Can Real Estate Make You Rich? The answer, of course, is yes--if you avoid the pitfalls. Our guide to investing wisely in vacation homes, rental buildings, distressed properties, land and small-scale development deals.
(MONEY Magazine) – More millionaires are made through investing in real estate than any other way. Sound familiar? It's a classic piece of conventional wisdom, in that there's really no way to know whether it's true. And though it's been confidently repeated by such luminaries as Andrew Carnegie and Theodore Roosevelt, our suspicion is it's not.
And yet, there's a reason that it rings so true. Real estate, after all, is the quintessential scarce resource. You simply can't go out and create new land. So it seems only natural that its price would keep going up and up. There's also something intuitive about real estate: Compared with, say, the abstract nature of corporate equity, real estate is tangible. We see it. We rent it. We walk on it. We live in it. And, chances are, we've made money off it: Of the more than two-thirds of Americans who own their own homes, a significant portion have seen them appreciate in recent years.
And then there are all those intriguing stories we hear, especially from those who have walked boldly in the world of real estate investment by buying a second home, putting some money into rental properties or foreclosures, or even taking a flier on a piece of land. Take Veeda Kelley, for example, a 55-year-old social worker and mother of two in Cleveland Heights, Ohio who bought her first multifamily home at age 29. "I lived in part of it and rented the other part," she recalls. "It allowed me to supplement my income and not be away from my children in the evening." Or Andy Schlotterbeck, who earlier this year bought a run-down two-family rehab in Cincinnati for $40,000, put in $20,000 of work and three months later flipped it for $87,000.
Reinforcing the power of stories like these is the fact that the stock market is currently off its game--and, so far at least, real estate is not. "Real estate is one of the healthiest sectors of the economy," says David Lereah, chief economist of the National Association of Realtors. Also adding to real estate's current allure is its relatively low correlation with the stock market, which makes it a worthwhile hedge against an equity-heavy portfolio, says Marty Stone, co-author of The Unofficial Guide to Real Estate Investing. In addition, real estate is one of the few opportunities most individual investors have to use leverage, usually the exclusive domain of hedge fund managers and day traders. Consider: To purchase, say, a $200,000 second home, you're asked to put down 10%, or $20,000. If its value goes up just 5%--to $210,000--the first year you own it, you've made nearly 50% on your cash investment. How else could you do so much with so little?
But let's not get carried away. All the mythology and all the statistics should not cloud the fact that, historically speaking, real estate hasn't appreciated nearly as quickly as large U.S. stocks.
Even more significant, real estate--unlike stocks or bonds--demands an investment of not just money but time. In the simplest situations (for example, buying a condo on the beach), you'll have to hunt for properties, negotiate financing and arrange for someone to water the plants when you're away. Start purchasing rental properties and you're running credit checks, evicting delinquent tenants and fielding calls at 11 p.m. when the plumbing fails.
If, all things considered, investing in real estate still sounds appealing, we want to make sure you do it right. So in these pages you'll find our complete guide to getting started. We begin with second homes (think of them as starter investments) and move into the riskier, more complex realm of rental and distressed properties. Then we look at the no-guarantees terrain of land speculation and the quit-your-day-job challenge of small-scale development.
In each section, we discuss financing, an extremely different task from getting the best deal on a mortgage for your primary residence. The financing tips tend to build on one another from section to section, so even if you're more interested in buying rehabs than rental buildings, we suggest you have a look at the financing ideas throughout.
Here's what you need to know.
STARTER INVESTMENTS SECOND HOMES
If you're looking to dip your toe into real estate investing, a vacation home can be a good move. Buying a second home is in many ways like buying a first. You probably already know how to work with a broker, apply for a mortgage and shop for homeowners insurance.
And if you're not looking for a second income, well, that's fine too. In fact, it's probably best not to expect a vacation property to generate loads of revenue. Plan to enjoy the place yourself and, maybe, rent it out enough to cover a portion of your costs. That's how it worked for David Theobald, a San Francisco tech executive who purchased a two-bedroom condo in Sun Valley, Idaho back in 1997. By renting the house for three months last winter, he covered his homeowners dues and his gas, electric, phone and property tax bills for the year.
The long-term outlook for vacation properties is generally positive. Economist Mark Zandi of Economy.com predicts an upward trend over the next 10 years driven by--what else?--aging baby boomers with leisure time and money to spend. But demographics isn't going to work magic for everyone. The fact is, markets dominated by second homes are far more volatile than suburban home markets. That's because when folks are feeling flush they bid up prices in places like the Hamptons and Carmel. And when the tide turns, second homes are largely dispensable.
