Lesson 3 - Acquiring The Property
Finding The Property
Real estate investors should consider
all possible sources of properties available for sale.
Print Advertising
Newspaper classified and display
advertising is used both by real estate agents and by owners selling without
agents. Although newspaper advertising is the most widely known, there
are other publications that carry ads including magazines and newsletters,
both general and specialized business and real estate publications.
Signs
Although most larger properties
that are available For Sale usually do not have signs, single-family homes
almost always do and even the smaller residential properties (duplexes,
4-plexes) often do. You should certainly check out any properties of
the type you seek that do have signs.
Real Estate Agents
When one
is buying income properties larger than single-family homes, the
availability of many, perhaps most, properties is usually only known to real estate
agents. Also, a buyer does not usually save the commission
by not using a buyer's agent.
Web Sites
There are a number of sites that provide
information about real estate and sites that not only provide lots of
information, but also show many of the properties that are listed on the
MLS.
Special Sources
Foreclosures
Some real estate investors concentrate on buying
real estate foreclosures from banks and government agencies. The up-side
is that you can sometimes buy below market value, although properties often sell
for higher than market value because buyers get carried away with the excitement
of auction. The down-side is that the property has often been abandoned and
vacant for a substantial period.
The days of stealing a really good repossessed
property for a song are, for the most part, long gone.
However, if
"bargains" are your passion, start by taking our Buying
Foreclosures e-course.
Lender Owned Properties
If, at
foreclosure sale, there are no bids for more than the loan being foreclosed, the
lender ends up owning the property. Lender owned housing is usually
marketed through brokers having relationships with the lenders.
Tax Sales
Property taxes are a lien against real
estate. If taxes are not paid for a time, varying by state, the county
ends up owning the property. Anyone can then buy the property for
essentially the amount owed in back taxes. In theory, one might be able to
buy a property worth tens of thousands of dollars for back taxes of only a few
thousand dollars. There are, however, potential pitfalls including the
fact that most states provide for a redemption period for tax sale properties,
varying from a few months to a year.
Bankruptcy Sales
Another
source of properties that you might consider is bankruptcy sales.
Properties sold at bankruptcy auctions often go for under-market prices.
However, most bankruptcy auctions do not allow for contingencies, require a
significant deposit (usually 10 percent) upon successful bid, and require a
short escrow. One must complete all due diligence and have their financing
ready to go prior to the sale date.
Other Auctions
Properties are sometimes sold through the auction procedure even when no
foreclosure, tax, or bankruptcy is involved.
New Construction
Buying From a Builder
Buying a newly constructed property from a
developer/builder has both advantages and disadvantages.
Building It Yourself
An investor with the necessary knowledge and
experience can buy some land and build it himself. He can do this a
variety of way, from hiring a licensed general contractor to acting as general
contractor himself.
Selecting A Property
There are many factors that prospective landlords and investors must consider
before selecting an income property for purchase.
Property Type
More
than 50% of the housing in America is rental property, and about 60% of that is
single family housing, so there is always a market for that kind of property.
It also can have the highest appreciation rate over the long term.
Unfortunately, it will usually produce the lowest cash on cash return in early
years and management of a large number of single-family homes is significantly
less efficient than the same number of units in a single complex.
Commercial vs. Residential
There are numerous
differences regarding the ownership and management of commercial vs. residential
income properties.Some of the
important differences are summarized below. Pros and cons are generalities and do not apply to all properties or all
the time.
Residential
The residential category of real estate includes a number of different sub categories.
- Single-Family
- Duplex
- Townhouse
- Apartment
- Condo
When evaluating the functional utility of a dwelling unit, pay special
attention to it's use zones. The living area in a residential unit consists of
three major zones: living, sleeping, and work.
Commercial
Buying, managing, and selling commercial real estate
is, in general, somewhat different than residential.
Advantages
A generalized truth is that
commercial real estate activity is less regulated than residential.
Commercial properties are, in general, not
covered by fair housing law or lead paint regulations.
Leases for commercial properties are usually much
longer than for residential, often 3, 5 10, 15 years, or even longer.
Accordingly, there is less turnover of tenants.
Commercial property has little danger of future
rent control.
