So, you want to join the ranks of the landed gentry?

That’s great! Real estate can be one of the most rewarding investments that you can make. You’ll often hear people spewing forth stories of returns in the hundreds and sometimes thousands of percent! With returns like that why doesn’t everyone invest in real estate? Good question.

There are many types of real estate investments, but the most accessible to folks just starting out is a “buy, hold/rent, and sell” type of investment. To explain why everyone is not rushing out and investing in real estate, here are some of the realities:

1. Starting to invest in real estate takes time

Real estate mechanics(what it takes to buy, hold, and sell a property) are much more involved than the mechanics of other investments like stocks and bonds. To be successful, you should really spend a lot of time learning. Modern Real Estate Practice is a nice, thick 300 page book that real estate professionals read before taking their licensing exams. I recommend that every real estate investor read it. It will save you money.

2. Real estate is a very local business

Successful investment in real estate takes local market research. Just as you should research a company before buying its stock, you should research a locality at all levels(state, city, county, sub-division, street, house) before buying real property.

3. It’s hard to make serious money without serious leverage

The power of real estate is in leverage. Leverage in real estate is just like trading stocks on margin. You get a loan and you secure it with a mortgage on the property you are buying. This loan increases the risk of your investment because you have to make monthly loan payments. At the same time the loan dramatically increases the return or loss of your investment because you have a lot less cash in the deal and therefore appreciation or depreciation have a more dramatic effect on your ROI. Understand mortgages and the mortgage system, and you will be way ahead of many other investors.

4. Real estate can be very illiquid

Real estate has real transaction costs. Where you can spend about $20.00 to buy and sell a stock. You will typically spend 3% of the loan amount to buy a residential property and up to 6% to sell one. In normal markets where real estate is not appreciating at 20% per year, it takes time to earn back these transaction costs. A rule of thumb is 3-5 years.

5. Real estate can be real time consuming

Unlike a stock, where you buy it and read about the company in the news while sipping your morning coffee, successful real estate investment takes time. The time spent doing relatively mundane tasks like finding tenants, fixing leaks, paying bills, etc., adds up. Don’t get into real estate investing without planning to spend that time.

6. Your are in control

When you invest in a stock, you are betting that the company, and sometimes more importantly, the company’s CEO and management team, is working to grow your investment. When you invest in real estate, you are hiring yourself as CEO. The responsibility is yours to make sure things like keeping a property occupied gets done. This control is what allows you to be better than all those other investors and is one reason why high returns are possible.

To sum things up, real estate is a great investment with significant
potential for high returns, it’s a great way to build wealth without
having any to start with, and it’s a a pain in the ass compared to stocks.

Real estate is a great investment for some and a horrible investment for others. If you think it might be for you, or if you don’t know which category you fall into, continue down the rabbit hole and follow your gut. Perhaps even cut your teeth on a small project or team up with friends so you all can learn without too much risk.

Lots of theory, little action. Here are some things you can do now to get started:

• Go to a local real estate website or Realtor.com and do some quick searches to determine the price range of the type of property you’d like to buy. Don’t obsess about small details, just get a feel for the different types of properties out there(2 vs. 3 bedroom), sqft, etc. From this, pick something interesting. You probably aren’t going to buy what you pick, but it will give you something real to talk about when you are speaking with vendors.
• Call a friend and schedule a date and time to drive around areas that you think might be interesting. Note down the addresses of properties that look interesting.

One way to quickly evaluate a rental property investment is is to calculate the percentage down needed in order to make the property’s monthly mortgage service(including taxes, insurance, and PMI if any) equal to the monthly rental income. The higher the percentage down required, the less interesting the property is as an investment.

The hardest part about this back of the envelope calculation is acquiring the rental market knowledge necessary to accurately estimate the probable rental income for a property. To find this information, check out craigslist.org, grab local papers, or contact local brokers to ask them about similar units that they may have on the market.

Most Americans treat the house that they live in as a monetary investment, perhaps even the largest investment of their life. This is bad, because one’s house is generally a horrible monetary investment.

Take for example, a single family house that is purchased for $100,000 with 5% down. Let’s assume the following:

• 95% of the purchase is financed at 6%
• long term housing appreciation averages out to 3% a year
• no primary mortgage insurance is being paid

At the end of 30 years, the house would be worth approximately $242,000. Seems pretty good, until you look at some other expenses associated with the property:

• mortgage interest payments: $110,000
• taxes: $47,500
• homeowner’s insurance: $7,500
• 5% sales fee: $12,000

Total expenses come to a whopping $177,000. We’ll add the $100,000 they paid in principal, and now the house worth $242,000 cost a total of $277,000 not counting tax advantages. Adjust for tax advantages at a 25% income tax rate, the total cost is still $237,000. Throw in a new roof, a couple of paint jobs, and a few remodelling projects, and it’s fairly clear that even if our example doesn’t include all the details that no money has been made on the house.

Seems depressing doesn’t it? If you think of the house that you live in as an investment, then yes, it is. Here’s the good news though – instead of thinking of your house as an investment, think of it as a savings account. After 30 years, you would have saved a whopping $230,000. Compare this with the $0 you would have if you rented the entire time, and all of a sudden, things don’t look so bleak.

Now, think of that rental property you own and ask yourself why it is an investment. You’ll quickly come to the conclusion that it’s an investment because your tenants are paying for most of your costs(including the principal payments on your loan). By paying down your loan, they are effectively putting cash into a savings account for you, and at the same time, this “savings account” is growing in value at 3% of the total value of the house per year, which for the first few years of owning a property that is leveraged 95%, translates into a 60% return on investment each year. Not too shabby.

