Investing for Profit

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Real Estate Investing for Profit

The prolonged downturn in the United States real estate market is a great opportunity for a savvy investor. With a glut of underpriced and foreclosed homes on the market, it is possible to find genuine bargains and make substantial profits, if you have the patience to do careful research and strategic investing. Compared to other investments like equities or precious metals, real estate built on a firm foundation – even when people have no money for luxuries, they need places to live. But as the recent real estate bust has shown, you can still lose money on real estate if you are not careful about choosing and financing your investments.

Before you move into the property investment market, take some time to read up on it and watch property prices online. Consider doing a few “fantasy” investments, in which you select properties, and enter all the buying and upgrading costs into a spreadsheet. Then wait, see the price at which the properties sell or rent, and calculate whether you would have made a profit. Once you start making profits consistently on your fantasy properties, you are ready to invest real money.

Investing in residential real estate is a five step process. The stages are:

  • Strategic Analysis
  • Searching for Properties
  • Evaluating the Property
  • Finalizing the Purchase
  • Realizing the Profit

Strategic Analysis

You can make a profit in residential real estate two ways. The first way is to buy a property, fix it up, and resell it, a strategy known in the industry as “flipping.” The second way is buying an investment property and renting it out. Which of these strategies will be best for you depends on economic climate and your own preferences and aptitudes.

In recessionary periods, rental markets are often better than purchase markets as people who can no longer afford mortgages move into rental properties. The reverse is true in inflationary periods, when people get higher wages and move out of rental housing and buy their first homes. Study the economic micro-climate of your location carefully, and evaluate the conditions of property rentals versus sales carefully. Look at economic indicators to project rental vs. ownership statistics at least two years into the future.

Next, evaluate your own skills and available resources carefully. The “fix and flip” strategy works best if you have limited funds, substantial free time, and good home maintenance skills. If you need to pay contractors to do most of the fixing, you are unlikely to make much money. Especially in times of tight credit, buying to rent requires more liquidity, adequate funds to handle an investment with a longer-term return, and the ability to manage finances, taxes, and tenant relations carefully (or the cash cushion to hire a property management company.) Rentals are good for steady income and tax reduction but often do not produce steady profitability until you have four to six occupied units. They are best for patient investors thinking in five to ten year terms, while fix and flip investing is better for short term profitability.

Searching for Properties

Good bargains are snapped up quickly. The more quickly and efficiently you search for properties, the more likely you are to find the most profitable opportunities. You should start by knowing neighborhoods. Track the history of house purchases in a given neighborhood for the past year, paying attention not only to the details of the properties, but also to asking vs. selling price and time on market. Also track rental prices and learn whether the neighborhood is primarily owner or renter occupied. Crime statistics and planning permissions give useful information about the desirability of a given area.

Decide on the market segment in which you intend to specialize. The luxury and the subsidized housing markets are very different. Many investors target a middle income range, because in a downturn, the upper middle income segment will downscale to it and in an upturn the aspiring homeowner will move up to it. Generally the extreme high and low ends of the market carry higher risks than the middle range. High crime areas and subsidized housing markets are generally not ideal for the inexperienced investor as they carry higher risk than middle income neighborhoods. Similarly, the “student slums” near university are a very specialized market, involving relationships to university housing offices and dealing with multiple unrelated (and often unreliable) tenants and high summer vacancy rates. For your first property investments, middle class single family or duplex housing is probably the best place to start.

The better your research skills, the better your chance of finding a good deal. Search online and print publications, especially locally oriented ones. Drive around your target neighborhood regularly and look for signs that owners are preparing to sell. Walking a dog in a neighborhood is a great way to pick up all the local gossip and hear about potential sales before they are actually on the market. Build a relationship with an experienced realtor as well, as they may have connections you don’t.

Evaluating the Property

When you find a property, evaluate it realistically. First, you should never buy a house that is the most expensive in a given neighborhood. Look for a property that is below the average value for the neighborhood and upgrade it to the neighborhood standard. Experienced realtors find three nearby houses of equivalent size and condition that have sold in the past three months to use as “comparables” in order to evaluate pricing.

The ideal property is structurally sound and below the price of your comparables. Often, the reason for this will be that it has a hidden flaw, is priced for quick sale, or is cosmetically awful. Ignore cosmetics; you can paint over purple walls, replace bright orange shag carpet, and remove the hideous garden gnomes. Look for solid fundamentals.

Search carefully for negatives like being on a high traffic corner, backing on to noisy commercial buildings, drainage issues, and similar property-specific features that might account for a low prices. Look very carefully for water damage and other structural issues that demand expensive repairs.

If you intend to flip a property, calculate the repair costs (including your time and materials), property price, and buying and selling costs extremely carefully. Add 10% to you calculations for unexpected costs, which like Rumsfeld’s storied “unknown unknowns,” always seem to happen.

If you intend to rent out the property, consider initial investment, carrying costs, initial repairs, and ongoing maintenance costs, assuming a standard vacancy rate and time to rent for the neighborhood. Ask whether you will recoup your initial investment in a reasonable period and whether your ongoing profits are significantly better than what you would obtain in equity and bond markets.

In both cases, consult an accountant as a significant part of your return on investment will derive from the tax advantages of property investment.

Finalizing the Purchase

After inspecting the property closely and analyzing both its financial and physical attractiveness, you are ready to make an offer. Make sure to have your financing lined up early so that a deal isn’t held up by the bank.

Shop around carefully for the best mortgage for your specific needs. If you intend to flip a property, you want low initial rates and low fees, but for a property you intend to rent out, a long term fixed rate mortgage may be a better deal, especially given that interest rates are likely to rise in the long term. Next, think about creative finance options, such as having the current owner pay for upgrades you specify and then including those upgrades into the purchase price.

Make sure to do your title search and contract negotiations carefully, reading all of the fine print.

Realizing the Profit

First, keep all receipts so that you can fully take advantage of the tax breaks available to real estate investors. Much of the benefit to real estate investing has to do with tax advantages.

Whether you intend to flip a property or rent it, keep control of your repair and cosmetic upgrade costs. Remember, it’s not your own home; it’s an investment. Using one type of ivory or white satin paint throughout, for example, may be boring, but it will save money and not offend buyers (beige is never a deal-breaker). Remember that “if it ain’t broke, don’t fix it.” If something is shabby, broken, or discolored, it needs to be fixed. If it’s just a matter of taste, don’t waste your money on it. A malfunctioning hot water heater or leaking roof must be fixed. An ugly door knob or unfashionable towel rack can stay.

Whether you are showing the property to renters or buyers, staging is important. Make sure everything is immaculately cleaned and in perfect repair.

For flipping a house, your profit depends not only on the sale price, but on time to market. You want to realize your profit as quickly as possible in order to free up capital for your next property. Consider creative financing possibilities or even trading for another property to flip quickly.

If you intend to rent a property, be patient. This is a long term investment with a gradual return. Take the time to do extensive checks on potential renters. The five guys who got kicked out of a fraternity house for being too rowdy may be your first prospects, but they are not your best option. Make sure to check out the fair housing laws, and have rental agreements that clearly specify such matters as who does what inside and outside maintenance and pet deposits. Consider carefully whether you have the skills and time to manage the property yourself or whether you would be better off using a property management company.

Finally, before you realize your profit from one investment, make sure to have the next one lined up

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