Disadvantages - How
To Eliminate or Minimize Them
In spite of the above
advantages of commercial rental property, there are, as might be expected, also
characteristics that represent potential disadvantages. These potential
disadvantages can be avoided or at least significantly reduced with proper
knowledge.
Economy
One potential disadvantage of
commercial property is that it tends to be more easily impacted by a bad
economy, but there are ways to protect against a bad economy.
Lease Documentation
Although the allowed terms and conditions of commercial leases are more flexible
than residential, and partly because of that, the lease documents themselves are
generally much more complex. It is not unusual for a commercial lease to be 20 or many
more pages of single-spaced typing.
Different categories of commercial properties require different lease clauses
and even for the same property specific tenants may require customized leases
due to the nature of those tenants' businesses.
Length of Leases
The fact that commercial leases are relatively
long was listed above as an advantage, but this same fact can sometimes become a
disadvantage. Since rent increases are usually defined for the term of the
lease, and sometimes even for subsequent renewal,
means that the owner may not be able to keep up with rapidly escalating market
rents. Of course, in a bad market, the automatic increases work to the
owner's advantage.
In order to avoid the long-term lease being a
disadvantage, the owner must simply make sure the leases provide for periodic
increases that are reasonably certain to keep his rent up to expected future
market rents.
Tenant Improvements
Spaces in commercial properties are often
remodeled or completely rebuilt when new tenants take over. Because
this can be a costly project, the lease should be very clear regarding how the
cost of these improvements are allocated between lessor and lessee. The owner must also protect himself against mechanics liens by a
tenant's contractors by posting Notices of Non-Responsibility.
Recourse
The
tenant of a commercial property is often a corporation or other entity having
limited liability. If a failing corporate tenant defaults, there will
likely be no recourse in collection of rents or damages. This problem is
avoided by requiring that financially qualified person or persons, whether
principals of the entity or third parties, become personal guarantors of the
lease. Having guarantors is of benefit not only during the period of
ownership, but also when seeking financing or selling the property as the values
of the existing leases are enhanced.
Purchasing, Financing, Selling
The purchase and sale
of commercial property often requires more documentation and more investigation
than residential.
Commercial properties are also, in general, harder to finance or refinance, in
that larger down payments are required and interest rates are higher.
Special Concerns
Although the government has less interest in many aspects of commercial
properties, there are several areas where that does not hold.
First, environmental issues can be a concern.
Past use of chemicals on the premises of certain types of commercial properties,
even if occurring under ownerships many transfers back, can be a serious
liability for a new owner.
Second, commercial property can be impacted by
the Americans with Disability Act (ADA).
Accordingly, much more investigation is usually required for purchase of a
commercial property compared to residential. This is not a reason to avoid
commercial property, however. It simply means the buyer and manager must
exercise reasonable care.
Types of Commercial Properties
Each type or category of commercial property has its own specific
peculiarities.
Retail: The retail category includes
any space leased to any business that sells anything (e.g., grocery store,
restaurant, bookstore).
Office: Tenants in this category
usually operate service businesses (e.g., real estate, insurance, accountants,
attorneys).
Industrial: Industrial space is usually
suitable for manufacturing use.
Warehouse: Warehouse property is used
for storage of items.
Storage Units:
Although storage units space is more often rented to non-business persons for
personal use, we consider it to be a commercial category because, since no one
usually lives on the premises except perhaps a manager, it is not residential.
Mixed Use:
Mixed use covers any property where spaces in the complex are not all one of the
categories discussed above.
Many Small vs. Few Large
There are numerous differences regarding the
ownership and management of many small properties vs. a few large properties
(e.g., 10 single-family and 5 duplexes or one 20-unit building) that one should
consider.
Although it is usually true that a few
large properties are
preferable to many small properties, such is not always the case.
For example, diversification could be the primary consideration if one were
concerned about the future economic future of the area.
More importantly, a beginning investor will not usually be able to start
with large properties.
Location, Location, Location
Real estate professionals tell
buyers and sellers that the three most important things that determine real
estate values are: location, location and location. For
example: an 1,800 square foot, three bedroom ranch, on the waterfront, sells
for substantially more than the same home on the lower east side of any large
city. You will also note that a typical home in Santa Barbara, CA sells for
two or three times what it would in Cleveland or Detroit.
