Finding The Property
Real estate investors should consider all possible
sources of properties available for sale.
Print Advertising
Newspaper classified and display advertising is used
both by real estate agents and by owners selling without agents. Although
newspaper advertising is the most widely known, there are other publications
that carry ads including magazines and newsletters, both general and specialized
business and real estate publications.
Signs
Although most larger properties that are available For Sale usually do
not have signs, single-family homes almost always do and even the smaller
residential properties (duplexes, 4-plexes) often do. You should
certainly check out any properties of the type you seek that do have
signs.
Real Estate Agents
When one is buying income properties larger than single-family
homes, the availability of many, perhaps most, properties is usually only known
to real estate agents. Also, a buyer does not usually save the commission
by not using a buyer's agent.
Web Sites
There are a number of sites that provide information
about real estate and sites that not only provide lots of information, but also
show many of the properties that are listed on the MLS.
Special Sources
Foreclosures
Some real estate investors concentrate on buying
real estate foreclosures from banks and government agencies. The up-side
is that you can sometimes buy below market value, although properties often sell
for higher than market value because buyers get carried away with the excitement
of auction. The down-side is that the property has often been abandoned and vacant
for a substantial period.
The days of stealing a really good repossessed
property for a song are, for the most part, long gone.
However, if "bargains" are your passion,
start by taking our Buying
Foreclosures e-course.
Lender Owned Properties
If, at foreclosure sale, there are no bids for more than the loan being
foreclosed, the lender ends up owning the property. Lender owned
housing is usually marketed through brokers having relationships with
the lenders.
Tax Sales
Property taxes are a lien against real estate. If taxes are not
paid for a time, varying by state, the county ends up owning the property. Anyone
can then buy the property for essentially the amount owed in back taxes. In
theory, one might be able to buy a property worth tens of thousands of
dollars for back taxes of only a few thousand dollars. There are,
however, potential pitfalls including the fact that most states provide
for a redemption period for tax sale properties, varying from a few months
to a year.
Bankruptcy Sales
Another source of properties that you might consider is bankruptcy sales. Properties
sold at bankruptcy auctions often go for under-market prices. However,
most bankruptcy auctions do not allow for contingencies, require a significant
deposit (usually 10 percent) upon successful bid, and require a short
escrow. One must complete all due diligence and have their financing
ready to go prior to the sale date.
Other Auctions
Properties are sometimes sold through the auction procedure even when
no foreclosure, tax, or bankruptcy is involved.
New Construction
Buying From a Builder
Buying a newly constructed property from a developer/builder
has both advantages and disadvantages.
Building It Yourself
An investor with the necessary knowledge and experience
can buy some land and build it himself. He can do this a variety of way,
from hiring a licensed general contractor to acting as general contractor himself.
Selecting A Property
There are many factors that prospective landlords
and investors must consider before selecting an income property for purchase.
Property Type
More than 50% of the housing in America is rental
property, and about 60% of that is single family housing, so there is always
a market for that kind of property. It also can have the highest appreciation
rate over the long term. Unfortunately, it will usually produce the lowest
cash on cash return in early years and management of a large number of single-family
homes is significantly less efficient than the same number of units in a single
complex.
Commercial
vs. Residential
There are numerous differences regarding the ownership
and management of commercial vs. residential income properties.Some of the important
differences are summarized below. Pros and cons are generalities and do not apply
to all properties or all the time.
Residential
The residential category of real estate includes a number of different
sub categories.
- Single-Family
- Duplex
- Townhouse
- Apartment
- Condo
When evaluating the functional utility of a dwelling
unit, pay special attention to it's use zones. The living area in a residential
unit consists of three major zones: living, sleeping, and work.
Commercial
Buying, managing, and selling commercial real estate is, in general,
somewhat different than residential.
Advantages
A generalized truth is that commercial real estate activity is less regulated
than residential.
Commercial properties are, in general, not covered
by fair housing law or lead paint regulations.
Leases for commercial properties are usually much
longer than for residential, often 3, 5 10, 15 years, or even longer. Accordingly,
there is less turnover of tenants.
Commercial property has little danger of future
rent control.
