned with the day-to-day fluctuations in stock value.

riskless transaction

any transaction in which the actual risks are transferred to someone else; for example, lenders and mortgage brokers who, when they underwrite and then sell loans, transfer the risk of lending to investors in mortgage pools.

The same is true when you invest in growth-oriented mutual fund shares. The company’s management buys shares in companies considered to be good growth stocks. If the mutual fund’s management is right, your shares will grow over time.

risk tolerance

the level of risk or type of risk a person is able to stand, based on experience in the market, knowledge about investments, personal income and available capital, investing goals, and the ability to keep capital invested for periods of time.

With either direct purchase of stock shares or mutual fund shares, you depend on the quality of management to achieve your goals. With many different choices on the market, you accept certain risks in the selection process, and that is always a part of the investment equation. These same risk elements apply to real estate as well. You always accept risk when investing, and real estate, like other alternatives, comes with specific risks. In real estate, these risks include three possibilities:

1. The property investment may lose value or fail to appreciate according to your expectations. All investments contain this risk. Even insured savings accounts can deteriorate when interest rates are lower than inflation. The basic market risk is the best known and, for most people, the primary form of risk. It is fair to say that, in most regions, real estate has to be held long enough for appreciation to occur, and the real risk is that you do not know in advance how long that will be.

growth stocks

stocks expected to increase in value over time.

2. You may not be able to find tenants or to charge rents adequate to cover your monthly expenses. When a large number of rentals are available and there are relatively few tenants, market rates level out or drop. To avoid vacancies, you may have to reduce rents. The opposite is true in periods of high demand. With too few units and many tenants, your market rates will rise.

3. Your tenants may not pay the rent that is due or may not care well for the property. In real estate, tenant problems are frustrating because such problems force you to confront matters at once or lose money. Invariably, that means dealing with people who are having problems beyond the landlord-tenant relationship, who are immature and irresponsible, or who simply want to avoid paying the agreed-on rent. Proper screening and review, and checking of references, reduce these problems dramatically and should be requirements of being a landlord.

These basic risks are not the whole story, but they are major considerations when you are evaluating the possibility of investing in real estate. These problems will not seem as formidable when you actually buy a property and begin managing it. With patience, caution, and maintenance, property will appreciate over time when it is carefully and intelligently selected. You will also learn by experience how to screen tenants, set fair rents, and confront problems before they turn into crises. Just as parents learn on the job, landlords have to discover the problems that arise with tenants and learn how to avoid these problems in advance.

Risks are manageable, as long as you are aware of them. A common mistake is to look for ways to eliminate risk, when, in fact, smart investing calls for awareness and risk management. Some risks can be mitigated. For example, buying fire insurance protects you against a loss of a rental home; not to carry such insurance is to assume more risk than you can afford. You need to evaluate the different types of risks involved with investing in real estate, and then determine how much risk—and what kinds of risks—you are willing to assume. The speculator is willing to take the risk that the real estate market may not support the strategy of buying and selling homes in a short period of time. If the speculator’s timing is off, the strategy will result in a loss, or the property will have to be held longer than intended.

Most people begin their real estate investments by studying and comparing prices. You should always keep in mind the risk rule in real estate: The greater the risk, the lower the price. For example, real estate in a poor location will naturally cost much less than real estate in a prime location. The risk in such a case has to do with the potential for appreciation. The price in the poor location is less likely to rise at the same rate as prime property and, in fact, could even fall. As average market prices rise, the tendency is for better-than-average properties to rise faster than average and for poorer-than-average homes to lag behind. Good investing requires foresight. In addition to estimating and calculating the risks and potential profits, you need to become adept at identifying the good and bad points about all of the factors affecting price and value: location, timing, and local economic conditions (now and in the future). This is exactly the same type of analysis all investors need to perform. However, instead of studying financial statements of companies and looking at market index trends, the real estate investor has to be able to read social, political, economic, and demographic trends within a city and region.

This book assumes that your goal is to invest for future appreciation. Certainly, speculation is one alternative, but that profile does not fit most people in terms of available capital, financial goals, or market expertise. The main focus here is showing you how to get started by buying one or two rental houses, then how to build up equity while managing property and coping with tenants and, ultimately, how to create a profitable investment for your future financial security.

seasoned real estate

real estate that has been owned long enough for market value and equity to accumulate.

Long-term investing requires a commitment longer than two or three years. In fact, “long-term” generally means 10 years or more because it takes that long to create seasoned real estate. As you make monthly mortgage payments and as property gradually increases in value over time, seasoning occurs.

