Oftentimes, people begin investing in Real Estate because it is less volatile than say…investing in the stock market, a “safe” investment, if you will. Before jumping on the “safe-investment boat”, know that there is some leg-work to do. I’ve seen many new investors come across a run-down home and when looking at it, suddenly have the look of the wide-eyed blond on the 2015 Cast of the Bachelor (if you missed the premier of the Bachelor, this likely isn’t funny, but I’m sure you get the idea). They know it looks really “bad” and it could look really “good” but aren’t really certain how to put the numbers to work to make sure this potential real-estate investment (whether flipping, or holding to lease out) will reap them the financial nets one desires. (Translate: a cheap house does not always = a good investment).
There are many benefits to investing in real-estate…cash flow, depreciation (or a write-off on your taxes), and principal reduction (read: EQUITY!). “Appreciation” as they say….is “icing on the cake”. An experienced Realtor should be able to navigate you through the process if you are new to investing and even help you manage the curve-balls if you are an experienced investor, and let’s face it-there are always curve-balls). There are formulas and figures you must know and numbers you must crunch to make sure you end up on the winning-end of the deal.
Let’s start with home-flipping.
Hard money lenders are expensive, but a great asset if you can not afford to pay cash just yet (or while you are saving the proceeds from your first few flips TO pay cash). Hard money lenders function “like” cash in that they can generally close in a few days. They do want to protect their money just as you would yours and always lend with the mentality that this person “could” buy the home, then move to an island far away and never be heard from again. That being said, they will want to see good ARV (“After Renovation Value”) numbers. If there’s home you feel is a good deal for 100k but the renovated comps in the area are only selling for 140k, this home is NOT a good fit. Why? Hard money lenders (on average) will loan 65-70% of ARV (meaning on this example, they would lend 98k). You’re only 2k away, right? WRONG. There are closing costs, lender-points on the front AND the back-end…and you haven’t yet accounted for the actual renovation costs, which could be 25-30k. (You’ll want to have 10-15k of your own cash saved to (as they say) have some skin in the game. Don’t worry…you’ll make this back, and then some 🙂
As you may guess, the higher-priced properties yield higher rewards, but generally require more investment, which means higher risk: 1650 sf cost much less to renovate than say, 3,000 SF. (Afraid yet? Don’t worry…there is a rhyme to the reason). Focus on areas such as Richardson Heights in Richardson which has homes that have been renovated and have sold for much more (than they were pre-renovation). Otherwise, you can load a 135k home up with amazingly beautiful upgrades and want to sell it for 245k and may actually have someone fall in love with it and be willing to PAY that much…but it could fail to appraise for $245k because there aren’t enough comps to compare it to within a specified area that “have” been renovated. Guess what happens then? You lower your head and have to reduce the sales price because (unless they are paying cash or willing to pay over the loan value out of pocket), no lender will lend on a home that does not appraise.
Keep in mind that most of these “great deals” are sold “AS-IS” and without warranty. A 30k renovation could be night and day difference if the rehab is only cosmetic. Look at the big-ticket items when looking at a home for investment. How does the roof, water heater, HVAC system, furnace, plumbing, electrical panel and foundation all look? Although I “always” recommend a home-inspection for any hidden defects…many investors have learned what to look for and bypass this stage as you typically find the same issues over and over again and tend to have the pricing memorized. Even if sold as-is, some of these things may be items your Realtor could still negotiate for you.
It takes a little bit of guess-work to put together your “renovation budget” which you will break down and submit to your hard money lender of choice for them to approve. They will pay your contractors in draws (make sure to budget for this cost as well; they do charge a fee for each draw 😉 With a little experience, know-how and contractor contacts, you will find this step much easier to handle. As you may guess, all renovation budgets will vary on each condition and potential ARV of a property, so a lot of calculations and though must go in to this critical step. Do know that in North Texas, it is still very much a sellers market and if looking under the $200k purchase-range, there may not be a property readily available that fits your needs–it may take months to find the right fit. Don’t make the mistake of getting in a rush to buy and make a terrible decision on the property itself. You want a property that is in an area that moves quickly and in one that will appraise, such as the Richardson Heights area of Richardson, where there has been a lot of renovation. Follow these guidelines and you can have a $150k property that you can rehab for 25-30k and resale for $230k (in the right neighborhood). With this scenario, you would net about $36k post Realtor fees (calculated on a 6% listing. I always give my investors discounts if they have also purchased the property through me). Not a bad profit in 3 months (1.5 month to renovate, 1.5 months to close), right? Although much more difficult to find than rental property, they provide a quick return when done correctly.
Let’s talk about rental property.
If the fear of a bad tenant does not terrify you, and you have had good experience with other rental property and verify and screen your tenants well, rental property may be the investment for you. (*Remember also that there is less risk with multi-family homes since they will never all be vacant at the same time). For the examples below, to simplify the numbers, we will use single-family homes. The question is…how do you know if a rental property is a good investment?
Buying property to lease out does not give you an immediate, large return. However, it does give you cash-flow, principal-reduction (you basically have someone else paying the payment so that you can someday sell and make a profit), a discount on your taxes, and hopefully appreciation. You’re sort of like a human-IRA in that you hold the investment until its ready to be sold 🙂 So, how do you know if it’s a “good deal”? Most people want a 10% Cap Rate (“Capitalization Rate”) or your Gross Annual Income divided by your purchase-price. Example: If you purchase a home for 165,000 in Collin County and you can lease it for $1350 per month (1350 x 12= 16,200 / 165,000), you have a 9.8 Cap Rate. That’s it! (I’m just kidding; you didn’t think it would be THAT easy, did you?). Remember, there are still taxes to consider, vacancy loss (assume 10% vacancy loss over a year for padding), HOA Fees, a management company if you pay one to take care of the details and “manage the property”, etc.
If you’ve ever looked at your company budget, you would find it looks similar to the budget you will have for your rental properties–THEY become your business and you must treat them as such:
Annual Rent – Vacancy = Gross Operating Income
Gross Operating Income – Operating Expenses = Net Operating Income
NOI – Debt Service for a year (Your Mortgage and Insurance) = Cash Flow Before Taxes
Annual Debt Service – Interest = Principal Reduction (EQUITY building!)
Net Operating Income – Interest – Total Depreciation = Taxable Income x your tax bracket = Taxes Paid or Saved. (If you get a negative number, that’s the amount you SAVED 🙂
and of course
The Return on Investment of your Rental Property is the Cash Flow Before Tax + Principal Reduction + Tax Saved divided by your Cash Invested (your total amount finance)
Considering Real Estate as an investment, alternate source of income or wanting to reduce your taxes? Feel free to contact me; I would love to help…or answer any questions that you may have.
Amy S. Arey, Realtor | Halo Group Realty, LLC | 214.901.1341-Cell
Serving North Texas since 2002!