Real Estate Investors – Get off the sidelines and into the game in a "Slow" market
For months many real estate agents have been hanging around wondering where their next sale would come from. Bad news gets off the front pages so everyone can see how bad the real estate market has gotten. Thickets of real estate signs explode out of the ground like the peak of any mushroom season. Sellers are now accepting the story believing that the market is slow. For buyers who just six months ago suddenly jacked up prices on low-cash-flow properties, these same properties have turned ugly overnight.
Astute investors are always looking for buying opportunities. Whether it’s stocks, coins, gold, bonds, collectibles, vintage cars, or real estate, investment principles apply. The typical successful opponent looks for places to make a move. If there aren’t any worthwhile stocks, they just stay liquid and move into cash. When the general public begins to wring its hands, the astute investor begins to lean forward on the edge of their chairs and begins to focus their collective gaze on potential opportunities. Currently, there is a large inventory of properties listed on the market on the Multiple Listing Services (MLS) in many areas. Some of these potential opportunities have motivated the seller, others have not. You need to focus on listed properties that have a motivated seller.
A lot of cash is pouring back into the stock market with companies like Google pushing it past $500 a share. Many “hot” stocks don’t have a lot of gains, but they do have great stories and lots of so-called promise. Like the dot-com companies in the 1990s, there was a lot of fuss and heartbreak over the hype. After the stock market crash, billions flowed into the real estate business as an alternative to the madness of the stock market. With the ENRON and WORLDCOM fiascos, the decision to move into real estate was much easier for many investors. Who could you trust at the time? The answer for many was to buy and self-manage their own real estate portfolios. Having saved their wounds and after taking the property management “cure”, many disillusioned investors are now returning to the stock market. Some vacancies have increased in some areas with so many investors buying single-family homes and condos that absorption of these properties has slowed. The combination of higher vacancy factors and property management excitement precipitated an exodus back to the stock market. For many new to the game, real estate investors with a strong desire to return to the stock market are leading to cloudy thinking and many will accept an offer that hasn’t been heard in six months. The astute investor will target those motivated sellers and make many offers to get a real estate deal that has cash flow and an opportunity for appreciation.
An early axiom of real estate investing is based on making money by BUYING. There is little use overpaying for a property that has little to no cash flow with some appreciation. When the market gets overvalued, just like the stock market, the smart money looks for other opportunities or locks into their cash and waits. In many markets, opportunity is knocking on the door. Interest rates are currently at a very low rate for a while. The Real Estate Investment Trust (REIT) learned shortly after the 1986 Tax Act that highly leveraged properties without earlier shorter depreciation benefits gave little cash flow. It is the same with the real estate investor. Going for more than 80% loan-to-value financing is asking for trouble EXCEPT in an area of high appreciation. There are some pockets, however currently they are far away and few in between.
Taking a quad as an example, it would be good to focus on properties that have the potential to fetch high rents on the market with a few tweaks. Two bedrooms would be most desirable. There are many rental clients who need the extra bedroom for home office space and/or for starting families. One-bedroom units have limited rent control advantage in the market. In some markets, for example, a quad might be on the market for $375,000. Rents are in the range of $850/mo. This would give a gross rental income of $3,400/month. With a 5% vacancy factor, adjusted gross income is $3,230/mo. Rental customers pay their own electric, gas, cable, and water and sewer with separate meters for utilities. Taxes are $350 per month and insurance is $220 per month. For this example, let’s use 10% of the revenue collected for the management cost, whether self-managed or not. The investment must be carried out independently. This would be $323/month for administration. Use $200/mo for lawn care and maintenance. The idea is to have well-maintained properties and keep them that way to get the highest rents. This would result in the following: $3,230 adjusted gross income minus -$350-$220-$323-$200=$2,137/month available for debt service. Right now, with a seller paying up to 6% of closing costs and prepaying, there would be something left over to help the buyer shop for the lowest rate. With 375,000 x 6% = $22,500. Closing costs and prepayment with full escrows for taxes and insurance could be in the $12,000 range. That leaves $10,000 for a rate reduction. With an 80% loan to value, $375,000 x 80% = $300,000 for the mortgage amount. At 6.25% par rate for a 4 unit investor loan based on a fully documented loan, there is a 1% lender increase in price for a 3-4 unit at 80% LTV .
So with the purchase, the buyer can get a 30-year fixed rate of 5.75%. The principal and interest payment would then be $1,750.72/month for principal and interest. This would leave an initial cash flow after debt service without benefit of interest and depreciation of $2,137-$1,750.72/mo = $386.28/mo of cash flow. The interest deduction would be $17,250/year. Depreciation with $75,000 on the land, improvement at say $300,000/27.5 = $10,909.09/year. Therefore, our after-tax cash flow would be Net operating income: $25,644/year – $17,250 interest deduction – $10,909 = ($2,515) tax loss. If the owner is in the 30% tax bracket, this would save $754 in federal income taxes.
So the total after taxes is $386.28 x 12 = $4,635.36 + tax savings of $754 = $5,389.36. With a cash down payment of $75,000 with seller help in closing costs and rate reduction, the return would be $5,389.36/$75,000 = 7.19% after taxes. If a conservative appreciation rate of 4% were allowed, then the initial investment of $375,000 x 4% would theoretically appreciate by about $15,000 over time. So the total adjusted return would be $15,000 + $5,389.36 = $20,389 .36/$75,000 = 27.18% minus, say, 4% inflation or a net return of 23.18%. It should be noted that the performance would be muted with capital gains taxes and a depreciation recovery at the end and so on. If it were self-managing, that money could go toward additional upgrades or pocket money. This is not a bad deal for an investor who thinks long term. It is an example of leverage at work.
If a certificate of deposit paid, say, 6% on $75,000, you would get $4,500 and again in a 30% tax bracket, the return would be $4,500 x 30% = $1,350 for a total return of $4,500-$1,350 = $3,150/$75,000 = 4.2% compared. However, if inflation were 4%, the net gain would be 0.2% without risk. The previous investment is calculated with the established management.
For many astute investors, the time is now. With good prices and the seller’s help in closing costs and interest rate, buying the investment property may make some sense from an investment standpoint. The key is to find a motivated seller and a property that can get the best rentals and make multiple offers. For buyers with credit problems, taking second mortgages from the seller at a low rate can also make the numbers work. In any case, it is time for many real estate investors to get off the sideline and move hard in this soft real estate market with the primary goal of finding and acquiring properties “that make sense” with cash flow. The market calls for offers.