--Remember: Location, location, location. Okay, so it's a cliche. It also happens to be true. You'll fare best if you choose a market where further development is difficult. The fewer sparkling new McMansions, the greater the demand for your charming old Cape when it's time to sell. And be wary of towns where prices have risen 20% or more in the past few years. Speculation may have driven the market up, and prices could head south just as quickly.
--Infrastructure is a must. You may not want to see your neighbors, but too much isolation can cost you. Ideally, choose a town that's easy to get to. Property values also hold up best in locales where there's more than one attraction, be it the slopes or the seashore. Access to gambling, golf or cultural events, for example, are pluses. And you generally want to see at least some industry--it helps sustain the area during economic downturns--and a chamber of commerce that actively promotes the community.
--Police your own borrowing. In years past, lenders generally wouldn't write you a loan for more than you could afford. They also required higher down payments and charged higher interest rates on second-home loans than on primary mortgages. Not anymore. According to Doug Naidus, president of MortgageIt.com, you'll now see only a slight--0.125%--premium in interest rates, while down payments can be as little as 10%. That means it's up to you to police your borrowing. And be especially conservative in this economic climate when estimating rental income. A good rule of thumb is to take what you'd earn if you could rent consistently and discount it by at least 25%.
--Count your other costs. If you live far from your property, you may need to employ a local manager to tend the grounds, screen your tenants, act as a handyman or simply stop by after a storm to make sure the electricity is working. Also understand that the more rural your location, the more you'll pay in homeowners insurance. And remember, you have to get there, so count your travel costs too.
--Find a good accountant. Because the Internal Revenue Service has complicated rules for part-time landlords, renting out your vacation home is likely to take you into some entirely new tax territory. Here's the down and dirty.
If you rent your house 14 or fewer days a year, it's considered a standard residence. Mortgage interest is deductible on up to a combined $1.1 million in principal, and you don't have to report the income.
If you rent more than 14 days a year but also use the house yourself more than 14 days (or 10% of the time it's rented, whichever is longer), it's still considered a residence. But you do have to report the income, and deducted expenses can't exceed rental income.
Finally, if you rent more than 14 days a year and use the house yourself for 14 or fewer days (or less than 10% of the rental period, whichever is longer), it's considered a pure rental property. The expenses you can deduct depend on how involved you are in managing the property--so talk to your accountant.
BUILDING BLOCKS RENTAL PROPERTY
"A surgeon can earn $200,000 a year. But the day he stops being a surgeon, his income stops," says Cincinnati real estate investor Andy Schlotterbeck. His own livelihood, on the other hand, produces cash flow largely independent of his day-to-day activity. That's the appeal of buying rental property.
Which is not to say you're going to make $200,000, or anything close to that, from a four-plex. It takes the combined revenue from Schlotterbeck's 20 multifamily properties--which it's taken him a good five years to accumulate--to generate his respectable $50,000 in annual profits.
The value of rental properties and their income-producing power stand a better than average chance of growing over time. "The rental market is better than any other part of the housing market," says economist Zandi. Like the second-home market, rentals are helped by demographics. Not only are the children of the baby-boom generation at an age when they're more likely to rent than to buy; you also have the boomers themselves, who'll soon be empty-nesters looking to trade down, many into rentals.
A strong environment, however, doesn't make being a landlord easy. Here's how to make it work.
--Pick the right town--or part of town. Cities and areas that draw young people who are just coming out of school tend to have thriving rental markets. For example: Austin, where entrepreneurship is rampant and graduates of the giant U of T often stick around.
--When you go to buy, pretend you're the tenant. This is not the same as avoiding places you wouldn't live yourself (you may be way beyond these markets). And it doesn't mean shying away from homes that need a facelift (doing a little work can significantly up your profit). But busy streets with lousy access to public transportation and no convenient parking? Keep looking.
--Be selfish. You're not going to be able to take all the work out of being a landlord, but you can try to minimize it. Andy Schlotterbeck, for example, won't buy a rental more than 10 minutes from home. Otherwise, just getting there would take up too much of his time. William Bronchick, a real estate investor in Denver, likes to put his money into apartments and condo units. Why? "No grass and no roofs," he explains. Plus, multifamily homes generally require more repairs because the owner is responsible for common spaces.
--Get tough. Once you become a landlord, it's your job to screen tenants, collect rent and evict delinquents. Those with experience say you should learn the landlord-tenant laws of your state, find a good attorney and get tough. "When I'm wearing my landlord hat, I'm Tony Soprano," says Bronchick. "I don't get personal with the tenants. If they don't pay, I post the proper notices and start the legal eviction proceedings early. Every day you let someone slide, you're basically lending them money."