The Real Estate Cycle

Real estate investments react to economic cycles, as do all investments. The major points in the cycle—falling and rising prices, for example—are characteristics of supply and demand. The tendency dictated by this basic economic idea—that prices rise and fall according to levels of supply and demand—is the guiding force in selecting investments, timing purchases and sales, and selecting one investment over another.

supply and demand

the economic conditions in the market that affect prices. When demand is greater than supply, prices tend to rise; when supply is greater than demand, prices tend to fall.

market economy

a market in which prices are not set but vary with purely economic factors, specifically supply and demand.

In a pure market economy, prices rise and fall in accordance with the dictates of supply and demand. Higher demand places pressure on the supply, and prices rise; lower demand softens the market, so that prices fall. The same features are found in the stock market, which often is called an “auction marketplace.” This means that prices change specifically because the mix of sellers and buyers changes. When more buyers want a limited number of available shares of stock, this drives up the price; and when the number of sellers grows, this forces down the price of the stock. An ongoing auction is underway when the market is open.

Real estate does not change hands in an auction marketplace. Stock exchanges are public, and millions of individual trades result in tremendous share volume every day. In real estate, brokers are not bidding and negotiating from moment to moment; and real estate sells in large, single units rather than in millions of small shares. Offers are placed in writing through real estate agents and based on asked prices. Prevailing market conditions determine whether a potential buyer makes a full-price offer or tries to negotiate a lower price. The same conditions also affect the seller’s response. A firm seller sticks to the asked price or stays close to it, but when the market is soft, sellers have to accept lower bids or their properties will not sell.

Although the rules of contracting for buy and sell prices and making and closing a deal are the same for stocks and real estate, methods are different. In the minds of most investors, the rules are different as well. For example:

✔ Many people who can afford to buy 100 shares of stock would be faced with much more demanding financial arrangements if they were to bid on real estate. Accordingly, the stock market is available to many more investors, and trading can occur frequently and in relatively small increments.

✔ Stocks are often bought and paid for in cash, whereas real estate more likely involves financing.

✔ Real estate prices are naturally higher than shares of stock, so the entire process of buying and selling—comparing, negotiating, bidding, offering, and closing—tends to be more formal and take longer.

✔ Real estate does not trade hands as frequently as stocks, so the trading volume in real estate is much smaller, and indicators based on sales volume tend to cover periods of months and years rather than tracking methods used in the stock market, such as hour-to-hour or day-to-day volume.

motivated seller

a seller who is very anxious to sell, meaning that the seller is more willing than a firm seller to negotiate on price and other terms.

Reasons for selling are different as well. Sellers of stocks often want to take short-term profits and move on to other issues, or simply want to move their money to another stock, which they believe would make a better investment at that moment. The real estate seller may be anxious to sell for a number of different reasons. A motivated seller wants to find a fast deal in order to get the equity out and move on. Motivated sellers may have made an offer on another house, be moving to another area, or be making other major life changes. The degree of anxiety to sell will dictate how much negotiation the seller is willing to undertake. In a very soft market—in which many homes are for sale and few buyers are available—it may simply be impossible to sell a property, at least immediately. In the auction marketplace of the stock market, there is always a ready buyer. The price may be low because demand is low, but shares of stock on a public exchange can be bought or sold at the current price at any time.

real estate cycle

the trends in real estate values, affected by ever-changing levels of supply and demand. The cycle describes changes in construction activity, available supply of real estate for sale, credit available for financing, interest rates, population and job demographics, and attitudes among buyers and sellers at any given point.

The events and conditions influencing real estate values are referred to as the real estate cycle. Although many factors affect the cycle, including population, the job market, interest rates, financing, construction levels, and many other economic changes, the real estate cycle moves in a fairly predictable sequence over time. The stages vary in length of time and rapidity of change based on the collective changes in market conditions; however, six distinct points can be identified in the course of the real estate cycle. These are summarized in Figure 1.1.

FIGURE 1.1. The real estate cycle.

1. Demand begins to rise. Demand rises for many reasons—often for a combination of reasons. The fact that more buyers are looking for property now than a year ago is a symptom of rising demand. It may be caused by growing population, job creation, and other factors. The forces that create demand cannot be isolated or easily identified; demand is usually a general trend involving many parts. One element of demand results from a decrease in construction activity, leading to housing shortages. In a truly efficient economy, developers always build exactly the number of new homes required to meet the needs of the immediate future, while maintaining supply and demand in a healthy balance so that values gradually rise with moderate inflation. But, that is the ideal world, and the real world rarely acts that way.

2. Construction activity increases. Why do developers increase their rates of construction? At the beginning of the cycle, the general perception is that demand is on the rise. At that moment, the perception is correct. The trick, however, is to know when to stop building new homes. Construction activity is responsive. As demand increases, so do the construction rate and pace. That pace often exceeds actual demand, so that as the cycle tops out, the consequence is oversupply.