Always remember that property you consider for
investment should be located in places where people want to live. Communities and their neighborhoods, normally go through four-stage
cycles, progressing through growth, maturity, decline and finally
rehabilitation. Property values rise with growth, stabilize, then typically
fall during the decline stage. The most dramatic price increases usually occur
during the comeback rehabilitation phase. Real estate investors should always
make a careful study of the property's location with these kind of inevitable
cycles in mind.
Stay Local
If you live in Maine, don't buy income
property in California. That is, unless you are talking about a complex
with hundreds of units that will justify hiring a competent professional
management team, including a property manager, resident managers and
maintenance personnel, you will need to keep close watch over your rental units.
And, even if you use a typical property manager, you can't do that from across
the country or even across the state. See our Web page Selecting
a Property Manager. The subject of
management is discussed further in a later
lesson of this course
and is covered in even more detail on other RHOL pages and in the
Managing Income Property e-course.
Neighborhood
Prospective buyers should complete a
thorough inspection of the neighborhood and its environs prior to purchasing
rental property, . They should also try to get a clear picture of the
neighbors as well as the surrounding a property.
When you invest in real property, whether your
personal residence or as a rental property, you are actually investing in a
neighborhood.
It always pays to participate in neighborhood
improvement campaigns.
Government
There are several types of government controls that affect the income and
value of rental property. The very worst among them, of course, is
rent control. Followed by
environmental pitfalls, strict code enforcement, mandatory inspections,
and zoning and a myriad of other regulations and requirements that seriously
affect income property values. Another type of government control that
can actually increase the value of existing properties is growth restriction.
If a property is located in an area that has,
or is considering rent control, the price of the property must reflect the
impact rent control has on income and the economic feasibility of maintaining
or improving the property. Mandatory rental inspections are also potentially
very expensive; primarily because they are usually subjective.
Zoning is a major consideration in the purchase
of commercial properties, but affects the permitted uses of residential
property as well.
Timing
Although location is usually
considered to be the most important factor (in fact the first three factors)
in determining real estate values, many experienced investors feel that
the three most important factors likely to affect the value of an investment
are: timing, opportunity, and information
(inside or otherwise). The timing of a real estate purchase is just
as important a consideration as location and price. Real estate is a local
investment; property values depend heavily on the current state of the local
market.
It is probably best to purchase property in a
market of rising values. Many investors always try to predict the bottom
of a poor market, and make purchases at that time; but often their predictions
are just a little off and property values continue to decline.
Age
Chronological age is the number of years since a structure was built, but perhaps more
important to an investor is the effective age, the age that the
improvements appear to be. Actual age and effective age are similar when a
structure is new, but change quickly when it has been allowed to deteriorate.
Some homes may be in beautiful condition physically, but their decorating
schemes and floor plans become outdated because tastes change or because needs
change.
The greater the effective age of a structure, the
more substantial will be the loss of value. Effective age can often be reduced
by routine maintenance and regular updating.
It should be noted, however, that an older
structure will never have an effective age of "new", regardless of updating.
Certain features always betray the fact that the structure is not new.
Condition
A property that is a good candidate for real
estate investors almost always looks to be in bad condition. That's OK, if it
has the "right things wrong with it." For
example, needing paint, a sagging porch, bare bones landscaping, ugly
wallpaper, or being dirty and unkempt are easily fixable. However, the "wrong things wrong"
are problems that cannot be cured except at relatively great expense such as
tiny bedrooms, lack of closets, steep narrow stairways, one bath, and, most
importantly, bad location.
Price
Many new investors make the mistake of
buying "bargain" property for rental housing - because
that is what the man on TV
told them to do - without understanding why tenants
choose the location the want to live in, and the kind of home they want to
rent. To get good tenants you must own decent, safe and affordable housing in
areas where people want to live. Schools, transportation, shopping, churches
and jobs all affect the amount of rent a tenant will be willing to pay to live
in your property. And that determines the price you can pay for a rental
property.
There are legitimate reasons for a decent
property to sell well below market. For example: divorce, death, and
taxes, can motivate sellers to take a quick cash offer that they would never
agree to under normal conditions. But perhaps the most common reason a seller
can't get a fair price for their property is inadequate professional marketing
or "deferred
maintenance".
