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Cliff Hockley, CPM
President, Bluestone & Hockley Real Estate Services
If you believe what it says, late night TV is full of great ways to invest in real estate. Most investors are looking at the big payback with no money down. That is like going to the store to buy a watermelon and offering to pay for it with a paperclip (a highly unlikely feat which my daughter successfully managed to do this summer at camp).
It takes forethought and preparation to be successful in real estate. You also need to realize that buying real estate is a little like investing in the stock market. If you don’t know what you are doing, you can make a costly mistake.
Choosing Your Investment
Beginning investors should start with small projects, just like Walter from Hawaii. He has been involved in real estate for over 12 years. He has invested in various two- to seven-unit properties. Properties, both commercial and residential, in good locations have made money for him. The properties he purchased in marginal locations, with high leverage down payments, or with marginal tenants have not worked out for him.
Walter started with a duplex, which he later refinanced to buy a four-plex. Then he painted and put a new roof on the four-plex, then sold it for a seven-plex. He also bought a four-plex with one-bedroom units on the edge of a good area. He renovated the units and installed new siding, but in the end, he was lucky to receive a return on his investment. His challenge was that he lived far away from his investments in Oregon and could not pay enough attention to the renovation. The moral of the story is that fixer-upper investments work best if you live in town and do the work your self. Other factors hampered the success of the investment, such as the marginal location, a less than ideal tenant mix, and a market that was more suited to two-bedroom units rather than one-bedroom units. Walter learned more with each investment. He also learned to be conservative.
Whether you looking to purchase a house, duplex, 50-unit apartments, or commercial property, you need to have a good handle on the income and expenses as well as the location and tenant mix. Are the rents you use in your projections realistic? Are the expenses correct? Is the interest rate on the money you are borrowing one you can live with? What happens when you have a vacancy? Is there enough cash flow to cover it? Are you putting any money aside in a reserve account? How much money do you have to spend on repairs? Some investors believe that they should never repair a property. Unit inspections in occupied units will uncover problems that can be solved while the tenants are still living there and while there is cash flow, rather than waiting for a vacancy.
The West Coast and the Sun Belt are currently better bets than investing on the East Coast. Larger cities are safer investments than very small towns. Cities located on freeways also tend to be safer for investments. Vacation destinations or towns that are economically diversified will be more stable as well. For example, if your town is a one-mill town, you have more risk and your appreciation growth is not as strong as a city that has a high-tech base or is a vibrant port city.
Another client had 13 houses in the 1980’s and lost them all. So he went back to being a painter and started all over again one house at a time. His goal is to have 20 houses to retire on. He adds bedrooms, renovates, upgrades, and paints them, and then he either sells them so he can buy two more or holds them. Remember that the economy, interest rates, layoffs, job opportunities, and construction trends have an impact on every investor. Watch the trends; log on to appraiser websites to understand how many units are in the marketplace.
Planning an Exit Strategy
An investor always needs to have an exit strategy, preferably more than one, when he or she buys an investment. You need to have a vision of when you will sell it and if you will take the money and pay taxes or complete an IRS 1031 tax deferred exchange. Is your plan to have enough money for retirement? Are you going to pay off the property or refinance it and use the proceeds to buy another investment?
If you live in a depressed marketplace you need to decide if the weak economy will last a long time or if the area will pull out of it. This information is critical to your exit strategy. If you cannot find a buyer when you are ready to sell, what are you going to do? Structure your mortgage with out prepayment penalties, or make sure that your loan can be assumed. You also need to check what the loan assumption costs will be and if the terms of the financing change with the assumption. Remember banks structure loans to benefit their bottom line. Conduit financing can be very hard to assume or refinance. It pays to research many financing options before you make a final decision, and interest rates should not be your only focus.
These are not easy decisions, and they are not etched in stone, but they give you direction. For example, you invest with your best friend and her husband, but she gets divorced and needs the funds out of the investment to pay off her husband. What would you do? Another variable is your health or your family’s health, and you may have to liquidate the real estate to pay off some bills.
A prudent real estate investor will always be thinking about the next step before he or she purchases real estate. Your exit strategy will help you make a better decision as you invest into the future. Plan your goals ahead. No one is forcing you to buy. Pick your time, and pick a property you can live with into eternity. Worst case, if the market does not move the direction you expect and the value does not go up, at least your tenants are paying off the loan.
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