A MUST-READ GUIDE TO REAL ESTATE INVESTING DURING ...€¦ · The Getting Started In Series Getting Started In Online Day Trading by Kassandra Bentley Getting Started In Asset Allocation

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Real Estate

A MUST-READ GUIDE TO REAL ESTATE INVESTINGDURING TURBULENT TIMES

GETTING STARTED IN

REAL ESTATE INVESTINGT H I R D E D I T I O N

Given the current state of the economy, you might be asking yourself if right now is the right time to be investing in real estate. With the third edition of Getting Started in Real Estate Investing as your guide, you’ll quickly discover how a combination of commitment and caution can help you make it in today’s market.

Designed for investors who want to get started in real estate, but don’t know where to begin, this reliable resource will help you break into this fast-moving fi eld and build equity the right way. Getting Started in Real Estate Investing, Third Edition addresses everything from selecting the right properties and becoming a landlord to using the proper tax strategies and fi nding the right professionals to work with. It also outlines issues you must be aware of in light of recent events, including the best ways to fi nance your real estate investments, considering the status of mortgage fi nancing, and new requirements that may be thrown at borrowers.

The new edition is updated to include information on:

• Surviving in the post-bust housing market• Picking investments with the new credit realities• Looking ahead to future housing booms• Reading the emerging housing trends

Written in a straightforward and accessible style—with a focus on residential and multifamily properties—Getting Started in Real Estate Investing, Third Edition also contains helpful information that will allow you to analyze your fi nancial ability to buy and hold real estate as well as avoid potential pitfalls.

In order to excel in real estate investing, you need to start by defi ning what you want to do and how much risk you can afford. But ultimately, success depends on making informed decisions about where and when to invest, and Getting Started in Real Estate Investing, Third Edition gives you the tools to achieve these goals—even under the most diffi cult market conditions.

MICHAEL C. THOMSETT has written more than sixty books on investing, real estate, business, and management. He is the author of several Wiley books, including the eight editions of the bestselling Getting Started in Options, as well as Getting Started in Property Flipping and the two previous editions of Getting Started in Real Estate Investing.

Cover Design: Paul McCarthyCover Illustration: © Getty Images

$19.95 USA/$23.95 CAN

G E T T ING S TA R T ED IN

REAL ESTATEINVESTING

MICHAEL C. THOMSETT

T H I R D E D I T I O N

With special coverage of how tonavigate the subprime situat ion

THOMSETT

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Getting Started In

REAL ESTATE

INVESTING

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The Getting Started In Series

Getting Started In Online Day Trading by Kassandra BentleyGetting Started In Asset Allocation by Bill Bresnan and Eric P. GelbGetting Started In Online Investing by David L. Brown and Kassandra BentleyGetting Started In Investment Clubs by Marsha BertrandGetting Started In Internet Auctions by Alan ElliottGetting Started In Stocks by Alvin D. HallGetting Started In Mutual Funds by Alvin D. HallGetting Started In Estate Planning by Kerry HannonGetting Started In Online Personal Finance by Brad HillGetting Started In 401(k) Investing by Paul KatzeffGetting Started In Internet Investing by Paul KatzeffGetting Started In Security Analysis by Peter J. KleinGetting Started In Global Investing by Robert P. KreitlerGetting Started In Futures, Fifth Edition by Todd LoftonGetting Started In Financial Information by Daniel Moreau and Tracey LongoGetting Started In Emerging Markets by Christopher PoillonGetting Started In Technical Analysis by Jack D. SchwagerGetting Started In Real Estate Investing by Michael C. ThomsettGetting Started In Tax-Savvy Investing by Andrew Westham and Don KornGetting Started In Annuities by Gordon M. WilliamsonGetting Started In Bonds, Second Edition by Sharon Saltzgiver WrightGetting Started In Retirement Planning by Ronald M. Yolles and Murray YollesGetting Started In Online Brokers by Kristine DeForgeGetting Started In Project Management by Paula Martin and Karen TateGetting Started In Six Sigma by Michael C. ThomsettGetting Started In Rental Income by Michael C. ThomsettGetting Started In REITs by Richard ImperialeGetting Started In Property Flipping by Michael C. ThomsettGetting Started In Fundamental Analysis by Michael C. ThomsettGetting Started In Hedge Funds, Second Edition by Daniel A. StrachmanGetting Started In Chart Patterns by Thomas N. BulkowskiGetting Started In ETFs by Todd K. LoftonGetting Started In Swing Trading by Michael C. ThomsettGetting Started In Options, Eighth Edition by Michael C. ThomsettGetting Started In a Financially Secure Retirement by Henry HebelerGetting Started In Candlestick Charting by Tina LoganGetting Started In Forex Trading Strategies by Michael D. ArcherGetting Started In Value Investing by Charles MizrahiGetting Started In Currency Trading, Second Edition by Michael D. ArcherGetting Started In Investment Analysis by Warren Brussee

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Michael C. Thomsett


John Wiley & Sons, Inc.

