By Kathy Batesel
Roy Kroc, the man who turned a small hamburger stand into a multi-billion dollar enterprise known worldwide as McDonald’s, once told a reporter that his business was not hamburgers but real estate. Kroc didn’t invent the hamburger restaurant that made him wealthy. He’d obtained the founders’ agreements to let him sell franchises. Kroc only earned a small percentage of each franchise sold, not enough to meet expenses, so he devised a way to purchase land upon which franchises would be placed and require franchise owners to lease the land back. Then, as now, real estate can provide extremely profitable returns with relatively low risk for both novice and experienced investors if they understand certain principles.
Even beginning investors can profit from real estate. After realizing a $40,000 profit on the sale of his home when he relocated to another state, Ken B. put a down payment on a new home for himself and bought a fixer-upper for $25,000 cash. He spent another $10,000 fixing it up, then rented it for $450 per month.
A couple years later, he sold the home he’d purchased for himself, this time getting a check for $36,000. He put $20,000 down on a bigger home for himself and bought a duplex for $127,000, using $14,000 down. His payments on the duplex are just under $950 per month, and he consistently receives $1,200 per month from tenants.
For his $49,000 investment, he receives $8,400 profit each year after deducting the duplex mortgage payment. For stocks or mutual funds to provide a similar return, they’d have to achieve a 17% annual return.
Granted, he sometimes has to pay a portion of the mortgage payment while the property is vacant, and he must spend time and money to maintain the property, factors he considers very worthwhile for the return he earns. Since he plans to hold onto the properties for many years, he expects that when he does sell, he’s likely to make a tidy profit from the equity that was paid by tenants for the years he holds onto them.
Understand Real Estate Economics
During the housing bubble, many investors purchased houses with the idea of renovating and reselling or “flipping” them. They made obscene amounts of money on their flipped properties. That is, until the housing bubble burst. The seller market that permitted property owners to command high prices on their houses vanished, seemingly overnight. The only “flipping” that took place was the sudden shift to a buyers’ market. Sellers were obligated to pay the mortgages on properties they found difficult to sell as prices dropped.
The housing market collapse didn’t hurt all investors, though it probably presented challenges for most of them. Savvy investors who calculated the risks ahead of time and had a sound contingency plan continued to profit.
In a sellers’ market, many investors simply want to move property because it’s easy to do and highly profitable. Buyers’ markets indicate that fewer people can obtain mortgage loans. Successful real estate investors capitalize on turning their properties into rentals while awaiting a fortuitous marketplace. They may offer traditional leases or lease options. Lease options require some additional deposits from a buyer at the start of a lease and allow the buyer to purchase the property for a predetermined price during the term of the contract. When the tenant does not purchase it, the additional deposit money is kept by the owner.
Those who prefer not to be landlords take advantage of the market by offering owner financing to those would-be buyers who can’t obtain loans. They earn interest and principal, do not have to manage the property, and if the buyer defaults, they can foreclose to take back possession and offer the house at full price again, keeping the money they’ve made. Often, these contracts have a balloon payment date by which buyers must pay the full amount owed or get a loan to do so. Because some deeds of trust prohibit this method of sale, all investors should consider whether this is something they would find profitable and negotiate it out of their lender’s terms or find a mortgage broker who allows wraparound financing.
Recognizing that real estate can be profitable in both buyers’ and sellers’ markets won’t ensure profitability, however.
A common and costly mistake made by novice real estate investors happens when they calculate their expected returns. They think, “I’ll be able to sell it for $30,000 more than I paid for it.” Instead, they should heed the wisdom of investors that have come before: You don’t make money when you sell a property. You make money when you buy it.
When planning to flip a property, unless an investor has a ready, willing, and able buyer who has already signed a contract to purchase it, he or she shouldn’t use calculated profits as the most significant factor in determining whether to buy. The more important question is “Could I lose money?”
Costs of unforeseen repairs, estimating errors, and carrying costs can quickly eat up potential profits. Beginning investors should only purchase properties that they believe are 100% immune to loss. This means they should acquire it below market value, and that the cost of repairs plus the purchase price will still be below market value. To determine market value, they can obtain recent sales data on comparable properties from their Realtor. Finally, if they anticipate renting it, their research should provide enough data to show that they’ll receive enough to cover the mortgage, maintenance, taxes, insurance, and property management, plus provide extra to cover periods of vacancies and advertising for new tenants.
Learn from the Wise
Many successful real estate investors build good rapport with one or several Realtors. They choose real estate agents who are investors themselves. A Realtor who fully understands real estate investment recognizes great opportunities and doesn’t waste time with so-so properties. They can locate tenants, address obstacles, provide sound feedback on feasibility, and help them negotiate well for properties they’re interested in purchasing.
Specialty groups focus on generating wealth through real estate investment, and the novice investor can learn a great deal from attending their meetings. However, these groups can also be a breeding ground for fraudsters who promise to help with acquiring and rehabilitating properties. Greg S., had never purchased a property before, but was interested in acquiring real estate for profit. A man in the group he attended owned an investment company and offered to help Greg acquire his first property. Greg paid cash for the property, which was undergoing repairs by the man’s company when Greg elected to purchase another house, also for cash, again using the man’s company for help.
Greg hadn’t signed any contracts and had been assured that the company handled all the paperwork.
Months later, Greg discovered that he did not actually own the second property. The man had put his own name on the contract as the buyer! Eventually, he contacted a diligent real estate agent whose knowledge of state real estate laws helped him obtain the deed he’d paid for, but the devious “company” never finished the promised repairs, and the small amount of shoddy work they’d completed had to be redone.
Although it has low liquidity, real estate is an excellent investment vehicle for those who prefer to manage their risk, have direct involvement in growing their net worth, and want to make consistently high returns on their money if investors follow these guidelines.