How to Invest in Real Estate: 5 Scenarios to Consider
The first question to ask yourself is what are my real estate goals?
Am I looking for a quick return or short term gain? Am I looking for income? Am I looking for a long term gain? Am I looking to use my primary residence as a fix and flip investment opportunity? These questions can actually bring about additional questions that can help you focus your real estate investment goals. I personally believe that real estate is a great investment strategy that anyone can find a successful path to wealth and financial gains. Let’s answer some of these questions and share different investment strategies and ways to buy investment real estate.
How to buy real estate if you are looking for a quick return or short term gain.
This real estate investment strategy is very popular and more notably called flipping. There are numerous books and resources that are published that can guide and share strategies for flipping. To be clear, flipping is very challenging and takes skill and resources to be successful. To be successful, you will need to find, analyze, purchase, rehab, and sell a property for a profit in a short period of time. Finding flips is not easy. Most investors that are successful at flipping, find off-market opportunities that are in poor condition or some form of distress. These investors can analyze the cost and time to rehab quickly. Often times, these investors will need to budget in cost overruns as expenses can rise with rehab surprises. Once you find a flip, being able to negotiate a below-market purchase price is paramount. Most sellers are not willing to “give their homes away.” This is the art of the deal for these investors. How to negotiate with a seller to maximize their potential profits while minimizing their risks. The most successful flips I’ve seen have been by investors that find off-market properties for incredible bargains, such as estate sales, probate sales, short sales, bankruptcy sales, foreclosures, and word of mouth sales. This process takes patience and the where with all to pounce when the right opportunity presents itself. The most successful flips also are able to not only repair a distressed property, but they enhance the property. This can be achieved by tearing down walls and opening up the floor plan during the renovation. This can also be achieved by adding an addition or a level to the home in addition to a full remodel of the home. No longer is it enough to add fresh paint and new carpeting to be wildly successful in the flipping space. After the rehab, knowing the market and selling for maximum returns is paramount. I personally have investor clients that I work with and sell their flips. I am engaged with them during their entire process and help them gauge their market strategy before they even purchase a home. I make recommendations on how to renovate to achieve maximum returns. The flip process takes focus and a team to be successful. Many flip investors will use hard money lending to acquire funds necessary to purchase the flip opportunity. I have had flip investor clients that have even used self-directed IRA funds to flip homes. Funds are necessary for both property acquisition and property renovations. Short term financing options are expensive. This is why speed to repair and resell is an important factor for flip investors.
How to buy a real estate investment if you are looking for income.
This real estate investment strategy in comparison to flipping is like the old fable, The Tortoise and the Hare. Flipping is fast and furious and investing for income is slow and steady. Investing for income is straight forward. Finding a home or investment that has a good yield for cash flow. In the northern Virginia market place finding a home that returns over 5% cash on cash return could be considered a good income-producing property. Other investments, such as multi-family units and commercial real estate investment, may also provide good net income opportunities. Finding great long term tenants to keep turn over low is critical for this type of investment strategy to be effective. Also, having low operating expenses is important. Low taxes, low community fees, and minimal repair or maintenance requirements help keep income production high. These wonderful investments are sometimes called cash cows! This type of investment is not flashy, exciting, or sexy! Every month as an investor in income-producing property, I celebrate the monthly rental deposits. This type of investing requires cash to provide the highest monthly income opportunity. Stock market volatility is currently high. Perhaps reallocating some stock market positions can yield enough cash to purchase an investment property for income-producing strategy. Using 401k funds is also an option to produce enough cash to purchase an investment property for income growth. This can be achieved by rolling over IRA and 401k dollars into a self-directed IRA. Many people do not realize that a self-directed IRA can invest in just about anything, including real estate. The gains (monthly rent and property appreciation) are reinvested into the self-directed IRA. For example, in late 2017, I purchased a townhouse for $260,000. At today’s market valuation, the home is currently worth about $290,000. I’ve had stable, wonderful tenants paying $1750 per month. My annual expenses for this property are roughly $3000. In 20 months, my income after expenses has been approximately $30,000. This is roughly 6.9% cash on cash return on my original investment before the tax benefits I receive through depreciation just from the income received through rents. I will not realize market appreciation until I sell this home. If I evaluate my returns to include market appreciation I am looking at a 13.8% gain currently. When I chose to sell this home, I would likely utilize a 1031 exchange and purchase another investment property and defer the tax on capital gains. Another reason I like having investment property is that I have more control in the management of the property than I do with the whims of the market driving my stock portfolio. It is important to note that I will always have a balance of both, stock and real estate investments in my portfolio.
How to buy real estate investments when looking for a long term gain.