3. Demand slows. When we say that demand slows, we could mean that demand actually decreases or that the rate of new construction accelerates beyond a more moderate demand curve. As long as construction and demand are moving at the same pace, there is no relative change in the real estate cycle. When demand slows for either reason, this event signals that the top of the cycle is approaching. You will recognize this point by an increase in the time required for listed property to sell. In some markets, homes under construction are sold literally faster than they are built. But if builders start accumulating an inventory of finished homes that are not selling right away, this is a sign that demand is slowing (or that construction has outpaced demand).

4. Supply exceeds demand. The cycle tops out and begins to decline at the point when property available and on the market exceeds demand. This does not mean that no real estate is selling. It does mean that supply is larger than it needs to be and that demand is not high enough to move the inventory of available property. As a consequence, prices tend to level off or fall. The cycle may stall—meaning, new construction is meeting demand, but prices do not rise because the inventory is perpetually higher than it should be.

5. Construction activity decreases. No market can sustain a holding pattern for long. When inventories of available property are too high, construction eventually falls off, at least temporarily. Builders and developers, like everyone else, do not always recognize the point in the cycle until it is too late. So, at the point where prices have become soft and supply is too high, builders realize that they cannot continue to develop the market at the previous pace. Another problem in trying to watch and predict cycles, whether in real estate, the stock market, or other markets, is that you do not know whether specific signals indicate changes tomorrow, next week, or next year. Timing is the difficult part.

6. Demand bottoms out. At the end of the cycle, demand is at its lowest; construction activity has stopped for the most part; and no changes are in sight. A cycle may remain at its bottom for a few weeks, a few months, or many years. No two cycles follow identical wave patterns, and there may be numerous false starts along the way. The word “doldrums” appears in financial articles, and experts proclaim that the opportunities in real estate are over, once and for all. This statement is one of the predictable events at the bottom of the cycle. Remember, however, that such categorical predictions—like predictions that inflation is gone forever—are always wrong. The end of one cycle is also the beginning of another one.

In practice, cycle length varies considerably. The downtrend from 2006 to 2008 was exceptionally long and widespread compared to previous cycles. Although cyclical trends vary by region, the complexity of cyclical movement and the many varied underlying causes of accelerated or slowed change cannot be simplified.

Key Point

No two economic cycles are identical. Real estate cycles vary in duration and severity owing to a variety of supply and demand influences, as well as conditions in other markets, such as the credit market.

The effects of supply and demand are easily understood, but the general economic theory remains unchanged. By remembering that cycles are all different from each other, it is possible to make a basic observation:

1. Supply rises and demand falls.

2. Demand rises and supply falls.

This cycle, like all cycles, involves the cause and effect of supply and demand. (Please see Figure 1.2.) You are aware of the variables in the cycle and the complexity of influences that have to be added into this, but the basic equation remains the same. One way to better understand why cycles move the way they do is to understand that, in the first half of the cycle—when prices are rising—the price curve tends to run ahead of the demand curve. On the other side, when prices are falling, the price curve lags behind the demand curve. The trends run out, and the cycle begins again—thus, the wave effect.

FIGURE 1.2. Supply and demand.

Changes in relative levels of supply and demand are nothing less than the sum of all influences in the market at that moment. If developers ceased building altogether because of excess supply, demand would eventually use up that inventory, and the cycle would be forced to begin anew. If employers came to town, demand for new housing would accompany new jobs. However, we can never have absolutes, such as construction levels stopping altogether or a complete turnover in the job market. Such influences tend to occur incrementally rather than in single motions. So, in reality, when we talk about supply and demand, we are really describing a trend that involves all of the complex economic, social, and intangible influences at work in the community.

Real Estate Rules of Thumb

The factors that influence real estate values are complex, as they are in most markets. Just as determining why a particular company’s stock sells for $80 per share whereas a comparably capitalized competitor’s stock is worth $60 can be elusive, so does the same difficulty apply to the real estate market. You simply cannot compare between regions. Thus, a single-family home of 2500 square feet, less than five years old, may be priced at $1.2 million in San Francisco but at $165,000 in Indianapolis. Even with a thorough understanding of all the influences creating variances in supply and demand, differences in price cannot be easily explained. This makes an important point, however: Before buying real estate, it makes sense for any investor to study the local market and to attempt to understand the kinds of growth rates likely to occur in coming years. This involves analysis of historical price changes, the local economy, available land, costs of construction, and migration trends.

Key Point

The more research you perform about your current real estate market, the better. This defines how well you will time your decision to enter the real estate market.

