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.
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.
Have you ever rehabbed a house before? It can be a way to make a lot of money because you are increasing the value of the house and should get a premium for this. But beware about your choice of what to buy depending on what you have done before.
If you are a contractor, electrician or something like that and work on houses anyway you are in pretty good shape. You should be able to estimate how much the job should cost fairly accurately. Your problem is going to be you want to do it all yourself. Remember that time is money. It is quite likely that you will make more money buy having some of the work done by other people you know in the business which will allow you to fix it up faster and sell it faster and get on to the next one.
If you aren’t a contractor but fairly intelligent, you can learn what you need to know. For the first one you do, find a house that needs minor repairs. You don’t want to learn on a really complex one. Work up to it. You will be glad you did. Otherwise you could completely misjudge, take a bath on the first one and never want anything to do with real estate again.
Also, do you want to have the house inspected? If you don’t know what to look for, that might be a good idea, but if someone else puts in a contract without an inspection clause, you probably won’t get it. You also won’t know how to bid because you won’t know how much repairs are going to be.
How to get around this problem?
Have several contractors come in and bid the job before putting in the offer. You will be amazed because the prices will be quite different most likely. There will be a learning curve and a cost associated with it. Offer to pay the contractors for their time to come in and give you advice as well as a quote.
Get 3 of them and walk through with them and have them tell you what they think the property needs. This will vary as well. Take notes as you walk through. You will learn a lot, especially comparing what the 3 of them say. Based on what they say, figure out what you want done and then tell them what you want them to give a price for. Otherwise, each of their quotes will be for doing different work and you won’t be able to compare them.
Use that to figure out how to put in a bid on the house.
What is Subject To?
It means buying subject to the existing mortgage. You write a contract with the owner but the original agreement between the bank and the seller stay in place.
The terms can be whatever are agreed to. For example, you agree to pay the mortgage for 2 years and then pay off the mortgage. In this case, the price is the amount of the mortgage. Or you could agree to pay the mortgage but when you pay off the loan by refinancing or selling, you have agreed to pay another amount besides just the mortgage.
The amount of sale could possibly be below the amount still due on the mortgage and the seller would have to come up with the difference.
Who owns what?
So once the transaction is done, the buyer owns the deed and has control of the house. The mortgage is still in the seller’s name. The buyer has not assumed the mortgage and has no obligations there unless something has been written into the purchase contract. But the mortgage company has no rights over the buyer. If payments are stopped, the only person who will be hurt is the seller. But it is completely unethical to go into a transaction expecting to never pay the mortgage and screwing the seller. This will quickly destroy your reputation. Don’t even think about it.
Due on Sale Clause?
Basically all mortgages have a due on sale clause which says that if ownership changes or other factors change, the bank has the right to call the full amount of the mortgage due. BUT, It is at the bank’s choice. It doesn’t have to call the loan due and if the loan is current and being paid on time, it is unlikely to. Why?
When interest rates on existing mortgages were 6-8% and the going rate for new mortgages was 12-14%, it made sense for the banks to exercise the due on sale clause because they could make more money with a new loan.
And now? Say the existing loan is 6-8% and rates are in the 3-4% range. Why would a bank call a loan that is being paid? In addition, if they have to go through the foreclosure process, they have significant expenses and probably aren’t getting paid anymore.
In addition, because of regulations banks need to keep a certain amount of assets as cash or liquid assets that are easily sold. But they are also able to lend out multiple times their assets. If the reserve requirement is 10%, they can lend out 10 times their assets. So, if they foreclose on a $200,000 loan, that is considered a bad asset and that is $2 million less that they can not loan out and make money on.
Why sell subject to?
People are frequently willing to sell subject to when they need to sell quickly or have a financial problem and are worried about their credit being hurt. There may also be no equity in the property and they want to sell but can’t afford to pay the costs. They may be moving or getting married or divorced or buying another house and need to sell this one quickly.
Frequently the main worry is that the mortgage will be paid. You can explain that you have incentive to pay or you will lose any equity in the house. You can also set up payment through a third party. That way they will know it is getting done and you definitely don’t want to pay them and hope they pay the mortgage. You could set up a joint bank account with autopay to the lender as a solution too. Other than autopay you would want any withdrawals to need both signatures.
Why buy subject to?
It is a no money down way to buy property unless you have to catch up some back payments. You don’t need to qualify for a mortgage and don’t need to come up with a down payment. It is great for investors, people with damaged credit and can’t get a loan but who have cash flow, or young people trying to get into their first house.
How to Make Money?
If the rents in the area are $1200 a month and the mortgage is $1000 a month, you will be making $200 a month. (Put the money aside and don’t spend it in case you need it for repairs.)
What if the rents in the area are $1000 instead? You would have no interest in the deal because you don’t want to just break even, you want a minimum of $200 per month cash flow to be worth it. Some sellers will pay you the $200 per month just to keep their credit from being trashed. It is far better than paying the mortgage of $1000 per month.
If rents are below the mortgage amount it is still possible the seller will pay the difference and your $200/month postive cash flow.
Another way to make money is to spend the money you might have paid on a downpayment in fixing up the property. Then sell the property and make your money that way.
A book that goes into all of this is by Wendy Patton.
The above is informational only and not legal advice. Each state has different laws and frequently there are differences between counties, cities and towns. You need to check with your lawyer and other appropriate professionals.