Keep in mind that these analyses are monetary only. They do not take into account emotional and other personal benefits derived from owning a house, nor do they address the fact that you have to live somewhere!

As I’ve mentioned in earlier posts, owning and managing property is more like running a business than owning a stock. Here’s a quick rundown of how I might categorize the major competencies necessary in a successful real estate investment business:

• marketing
• accounting
• tenant management
• information management
• asset management

Most landlords start out somewhat proficient in one of these areas, and less so in the others. When owning one or two properties, this lack of proficiency can be pushed through with some common sense, preparation, and entrepreneurial courage. With a bit of luck the new landlord can learn things the hard way without making any mistakes that kill her business.

However, once a landlord owns more than two small buildings, infrastructure, proficiency, and discipline start becoming necessities. The landlord must begin keeping track of significant amounts of information related to rent payments, mortgages, taxes, insurance, repairs, etc. Without the proper support systems in place, the landlord will begin making mistakes that significantly affect not only their profitability and return on investment, but also her ability have a stable portfolio.

For example, assume a landlord owns a single unit that rents for $1000/month and that this amount covers her mortgage payment plus standard costs. An 8%(1 month) vacancy rate translates to lost revenues of $1000/year. Assume that this landlord makes $50,000/year in her profession. $1000 is 2% of her earned income. Now fast forward and assume that same landlord now has five units, but still has that same 8% vacancy rate. These vacancies are now costing that landlord $5000/year – 10% of her earned income. All of a sudden, the same performance goes from impacting the landlord’s cashflow slightly to significantly impacting her cashflow.

This is a simplistic example of how part-time real estate investors must continually improve their operational skills and infrastructure in order to effectively grow their portfolio. There are numerous other areas where inefficiencies are negligible in the beginning, but begin to be significant as a landlord’s portfolio grows. In the future, I’ll explore each of the competencies in more detail.

The bane of the real estate investor is empty units. Even a relatively low vacancy rate can change a great investment into a mediocre one. In trying to keep units rented, landlords who manage their properties themselves make several common mistakes. They:

• start too late
• advertise in the wrong place
• respond too slowly

As a landlord, start marketing vacancies before they happen. If your state allows sixty day notice to renew a lease, make sure you have a renewed lease in hand at the sixty day mark. If not, start marketing your property. With the advent of free services like craigslist and iiProperty(shameless plug for my new company’s service) landlords no longer need to spend a lot of money on advertising, so there is no risk in advertising early, even if you’re not sure about existing tenants staying. (I don’t think there is a legal issue here, but check state law on this one)

When you do start advertising, advertise in the right place. If you’ve got a high-end apartment for rent, make sure your advertising channel reaches people who can afford a higher rent. Throwing an advertisement in the classifieds might not be your best choice – for example, high-end rentals typically are rented through local, high-end real estate brokers. Ask advertisers that charge about the economic demographics of their viewers/readership.

When you start advertising, make sure you’re ready to go. Tell your tenants that the apartment is being advertised and that you may need to be showing the apartment with 12 or 24 hour notice(again, check state law here). Politely ask them to keep their apartment relatively clean during this time. And make sure you respond quickly to potential tenants. If you don’t, the landlord down the street might get a tenant that would have preferred your apartment, simply because the tenant wanted to make a decision quickly.

Start early, advertise appropriately, and respond quickly. If you do these three things consistently, you will lower your chances of being in a situation where you are trying to decide about having a unit vacant or taking a less-than-perfect tenant.

If you are thinking of investing in real estate, there are a few things to consider.

First, there are many types of real estate investment, and investors typically specialize in a few, so develop some breadth of understanding before diving into the market. Second, understand that some of these investments are much more hands off than others. Third, for the RE investments that are hands on, it is important to view these investments as businesses.

There are many mini-articles describing the most common types of investment accessible to beginning investors. These descriptions are useful, but also useful is an understanding of the base factors that define the different investment types. These factors are: the type of property purchased, what is done to the property, and the end vehicle used to pass control to another investor.

There are many types of property to buy: simple control (lease option, long-term lease), managed equity (shares in a REIT), barren land (no assets on land), land and assets (trees, minerals), small residential (single family through three family), medium residential (four unit through twenty unit), larger residential (20+ residential units), small commercial, medium commercial, large commercial, and industrial.

Once you have a property, you choose one or more of the following actions to perform to create value: hold, protect, clean, maintain, repair, upgrade, build, lease, harvest assets, repackage(condo, reparcel). Each of these actions take varying levels of experience, knowledge, and time. Not all properties lend themselves well to all of the actions. Matching the type of property to the action is the one of the skills of a great real estate investor.

Eventually, in exchange for liquid capital, a saavy investor passes control of the property into the hands of another investor. The new investor is ideally one with different specialties who can realize more profit from the property because of market conditions. Control can pass in a variety of ways and is dependent on the standards of the area. Selling and long term leasing of property are typical options. Repackaging property into an equity vehicle and selling the equity is another way of freeing capital for further investment and diversifying risk.

An investor’s choices in the three base factors, their implementation, and market factors all define an investment’s return and determine the risk/reward ratio and time commitment required. Real estate investing can be extremely rewarding, especially for the prepared. Start small, but develop a breadth of knowledge that will provide you with the ability to recognize opportunities that others can not.