Getting Started In

REAL ESTATE

INVESTING

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Copyright © 2009 by Michael C. Thomsett. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization through pay-ment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 RosewoodDrive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created orextended by sales representatives or written sales materials. The advice and strategies containedherein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or otherdamages.

For general information on our other products and services or for technical support, please con-tact our Customer Care Department within the United States at (800) 762-2974, outside theUnited States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears inprint may not be available in electronic books. For more information about Wiley products, visitour web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Thomsett, Michael C.Getting started in real estate investing / Michael Thomsett. — 3rd ed.

p. cm. — (The getting started in series)Includes bibliographical references and index.ISBN 978-0-470-42349-3 (pbk.)

1. Real estate investment. 2. Real estate investment—United States.I. Thomsett, Jean F., 1947- II. Title.HD1382.5.T564 2009332.63�24—dc22

2009004116

Printed in the United States of America.

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www.wiley.com

v

Contents

About the Author vii

Introduction

The Allure of Property 1

Chapter 1

Should You Be a Real Estate Investor? 5

Chapter 2

How to Choose Property 43

Chapter 3

Financing Your Investment 69

Chapter 4

The Cost of Borrowing 93

Chapter 5

Tax Benefits of Real Estate 115

Chapter 6

Setting Up Your Books 151

Chapter 7

Managing Your Investment 164

Chapter 8

Analyzing the Market 183

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Chapter 9

Analyzing Your Financial Capability 202

Chapter 10

Working with Professionals 213

Chapter 11

Becoming a Landlord 234

Chapter 12

The Fixer-Upper Market 257

Chapter 13

The Property-Flipping Market 270

Chapter 14

Passive Investments 282

Chapter 15

Other Ways to Invest 300

Chapter 16

Setting Your Investment Goals 309

Appendix 319

Glossary 333

Index 349

vi CONTENTS

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About the Author

ichael C. Thomsett is a long-time real estate investor, with experi-ence both as a landlord and in the fixer-upper market. He beganwriting full time in 1984, and has since published more than

70 books and 500 magazine articles. Among his books are several in theWiley Getting Started In Series.

Thomsett’s real estate books include three editions of GettingStarted In Real Estate Investing , which has been a successful and best-sellingbook since 1994. The current edition is completely updated based on thedramatic changes in both the real estate and credit markets in recentyears. Other books in the same series include Thomsett’s Getting StartedIn Options, which came out in its eighth edition in 2009 and has soldmore than 250,000 copies. He also wrote Getting Started In Property Flip-ping and Getting Started In Rental Income, as well as many other books inthe same series.

Today, he lives near Nashville, Tennessee, and continues writing fulltime. The author’s web site is www.MichaelThomsett.com.

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The Allure of Property

hy is real estate so universally popular as an investment? Thereare several reasons, and before considering real estate as a pos-sibility for yourself, you may want to review the answers to this

important question. You will see that, with its different investment ad-vantages considered together, real estate is difficult to match by other in-vestments.

However, even with real estate’s long-term advantages, you have tobe cautious when committing money to a real estate program. As a gen-eral rule, real estate takes time to appreciate, and getting money out is notalways easy. All markets are cyclical, and real estate is no exception. Whenyou consider the extended downward cycle in real estate in most areasfrom 2006 into 2008, you quickly realize that real estate requires a com-mitment in both time and money.

All real estate is local. Even while the extended downward cycle pre-vailed on average from 2006 until 2008, there were a few areas whereprices held up and even increased. Seattle, Washington, and Portland,Oregon, were among the best markets during these generally difficulttimes. So when you judge your local market, you need to study local con-ditions rather than regional or national averages. Real estate is an incred-ible investment, as long as local conditions are at the best point in the cy-cle. This is true because of five specific attributes.

First, it is one of the few finite investments. There is only so muchreal estate to go around, and when it is used up, prices have to increase.With a limited amount of space, the land available for development ofhousing, office, commercial, industrial, recreational, government, and

1

Introduction

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lodging purposes is also limited. Not all land is appropriate for develop-ment. When the land is too steep, too wet, or in protected areas, it has tobe eliminated as potential development land. When all of the topograph-ically prohibitive land is removed from consideration, and whengovernment-owned conservation lands are removed, there is only a rela-tively small amount of land remaining. Even beyond that, of the availableland, not all of it can be developed because of zoning restrictions or thesimple fact that the current owner does not want to sell. In comparison tothe finite nature of real estate, corporations and most mutual funds can is-sue more shares if the demand from investors is strong enough. In theory,there is no limit to the number of investors in popular stock market issues.

