Guide to Buying Investment Properties
Chapter 1: Your Home is NOT an Investment Property
As a hard and fast rule of real estate investing, your home is not an investment property.
Owning a house is not the same as investing in real estate. For you to consider your home an investment, it’s got to generate actual profit, or “cash flow”. This is the most basic concept of real estate investment.
What’s the explanation for the perception versus reality? Well, generally, when homeowners calculate their “investment returns”, they often don’t take into account the reality of the costs involved with owning a property. Generally, all they do is to subtract the cost of their down payment from the proceeds of the sale and consider that to be their profit. But they neglect other factors: maintenance, the declining value of renovations, and the interest incurred through long-term mortgages.
No matter the increased value of your home over time, you can only borrow against it or sell it. In the end, homeownership is a wise financial move. Not spending a certain amount of money by renting instead of buying over the years is a fiscally sound decision. This e-guide is here to help you understand the basic concepts of investing in real estate.
Chapter 2: Getting In on the Ground Floor: Where to Get the Money and Build a Network for Investing in Real Estate
Real-estate investors make money by providing one of life’s necessities. Done properly and prudently, real-estate investing can provide considerable wealth and income, and the capital investments are quite minimal. If you’re seriously considering making your first investment purchase, it’s good to plan on at least one full year of preparation before you close on your first property. A great deal of that time will be spent on educating yourself on the ins-and-outs of investing, and further on a great deal of research should be put into the specific neighborhoods and properties that you’re planning to buy in.
Once you’ve decided to take the plunge, you may be asking yourself “Where will I get the money?”. Fortunately, it’s not as hard as it seems to generate startup capital. For example, if you’re looking into investing in smaller multi-unit properties, you can get a quality loan with as little as 3% down if you plan to owner occupy one of the units.
Another potential source of capital could be your retirement fund. If you save in an IRA, the IRS will allow you to take out up to $10,000 penalty-free to buy a first home. And don’t be discouraged by the term “first home”. If you haven’t owned a home for 2 years, the IRS will consider any home you buy to be a “first”. Additionally, lenders will include future rental income along with your salary when computing your loan eligibility. A good standard is to try and keep your “PITI” (Principal, Interest, Taxes, Insurance)—under 25% of your pre-tax income, including the rental income.
Now it’s time to decide what kind of investor you’d like to be. Would you prefer to be a resident landlord to supplement your current salary? Or perhaps you’d like to cast aside your day-job and become a full-time developer in commercial real estate? These are important questions to decide, as it’s imperative to have a well-defined business model if you want to find success in that business.
Whether you’re relatively new to the business or a seasoned veteran, networking is always crucial. Networking in the real-estate world as a novice can help you navigate uncharted waters and guide you to investments that are right for you. There are many ways to network. Working with a knowledgable brokers, like us, is one and this will also give you access to the data bank of properties listed for sale in MLS and to off market opportunities that are many times shopped through broker networks.
Outside of working with an agent, most metropolitan areas and social media sites have real-estate investing groups who meet and share information and forge partnerships. Utilize the tools already at your disposal.
Most importantly, however, is to realize that real-estate investing is a business, and business is work. There are no “get-rich-quick” schemes. It’s possible to make a fortune overnight, but highly improbable. Avoid scammers and “gurus” who invite you to pay hand over fist for seminars and educational materials, promising you mansions and yachts and exotic cars. These people make their money selling fantasies, not real estate. Be practical, be resourceful, and do your research.
Chapter 3: The 3 Most Important Questions to Ask Before Investing
When evaluating potential properties to purchase, it is important to always ask these three questions:
“Is buying this property the best use of my money?”
“Will this property pay for itself?”
“Can I increase the value of this property?”
The answers to these questions should become readily apparent as you go through your due diligence—the in-depth research which precedes any real estate purchase. In the end, if the answer to each of the three questions is not a resounding “yes”—then you should not make the purchase.
