What to consider when investing in Real Estate

What to consider when investing in Real Estate

Last week I published a blog title “Is Mortgage Debt Good or Bad”  where I expressed the opinion that your personal home should not be considered as an investment.  Let’s address buying real estate as an investment.

First thing that you should know about me is that I’m a real estate girl through-and-through. All I think about is real estate so it’s only natural that I promote buying real estate as an investment. I don’t know anything about any other type of investment. In order to establish a well-rounded and diverse investment portfolio, be sure to get lots of advice from as many professional as possible when making decisions about where to invest your money.

The first two questions to ask yourself in any investment is what type of payoff are you looking for and what time are you able and willing to put into the investment.

Let’s Talk About Time

Like any investment; risk increases when you look for a quick payback.   If you want a high return, you’ve got to be willing to take the risk associated with short-term gains. Likewise, if you can give an investment time, you can opt for a slower return and let the magic of time work for you rather than against you.

Increase your return AND lower your risk using the magic of time.

Increase your return AND lower your risk using the magic of time.

Almost every investment includes transaction fees and real estate transaction fees are extremely high.   If you are going to buy and flip real estate, you have to be painfully aware of the transaction fees.   The real estate bust was littered with amateur builders, flippers and investors who either planned to sell on their own to cut transaction fees or didn’t account for them when they made the original purchase.   Don’t make this mistake, it is an extremely difficult one to recover from.  Either buy and hold, or know your transaction fees going into the investment.

Additionally, be particularly mindful of the Red Flags and avoid any properties with any type of external obsolescence.

Flipping Real Estate Property

So let’s assume you want a fast return and you’ve decided real estate investing is for you.  There are few investments I know of that can do this for you as well as buying and flipping.     The easy math is you cannot pay more than 65 cents on the dollar for the original purchase.   Let’s break it down.

You find a fixer that you feel confidant you can handle the renovations.  The cost to purchase is $200,000 and you estimate it will need $50,000 in work.  The estimate for fair market value of this home in good condition is $300,000.    That leaves $50,000 for you to pay the fees involved with both the buying and selling transactions.

When you bought the property you took out a loan and also used cash on hand.   Let’s assume the costs of this loan as well as the title and escrow fees equal $5,000. You’re now left with $45,000.  But it’s going to take you 60 days to complete the work and you are assuming an additional 30 days to market the property. That means you’ve got 90 days of interest to pay for the loan you took out. Assuming a 5% interest rate, you are going to pay about $700 per month in interest, account for property taxes and that’s closer to $900 per month while you renovate and market the home. Your pile of money is now reduced $2,700 to $42,300.

Once the home is renovated, it’s time to list it for sale with a real estate firm.    In the State of Washington, you will pay 1.78% in excise tax, let’s assume a 7% commission (yes commission are negotiable, but they are rarely zero)  and of course title and escrow fees are due again. This number will bring you to roughly 9.5% of the total sale, or $28,500. This leaves you with $13,800.

In order to make this $13,800 you risked the following:

  • $40,000 cash in order to obtain the loan
  • 90 days of renovations and work
  • The risk of running over budget on time and/or repairs

What sounds like a $50,000 gain at a cocktail party has quickly dissolved because of the transaction fees.  To be sure there is money to be made, hopefully this exercise will help you make peace with the risk involved in these short-term transactions.

Buying and Holding Real Estate

Now we are talking my language.  If I could compose a real estate love song, it would be titled, “Buy and Hold”.   The wonderful thing about buying and holding real estate is there are many ways you can approach this.   From buying vacant land to buying rental properties or commercial space.   Here are the questions to ask yourself:

  1. Is this meant to create short-term cash flow?
  2. Do I care more about the expected appreciation of the property or monthly cash flow?
  3. Am I looking to be negative cash flow for tax purposes?
  4. Do I want to create a retirement investment that will bring me a monthly annuity?
  5. Do I have another purpose; i.e. buying a home now for my kids to live in later?

Depending on your individual goals, there are a number of ways to reach them using real estate.   Let’s break down a scenario of buying a rental property with the intention of creating a monthly income at retirement.

Buying a Long Term Rental

Let’s assume you are buying a home for $285,000 with the sole intention of a long-term rental.  Let’s also assume that you are 30 years old.    The interest rate is 5% and you’ll be taking a 30 year loan on the property.

Renton home bought for the sole purpose of a long term rental investment
Renton home bought for the sole purpose of a long-term rental investment

The cash required is 20%, so you’ve got to come out-of-pocket $57,000.  The principal and interest payment on the remaining balance is $1224 per month.  Property taxes and insurance will be an additional $367 per month.  This home also requires monthly home owner dues of $20.  The total cost per month to hold this home is $1612 per month. Zillow estimates that this home will rent for $1800 per month.

With this case study; you actually have positive monthly cash flow (less the down payment).   Let’s fast forward five years with the assumption that the rent, property taxes and the value of the home has been flat the entire time.

You’ve made a positive cash flow each month of $188 (* 60 months) = $11,280 income.   Additionally the rent has contributed to paying down the principal balance by $18,280.   The initial investment of $57,000 is still in the property as equity and the additional equity $18,280 is also realized.

Now to play the devil’s advocate, if you were to sell the property at the five-year mark, you’d be up a little over $29,000 but you’ve also got a cost to sell of 9.5% or over $27,000 in transaction fees. Without real estate appreciation, you’d be in trouble.  The good news is that real estate usually appreciates over a five yer period.

But We Have Other Factors to Consider

Let’s keep it easy for now and just assume that this property stays flat for the entire 30 years. Let’s also assume that there is no inflation and that rents and property taxes stay the same. With these assumptions you would have an annuity at age 60 that pays you $1800 per month, and an asset worth $285,000. The income generated over the last 30 years has equaled (360 months * 188) $67,680 and the income has paid for 80% of the asset.

I say sign me up every day and night for this program.

Okay, but back to the real world. Inflation exists, property values will go up and down over the course of time (but if history is any measure) it will mostly go up and that gain will mostly correspond to inflation. But here is the magic of time in real estate. The interest rate is locked for 30 years. So as inflation rises so does the cost of rents, home owner dues, property taxes and other expenses related to owning property. However, the majority of your costs (principle and interest payment) remain fixed and are therefore protected against inflation.

So Why Doesn’t Everyone Invest in Real Estate?

The other factor we haven’t touched on yet is the work involved. Owning rental properties means cleaning homes when a tenant moves out, time spent screening tenants, reviewing rental agreements, staying up to date on the landlord/tenant laws, and so on and so on. I won’t mislead you, it’s a lot of work.

And there are risks.  A bad tenant can cost you thousand of dollars in repairs and/or legal fees.   Life happens while you make other plans and you may have to sell earlier than you wanted or planned.

These risks are the same reasons large corporations cannot buy single family homes in bulk. It’s why Warren Buffet said in March of 2012, “I’d Buy Up ‘A Couple Hundred Thousand’ Single-Family Homes If I Could” The amount of work required per property does not pay for itself in the short-term. But in the long-term, it’s like owning a printing press and I highly recommend it.

Need more help, just call or email me.  I’d be delighted to help you invest wisely in Real Estate.

For more from Warren Buffet watch this short video clip.