Second, real estate has a track record that can only encourage in-vestors. Real estate investments have gained in value in the past partly be-cause of the limited amount of real estate and partly because of other fac-tors, such as tax benefits. The historical record for real estate, like allmarkets, has had ups and downs. But over time, real estate has kept pacewith inflation and has usually exceeded the Consumer Price Index (CPI)growth rate. The real estate cycle is highly predictable, following patternsbased on normal supply and demand and varying regionally but in thesame manner for each cycle. This is not true of the other popular invest-ment, the stock market, in which investing may often be compared to ablindfolded roller coaster ride—more exciting and potentially more prof-itable, but not always as stable.

Third, real estate investors enjoy exceptional federal income taxbenefits. These benefits are unlike those available for any other invest-ment. The 1997 Taxpayer Relief Act dramatically improved the tax ben-efits of owning your own home by eliminating the tax on profits for thefirst $500,000 when primary residences are sold. This may not directlybenefit investors, but many possible strategies will evolve from this newlaw and will be explained later in this book. For investors, too, tax bene-fits are significant. You are allowed to deduct all of the necessary expensesconnected with owning rental property, such as for repairs, cleaning, ac-counting, interest, property taxes, and others. You can also write off thecost of buildings and other improvements over a period of years. The taxlaws also provide exceptions for real estate investors to claim losses thatwould otherwise not be deductible.

Fourth, real estate is an investment you can see. There is somethingsatisfying and reassuring about owning an intrinsic property. This givesyou the opportunity to care for the investment and keep its value up by

2 INTRODUCT ION


direct actions you take right in your own community. Even by testifyingbefore your elected officials in decisions affecting your property value,you are directly involved in protecting your investment and in influencingits future market value. In comparison, investing in stocks directly orthrough mutual funds yields an account statement and perhaps a certifi-cate, but you never get to see your money at work like you do with realestate. In the stock market, you own part of an intangible whole andnever directly own an actual piece of a company’s real assets.

Fifth, real estate is considered one of the basic necessities. Peopleneed shelter, and housing provides them with that. Even commercial, in-dustrial, and other types of property all relate to demand for those uses,based on local population. So investing in real estate means you are in-vesting in the value of your own community. As a responsible investor,you are a participant in planning to maintain your town’s way of lifewhile also putting your capital to work.

The primary emphasis of this book is on investments in residentialproperty, mostly houses or limited multifamily properties (e.g., duplexesor triplexes). Most people start out with these fairly modest and afford-able properties because they can be easily rented out so that rent incomecan be used to make mortgage payments and to pay for maintenance andutilities. As a general rule, more complex real estate investments in com-mercial or industrial properties require more money and higher risks.Many real estate investors move into the nonresidential areas later on butstart out by acting as landlords in residential markets.

As a real estate investor, the best starting point is to identify condi-tions affecting value in your city or county and to estimate where the realestate cycle is at the moment. Of course, you want to buy at the price bot-tom and not at the top. But identifying these precise times in the cycle isnot as easy as it is in hindsight, so you will also need to develop keen ana-lytical resources. This book helps you identify those sources and the expertsyou will need to include as part of your investment “team” of advisers.

As a starting point, take three initial steps:

1. Become familiar with local conditions and economic influences(e.g., employment or rental unit supply and demand) to defineyour local real estate cycle.

2. Gather the information you need to make an informed decision,remembering that smart investing requires analysis and strongdata.

The A l lure o f Property 3


3. Set goals for yourself and develop a series of logical investingrules, including identification of various kinds of risks and thelevel of risk you are willing and able to assume (i.e., your “risk tol-erance”), and resolve to limit your investments to those levels.

This book is designed with you in mind. A starting assumption isthat you are going to need guidelines to accomplish these three steps andto move into the specific steps you need to become a successful real estateinvestor. This includes numerous resources, both online and through var-ious professionals; forms and worksheets; and guidance in preparing anddocumenting your taxes and keeping your books.

In the coming chapters, you are going to find easily referenced and or-ganized information. Each chapter focuses on a specific issue of real estateinvesting and includes many useful tools: illustrations, examples, forms,charts, and definitions in the margins as each term first appears in the text.This format is designed to help you move through the discussion so that youdo not have to backtrack to find important supplementary material. All ofthe definitions are also repeated in the glossary at the end of the book.

In Chapter 1, the first important question is asked: “Should you bea real estate investor?” This is an essential starting point because (1) noteveryone wants the same thing from a real estate investment, and (2)some people are simply not suited for real estate, based on personal goals,temperament, or income.