While real estate may seem like a sure-fire investment, the fact is that the housing boom of the early 2000s has since left building prices in many boom regions too high to produce adequate income. Although not a high-level risk, real estate investing still ranks in the midrange of investment risks.
A good barometer to assess an investment’s worthiness is to calculate it’s internal rate of return (IRR), and compare it with the current interest rate on a 10-year note from the US Treasury. For as long as the government continues to pay its creditors, there is no safer investment than to loan the US money. If your investment property can’t beat the guaranteed profit on a Treasury note, then it’d be best to leave the gambling for the casinos and invest meticulously.
So—is your investment going to pay you more than a Treasury bond? You always want to temper your financial risks and ensure a positive cash flow on your properties. Savvy investors use leverage to their advantage, having a property pay for itself. Leverage can be attained by buying properties in dire need of repair and taking out a mortgage-rehab loan which covers 125 percent of the property’s price. Another is to use the rent acquired from the tenants in a multi-unit property to pay for that building’s mortgage and maintenance and keep what’s left as profit.
These are but two examples of positive “cash flow”. Cash flow is the bottom line. Novice investors tend to base their purchases on what they think they can sell the building for in the future, as opposed to what it generates now. It is imperative to structure your purchase so that the building covers its own costs. To get a clear picture of a building’s costs, you and your accountant should question the seller on every cent coming in and going out of the building, and carefully inspect all the seller’s financial records relating to the property. Incomplete or shoddy records are warning signs.
Finally, you’ve got to figure out if and how you can raise the property’s value. Landlords can be helpful in this area—from freeing up your time by dealing with the day-to-day minutiae of building maintenance to coming up with their own ways to increase revenue.
You’ve got to imagine how the building could be when assessing its potential. Is there space for a coin laundry? Can you rent parking spaces to tenants? Many cable and internet providers will make you a deal on wiring an entire building. You could pass some of the savings on to your tenants and pocket the remainder of the profits. Some localities allow “mixed use” of properties, which would allow for some spaces to be used commercially—such as a doctor’s office or small legal practice.
The bottom line is to carefully consider all three questions. Once you’re sure that the answer to all three is “yes”, then you’re ready to buy a building!
Chapter 4: Finding, Buying and Closing the Deal
The old realtor’s adage about “location, location, location” is just as relevant today as ever. It’s important to realize, however, that a desirable location for your home may not be a desirable location for your investment property—especially if you’re looking for a commercial property.
In newer cities and suburbs especially, you’ll notice that commercial and residential areas are very segregated. Zoning laws and business practices typically group properties with similar uses: residential, commercial, industrial, etc. In older cities, however, you usually find greater population density—and with that, you’ll see more “mixed-use” neighborhoods. Do your due diligence, but whatever you do, don’t make a firm offer on the first place you see.
Another “don’t”: buying a cheap property in a blighted part of town simply because it’s relatively inexpensive. Sure, it may seem like a steal, but one building alone will not attract the young, hip crowd you’re hoping for. It’s better to be an early investor in an up-and-coming neighborhood than to be the first investor in a neighborhood who’s future still has yet to be seen.
Finally, be wary of long-distance real estate deals. While it may seem tempting to invest in a hot neighborhood on the other side of the country, putting your money in faraway hands can be a recipe for disaster. How quickly could you react to a crisis? How long would it take to find out if a tenant skipped town? If these scenarios aren’t enough to scare you off the prospect of long-distance investing, then at least be very careful about who you hire to manage the property. Your real-estate agent might be your best choice, as they have a financial interest in the property and they’ve got a lot of contacts to help you find renters.
Now it’s time to determine the value of a given property. During your research, the sellers and real-estate agents have most likely shared with you simplified financial statements for various properties. This information should be interpreted with a healthy bit of skepticism, as it’s not uncommon for sellers to pad the rents and underreport operating costs. A good rule of thumb is to shave 10 percent off of the reported income and at 15 percent to the reported costs. Be sure to inspect the seller’s financial records with the help of professionals—now’s the time to utilize your accountant and your attorney. You don’t want any surprises, so ask to see all the receipts. If there isn’t a paper trail of every bit of income generated and every significant expense paid for, be wary. Sloppy accounting on the seller’s part is a red flag.