Disadvantages - How To Eliminate or Minimize Them
In spite of the above advantages of commercial rental property, there
are, as might be expected, also characteristics that represent potential
disadvantages. These potential disadvantages can be avoided or
at least significantly reduced with proper knowledge.
Economy
One potential disadvantage of commercial property is that it tends to
be more easily impacted by a bad economy, but there are ways to protect
against a bad economy.
Lease Documentation
Although the allowed terms and conditions of commercial leases are more
flexible than residential, and partly because of that, the lease documents
themselves are generally much more complex. It is not unusual
for a commercial lease to be 20 or many more pages of single-spaced
typing. Different categories of commercial properties require different
lease clauses and even for the same property specific tenants may require
customized leases due to the nature of those tenants' businesses.
Length of Leases
The fact that commercial leases are relatively
long was listed above as an advantage, but this same fact can sometimes become
a disadvantage. Since rent increases are usually defined for the term of
the lease, and sometimes even for subsequent renewal, means that the owner
may not be able to keep up with rapidly escalating market rents. Of course,
in a bad market, the automatic increases work to the owner's advantage.
In order to avoid the long-term lease being a
disadvantage, the owner must simply make sure the leases provide for periodic
increases that are reasonably certain to keep his rent up to expected future
market rents.
Tenant Improvements
Spaces in commercial properties are often remodeled
or completely rebuilt when new tenants take over. Because this can
be a costly project, the lease should be very clear regarding how the cost of
these improvements are allocated between lessor and lessee. The owner must
also protect himself against mechanics liens by a tenant's contractors by posting
Notices of Non-Responsibility.
Recourse
The tenant of a commercial property is often a corporation or other entity
having limited liability. If a failing corporate tenant defaults,
there will likely be no recourse in collection of rents or damages. This
problem is avoided by requiring that financially qualified person or
persons, whether principals of the entity or third parties, become
personal guarantors of the lease. Having guarantors is of benefit
not only during the period of ownership, but also when seeking financing
or selling the property as the values of the existing leases
are enhanced.
Purchasing, Financing, Selling
The purchase and sale of commercial property often requires more documentation
and more investigation than residential.
Commercial properties are also, in general, harder to finance or refinance,
in that larger down payments are required and interest rates are higher.
Special Concerns
Although the government has less interest in many aspects of commercial
properties, there are several areas where that does not hold.
First, environmental issues can be a concern. Past
use of chemicals on the premises of certain types of commercial properties, even
if occurring under ownerships many transfers back, can be a serious liability
for a new owner.
Second, commercial property can be impacted by
the Americans with Disability Act (ADA).
Accordingly, much more investigation is usually required for purchase
of a commercial property compared to residential. This is not a
reason to avoid commercial property, however. It simply means the
buyer and manager must exercise reasonable care.
Types of Commercial Properties
Each type or category of commercial property has its own specific peculiarities.
Retail: The retail category
includes any space leased to any business that sells anything (e.g., grocery
store, restaurant, bookstore).
Office: Tenants in this
category usually operate service businesses (e.g., real estate, insurance, accountants,
attorneys).
Industrial: Industrial space
is usually suitable for manufacturing use.
Warehouse: Warehouse property
is used for storage of items.
Storage Units: Although
storage units space is more often rented to non-business persons for personal
use, we consider it to be a commercial category because, since no one usually
lives on the premises except perhaps a manager, it is not residential.
Mixed Use: Mixed use covers any
property where spaces in the complex are not all one of the categories discussed
above.
Many Small vs. Few Large
There are numerous differences regarding the ownership
and management of many small properties vs. a few large properties (e.g., 10
single-family and 5 duplexes or one 20-unit building) that one should consider.
Although it is usually true that a few large properties are preferable
to many small properties, such is not always the case. For example, diversification
could be the primary consideration if one were concerned about the future
economic future of the area. More importantly, a beginning investor will
not usually be able to start with large properties.
Location,
Location, Location
Real estate professionals tell buyers and sellers that the three most
important things that determine real estate values are: location,
location and location. For example: an 1,800 square foot, three
bedroom ranch, on the waterfront, sells for substantially more than the
same home on the lower east side of any large city. You will also note
that a typical home in Santa Barbara, CA sells for two or three times
what it would in Cleveland or Detroit.