For example, you may be interested in developing a long-term in-vesting plan over an entire lifetime involving wealth-building throughreal estate, or you may only want to hold properties for a few years hop-ing for rapid price appreciation. The difference between long-term in-vesting and speculation requires entirely different approaches to how youbuy and sell and which properties you pick. Some people want to con-vert their current home to a rental property and then move to a larger ornewer home, a step many people take when the market is slow but rentaldemand remains high.

This book is designed primarily for investors who want to get startedin one of the various investment formats but are not sure how to begin orto break into the market modestly and build equity in one or more rentalproperties over time. The important point is that, as with all investments,you need to define what you want to do and how much risk you can af-ford, and then look for good matches in the current market. Success alwaysdepends on making informed decisions about where and when to invest.

4 INTRODUCT ION


5

Should You Be a RealEstate Investor?

eadline: “The big run-up in real estate values is now over.”This headline could easily have appeared in any U.S.

newspaper in 2006, 2007, or 2008. But, looking back overtime, the same pronouncements were made at various times in the1970s, 1980s, and 1990s. Real estate values change every few years,and the cycles are continuous. The big difference in the cycle that be-gan a downward spiral in 2006 was that additional economic condi-tions aggravated the situation. These included liberal credit, wide-spread speculation, and predatory lending practices. Making mattersworse, big financial institutions jumped into the speculative trend,investing billions of dollars in mortgages through formalizedprograms.

You have probably seen and heard the bad news for yourself. Fore-closures are up, housing prices are falling, and the number of homes onthe market is higher than ever before. Adding to the problem are “ex-perts” on television financial programs, some announcing that the hous-ing crisis will last another two to three years. In fact, however, no one canreally illustrate the market cycles that way, and financial news programsthrive on bad news. Unfortunately, this only makes things worse becauseaudiences become increasingly afraid when they hear the endless streamsof negative forecasts.

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The downtrends always end, and the market always turns upward.But, knowing how long it will take can be very difficult because so manyfactors influence the timing of every cycle. Wherever the market is at thismoment, it will be at a different place next year; and, in the future, thepattern will be repeated.

The uptrend cycle is also interesting. Once real estate cycles turnaround, the same doom-and-gloom experts will tell you that you havemissed the boat and that you should have bought last year. These expertsfail to realize that, with real estate, even when you have missed the latestboat, there will be as many “boats” coming in the future as you havemissed in the past—if not more. Real estate is not a one-time opportu-nity, as it is made to sound on financial programs. Many factors—shiftsin the job market, population growth and migration trends, regionaldesirability, and economic factors like interest rates—all mean that realestate opportunities occur not just once, but repeatedly and in very pre-dictable cycles.

The many advantages of owning real estate are difficult to beat withother forms of investment. Real estate comes with the usual investmentrisks, but some very special risks related to real estate should also be keptin mind when you compare it to alternatives. With real estate, you gaintax advantages and direct control over the asset, and attain the ability toborrow money to purchase a property without being taxed on the moneyborrowed. (In fact, by refinancing, it is possible to keep your capitalworking while you still own the property.) In exchange for these advan-tages, you need to buy an expensive property, place yourself in debt, andin most cases, be unable to get your cash out through a quick sale. Youalso cannot sell part of your investment as you could stocks or shares ofa mutual fund.

Real estate provides you with a combination of benefits andcontrol. You can influence the value of a property with landscaping,

6 SHOULD YOU BE A REAL ESTATE INVESTOR?

Key Point

Endlessly hearing bad news affects investors and adds to their

apprehension. Remember, however, that when things sound the gloomiest,

it is the best time to buy.


roofing, a new coat of paint, and interior design, forexample. When you buy stock in a corporation, itdoes not give you the right to go to corporate head-quarters and sit in on management meetings, andyou cannot own the specific assets represented byyour shares. Stock ownership gives you a portion ofownership in an intangible unity called “equity,’’which collectively owns the company and appointsexecutives and managers. This is an importantdistinction.

One of the risks that many first-time real es-tate owners do not consider is that if you becomea landlord, you will have to interact with tenants.This means that they may call you in the middleof dinner or while you are trying to watch thegame on Sunday. These problems keep manywould-be investors out of the business entirely.But, with careful screening of applicants and bythe proper use of a telephone answering machine,you can achieve a relatively comfortable balance,while still acting as a responsible and fair landlord.All you really want as a landlord is a tenant whowill pay the rent on time and do a reasonable jobof caring for your property.

Looking beyond the potential problems ofdealing with tenants, the potential gains from in-vesting in real estate make it worth a serious look.Let us begin by establishing a few important dis-tinctions. Real estate is land plus permanent im-provements, which most often means buildings.You may also become involved in the rights at-tached to the ownership of real estate, broadlycalled real property. Also be aware of the importantdifference between the full value or price of real estate, as opposed toequity, which is the portion you own after deducting debt. Equity is thepurchase price (or current value of the property) minus all outstandingdebt balances.