With this information, you’ll be able to make a reasonable calculation of a given property’s capitalization rate. The “cap rate” is the most important calculation a property investor makes—the most fundamental indicator of a property’s value. It is easily calculated with the following formula: Net Operating Income ÷ Purchase Price = Cap Rate. Buyers ideally want a higher cap rate, since it indicates a greater return on investment. But obviously other factors will affect the cap rate—similar buildings in more-desirable neighborhoods will have lower cap rates than buildings in more marginal, higher-risk parts of the same town. You’ll also want to factor in “sales comparables”, which will let you know what other similar properties sold for, as opposed to just what sellers ask. In most states, real-estate sales figures are public record. This information can help you adjust your bid accordingly.
Finally, you’ll want to bring in your contractor and join him on a thorough inspection of the property. If it’s an apartment building, you’ll want to inspect the interior of each individual apartment. The seller should help you arrange this. It’s a good opportunity not only to spot any significant issues with the building, but also to meet your future tenants and get a handle on how they treat their personal spaces within the building.
Assuming all of this goes well, it’s time to get your documents in order to submit to your lender. You’ll need a loan application form, a purchase contract, the building’s financial documents, and copies of your tenants’ leases. If you’re buying a larger building or launching a company which will acquire multiple properties, you’ll also want to submit your business plan. You can find business-plan templates online—one of the most popular for real-estate investing is MSN Real Estate by Palo Alto Software (www.bplans.com).
Assuming everything goes smoothly, it’s time to build a relationship with one more new business partner and friend—the IRS.
Chapter 5: Why the IRS is Your Friend
Since the very formation of the United States of America, our government has actively encouraged real-estate investment, speculation, and development. And while no investor looks forward to tax time, real-estate investors often find themselves at a great advantage when the IRS comes looking for their share. As a matter of fact, real-estate loopholes are deeply embedded in the tax laws. Here we will go over some of these loopholes to ensure that you keep the lion’s share of your real-estate investment profits.
One of the principal rules in real-estate investing is that no property should cost more than it makes. However, from a tax-paying perspective, this isn’t necessarily the case. When April 15th comes around, it’s actually in your favor if your finances appear to be a bit in the red. Why? Because the government will actually compensate you for your losses by cutting your taxes. For example, anyone who makes less than $100,000 a year can deduct as much as $25,000 of “passive activity losses” against regular non-real-estate income.
Here’s how it works: for tax purposes, “earned income” (income earned as wages or salary), is treated differently than “passive activity income” (money received from the tenants of your rental properties. Earned income is taxed from the first dollar you make, whereas passive activity income isn’t monitored or taxed until you declare the amount earned. Moreover, only after all of your operating expenses are covered will you have any taxable income—but even then, you’ve got more deductible expenses in the form of “depreciation”.
As it turns out, Congress has written the tax laws to allow landlords to depreciate the “improvements” made to the land (buildings, garages, driveways, etc.). Even though, technically, most land doesn’t depreciate in value, Congress wants to encourage property investment and create housing, so it maintains the fiction of depreciation to help incite individuals to operate rental properties. Subsidizing depreciation in this manner gives you, the property owner, the right to transfer a portion of the cost of your real-estate investment to other taxpayers! Additionally, you’re even allowed to use the depreciation write-off to cut your taxable income even if you’ve made money!
Not only is all of this legal, but the government actually requires real-estate investors to take depreciation. On the flip side, investors are required to give a quarter of the depreciation back when a property is sold in the form of a 25% “recapture” tax.