--Get a grip on the financing. Buying rentals requires more up-front money than buying a first (or even a second) home. Most lenders want to see at least 25% down. Rates are typically a half-point higher than those for first-home mortgages. And although you may be banking on full occupancy, the bank itself will likely discount your potential income by 25%. And the bankers will probably want to see signed leases in advance.
BUYING LOW (REAL LOW) DISTRESSED PROPERTIES
If sitting around collecting rent sounds a little too slow for your liking, there is another way. It's risky, of course. But then, getting rich faster usually is. We're talking about foreclosures and distressed properties. You buy 'em for a song, put in new kitchens and baths, then sell a few months later for double what you paid. Or at least that's the theory.
During the early '90s, buying foreclosures was all the rage. There were plenty of homeowners in financial hot water willing to unload their homes for the value of their notes. Then came the good years--so many, in fact, that much of the foreclosure business dried up.
Now the sharks are circling again--with good reason. Americans are overextended. Not only do we have more credit-card debt than ever before, we have less equity in our homes than at any time since the 1960s. If this downturn lasts much longer, economists predict, we'll see lots of foreclosures--not just in the $50,000 market, but in the over-$300,000 range as well.
No one's arguing the fact that there's money to be made. But despite what you may have heard from late-night infomercials, it's not easy, and you can't (or at least shouldn't) do it with no money down. The fact is, because banks generally won't lend money for a distressed property, many of the bottom fishers who thrive in this market take risks most of us wouldn't consider: financing purchases on credit cards, taking out a second mortgage, borrowing from a life insurance policy or tapping into an IRA. We can't endorse moves like that. Here's the right way to do it.
--Get an education. Not the kind you get from watching an infomercial. Instead, check out local real estate investment associations (known as REIAs). Start going to meetings and get to know the other investors in town. Beware: Sharks sometimes lurk at these clubs, ready to take advantage of newbies. But REIA members are also known to be generous--to take newcomers by the hand and teach them how to find deals and fix up and finance properties.
--Pick your strategy. Every investor has a favorite way of finding properties. Some get tips by buddying up to the mailman, who knows when houses are vacant. Others seek out the help of real estate agents, who are able to search the multiple-listing services for distressed properties by typing in keywords like "handyman's special," "vacant," "as is," "needs repair" and--a favorite of many--"bank owned." For $35 a week, William Bronchick buys lists of all the foreclosures in the Denver area from a service he found in the Yellow Pages under "mailing list services." He sends every property on the list a postcard with his phone number and the exhortation "We buy houses!"
--Learn the difference between distressed and disastrous. Andy Schlotterbeck, who is president of his local REIA, says the ideal distressed purchase is a house that looks awful on the surface--scaring away potential competitors--but is structurally sound. A kitchen with holes in the walls and crumbling countertops, for example, is much easier to deal with than asbestos shingles, termites, lead-based paint or a deteriorating fireplace.
--Know how much you can pay. Doing the math in advance is the key to making a profit. Here's how Bill Goacher, founder of a REIA in North Carolina, crunches the numbers: First, his aim is always to get back at least $2 for every $1 he spends to renovate. He knows that his fix-up costs generally run about $10,000. And he knows that fixed-up rehabs in his area typically sell for about $95,000. In order to earn a $20,000 profit, therefore, the most he can pay for a property is $65,000. (He'll also spend another $6,000 or so in real estate commissions, $1,000 in transfer fees and $3,000 in carrying costs.)
--Be prepared for creative financing. Few big banks are willing to take the risks required to make loans in this marketplace. The last thing a bank wants is to end up the proud owner of a run-down house. "I've tried to make Bank of America my bank for a decade here, and they could not care less," says Goacher. Smaller local banks, he's found, are generally more willing, but they tend to require a 20% down payment. That's a little rich for many REIA members (many of whom, remember, are tempted by the market's "no money down" allure). So distressed property investors often turn to one another for operating cash. One member becomes the "mouse," running around finding properties. The "elephant," meanwhile, provides the money. When they flip the property, mouse and elephant split the proceeds.
--Get real. Buyers of distressed properties will swear up, down and sideways that you will always come out whole. It's simply not true. According to Bronchick, who teaches seminars on the distressed-property market, most beginners are unrealistic about how much cash you need in reserve, how much repair work (and time) a place needs and how much rent they're going to be able to take in. Also, says Bronchick, newbies get cheap on "stupid things" like buying advertising, paying a broker and landscaping, even though such relatively minor expenses often have a disproportionate impact on the bottom line.