Shou ld You Be a Rea l Estate Investor? 7

real estate

land and all

permanent

improvements

on it, including

buildings.

rights

intangible assets

added onto real

estate, which have

value not because

of the land itself

but because of the

advantages these

rights provide.

real property

real estate plus

the rights

attached to it,

such as leases,

easements, and

estates.


Should You Buy Real Estate?

The pros and cons of owning real estate help you not only to understandthe breadth of this market, but also to decide whether the market is ap-propriate for you. A checklist of points to consider:

Positive Attributes of Real Estate

1. Direct control: It is up to you, the owner, to maintain and im-prove your real estate investment. You do not have this kind of control inany other type of investment.

2. Monthly income: Rent income pays all or most of your mortgage.This means that tenants pay your debt and that, as market values in-crease, you benefit.

3. Tax benefits: Real estate is the only investment in which you areallowed to deduct annual losses. You are allowed to deduct property de-preciation, as well as interest, taxes, utilities, insurance, and maintenanceexpenses.

4. Historical returns: Although real estate cycles can last a while andmarkets can be tough, historically, returns from real estate have been bet-ter than in any other market.

5. Insurance: Real estate is one of the few investments that yieldsmonthly cash and is insured. Through your casualty insurance plan, youare protected against fire, liability, and other losses.


Key Point

Check positive and negative attributes of any investment to identify

risks and rewards of the decision.

Negative Attributes of Real Estate

1. Landlord issues: When you work with tenants, you are likely toexperience some problems. Tenants can be demanding and, in somecases, they may even do damage to your property. Some investors arewell-suited to take on this risk, but others are not. It is wise to know inadvance how you feel about working with tenants. It also is imperative


to check references carefully to make sure you get the best possibletenants.

2. Cash problems: Whether or not you have tenants who pay theirrent, you have to pay your mortgage every month, as well as insurance,taxes, and utilities. So, extended vacancies or, even worse, having ten-ants who do not pay rent on time will negatively affect your cash sit-uation. If your personal budget is not strong enough to carry youthrough a vacancy period, you could face problems with yourinvestment.

3. Market conditions beyond your control: Cycles vary not only byduration, but from one region to another. These factors are unpre-dictable. So, as a real estate investor, you have to be willing to go alongfor the ride, no matter how long it takes or how many twists and turnsare going to be involved.

4. Financing restrictions: As a homeowner, getting financing is rela-tively easy compared to getting investment property financing. You maybe required to make a larger down payment and payhigher interest, as well as other loan fees. You mayalso be limited in the number of investment proper-ties you will be allowed to finance. Lenders are goingto be concerned about your personal financial strengthand ability to continue mortgage payments, even ifyou have vacancies in your investment properties. Inaddition, to succeed as a real estate investor, you aregoing to need exceptionally strong personal credit.

Real Estate as a Growth Fund

Some investors buy real estate for the long-term ap-preciation and tax advantages it provides. In com-parison, the speculator is an investor who attempts tomake the greatest possible profit in the shortest pos-sible time and is willing to take higher risks thanlong-term investors because short-term profits willbe much higher. Speculators often are accused of be-ing opportunists in the market, but that characteri-zation is not always accurate. The speculator is sim-ply taking a different approach to investing. The

Rea l Estate as a Growth Fund 9

equity

the portion of real

estate you own. In

the case of prop-

erty bought for

$100,000 with a

$58,000 mort-

gage owing, the

equity is the dif-

ference, or

$42,000.

speculator

an investor who

buys property

with the goal of

earning the great-

est possible profit

in the shortest

possible time.


same distinctions can be seen in the stock market. Some investors buylong-term growth stocks, whereas others try to guess where short-termprice run-ups will occur. In all such instances, speculators chase afterhigher profits, but they also assume considerably higher risks. With thatin mind, some long-term investors believe that speculators often do notachieve as much in the long run because real estate, by its nature, is a long-term investment. Both approaches have their good and bad features. Con-sider the following examples, which compare two investors who each have$50,000 to invest.


Key Point

Decide ahead of time if you want to get into the market as a long-term

investor or a short-term speculator. This will affect how you invest.

Example

Karen invested $50,000 as a down payment on a $160,000 triplex.Her rents more than covered her mortgage payment, and she heldonto the property for eight years. At the end of eight years, she soldthe property for $235,000, realizing a capital gain of $75,000.During the holding period, she enjoyed positive cash flow and taxbenefits and, upon sale, she earned a profit on the investment.Mortgage payments and other expenses were covered by rentreceipts.

Example

Adam paid cash for a run-down house in need of many repairs,mostly cosmetic. He landscaped the yard, painted inside and out,repaired the broken windows, and upgraded the plumbing and elec-trical systems. The total of his purchase price and repairs came toabout $50,000. He sold the house about eight months after hebought it and, after closing costs, netted $60,000. He made a netprofit of $10,000 (before taxes) in less than one year.

