Some of the gurus make it sound easy to buy apartment complexes. They say you look for a poorly run apartment building with insides in need of paint and carpeting, the metal railings unpainted and rusting, perhaps the grounds poorly kept and probably a high vacancy rate. Continue reading Apartment Investing
So if you are going to rehab a house, you need contractors. First you might want to read the segment on rehabbing.
Paint and Carpet
For a simple job, that people call paint and carpet, you would just go in and paint the house and either clean or replace the carpet and refinish any hardwood floors if they need it.
If you are going to get a carpet cleaning done, you should go for steam carpet cleaning. It is more effective. Otherwise, check around and get several prices for replacing the carpet.
Retail stores have ways of tracking what is selling. One is dollars / sq. foot. You look at the items in one area over a certain amount of time. Take the amount of sales in that time and divide by the square feet of floor space they take up. Then compare to other items in other parts of the store. This way you can get an idea of what is making you the most money.
Another tracking statistic is turnover rate which has more application to real estate investing. Let’s say you have two products and product A has a $1 profit and product B has a $2 profit. Which is better? It is not necessarily B.
What if you only sell one of B a week and you sell 100 of A a week. So on a weekly basis, Product B has a turnover rate of 1 and product A has a turnover rate of 100. A is far outperforming B even though you make less per sale.
Banking and Finance have similar concepts and since their “product” is money, it involves how often do they reuse or re-lend their money but that is a whole other discussion so we will leave it at that.
Turnover in Real Estate
Many people who start investing in real estate have some connection to it, such as being a plumber, a contractor, or an electrician for example. They figure they will save money by doing as much of the work themselves as possible.
That is fine if you are looking to just supplement an income, but isn’t good if you are trying to grow this into a business so you don’t have to work everyday.
An Example of Turnover
Let’s say that it normally takes you 4 months to rehab a house when you are trying to do a lot of the work yourself. (Sometimes these types of projects take a year or two instead of 4 months. Then you have to factor in carrying costs as well.)
Let’s also assume you usually make $30,000 profit on a rehab.
Now, if you were to hire other people to do the work, who weren’t doing it nights and weekends, but full time, they would get the work done a lot faster. We will assume the rehab will be done in a month and a half and the extra cost is $10,000 so your profit is only $20,000.
Conclusion on Turnover and Leverage
So in one case you take 4 months which means you could do 3 rehabs in a year and you make $30,000 profit on each for a total of $120,000.
In the other case, it takes 1.5 months which means you can do 8 rehabs in a year and make a profit of $20,000 on each for a total of $160,000 in profit.
So by hiring other people and leveraging their services for time, you can make more money and grow faster if that is what you want.
The numbers will vary, but you get the concept. Be aware of time and do some calculations to see if it makes sense to do some tasks yourself and what you will hire others to do.
One question some people have is where should I look? Should I look in the wealthy areas, the middle class areas, the poor areas or the hood? To some extent any of them will work, they just take somewhat different strategies and temperaments.
Investing in Really Bad Areas
If you want to invest in the hood, the really bad areas, are you comfortable going to those areas? What about at night? Yes, you can get properties for very little money, but it might be a bit more difficult to get financing than in somewhat better areas.
In addition, how much of a hard ass are you about being a landlord. If you are a soft touch, you are going to get abused financially as a landlord, especially in these areas. If you aren’t really tough and experienced as a landlord, or have someone who can do property management for you, avoid these areas.
There will be little appreciation in value, in fact, possibly depreciation depending on what is happening in the area. Also, if you want to sell, you will probably only be able to sell to another landlord who is also going to be looking for a deal.
Investing in Expensive Areas
If you want to go for the really expensive areas, you will probably be looking for foreclosures. You would then do any repairs necessary and sell it. This is called flipping or wholesaling. Flipping is legal, but got a bad name because a lot of people committed fraud while doing it. Fraud is obviously not legal. It would be tough to buy a place in this price range and rent it out and make it cash flow. Also, if you make a mistake or miscalculation it is going to cost you a lot more money on one of these properties.
