What should I know about investing in real estate?
Real estate investment has been the foundation of many wealthy families throughout the history of the United States and it continues to be today. Having owned investment real estate, helped many clients purchase and manage investment real estate and watched the real estate market for the last 10+ years I have a few observations that I would like to share with anyone considering purchasing investment real estate:
Real estate is a vehicle to grow your investment over time, it is not a short term strategy. Most of the successful real estate investors that I have seen all have one thing in common: they have a job or a business that supports their family and they invest their savings in real estate. It is very hard to make a living from investment in real estate unless you start with a large amount of money. For the average investor, the power of real estate investment comes over time. A $120,000 home purchased today with a 20% down payment ($24,000), leased for $1,200/month, will make about $5,000 per year after expenses. That is a good way to supplement your income, but it would be hard to live on. However, after 30 years the mortgage will have been paid off by your tenants over time along with your $5,000 per year income. With appreciation of just 2% per year your property is now worth $213,000 and you own it free and clear. Without a mortgage payment you are now making over $10,000 per year, or you can sell the home and buy something else.
“Flipping” houses is a profession, not a hobby. We have all seen television shows that show investors flipping homes and making huge returns. What they often don’t show are the homes that lose money, the unforeseen problems that can be expensive, and the costs associated with owning and selling the home over and above the renovation costs (property taxes, insurance, finance costs, realtor commissions, closing costs, title policy). In order to make money buying and renovating homes you need to purchase homes at a low enough price to make a profit, know exactly what your renovation costs will be, and have the experience to bring the project in on budget. An experienced renovation investor will also know what the buyer’s inspector, lender and appraiser are going to look for and make sure they have addressed all of those issues. Too many times I have been showing houses and come across a poorly done remodel that is priced over what the market will bear. The finishes are either sub-standard for the price range or installed poorly, the cosmetics were addressed and the major systems were not, a load bearing wall was removed and not properly supported, or the investor ran out of money and was not able to complete the remodel. The investor then has to over price the home and hope that the buyer is willing to overpay to cover their losses.
Investment loans are different than primary residence loans. For a lender, the default rate on investment properties is higher than on primary residences and that makes those loans more of a risk. The logical reason for this is that a property owner in financial trouble is more likely to pay the mortgage on the home they live in than on their investment property if they have to choose one. To account for this risk lenders require a larger down payment on investment properties and charge a slightly higher interest rate. Some lenders may also require that you have additional cash reserves available to pay the mortgage payment in the event that you do not get the property leased right away. A typical investment loan requires 20% down which is 4 times more than a typical primary residence loan.
First time homebuyers have a great opportunity to invest in real estate. This will seem counter intuitive to many people, but it is true. Many first time buyers purchase their home using an FHA loan, which is a loan that requires only a 3.5% down payment and is insured by the government to encourage first time home buyers. This loan cannot be used for property that you are going to lease, it must be used for the home you are going to live in. A little know variation of this loan, known as an FHA 203(k) loan, allows a first time buyer to purchase a home needing a lot of work and to borrow the renovation funds along with the purchase. It is a lot more work for both the Realtor and the buyer, but in the end the buyer will end up with a newly renovated home at a cost that is generally lower than the market price of the home. Here is an example: We helped a buyer purchase a home for $83,000, it had a broken foundation and needed interior renovations and paint. The buyer spent $25,000 to renovate and repair the house. The appraisal on the home after renovations was $130,000. That buyer now has equity of more than $20,000 the day he moves into his new home.
VA and FHA buyers can purchase 2-4 unit properties. As long as you are going to live in one of the units, you can use an FHA or a VA loan to purchase a duplex, triplex or quadplex. There are a number of conditions about the property that must work as well such as the rents of the other units and the condition of the property, but this is a great way for a buyer to purchase an investment property. A few years later, you can move to another home and keep this property as a rental.