A comparison between these two examples is more complicatedthan it seems at first glance because the two people may be paying dif-ferent tax rates and because there is no way to know what future appre-ciation may occur on the fixed-up house, nor what rental receipts could


be earned by turning it into a rental unit. However, the illustrationsdemonstrate two different approaches. The first is the long-term strategy,aimed at achieving positive cashflow, tax benefits, and capital apprecia-tion. This example is not unusual, but it is ideal. The second exampledemonstrates how short-term strategies may work. The risk here is thatthe cosmetic repairs may not add enough value to the property to makeit worthwhile in such a short period of time but, again, the example isnot untypical. These outcomes do occur if the speculator understands themarket and knows good value when it presents itself.

The speculator made $10,000 on a fast turnaround of the prop-erty, which is a better annual rate than the long-term appreciation ap-proach. However, the speculator gained no tax benefits or positivecash flow during the holding period. As you can see, the decision tobe a long-term investor or a speculator depends on your tax circum-stances, your ability to manage market risks, and even your personaltemperament.

Speculators share a good part of the blame forthe national bubble that began to appear in 2006.By buying properties and quickly selling them toother speculators, a process known as property flip-ping (see Chapter 13), speculators rapidly drove upprices. In some markets, notably places like Miami-Dade, speculation in the so-called pre-constructionmarket was so severe that the county ended up witha nine-year supply of condo units. Even so, con-struction and speculation continued. Eventually, themarket ran out of new speculators, and it was im-possible to sell all of those units. This is what in-variably occurs when speculation runs wild.


Key Point

Watch what is going on in your area. If much building is taking place

but there appears to be little or no demand, you may be in the middle

of a bubble.

Combined with predatory lending practices that infected the marketsat the same time, the real estate bubble was exceptionally severe. Thelenders who made borrowing too easy, often giving loans to people they

pre-construction market

a market for prop-

erty that has not

yet been built,

popular among

speculators dur-

ing bubbles, when

prices are rising

rapidly.


knew could not afford them, aggravated the situa-tion as long as prices were rising. Speculation andpredatory lending were a dangerous and destructivecombination.

The riskless transaction that lenders and mort-gage brokers go through when placing mortgageloans has been and is one of the most destructiveforces in the real estate market—and will probablycontinue to be in the future. It is riskless for lendersbecause, as soon as loans are underwritten, theseloans are sold to agencies that package them in poolsand sell them. These pools operate like mutualfunds in that they are made up of numerous mort-gages. So, for the lender or mortgage broker, there isno real concern about whether a borrower is finan-cially qualified, or even whether the borrower canafford mortgage payments. Money is made by plac-ing loans in secondary market agencies, which cre-ate pools and then sell them to investors.


Key Point

A riskless transaction always damages the market because it creates

artificial economics. Anyone who watched real estate from 2006 to

2008 knows how much damage riskless transactions create.

A responsible way to get into real estate investing is to be realisticabout what you can afford. Every investment contains risks; in the past—especially during price run-up bubbles—many people naively believedthat no actual risk was involved. Many speculators lost significant capitalbecause they bought property at the worst possible time–when priceswere at their highest and just before the bubble burst.

A realistic approach to real estate investing should include a test ofhow well real estate matches your risk tolerance and personal goals. Addi-tionally, ask yourself how real estate investments are likely to compare tonon–real estate investments such as the stock market.

predatorylending

the practice of

granting loans to

borrowers despite

knowing they

cannot afford

payments; or

performing little

or no credit verifi-

cation to close

such loans; or

actively pursuing

current borrowers

to encourage

them to refinance

existing loans

with excessive

loan fees or high

interest rates.


In the stock market, certain stocks are referredto as growth stocks. Generally, this means that thestock’s value is expected to increase over time. Ifyou buy shares today and the estimate of futureprice growth is right, your investment will steadilygrow in value over many years. You will not be con-cerned with the day-to-day fluctuations in stockvalue.

The same is true when you invest in growth-oriented mutual fund shares. The company’smanagement buys shares in companies consideredto be good growth stocks. If the mutual fund’smanagement is right, your shares will grow overtime.

With either direct purchase of stock shares ormutual fund shares, you depend on the quality ofmanagement to achieve your goals. With many dif-ferent choices on the market, you accept certainrisks in the selection process, and that is always apart of the investment equation. These same riskelements apply to real estate as well. You always ac-cept risk when investing, and real estate, like otheralternatives, comes with specific risks. In real estate,these risks include three possibilities:

1. The property investment may lose value orfail to appreciate according to your expectations.All investments contain this risk. Even insured sav-ings accounts can deteriorate when interest rates arelower than inflation. The basic market risk is thebest known and, for most people, the primary formof risk. It is fair to say that, in most regions, real es-tate has to be held long enough for appreciation tooccur, and the real risk is that you do not know inadvance how long that will be.