Most investors go for the last two categories. If you are new to investing, this is where you should be looking.
Investing in Middle Class Homes
Middle Class “cookie cutter” homes is an area many people like. These are good for either fixing up and selling or for renting. Both depend on getting the right price as with any real estate transaction.
John Schaub, a very wise investor and a nationwide speaker on real estate only invested in these types of areas. He looked for properties he could rent. He figured the tenants would pay off the mortgage and then he had a great long term income stream.
In these areas you have a greater chance of appreciation than in poorer areas and they will weather any market downturns better than poorer areas. The other thing is that if you are looking to sell, you have a much larger pool of buyers. For expensive homes, the pool of buyers is small and for poor neighborhoods and especially the hood you also have few buyers except for landlords who are also looking for a deal.
Investing in Poor Areas
So the downsides of the poor areas were kind of covered above. They are likely to have less appreciation and there are fewer homeowners to buy the property. It can be a good area to build up rentals for income but the people tend to be harder on houses and do more damage than in more middle class areas. You will also probably be a bit more challenged landlording in these areas. However, the prices are cheaper so you can potentially get more property.
If you are savvy and know what the trends are, you can do very well by investing in a poor area that is being gentrified and moving to middle class. That way you get the best of both.
Hope that helps.
Fear! It can be incredibly difficult to make your first real estate investment. You don’t want to screw up and lose a lot of money. One key to this is finding a good contractor or contractors.
For your first time unless you have knowledge of building you will probably want to hire a general contractor who then hires and oversees all the subcontractors. Sometimes it is more expensive this way and other times good general contractors can actually save you money. But to start, use them and then get to know some plumbers and electricians and maybe to some of the subcontracting yourself.
How to Estimate Repairs Before Making an Offer
To put in a bid, you need to have a general idea how much a renovation will cost. You also need to make repairs that are appropriate for the neighborhood. You can put top of the line everything into a house in a blue collar neighborhood and lose your shirt and never get the value back out. Or you can put really cheap appliances and fixtures in a nicer neighborhood and have no one want to buy the house.
One way you can find contractors is to look up REIA on line. It stands for Real Estate Investment Association. Most cities have one. Go to their meetings and ask around for suggestions for good contractors.
Contractor as Consultant
When you find a house you think is a good buy, ask 2 contractors to meet you there (not at the same time) and go through the house with you. Tell them you will pay them for their time. It might be $100 to $200. But consider it paying for education. Your cost could be much much higher if you estimate wrong and buy at the wrong price.
Have them go through and tell you what they think should be done to fix up the house and what it will cost. You want prices for different things, not just a total price. You also need a list of what will be done. Most likely they will make different suggestions so you won’t really be able to compare their two proposals in a direct comparison. But you will get a good idea of the ball park number for repairs. You can then make your offer.
If the contract is accepted, you might then bring in a third contractor to give his ideas and a price. What you then want to do is figure out what features you like that all three have given you. Combine them into a list of features / repairs that you want and ask them for a price on this list. They shouldn’t have a problem doing this because it probably isn’t that different from what they gave you to start with.
Then choose one and sign an agreement with him to do the work. You do not have to pay this one for his time. The other two you should pay for their time since they are busy and could have been doing something else and have taken the time to educate you some. As you gain more experience you can still get 2 or 3 quotes but you won’t have to pay for their time usually because you have more experience and can tell them more specifically what you are looking for.
What is a 1031 Exchange? It is called that because that is the section of the tax code that defines what they are and how they need to be done. They are also called like kind exchanges or Starker exchanges. They are primarily used in real estate but can be used for other types of property as well.
Tax Free Swaps or Exchanges
So what is it? It is a swap of one investment asset or one business for another. Normally when you sell one and buy another there is capital gains tax to pay. If you follow the 1031 rules you will have little or no capital gains tax to pay when you exchange one property or business for another. Forbes has a nice little article on them.