But there’s another loophole investors can take advantage of when selling a property. In a “1031 exchange”, an investor may trade up to a more valuable “like-kind” property without paying taxes on the original sale. The 1031 exchange arises from the notion that there is no profit to be taxed if an investor sells one investment and then buys another. There are some stipulations—the exchange must be executed through an IRS-approved third party—a “qualified intermediary”. Additionally, once the original sale closes, the seller has just 45 days to find the replacement “like-kind” income property of equal or greater value, and just six months to close that deal.
There’s one more loophole that bears mentioning—the $500,000 homeowers’ exclusion. Congress allows all married homeowners filing jointly to pocket up to that amount out of the sale of a primary residence tax-free. If you and your partner have lived in a home for two years out of the previous five, you qualify. And you can do it again and again, with every house you’ve lived in for at least two years. The tax savings are unbeatable.
It’s important to note that all of this tax advice should be reviewed with your attorneys and financial advisors in advance of filing with the IRS. All of these techniques legal, but it’s always best to have specialists dot your “i’s” and cross your “t’s” for you. Remember, as with anything, honesty is the best policy. Report all your income, report your expenses, and as long as you stay within the bounds of believability and reason, the IRS is going to take your word for it.
Chapter 6: Buy a House or Small Apartment Building First
The novice real-estate investor should look to a house or small apartment building as a first property. These types of properties tend to be cheaper and easier to manage than other types of property. And, of course, you’ll want the best building you can find/afford in the best neighborhood. But what defines the “best” neighborhood? Well, it all depends on the type of landlord you want to be.
To make that decision, you’ve got to consider your likely tenants. Perhaps you’d like to invest in a trendy neighborhood with urban charm? These areas are immensely popular with young, single folk who will be willing to pay a premium to live in a “hip” part of town. The downside to this kind of tenant is that they’re likely to move more often than your older, more stable tenants.
Consider the flipside—investing out in suburban neighborhoods with lots of smaller apartment buildings and single-family homes—more sprawl, quieter, and closer to the good schools. These tenants are likely to be your younger families—they’ll be more cost-conscious, but likelier to stay longer whenever they decide make their home in a given place. Both of these options are solid, but it’s all up to you who you’d like to cater to.
Another type of property investment—the most basic type—is your so-called “in-law” units. This term refers to an extra living space which sits on the same site as a single-family home. Sometimes these “in-law” units come attached, but other times they take the shape of guest houses or “servant’s quarters” on the property but unattached to the main home.
It’s important to check your local laws regarding rental of your in-law units, but it’s not unheard of for people to ignore the spirit of regulation by renting to “nieces”, “nephews”, or distant “cousins”. Regardless of whether or not you want to operate in this grey area and rent on the sly, the most important advice we can offer is to always adhere to tax laws. Declare your income on the rental, lest you find yourself answering difficult questions to the IRS down the line.
That being said, the rental of your in-law unit can be of great advantage to you financially. Additionally, you’ll be able to write off all of your costs on the in-law unit, in addition to the “deprecation” on the unit itself. You’re also unlikely to have to pay any income tax on the money the unit brings in, and it will likely pay for a large portion of your own mortgage principle.
Weekend or vacation homes can be yet another entry-point into real-estate investing,. As with renting out your in-law unit, vacation home rental is not away to “get rich quick”, but rather a fiscally sound method of cutting back on your own home costs while earning a reasonable profit via tax savings and/or moderate profit. The greatest advantage for second-home owners is the IRS’s tax break of up to two weeks of tax-free rental income annually. If your vacation home is in an area with strong seasonal attraction, you can maximize your rental income during these “burst” periods. If your property is in or near a college town, you may be able to rent it out during the school year to pay the entirety of the mortgage and use it during the summer slowdown.
Let’s talk investing in small, single-family homes. The best way to turn a profit is renting houses, but you don’t want to purchase a house with an 80 or 90 percent loan. A great way to purchase a rental home in s desirable neighborhood without taking on such an imprudent mortgage is to shop for foreclosure homes or those that have gone through some type of government seizure. This is a complicated area to navigate for novice investors, as the foreclosure market is swimming with more sophisticated players—but there are still steps to take to get a great deal.