2. You may not be able to find tenants or tocharge rents adequate to cover your monthly ex-penses. When a large number of rentals are availableand there are relatively few tenants, market rates


risklesstransaction

any transaction in

which the actual

risks are trans-

ferred to someone

else; for example,

lenders and mort-

gage brokers who,

when they under-

write and then sell

loans, transfer the

risk of lending to

investors in mort-

gage pools.

risk tolerance

the level of risk or

type of risk a per-

son is able to

stand, based on

experience in the

market, knowl-

edge about invest-

ments, personal

income and avail-

able capital, in-

vesting goals, and

the ability to keep

capital invested for

periods of time.

growth stocks

stocks expected

to increase in

value over time.


level out or drop. To avoid vacancies, you may have to reduce rents. Theopposite is true in periods of high demand. With too few units and manytenants, your market rates will rise.

3. Your tenants may not pay the rent that is due or may not carewell for the property. In real estate, tenant problems are frustrating be-cause such problems force you to confront matters at once or lose money.Invariably, that means dealing with people who are having problems be-yond the landlord–tenant relationship, who are immature and irrespon-sible, or who simply want to avoid paying the agreed-on rent. Properscreening and review, and checking of references, reduce these problemsdramatically and should be requirements of being a landlord.

These basic risks are not the whole story, but they are major con-siderations when you are evaluating the possibility of investing in real es-tate. These problems will not seem as formidable when you actually buya property and begin managing it. With patience, caution, and mainte-nance, property will appreciate over time when it is carefully and intelli-gently selected. You will also learn by experience how to screen tenants,set fair rents, and confront problems before they turn into crises. Just asparents learn on the job, landlords have to discover the problems thatarise with tenants and learn how to avoid these problems in advance.

Risks are manageable, as long as you are aware of them. A commonmistake is to look for ways to eliminate risk, when, in fact, smart invest-ing calls for awareness and risk management. Some risks can be miti-gated. For example, buying fire insurance protects you against a loss of arental home; not to carry such insurance is to assume more risk than youcan afford. You need to evaluate the different types of risks involved withinvesting in real estate, and then determine how much risk—and whatkinds of risks—you are willing to assume. The speculator is willing totake the risk that the real estate market may not support the strategy ofbuying and selling homes in a short period of time. If the speculator’stiming is off, the strategy will result in a loss, or the property will have tobe held longer than intended.

Most people begin their real estate investments by studying andcomparing prices. You should always keep in mind the risk rule in real es-tate: The greater the risk, the lower the price. For example, real estate in apoor location will naturally cost much less than real estate in a prime lo-cation. The risk in such a case has to do with the potential for apprecia-tion. The price in the poor location is less likely to rise at the same rate



as prime property and, in fact, could even fall. As average market pricesrise, the tendency is for better-than-average properties to rise faster thanaverage and for poorer-than-average homes to lag behind. Good invest-ing requires foresight. In addition to estimating and calculating the risksand potential profits, you need to become adept at identifying the goodand bad points about all of the factors affecting price and value: location,timing, and local economic conditions (now and in the future). This isexactly the same type of analysis all investors need to perform. However,instead of studying financial statements of companies and looking atmarket index trends, the real estate investor has to be able to read social,political, economic, and demographic trends within a city and region.

This book assumes that your goal is to invest for future apprecia-tion. Certainly, speculation is one alternative, but that profile does not fitmost people in terms of available capital, financial goals, or market ex-pertise. The main focus here is showing you how toget started by buying one or two rental houses, thenhow to build up equity while managing propertyand coping with tenants and, ultimately, how to cre-ate a profitable investment for your future financialsecurity.

Long-term investing requires a commitmentlonger than two or three years. In fact, “long-term’’generally means 10 years or more because it takesthat long to create seasoned real estate. As you makemonthly mortgage payments and as property gradu-ally increases in value over time, seasoning occurs.

The Real Estate Cycle

Real estate investments react to economic cycles, asdo all investments. The major points in the cycle—falling and rising prices, for example—are charac-teristics of supply and demand. The tendency dic-tated by this basic economic idea—that prices riseand fall according to levels of supply and demand—is the guiding force in selecting investments, timingpurchases and sales, and selecting one investmentover another.

The Rea l Estate Cyc le 15

seasoned real estate

real estate that

has been owned

long enough for

market value and

equity to accumu-

late.

supply anddemand

the economic

conditions in the

market that affect

prices. When de-

mand is greater

than supply,

prices tend to rise;

when supply is

greater than de-

mand, prices tend

to fall.