This allows you to continue to grow the asset or business tax deferred. That is a huge bonus because you can leverage that money you didn’t have to pay in capital gains taxes into even more growth. Plus, you can do it as many times as you want. There is no limit on the number or frequency. (Always check with your lawyer and accountant to make sure nothing has changed.)
You don’t pay tax until you finally sell without doing a 1031 exchange. Using this method almost guarantees that you will pay only long term capital gains and not short term which is generally a much lower tax rate.
The rules are very specific for 1031 exchanges. Don’t try to do this on your own. Definitely use an attorney who has done a number of these so you don’t mess up and find you owe a lot of taxes.
Key Features to Be Aware Of:
– For business and investments only, no personal assets like your home
– You can’t exchange partnership interests or corporate stock. You can exchange paintings.
– It must be a like kind exchange. However like kind is fairly loosely defined but there are little twists that you need to be careful of.
– Delayed exchanges – You can’t always find something to buy of like kind immediately. If you have a middle man hold the money and then buy the new asset for you, it can still qualify despite not being a direct transaction.
– Designate the replacement – You must specify what you will buy within 45 days of selling your asset or business. Many people create a list of possible properties so they have options in case one falls through. If you take any money from the sale before the purchase is made it negates the 1031 exchange.
– There are rules about listing multiple properties. The IRS says 3 as long as you close on 1. But you can list a number as long as the value of all of them is not more than twice the value of the property being sold.
– You need to close on the new property within 6 months of selling the old one.
– Some tax if what you buy is less than what you sell. You are taxed on the difference in the two prices.
– Decreased debt will be taxed. If your mortgage on the new property is less than the mortgage on the old property, then that is considered a gain and the difference will be taxed even though you received no cash.
– No tax ever! How? Die! If you have done 1031 exchanges and have lots of capital gains and have never sold the property, when you die, you get a stepped up basis. The property is now valued at the value it had on the date you died and not the value you bought it for. So that effectively means no tax is ever paid.
These are most of the main points you need to worry about with a 1031 exchange. You can see why it is recommended that you use someone familiar with them to guide you through the process.
Hard Money Lenders
What are they? These are individuals or small companies who lend money to rehabbers to be able to do a rehab project on a house or building. They are not pay day lenders or pawn shops or anything like that.
They typically have their own investments in rental real estate and are knowledgeable about real estate. Obviously, they also need to have enough money to lend out to people. Considering that they lend from $20,000 to perhaps $200,000 or more on a single transaction, they need to have funds or access to funds.
I had thought that they did all the lending with their own money, but later in talking with some people found out that some of the hard money lenders had connections into insurance funds and money sources like that that would use some of their money on higher risk projects to try and increase the return on their overall portfolio.
What are the fees and rates?
The hard money lenders will charge you points and a high interest rate. A point means a percentage point of the loan. Typically the fee will be 4 to 5 percentage points, although if you are lucky, if you find the right lender, you might only have to pay two to three percent. So if the loan is for $50,000 and the fee is four percent, or $2,000 and you would only actually receive $48,000. Then the interest rate is typically in the twelve to eighteen per cent range.
Why are the rates and fees so high?
In some ways, its because they can be and because people are willing to pay. Why would someone pay this much when they could get lower rates at the bank?
1. Some people can’t get a bank loan so this is the only choice they have if they want to rehab a house.
2. Some people can qualify for a bank loan but don’t want to because of the time and effort involved and because of the other assets that the bank might want as collateral.
3. If done properly, and the rehab is done in a short amount of time and the property sold, it doesn’t really cost that much money.
You would never take out a hard money loan on a property you planned on renting. It would cost way too much and be very difficult to have a positive cash flow. This is when a bank loan or low cost private money should be used. But, if you are fixing up a house and turning around and selling it, you won’t be paying the high interest rates for very long.
Because of their experience looking at a lot of deals, hard money lenders can also help keep you from making a mistake in a purchase. If they don’t want to lend, chances are you need to take a second and harder look at the deal.