You’ll want to look into the public records of the county in which you’d like to buy, and seek out the clerk’s “lis pendens” list for properties with litigation pending. By the time a home has litigation pending, both homeowner and the mortgage holder are likely looking for a buyer, and quick. At this point, the homeowner has already missed at least three months of payments and is likely in dire financial straits. This means that they probably aren’t spending much on home maintenance, and the house and landscaping are likely falling into disrepair. Meanwhile, the lender hasn’t received their payments and is still legally required to wait an additional three to six months before it will be allowed to take over the property. So the lender is facing a potential year of lost income, in addition to the substantial costs which will be incurred after purchasing the property back at public auction.
This is where you come in. Ideally, you’ll strike a deal with the homeowner to acquire the building for the cost of making good on the back rent with the lender and any other creditors with liens against the property. This is called a “subject-to” purchase, and it is subject to approval by the principal lender. Now, you don’t want to simply pay the owner’s debts and take over an existing 90-plus percent mortgage—you’ll want to let the property slip into foreclosure, then lowball the lender. A foreclosed home is a lender’s failure, and they’ll be eager to recoup some of their losses. Your goal in this situation is to get the property at 30-40 percent below value.
Aside from foreclosures, another way to buy property at a serious discount is to shop for derelict, abandoned, or otherwise undesirable properties in the best neighborhoods—then rehabbing them and selling them within a short period of time. This is colloquially known as “flipping” a property. You’ll look for properties you can buy for 20 to 40 percent below the price of comparable renovated properties. For “flipping” a house, you should be projecting about 2 years ahead when speculating the value of the property when you sell. Despite the illusion of the phrase “flipping”, construction and renovation take time, and you’ll want to ensure a nice return on your invested time and money.
With this manner of investing, you’ll want to be especially focuses on where you can cut expenses. Steps such as getting your real-estate license can help you cut the sales commission in half. You can also save a lot on construction costs if you can do some of the work yourself. Plenty of construction work can be done by just about anyone—from hanging drywall to tiling to stapling insulation battens. Lastly, you could potentially save big depending on how you own the place. If you purchase the home as your principal residence, not only will you get a better mortgage interest rate, but you’ll get a very large tax break upon sale. As we’ve discussed previously, you can take up to $500,000 of the profit from the sale tax-free as long as you’ve owned and lived in the home for at least two out of the previous five years. This sort of investment definitely requires a certain commitment, but can certainly pay handsomely if you put it the effort towards a high-quality renovation.
Chapter 7: Going Commercial – Large Apartment and Commercial Buildings
While many of the principles of investing in smaller residential properties are the same as with larger apartment buildings and commercial properties, the bigger investments come with much greater costs—and potential rewards. Entering into this territory is not for novices. This level of real-estate investment requires a professional management and expertise. For this reason, it’s almost always better to own investment properties through some sort of corporate or partnership structure. There are four types of ownership you’ll want to consider in large-scale real-estate investing: sole proprietorships or general partnerships, limited partnerships, corporations, and limited liability companies.
A sole proprietorship is a standard one-person business, while a general partnership is a typical structure where you and a friend or spouse go into business together. These types of ownership fall under the same category, and are mostly suitable on a small-time level.
A limited partnership separates the “limited” partners (usually the financial backers) from the “general” partner(s). In their role, the limited partners are insulated from any liability towards any ofvthe business’s debts. The general partner enjoys no such insulation, and is in fact the one responsible for filing all financial paperwork and shouldering the financial burden.
There are two types of corporations: S corporations and C corporations. S corporations are generally small businesses with limited shareholders, while C corporations are much larger and may have tens upon thousands of shareholders. S corporations are the preferred form of ownership for real-estate investors, as they are separate legal entities, but they pay no corporate income taxes.