Always remember that property you consider for
investment should be located in places where people want to live. Communities
and their neighborhoods, normally go through four-stage cycles, progressing through
growth, maturity, decline and finally rehabilitation. Property values rise with
growth, stabilize, then typically fall during the decline stage. The most dramatic
price increases usually occur during the comeback rehabilitation phase. Real
estate investors should always make a careful study of the property's location
with these kind of inevitable cycles in mind.
Stay Local
If you live in Maine, don't buy income property in California. That
is, unless you are talking about a complex with hundreds of units that
will justify hiring a competent professional management team, including
a property manager, resident managers and maintenance personnel,
you will need to keep close watch over your rental units. And,
even if you use a typical property manager, you can't do that from across
the country or even across the state. The subject of management
is discussed further in a later lesson of this course and is covered
in even more detail on other "default.asp" pages and in the Managing
Income Property e-course.
Neighborhood
Prospective buyers should complete a thorough
inspection of the neighborhood and its environs prior to purchasing rental property,
. They should also try to get a clear picture of the neighbors as well as the
surrounding a property.
When you invest in real property, whether your
personal residence or as a rental property, you are actually investing in a neighborhood.
It always pays to participate in neighborhood
improvement campaigns.
Government
There are several types of government controls
that affect the income and value of rental property. The very worst among them,
of course, is rent
control. Followed by environmental pitfalls, strict code enforcement, mandatory
inspections, and zoning and a myriad of other regulations and requirements that
seriously affect income property values. Another type of government control
that can actually increase the value of existing properties is growth restriction.
If a property is located in an area that has,
or is considering rent control, the price of the property must reflect the impact
rent control has on income and the economic feasibility of maintaining or improving
the property. Mandatory rental inspections are also potentially very expensive;
primarily because they are usually subjective.
Zoning is a major consideration in the purchase
of commercial properties, but affects the permitted uses of residential property
as well.
Timing
Although location is usually considered to be the most important
factor (in fact the first three factors) in determining real estate values,
many experienced investors feel that the three most important factors
likely to affect the value of an investment are: timing, opportunity,
and information (inside or otherwise). The
timing of a real estate purchase is just as important a consideration
as location and price. Real estate is a local investment; property values
depend heavily on the current state of the local market.
It is probably best to purchase property in a
market of rising values. Many investors always try to predict the bottom
of a poor market, and make purchases at that time; but often their predictions
are just a little off and property values continue to decline.
Age
Chronological age is the number of years since a structure was
built, but perhaps more important to an investor is the effective
age, the age that the improvements appear to be. Actual age
and effective age are similar when a structure is new, but change quickly
when it has been allowed to deteriorate. Some homes may be in
beautiful condition physically, but their decorating schemes and floor
plans become outdated because tastes change or because needs change.
The greater the effective age of a structure,
the more substantial will be the loss of value. Effective age can often be reduced
by routine maintenance and regular updating.
It should be noted, however, that an older structure
will never have an effective age of "new", regardless of updating. Certain
features always betray the fact that the structure is not new.
Condition
A property that is a good candidate for real estate
investors almost always looks to be in bad condition. That's OK, if it has the "right
things wrong with it." For example, needing paint, a
sagging porch, bare bones landscaping, ugly wallpaper, or being dirty and unkempt
are easily fixable. However, the "wrong things wrong" are
problems that cannot be cured except at relatively great expense such as tiny
bedrooms, lack of closets, steep narrow stairways, one bath, and, most importantly, bad
location.
Price
Many new investors make the mistake of buying
"bargain" property
for rental housing - because that is what the man on TV told them to do - without
understanding why tenants choose the location they want to live in, and the kind
of home they want to rent. To get good tenants you must own decent, safe and
affordable housing in areas where people want to live. Schools, transportation,
shopping, churches and jobs all affect the amount of rent a tenant will be willing
to pay to live in your property. And that determines the price you can pay for
a rental property.
There are legitimate reasons for a decent property
to sell well below market. For example: divorce, death, and taxes, can
motivate sellers to take a quick cash offer that they would never agree to under
normal conditions. But perhaps the most common reason a seller can't get a fair
price for their property is inadequate professional marketing or deferred
maintenance
If you are buying property for rental housing,
the purchase price can be relatively unimportant. What is as important is: --
the amount of money it will take to make the property decent, safe, sanitary
and desirable to a desirable tenant, the terms of the sale, and the market rent
for that type of property in that neighborhood.
