How to Invest in Real Estate | Basics of Real Estate Investing

I wanted to, as concisely as possible, summarize an overview of real estate investing as I have internalized it so far.

In general, a lot of real estate is not particularly complicated – just difficult. It’s not rockets science, but it takes persistence and creativity to achieve success. The usual economic principles apply – buy low, sell high, minimize your risks and expenses.

Leverage

There are some unique benefits that come with investing in real estate, that differ from other entrepreneurial ventures, like starting a business. The biggest of these is the concept of leverage, where a bank will hand you a lot of money to invest in your “venture” just because they believe the tangibility of real estate protects them from risk.

The belief that they could foreclose on the house if you stop paying your loan, which they can then resell to another person, makes them more inclined to invest in you than in, say, a printing business that would leave them stuck with a bunch of expensive printing equipment.

1. Strategies

When it comes to investing in real estate, there are a few broad categories that the vast majority of investors will fit into.

The first, and most classic, is those who buy and hold on to their properties, renting them out to others. They don’t usually make a lot of money on any one property, but over time this monthly rent pays down the mortgage they paid to purchase the property, allows them to hold on to the property as its value hopefully increases, and gives them a few hundred dollars in their pocket every month which can still add up if they purchase enough of these properties.

Buy-and-hold

This first form of investing, landlording, is one of the only true forms of real estate investing. These other two common approaches are more like businesses that happen to be in real estate. They both can generate a lot of money for the people engage in them, but as soon as they stop engaging in them, the money stops too. These approaches are flipping and wholesaling.

Fix-and-flip

House flippers buy run down houses, or houses below market value, and pump money and work into them to bring them up to their true market value. After rehabbing these houses, they turn around and sell the property for a profit to a final buyer who is looking for a shiny new house. The underlying principle here is that a renovated house is worth more than just the purchase price plus the work put in, the same way that a computer is worth more than just the sum of its parts plus assembily – people will pay a lot more to receive a finished final product.

Wholesaling

Wholsealers are all about creating connections. They specialize in finding deals that are so good, that they can then turn around resell them to house flippers and make a profit by being the middlemen. Thus, you might have a case where a seller sells his house to a wholesaler, who immediately passes it on to a flipper, who renovates it and sells it to a final buyer.

 

2. Rehabbing

A key part of making the most money out of real estate transactions is renovating the house. As discussed above in flipping, this can force the appreciation of a property, in other words, extract value that the house has hidden within it as potential, and actually express it in real world worth.

For example, imagine all the nice houses in the area are selling for $200,000. You find a house that’s just like the other houses as far as size and location are concerned. But it’s run down and outdated, and you manage to buy it for $100,000. You then invest $50,000 to bring it up to standard, but after all that work the house is now worth $200,000, like all the other houses, so you now have an extra $50,000 in equity that you’ve extracted from the house.

What you do at this point, depends on your strategy. You could sell it to someone right away, essentially flipping it. The upside is you’ll get your cash right away, but you’ll also have to pay a lot of taxes for the profit, as well as all the fees associated with selling a house. You could choose instead to hold on to the house, and use that extra value take out a new loan on the property, potentially giving you more money to invest in the next deal.

 

3. Financing

So how do you pay for all of this? Real estate is area of big sums and potentially big returns. All the numbers are just bigger in this industry, so how do you get started? Here are some of the common ways to finance deals:

Mortgages

Mortgages – this is the most common way most people buy houses, usually for themselves. Mortgages have the lowest interest rates of any financing options, and often require very little money down – as little as 5 or 3.5 percent, and sometimes even nothing down.  However, mortgages can take the longest time and headache to actually obtain – a potential downside in a field where closing quickly on deals can give you an advantage.

Most mortgage lenders will not lend you money on a house that’s not in habitable condition, meaning you won’t have the opportunity to buy a place that needs rehabbing and make the extra “sweat equity” you would get from renovating it. (Some mortgages, like a 203k loan, do allow rehabbing, but they still make the process more complicated) Finally, keep in mind that most investment mortgages require a higher down payment on the investor’s part, usually at least 15% of the property’s cost.