Limited liability companies (LLCs) combine some of the best features of partnerships with corporations. LLC members are not liable for the LLC’s debts. LLC members also get to choose how they are taxed—like a partnership or like a C corporation.
The larger your company becomes, the more ownership situations you may find yourself in. It is not uncommon for a property to be owned by a partnership—or another entity—which is, itself, owned by another. That sort of ownership, however, is unnecessarily complex for novice investors, for whom LLCs are generally the best option.
When you go about acquiring your first larger or commercial property, you’ll see that many of the residential rules no longer apply. The financing, for example, will require a much larger down payment—usually at least 25 percent down on building acquisitions. The loan terms will likely be shorter, and interest rates will be higher. On the flipside, you’ll be more likely to find flexible lenders in local banks, as they have a vested interest in lending to local businesses, and they’re not beholden to the big residential mortgage backers Fannie Mae and Freddie Mac. Local banks can be quite welcoming to neighborhood investors—but be sure your business plan is impeccable.
Keeping your business plans in mind, keep in mind that in commercial investing, you’re also responsible for the businesses of your tenants. Your margins for error are much narrower—anything that goes on in the building that interferes with your tenants’ business will not be lightly tolerated. For this reason, the owners of most commercial properties utilize professional managers to oversee their buildings. As your own real-estate empire grows, you’ll likely find yourself in delegating to a management company and/or your own staff of managers and salespeople.
There are six different types of commercial investments: multifamily buildings and complexes, office buildings, retail properties, mixed-use properties, industrial properties, and land.
As mentioned before, property managers will become a necessity in commercial investments. Perhaps nowhere will they be of more service than in large residential properties. A residential building’s full-time supervisor—the “super—will save you time and money by focusing on the daily minutiae of life in the building. He or she will handle routine maintenance, handle the move-ins and move-outs of the tenants, and see to the preparation of vacant units for rental, in addition to a myriad of other duties. Supers in NYC are so essential that some command six-figure salaries!
If investing in office buildings, your interests are not that different than in large-scale residential housing. Your main concern here will be what type of office building you’d like to invest in. Office buildings come in three general types: “Class A”, “Class B”, and “Class C”. The buildings are classed by the condition of the property, the tenants, and the neighborhood.
Newer, state-of-the-art, landmark-style buildings that are home to large, well-known companies or other top-tier businesses are typically considered Class A. They’ll often have one high-profile tenant who’s paid for the property’s naming or signage rights, and generally command the highest rents.
Class B buildings are usually a bit older, and maybe not so cutting edge—but they’re still desirable to investors and tenants, as they’re usually located in or near desirable districts. They can also potentially be renovated and modernized into Class A properties.
Class C buildings offer low rents, high vacancy rates, and minimal bells and whistles. These properties are often renovated and converted to mixed-use. The returns on these investments can be incredible—but the process can be quite daunting.
Retail properties are generally beyond the financial means of novice investors, but a small retail center could be a feasible investment. Newcomers to these investments will want to concentrate on smaller strip malls or neighborhood centers. These investments can be quite lucrative if you can land a secure long-term tenant, such as a national food chain.
Mixed-use properties have been gaining popularity and transforming neighborhoods for the last couple of decades. They’ve consistently been integral to neighborhood revitalization, drawing in the always-desirable young, creative professional. Mixed-use properties show no sign of losing popularity, and they’re certainly within financial reach even for an inexperienced investor. Industrial properties are generally an unsound investment. You’ll likely be reliant on a single tenant, and manufacturing is a fickle business. It’s much better to have a mix of tenants in different industries. That way, you’re not left holding the bag if one goes belly-up.
Finally, we’ll look at land investments. There are two ways to make money in land investing: “banking” it, or developing it. Regardless of your preferred method, be sure that whatever land you buy is in the path of a community’s growth/expansion. Banking land is just what it sounds like. You purchase the land, and hold it until such a time that the value of the land has become valuable enough to sell at a nice profit. Land banking tends to work better in commercially zoned areas because it’s easier to make the land pay for itself while you wait for the value to increase. Common uses include parking lots or inexpensive buildings that produce a small income, but not as much as the full value of the property.