Typically, they will not give you all the money at once. They will split it into tranches (pieces) and give more to you once you have completed what you are supposed to. They will require you to give them a plan of what repairs your are going to make, in what order, and how much they will cost. They will also want to know what you are planning on paying for the property and what you expect to sell it for once it is fixed up.
If the lender doesn’t agree with these numbers, he may just say no. Or, he might tell you where he thinks you are wrong and how to change the numbers to ones he feels is more reasonable and that he will lend on.
How to Find a Hard Money Lender
Good hard money lenders can help you out and help educate you. Most have no interest in foreclosing and taking over the property. They just want to lend money and don’t want the hassles of foreclosure. However, there are others who look at it as a way to buy properties cheaply. There are many real estate clubs around the country. Search online for REIA which stands for real estate investment association. There is probably one near you. If you go to a meeting, you can ask around and get suggestions on good hard money lenders and ones to watch out for.
We discussed using rentals as a way of getting out of a changing market when you find yourself upside down. Much more pleasant is renting because that is your strategy. You want to build up a portfolio of properties so that you can retire on the income from the rents. Even better is if you have enough that you can hire a property manager so you don’t have to worry about the issues.
Renting has several benefits that investors know about but most people don’t think of. You only want to invest if you can get a positive cash flow each month. So the first benefit is positive cash flow. Another benefit occurs because of that. It means that your renters are paying your mortgage and insurance and taxes for you. Even better, rents typically go up over time but the monthly mortgage payment does not (unless you have a variable rate mortgage, then it might). That means your cash flow will increase with time. And when the renters have paid off the mortgage for you and the house if free and clear, the cash flow will really jump.
And finally, there is capital gains. Typically real estate increases in value over time (assuming it is maintained properly). Yes, sometimes it dips in value like it did in the 2007-8 time frame. But over the longer term, it has always steadily increased. That means that besides the cash flow, you will be getting an increase in the value of you asset, i.e. capital gains.
What is most impressive is the leverage. Typically you put 10-20% down on a house. Let’s use $100,000 as the value of the house because it makes the calculations easy. You put down $10,000 and get a mortgage for the rest. If you assume an increase in value of 3% a year, it won’t take that long for the value to go up 10%. Not bad, right?
Wrong, it is phenomenal. Why? Because you put in $10,000 and the value of the house has gone up 10% or $10,000 which is a 100 percent return on your money and that is not including the cash flow and the tax write-offs from depreciation etc.
Compare this with investing in stocks. If it goes up 10%, you money has increased 10%. If you invest in speculative stocks that can go up 10 times or more, the key word is speculative. You might also lose your money. You can also lose money in real estate, but you still have the underlying value of the property. So you have a leveraged upside but not a leveraged downside. Pretty nice.
There are several situations where you might want to rent. Hopefully you will never need to use one of them.
We will get the bad one out of the way first, but it can be a lifesaver if you need it. In 2007 and 2008 when the market turned down fairly quickly it caught a lot of people flat footed. Rehabbers who had bought places to fix up and sell found that by the time they had finished the rehab, the value of the house was close to the mortgages on it or even less than the mortgages. If they wanted to sell it, they were going to have to come up with money out of their own pocket. In other words, they were going to lose money on the project.
So, one solution to this is to take the hit and move on before the value decreases further. The other is to wait it out by renting it. The one problem is that by the time the market comes back, renters will have done enough wear and tear that you will need to do at least a minor rehab again.
One thing you need to figure out is what are the rents in the area and will you be in a positive cash flow situation. If you borrowed from a hard money lender at a high interest rate, this might not be a good option. You will be losing money each month. And the problem there is that if the value of the house has gone down because of the market going down you won’t be able to refinance it with a bank at a reasonable rate to make it cash flow. You are kind of stuck.
Depending on where the property is located, you may want to investigate Section 8 which will be discussed in more detail in another entry.