This type of investing is pretty straight forward but can be somewhat speculative, but hugely profitable. In this type of investing, finding areas of rapid growth and appreciation potential is key. Understanding area growth and employment patterns are very relevant. For example, in Northern Virginia with the announcement of a second Amazon Headquarter, a large land purchase by Microsoft in Leesburg, a huge investment by Micron Technologies in Manassas, would make some of these areas ideal targets for purchasing a long term investment property. With the forecast of large economic growth and job expansion, long term market appreciation is likely, so targeting these areas would be recommended. Purchasing an investment home in these areas can be achieved in several ways. Having at least 20% to 25% down-payment is important if obtaining financing for this purchase. Keep in mind that the smaller the down-payment, the higher the likelihood for negative cash flow. Some investors are willing to accept some negative cash flow for the promise of a high return on appreciation. Leveraging your resources and using other people’s money to create wealth is a great way towards success. This type of investment can yield an incredible return on your capital investment; however, it does open you up to more risk, especially when in a negative equity position and/or during a vacant period. As an example, an investor purchases a townhouse in Leesburg. In this example, I’ll use a townhouse that is listed in Exeter at $355,000. Anticipated rent for this unit is $2000 per month. For an investor using 25% down-payment at a 4.5% interest rate, the Principal and Interest payment would be $1350 per month. Adding in taxes, insurance, and HOA fees, will add roughly $450 per month to this investor’s outflow. In this scenario, we have positive cash flow, by about $200 per month! With all the expansion in the Leesburg area, it is reasonable to speculate an appreciation rate of 5%. That would be an annual gain of a little over $17,000 per year. In addition to the appreciation, you have a tenant paying off your debt and expenses. Your initial investment of $88,750 is growing at 28.6%. That’s HUGE! Even without property appreciation, leveraging and having a tenant pay off your debt is yielding you over 8% return on your initial $88,750 investment! Here’s another added benefit, depreciation. Since your income after expenses is only $200 per month, this is really not going to be a huge income tax concern. However, if you are able to take advantage of depreciation, this asset will shelter $9,635 for depreciation. The risk-reward factor is greatest with leverage. Vacancy risk and non-paying tenant risks are real but should be controlled with proper screening and diligence. In this example, there is a 5.3% capitalization rate and a cash on cash return of 2.85%. This is a great way to build wealth and have huge returns on investment.
Who said you can’t make your primary residence your investment?
This is the ultimate in investment options, in my humble opinion; however, so few people capitalize on this opportunity. The old adage my home is my castle tends to get into the way for many people and this stops them from looking objectively at their own homes as an investment. Additionally, this strategy requires renovation and frequent moves which can be difficult and unappealing for many families. But for those brave industrious investors, this is a great opportunity. So here’s a great way to make your primary residence your investment vehicle. My recommendation is for an owner occupant purchaser to buy an ugly home in a great neighborhood. The cost of renovation financing is a bargain for an owner occupant purchaser. Thinking with a “flip” mentality with a 2-year occupancy and renovation timeline can be such a wonderful opportunity for gains and growth. In addition, utilizing this strategy allows for all the growth and gains to be potentially tax free when the home is sold as a principal residence! What a winning proposition. So if you are considering purchasing a home, look for that dated, ugly, home that needs a bit of a facelift. Renovation financing allows you to mortgage the renovations and spread out the expense over 30 years at a very low-interest rate. Purchasing with renovation financing can be accomplished with as little as 3.5% down-payment for FHA renovation financing or 5% down-payment for conventional renovation financing. So let’s take a look at a listing that I have in Springfield at 7400 Jenna Road. This home has amazing bones but is very dated. Resales for renovated homes in this community sell over $700,000. This home is listed for $625,000. An owner-occupant purchaser may wish to renovate the kitchen and bathrooms in this home. They may also wish to replace the main level flooring. The cost to renovate, in my opinion, will be approximately $65,000. This work can be completed upfront with contractors using renovation financing and enjoyed by the homeowner. After 2 years, this home will have a likely value of $750,000, with a purchase and renovation price of $690,000. Assuming a down-payment of 5% on the renovated purchase price of $690,000, this cash invested in this opportunity is $34,500. Please remember that the home purchase would have spent 5% down payment no matter the home purchased, so this is a fixed expense. The added cost of the renovation financing and renovations will run roughly $500 per month. If this investor sold after 2 years, the additional monthly cost of the renovations will be $12,000, not the full $65,000 expense. If this investor capitalizes on the renovated value of the home, let’s say $750,000 after 2 years, his all in expenditure for this opportunity over and above his fixed living expenditures will be $12,000. His gains from renovations are $125,000 ($750,000 - $625,000) - $12,000, the actual paid renovation expenses financed over 30 years for the 2 year ownership period. That’s $113,000 in 2 years, most likely tax free. The leverage here is the renovation financing coupled with the owner occupancy. It’s genius, but it takes commitment to move every 2 years! Please remember that with renovation financing, the work is completed by licensed contractors approved by the lender. This type of financing does not require the work to be completed by the homeowner. The major inconvenience can be short lived with diligent contractors. Repeating this process every 2 years is an amazing way to build wealth! Taking your proceeds and using them to purchase rental property is strongly encouraged!
Additionally, a primary residence can be converted into an investment property. This too is a great way to build wealth and have tenants pay off mortgage debt. Again, this strategy will work well if there is enough equity for positive cash flow. I have had several of my clients do this type of investing purposefully and also accidentally. Sometimes when a homeowner wants to step up into a new home and they find themselves upside down on their first property, they rent this home and become “accidental landlords.” This is not the ideal way to become an investor and I often find these accidental landlords wanting out of their investment when they find themselves with equity. Those that do this purposefully, find that they grow their wealth through their tenant paying off their mortgage debt, positive cash flow, and property appreciation.
There are numerous other ways to buy investment property. The limit is based upon your creativity, and ability to finance/leverage your investments. What works best for you is a personal choice. It does not matter how you purchase your investment property, I only urge you to invest in real estate. Even if your investment is a diversification of your current portfolio, real estate investments are critical to the well-balanced investment plan.
Feel free to reach out to me to discuss options and individual strategies.
Long & Foster Real Estate