It’s harder to get a bank loan on raw land with no track record, and the real money is in development anyways. You’ll need development loans, which you can get—but you’ll be expected to have substantial interest in that land, and you may also have to put the land up as collateral.
It’s a different path to start on, but once you’re able to navigate the waters of commercial investing, you’ll see why it’s the preferred investment strategy of real-estate magnates. It’s a steadier business than residential investing, and this predictability can pay serious dividends in the long run.
Chapter 8: Do You Really Want to be a Landlord?
Before you sign on the final dotted line, you’ve got to ask yourself: “Do I really want to be a landlord?”. No one can answer this question other than you. You have to decide if you’re prepared to deal with the situations that will inevitably arise within your building once you take ownership. Sure, you may have hired one or more people to take care of certain issues for you—but if you’re not intimately familiar with your own buildings, you’re just waiting to be taken advantage of. On top of that, every job delegated means more money taken out of your own profit. Think about it. If you said “Yes! I’m ready to take on this responsibility!”, then great! There are many ways you can make your life as a landlord more manageable.
The first—and perhaps most obvious—is insurance. Fires, accidents, mudslides, burst pipes…calamities can happen anywhere, at anytime. Residential property owners have got to cover their investments. Insurance can be expected to cost you around 2.5% of your annual gross. You’ll want to carry different types of insurance—firstly, you’ll want “property and casualty insurance” to cover for general incidents. This insurance doesn’t cover the loss of tenants’ property, however, but you can require that your tenants have their own insurance as a stipulation of the lease. You’ll want additional, specialized property coverage to cover incidents not covered by the property and casualty insurance. Often, specialized coverage is specific to geographical hazards (i.e. earthquakes in California, tornadoes in Oklahoma, etc.).
Next, you’ll want to have liability coverage. This will serve as “umbrella” coverage, to compliment your general policy. Your liability policy should cover bodily injury, property damage, personal injury and damage from slander or false advertising. It’s not uncommon to carry liability coverage upwards of $1 million for a small property, due to the litigiousness of today’s society. It’s not a bad idea to bring an independent insurance agent and an independent adjuster into your network of real-estate professionals. You’ll need the agent anyways when closing on your property, and an independent adjuster (also known as a public adjuster) will work for you—not the insurance company. He or she will get a percentage of your settlement, but you’ll almost certainly get a better settlement when a public adjuster does your negotiating.
Once you’re properly insured, it’s time to choose your tenants! You’ll want to be very selective in your choosing, but you’ve also got to be aware of anti-discrimination and equal-opportunity laws. That being said, the law only prevents you from not renting to someone for the wrong reasons. You can rent to whomever you like. You’ll want your tenants to pass some strict criteria: the most important being their finances and rental history. You’ll want them to fill out a formal application giving you permission to conduct employment, bank, credit, background and reference checks. Depending on local custom, you may also be able to pay the costs of the background check (usually between $25-50). But don’t just rely on these services—you should also do some investigation. Call their references and employers to know the kind of person you’re considering as a tenant. If, in the end, your research results make you decide not to rent to this person, tell them in writing why the application—not the person, has been rejected. You don’t want to have to deal with a discrimination complaint down the road. Now you’ve chosen your tenant(s), you’ll need them to sign a lease. Leases don’t just set the terms between landlord and tenant—they create the value of the property itself! By documenting the building’s income with written leases, you’ll be able to provide future purchasers with the building’s future purchaser.