For example, as the baby boom generation has grown and begun to retire, population levels in that age range have grown in Florida, Texas, and Arizona, while shrinking in the Northeastern and Great Lakes states. A 2005 study estimating a shift in Electoral College votes by the year 2030 demonstrated how this population shift will dramatically change not only voting trends, but overall population age, notably in Florida, Texas, and Arizona.

Table 1.1 is a breakdown of the estimated change showing the largest gainers and losers:

TABLE 1.1.Estimated Electoral College Changes by Statea

TABLE 1.2.Total Increases in Electoral Votes for the Sun Belt Regiona

The study also estimated the overall change in Electoral College votes by region, estimated to occur by the year 2030, combining historical data with estimated future increases. Please see Table 1.2.

This long-term perspective of population trends demonstrates that influences on real estate are best viewed as long-term in nature. Whereas trends in the stock market tend to move rapidly and turn quickly, real estate is likely to demonstrate more consistent and long-term change over years and decades, rather than over months or weeks.

Key Point

The reality is that population groups migrate over time. The retirement of the baby boom generation may be the most significant factor in determining where real estate values increase in the next few decades.

Although analysis of long-term trends in demographic and economic terms provides valuable information, it also makes sense to be aware of real estate rules of thumb:

1. Real estate is a long-term proposition. It is not realistic to expect that you can make a killing in real estate in a very short period of time. Whereas some people have profited from fast speculation, the opportunities are much clearer in hindsight. In fact, the most successful speculations are made at the moment when virtually everyone else is doing the opposite. You buy when everyone else is selling, for example. Going into real estate with the goal of getting rich quick is a risky idea, and the odds work against you in that case.

2. Real estate markets are strictly regional. You have probably read in national magazines or wire service stories at various times about “the plight of real estate.” You may also be aware that a lagging real estate market described in such stories does not necessarily describe what is going on in your town. That is because real estate is always subject to regional factors, and rarely is local real estate drastically affected by national trends. For example, Northwest prices move for Northwest regional causes, and not because of population and employment trends in the East.

Employment is a good example. Changes in the job market directly affect real estate supply and demand; and yet, employment varies greatly from one place to another, often in places separated by only a few miles. Many people automatically assume that real estate conditions are the same everywhere, but this is a mistake. The assumption applies stock market thinking to real estate. However, whereas the stock market is national, real estate is strictly regional, so the rules are different. Never make up your mind about what is going on in your area based on a story written by someone living somewhere else. Depend only on regional news and statistics, and talk to real estate agents and bankers in your area before deciding the condition of the real estate market.

3.The big run-up is never really over. When real estate prices soar in a relatively short period of time (five years or less), a period of pessimism follows. We are told that we have missed the chance if we did not buy real estate several years ago and, even worse, the opportunity will never come again.

None of that is true. If, in fact, a recent run-up has peaked, this is only the end of one cycle; and the end of a cycle is also the beginning of the next cycle. By waiting for the right signals, you will still be able to time your investment decisions to approximate the bottom and top points. Even if you did miss the “big” run-up of the recent past, you still have time to get in at the bottom of the next cycle.

Why do cycles repeat? Despite the recurring predictions in the financial press that yesterday’s opportunities are gone forever, there remains a constant and growing demand for real estate. The initial demand is for housing due to a growing population, and housing demands spur related demands in manufacturing, industrial, and other sectors. But, can we depend on such demands increasing into the future? Yes. The population continues to grow. Even though the baby-boomer generation may stop buying homes, their children (and grandchildren) will continue the demand. There is no reason to expect the demand for housing to decline in the future. The U.S. Bureau of the Census projects that the population of the United States will grow more than 35 percent between 2010 (308.9 million people) and 2050 (estimated 419.9 million).1

Much of the growth will be attributed to two primary factors. One is a continuing trend in immigration. The second involves people born between the late 1960s and the late 1970s and their moving into home-buying age by 2010. This block of the U.S. population is expected to grow by 1.8 million new households between 2010 and 2020.2

Demand coming from population growth, whether due to changes in growth rates, immigration, or migration, is only one important reason creating ever-growing demand for real estate. This simply means that, as people move into the typical home-buying age, beginning at about age 30 on average, new demand for homes is created. Thus, the greater the increase in population, the higher the demand and, consequently, the more likelihood of continued long-term growth in real estate values.

Key Point

Real estate values do not grow for no reason. The clear effects of new demand are a primary driver for prices. Except for false demand (e.g., that created by speculation and predatory lending), future growth is predictable based on a simple understanding of the sources for new demand.

With these economic realities in mind, it is clear that any specific run-up in real estate prices is not a singular event. A specific price trend is going to end as the cycle turns, but the same pattern will recur in the near future. With the previously cited estimated 35 percent increase in the U.S. population by 2050, it is obvious that future demand for housing will be higher than it is today.