If you are buying property for rental
housing, the purchase price can be relatively unimportant. What is as
important is: -- the amount of money it will take to make the property decent,
safe, sanitary and desirable to a desirable tenant, the terms of the sale, and
the market rent for that type of property in that neighborhood.
What can you afford
Most real estate investors have a limit on the
cost of the property that they can buy.
There are several factors that affect that
limit. First, there is the amount of cash that you have available to
cover the down payment, loan costs, and escrow costs. However, even if
you buy the property with nothing down, zero loan costs and the seller covers
all escrow costs, there are still limits. One limit is usually imposed
by certain principles of economics. That is, the higher the leverage the
less the positive cash flow, even when there is no vacancy and no deferred
maintenance. Unless you manage to "steal" the property because of
special circumstances, it is likely that a zero-down
purchase will have a significant negative cash flow. While you might be
able to cover a $200 per month negative cash flow from a small single-family
house purchased with no money down, few investors can or want to cover the
$10,000 monthly negative cash flow from a 30-suite office building.
Another related limitation comes into play as
soon as you need financing from other than the seller. For a residential
property larger than a 4-plex and for most commercial properties, lenders will
loan only 70 to 75 percent of the value. Furthermore, the lender will
usually want to see that the buyer has 10 to 20 percent of his own money in
the deal, so the seller's willingness to carry 25 to 30 percent will not
usually allow you to buy with no money down.
So, the bottom line is that the maximum value
property that you can buy is limited to that for which you can afford the down
payment necessary to reduce financing to the level that the property will
produce at least a small positive cash flow or a negative cash flow that you
can carry with minimum risk until the property's Net Operating Income
increases sufficiently. While this varies with (1) the current interest
rate and financing costs, (2) the price you pay relative to gross income, (3)
the expenses relative to income, and (4) how much deferred maintenance comes
with the property, you can typically buy a property costing in the range of 3
to 4 times the cash that you have available.
What's It Really Worth
No one wants to pay more for
anything than it is worth. Understanding how to determine the value of
income property is probably the most important single skill for successful real
estate investment.
Fair Market Value
Fair Market Value is the most probable price that a property should bring
in a competitive and open market under all conditions requisite to a fair sale
with the buyer and the seller each is acting prudently and knowledgeably and
assuming that the price is not affected by undue stimulus. Implicit in this
definition is the consummation of a sale as of a specified date and the passing
of title from seller to buyer under conditions whereby:
-
Buyer and
seller are typically motivated,
-
Both parties
are well informed or well advised and each acting in what he considers his own
best interest,
-
reasonable
time is allowed in the open market,
-
Payment is
made in terms of cash in U.S. dollars or in terms of financial arrangements
comparable thereto, and
-
The price
represents the normal consideration for the property sold unaffected by
special or creative financing or sales concessions (adjustments must be made
for special or creative financing or sales concessions)
There are many different approaches to determining fair market value. Some of
these methods are meant to be used only for rough estimates, some are more
accurate in certain markets and for certain types of properties, and some are
considered to be generally accurate and are used by professional appraisers. A
valuation is always more an opinion than a fact.
RHOL has an e-Course,
Valuing Income Property, that discusses value in considerable detail and
shows you how to value a property using a variety of methods. If you have
not yet taken that course, you should do so. While you will not have to
complete that course prior to finishing this one, you will have to understand
how to determine value prior to an
actual purchase or sale.
Tax Ramifications
The IRS code is designed to provide
incentives or penalties that promote or discourage financial activity in
America, according to the political and public policy of the moment. Home
ownership and investments in rental property are perhaps the primary examples of
how effective the tax code is at effecting the value in what is purported to be
a free market place.
Although we do not believe that investors
should build or buy rental housing just for the tax benefits, they are certainly
a very important part of any investment plan. We provide further
discussion of taxation in a later lesson.
Conclusion
Real estate investors should consider
a multitude of sources when searching for properties.
For properties being purchased via foreclosure,
property tax, or bankruptcy sales it is very important to never buy anything
without extensive prior inspection.
By their nature, some of the sources usually
provide properties that require rehabilitation. Buying for rehab can be
either profitable or costly, depending upon whether one correctly assesses the
property.
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