What can you afford
Most real estate investors have a limit on the
cost of the property that they can buy.
There are several factors that affect that limit. First,
there is the amount of cash that you have available to cover the down payment,
loan costs, and escrow costs. However, even if you buy the property with
nothing down, zero loan costs and the seller covers all escrow costs, there are
still limits. One limit is usually imposed by certain principles of economics. That
is, the higher the leverage the less the positive cash flow, even when there
is no vacancy and no deferred maintenance. Unless you manage to "steal"
the property because of special circumstances, it is likely that a zero-down
purchase will have a significant negative cash flow. While you might be
able to cover a $200 per month negative cash flow from a small single-family
house purchased with no money down, few investors can or want to cover the $10,000
monthly negative cash flow from a 30-suite office building.
Another related limitation comes into play as
soon as you need financing from other than the seller. For a residential
property larger than a 4-plex and for most commercial properties, lenders will
loan only 70 to 75 percent of the value. Furthermore, the lender will usually
want to see that the buyer has 10 to 20 percent of his own money in the deal,
so the seller's willingness to carry 25 to 30 percent will not usually allow
you to buy with no money down.
So, the bottom line is that the maximum value
property that you can buy is limited to that for which you can afford the down
payment necessary to reduce financing to the level that the property will produce
at least a small positive cash flow or a negative cash flow that you can carry
with minimum risk until the property's Net Operating Income increases sufficiently. While
this varies with (1) the current interest rate and financing costs, (2) the price
you pay relative to gross income, (3) the expenses relative to income, and (4)
how much deferred maintenance comes with the property, you can typically buy
a property costing in the range of 3 to 4 times the cash that you have available.
What's It Really Worth
No one wants to pay more for anything than it is worth. Understanding
how to determine the value of income property is probably the most important
single skill for successful real estate investment.
Fair Market Value
Fair Market Value is the most probable price that
a property should bring in a competitive and open market under all conditions
requisite to a fair sale with the buyer and the seller each is acting prudently
and knowledgeably and assuming that the price is not affected by undue stimulus. Implicit
in this definition is the consummation of a sale as of a specified date and the
passing of title from seller to buyer under conditions whereby:
-
Buyer and seller are typically motivated,
-
Both parties are well informed or well advised and
each acting in what he considers his own best interest,
-
reasonable time is allowed in the open market,
-
Payment is made in terms of cash in U.S. dollars or
in terms of financial arrangements comparable thereto, and
-
The price represents the normal consideration for the
property sold unaffected by special or creative financing or sales
concessions (adjustments must be made for special or creative financing
or sales concessions)
There are many different approaches to
determining fair market value. Some of these methods are meant
to be used only for rough estimates, some are more accurate in certain
markets and for certain types of properties, and some are considered
to be generally accurate and are used by professional appraisers. A
valuation is always more an opinion than a fact.
LandlordAmerica has an e-Course, Valuing
Income Property, that discusses value in considerable detail and shows you
how to value a property using a variety of methods. If you have not yet
taken that course, you should do so. While you will not have to complete
that course prior to finishing this one, you will have to understand how to determine
value prior to an actual purchase or sale.
Tax Ramifications
The IRS code is designed to provide incentives
or penalties that promote or discourage financial activity in America, according
to the political and public policy of the moment. Home ownership and investments
in rental property are perhaps the primary examples of how effective the tax
code is at effecting the value in what is purported to be a free market place.
Although we do not believe that investors
should build or buy rental housing just for the tax benefits, they are
certainly a very important part of any investment plan. We provide
further discussion of taxation in a later lesson.
Conclusion
Real estate investors should consider a multitude of sources when searching
for properties.
For properties being purchased via foreclosure,
property tax, or bankruptcy sales it is very important to never buy anything
without extensive prior inspection.
By their nature, some of the sources usually provide
properties that require rehabilitation. Buying for rehab can be either
profitable or costly, depending upon whether one correctly assesses the property.