In a pure market economy, prices rise and fallin accordance with the dictates of supply and de-mand. Higher demand places pressure on thesupply, and prices rise; lower demand softens themarket, so that prices fall. The same features arefound in the stock market, which often is calledan “auction marketplace.’’ This means that priceschange specifically because the mix of sellers andbuyers changes. When more buyers want a lim-ited number of available shares of stock, this dri-ves up the price; and when the number of sellers

grows, this forces down the price of the stock. An ongoing auction isunderway when the market is open.

Real estate does not change hands in an auction marketplace. Stockexchanges are public, and millions of individual trades result in tremen-dous share volume every day. In real estate, brokers are not bidding andnegotiating from moment to moment; and real estate sells in large, sin-gle units rather than in millions of small shares. Offers are placed in writ-ing through real estate agents and based on asked prices. Prevailing mar-ket conditions determine whether a potential buyer makes a full-priceoffer or tries to negotiate a lower price. The same conditions also affectthe seller’s response. A firm seller sticks to the asked price or stays closeto it, but when the market is soft, sellers have to accept lower bids or theirproperties will not sell.

Although the rules of contracting for buy and sell prices and mak-ing and closing a deal are the same for stocks and real estate, methods aredifferent. In the minds of most investors, the rules are different as well.For example:

� Many people who can afford to buy 100 shares of stock wouldbe faced with much more demanding financial arrangements ifthey were to bid on real estate. Accordingly, the stock market isavailable to many more investors, and trading can occur fre-quently and in relatively small increments.

� Stocks are often bought and paid for in cash, whereas real estatemore likely involves financing.

� Real estate prices are naturally higher than shares of stock, so theentire process of buying and selling—comparing, negotiating,


marketeconomy

a market in which

prices are not set

but vary with

purely economic

factors, specifi-

cally supply and

demand.


bidding, offering, and closing—tends to be more formal andtake longer.

� Real estate does not trade hands as frequently as stocks, so thetrading volume in real estate is much smaller, and indicatorsbased on sales volume tend to cover periods of months and yearsrather than tracking methods used in thestock market, such as hour-to-hour or day-to-day volume.

Reasons for selling are different as well. Sellersof stocks often want to take short-term profits andmove on to other issues, or simply want to movetheir money to another stock, which they believewould make a better investment at that moment.The real estate seller may be anxious to sell for anumber of different reasons. A motivated sellerwants to find a fast deal in order to get the equityout and move on. Motivated sellers may have madean offer on another house, be moving to anotherarea, or be making other major life changes. Thedegree of anxiety to sell will dictate how much ne-gotiation the seller is willing to undertake. In a verysoft market—in which many homes are for sale andfew buyers are available—it may simply be impos-sible to sell a property, at least immediately. In theauction marketplace of the stock market, there is al-ways a ready buyer. The price may be low becausedemand is low, but shares of stock on a public ex-change can be bought or sold at the current price atany time.

The events and conditions influencing real es-tate values are referred to as the real estate cycle. Al-though many factors affect the cycle, includingpopulation, the job market, interest rates, financing,construction levels, and many other economicchanges, the real estate cycle moves in a fairly pre-dictable sequence over time. The stages vary inlength of time and rapidity of change based on the

The Rea l Estate Cyc le 17

motivated seller

a seller who is

very anxious to

sell, meaning that

the seller is more

willing than a firm

seller to negotiate

on price and other

terms.

real estate cycle

the trends in real

estate values,

affected by ever-

changing levels of

supply and de-

mand. The cycle

describes changes

in construction

activity, available

supply of real

estate for sale,

credit available for

financing, interest

rates, population

and job demo-

graphics, and

attitudes among

buyers and sellers

at any given

point.


collective changes in market conditions; however, six distinct points canbe identified in the course of the real estate cycle. These are summarizedin Figure 1.1.

1. Demand begins to rise. Demand rises for many reasons—often fora combination of reasons. The fact that more buyers are looking for prop-erty now than a year ago is a symptom of rising demand. It may be causedby growing population, job creation, and other factors. The forces thatcreate demand cannot be isolated or easily identified; demand is usuallya general trend involving many parts. One element of demand resultsfrom a decrease in construction activity, leading to housing shortages. Ina truly efficient economy, developers always build exactly the number ofnew homes required to meet the needs of the immediate future, whilemaintaining supply and demand in a healthy balance so that values grad-ually rise with moderate inflation. But, that is the ideal world, and thereal world rarely acts that way.

2. Construction activity increases. Why do developers increasetheir rates of construction? At the beginning of the cycle, the general


12

34

5

6

1.2.3.

5.4.

6.

Demand begins to rise.

Demand bottoms out.Construction activity decreases.Supply exceeds demand.Demand slows.Construction activity increases.

FIGURE 1.1. The real estate cycle.


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