THE WILD, WILD WEST BUYING LAND
The official MONEY take on highly speculative investments is this: If you want to take a flier, do it with a small portion--say 5% or 10%--of your portfolio. And know that you may never see the money again. That's our line on land speculation, which, more than the other types of real estate investment discussed here, is extremely risky. As HomeGain.com's Brad Inman puts it, you can find yourself with an investment that provides "no revenue, no income, no return and no enjoyment." Consider yourself warned, cowboy.
That said, we won't kid you. If you hit it right, you can make 20% to 50% a year on your money. And unlike rental properties, foreclosures or vacation homes, money from land speculation is made without ever unstopping a toilet or even rolling up your sleeves.
There are two types of land in which to invest: ag land--short for agricultural--and development land. Ag land is far less risky and is, in effect, a dividend play. You buy a plot and rent it to a farmer who works it. "It's a good solid investment, with a steady 3% to 10% annual return, depending on year and location," says John Rosengren, a land broker in Northwestern, Ill.
Development land, on the other hand, has no immediate use. You buy a plot and wait for a city or town or vacation community to move in your direction. The greater the distance from already-existing action, the greater the risk. If a city ends up moving away from you, instead of toward you, you could sit on a nonperforming asset for decades--or forever. Here's how to increase your chances of buying property that developers will eventually want.
--Know where to look. Land is typically sold through real estate specialists called land brokers. You'll find a land section in the classified ads of your local newspaper. But if you live in a metropolis, you'll probably need to look farther afield. Start by checking the Internet for leads.
--Bring in the experts. Of course, your leads may be of questionable quality. You may think you've found the next Aspen or Vail but in reality be sitting on a Superfund site. Hire a licensed appraiser who specializes in vacant properties, a surveyor, a soil engineer and a lawyer familiar with local zoning codes.
--Understand your goals. What are your objectives for the property? Are you planning to sit on it for 20 years? Can you afford to? Would you like to eventually build on the property yourself? Or are you counting on a commercial or residential developer to cash you out eventually? You need to have the answers to those questions before you apply for financing.
--Get ready to search for financing. "Ninety-nine percent of banks won't lend you money to buy land," says MortgageIt.com's Doug Naidus. "It's a harder asset to deal with. If the bank forecloses, what do they do with it?" The few that will play ball--mortgage and land brokers can usually lead you to them--generally restrict their loans to a 10- to 15-year time horizon in order to minimize their risk. And they'll routinely expect a down payment of 50% and a fat savings balance in reserve.
SO YOU WANNA BE TRUMP SMALL-SCALE DEVELOPMENT
If the idea of buying raw land seems a little, well, out there, maybe the suburbs are more your territory. That's where you'll find opportunities for buying up small properties, subdividing them and putting up another house or two--and netting a quick five- or six-figure profit.
Between skyrocketing housing prices and the disappearance of land on which to build new homes in popular areas in the past few years, there's quite a bit of money to be made from such small-scale development deals. Sarit Rozycki, for example, sold her last few new homes (some on properties she subdivided, much to the distress of the neighbors) for more than $1 million a pop.
But making these deals work is pretty much a full-time job. For one thing, there are the zoning boards. "You have to get permission from the local king of the local castle," says Stanley Duobinis of the National Association of Home Builders. There are, he estimates, 22,000 to 25,000 independent permit-issuing jurisdictions in the U.S., each operating under its own peculiar set of rules. Fail to play by them and your scheme will be shut down before it begins.
--Play politics. Even if you follow the rules, zoning boards still don't have to approve your plans. So it's worthwhile to attend board meetings even before you have a deal. Get to know the participants. Schedule a meeting and ask what the chances are for your plan--and how to increase them.
--Know your buyer. There's no use struggling to get your project done only to find there's no market for the final product. So get a handle on the sort of houses the market desires. An in-the-know real estate broker can help.
--Expect problems. If you don't budget for a few minor setbacks--bad weather, say, or last-minute design changes--snafus can easily eat into your profit margin, which can be slim. The average rate of return for professional builders, says Duobinis, is about 9%.
--Go halfway. Many experienced subdivision artists recommend selling the homes before they're built. "Do the groundwork," suggests Safia Khan, a real estate broker in Orlando. "Do the engineering. Get everything approved as blueprints. Then sell." But don't assume you'll always get full market values. Whereas large-scale developers have the resources to put up model homes, you'll likely be forced to sell from blueprints or computer-generated models--and buyers are less likely to stretch their budget for something they can't see.