The lease should indicate who will be living in the unit, the length of the lease, the cost of rent and how it is to be paid, the details of the security deposit, the tenants responsibilities vs. your responsibilities as landlord, and the terms of lease renewal. Again, it’s good to have your attorney provide you with a building-specific, rock-solid lease that incorporates local law and customs. Once the lease is signed and your units are occupied, your responsibility is now to uphold your end of the lease agreement. This will mostly entail maintenance. You’ve made a legal agreement with your tenant(s) to provide a functioning living environment. There will be inevitable maintenance emergencies that must be seen to immediately, but outside of those (hopefully rare) occasions, you’ll save yourself a lot of headaches by having a schedule and dedicating hours during which your tenants can schedule routine maintenance on issues within their homes.
You’ll also want to perform semiannual preventative maintenance inspections on air conditioning, heating units, refrigerators, etc. This sort of maintenance will not only save you money and time on emergencies—but the tenants will see you as a thoughtful and caring landlord. Despite the fact that you’ve held up your end of the landlord-tenant agreement, unfortunately, inevitably, you’ll have a tenant who does not. Regardless of how much you like a tenant; you must remember that your relationship with them is strictly business. If they do not abide by their lease terms, they must leave. And there’s no favoritism allowed here—rules must be enforced across the board, or you could find yourself in court.
Unruly tenants have to go—but eviction is to be enacted only as a last recourse. Before you get to that level, you’ll want to escalate the dispute very slowly. Your first step will be to talk to the tenant one-on-one. This can be don first via telephone, but if the problem is not resolved, you’ll want to speak face-to-face. Should the dispute continue further, you’d want to put the dispute in writing—giving the tenant clear, concise instructions to avoid being kicked out. The next step should be mediation. Many communities even offer free landlord-tenant mediation services. Your two final options are to offer the tenant a monetary “incentive” to vacate, thus sparing you more time with a unit that’s not bringing you any money. Lastly, you can hire the local sheriff’s department to deliver legal documents pertaining to the dispute. If this show of force still doesn’t work, then unfortunately you’ll have to enact eviction services. An eviction could easily take four to six weeks, and determined disruptors could potentially stretch this period to months. Every day that you’re involved evicting a tenant is a day that you are not making money on that unit, and that’s the last thing you want.
Chapter 9: REITs – Real Estate Investment Trusts
It may be the case that, after some soul-searching, you decide that being a landlord isn’t right for you. This is an important realization to make, but it does not necessarily mean that you’re ineligible to participate in investing in the real-estate market. There is one other option—take your investment capital away from Main Street and invest it on Wall Street. Now, technically, buying shares of real-estate companies on sale in the stock market is stock investing, not real estate investing. Once you’ve made your investment in a stock, you’ll have relinquished your ability to materially affect your investment’s performance. The best you can do is to monitor it—buy more if/when you think you should, and sell when you’ve made—or lost—enough money.
The best option in buying real-estate shares is to invest in “real-estate investment trusts” (REITs). REITs are corporations that develop, acquire and operate properties. The largest and most widely known real-estate companies are known as “equity” REITs, and they generally specialize in specific types of buildings. REITs are generally valued based on a measure called “adjusted funds from operations” (AFFO), which calculates the REITs profit and modifies it with its properties’ maintenance costs. In an REIT’s valuation, the AFFO, rather than reported earnings, is the main benchmark, because the investors know that the depreciation charged against reported profits is a phantom expense. REITs are also distinguished in their tax status: the corporation is exempted from income taxes and required to pass along the bulk of its income directly to its stockholders. For these reasons, REITs are traditionally viewed as income-producing investmens (though REIT investors generally pay higher income tax rates on their dividends).
Finally, just as with any stock investment, diversification is crucial. With REITs, you’ll either want to invest in one company with a broad portfolio (a diversified REIT), or a mutual fund specializing in REITs and real-estate-related investments. Concentrate on companies that operate in more than one geographic region so that your investment isn’t exposed to the ups and downs of a singular region’s economy. Remember, it rarely hurts to spread your bets.
Written By: Robert Rodriguez | Compass CalBRE 01859103.
Source: Crook, David. The Wall Street Journal Complete Real Estate Investing Guidebook. New York: Three Rivers, 2006. Print.