Hard Money

Hard money lenders – despite the negative sounding name, hard money lenders are basically money lenders who specialize in short-term loans for real estate investors. They will often finance all of the rehab costs and most of the purchase costs of a property, and unlike a bank, they move very quickly to help you close the deal. This comes at a cost though. Hard money has a much higher interst rate, usually between 10-15%, and will also charge you “points” a percentage of the loan, on top of the loan, as an “origination fee”. So if you borrowed $100,000 to purchase and renovate a home, and the lender charged you 4 points, you’d actually owe them $104k, and often need to pay the $4,000 upfront.

In general, hard money lenders give out short term loans, usually between 6 months and a year. This is both because they want their money back to make the next deal (remember those points that they get for every new deal), and becaseu the high interest rates put pressure on the investor to pay back the loan.

Exit strategies

How is this done, practically? By either selling the house (flipping it), or refinancing it with a mortage and holding on to it. Remember, banks will usually not  lend money to buy a run-down home. But once you’ve fixed it up by other means, and held on to it for a certain period of time (usually six months), they are happy to refinance you out of your more expensive loan. You thus get a lower interest rate and therefore lower monthly payment, allowing you to make a larger profit from your rental income.

Sometimes, you may have extracted so much equity from the house by fixing it up, that the bank will give you  even more money for it than you even owe the hard money lender, and you can walk away with cash in your pocket. How would this work? Let’s start with the premise that most banks will finance around 70% of the total home value. So say you buy a house and rehab it at a total cost of $100,000 (90% financed by hard money and 10% from your own pocket).

Because of all your hard work, the house is now valued at $160,000, and the bank will actually give you a $112k mortgage for it. You put a renter in the house to pay off the monthly mortgage, pay back the existing debts to others and yourself, and still walk away with $12,000 which you can put towards your next deal. This is referred to in the Bigger Pockets community as the BRRR  strategy – buy, rent rehab, refinance, repeat.

Private money

The third main way people finance their deals is with private money. There are many individuals who have money they are looking to invest in real estate, but for various reasons do not want to do the work themselves. Then can then hand over the money to you, the investor, to invest it for them. Since this is basically an agreement between two adult individuals, there are endless ways such a deal can be structured.

In broad terms, it usually takes on one of the two forms below, although sometimes the two can be creatively combined together:

  • Equity share – as in all investments, the principle is always the same: the higher the risk, the higher the potential reward. A lender can choose to have a stake in the property, and therefore make a percentage of the total profit when the house is sold – or a percentage of the rent when the property is rented out. The flip side though, is that if the deal goes south, they lose as well.
  • Interest-paying loan – safer route for investors, which usually leads to lower returns, is to lend out money and receive a fixed interest rate in return. Rates often average around 10%, since they generally need to be lower than hard-money lenders, and investors often begin to receive checks in the mail right away. This rate is fixed, and generally does not depend on how the deal itself performs. That is not to say that the loan is not secured, often this type of investor could still have a lien on the property as a form of securing his investment.

Again, since the needs of both parties can vary, there are many creative and diverse ways that these deals can be structured to the satisfaction of both parties.

 

4. Types of real estate

There are two broad categories where most people invest in real estate: residential and commercial.

In the US, a residential property is up to four units meant for people to live in, and can include single family homes, rowhomes, and condos.

Commercial properties include any location that is rented out for commercial purposes, such as stores and restaurants. However, it also includes apartment buildings with more than four units in them. So a building comprised of 10 two bedroom apartments is actually a commercial property.

There are a few key differences between residential and commercial investing. Residential properties are generally cheaper, and therefore more easily accessible and manageable for entry-level investors. Commercial properties are more expensive, and it can take more creativity and experience to structure their financing.

However, commercial properties have the distinct advantage that lenders will generally look more at the property itself and less at the person borrowing. If the numbers seem right, they are more likely to lend to you regardless of how many other assets you own (most banks don’t like lending to people who already have four conventional mortgages on other properties) or what your credit score looks like. The value of the property is also estimated based on the amount of money it brings in, as opposed to residential properties where you compare it to the value of other houses in the area.

Thus, even residential commercial properties are more like a business, where even if you’re in a bad area or other buildings nearby are not valued very highly, if you manage to make your building perform, you’ll have it valued more highly.

 

5. The Investment Process

Broken down into the simplest terms, the art of a successful real estate deal can be broken down into buying, fixing up, and selling. You want to buy a house as cheaply as possible, renovated it as quickly as possible for the lowest cost, and then selling or refinancing at the highest price possible.

Buying – finding properties to buy can be done in a variety of ways, from searching real estate listings online like Trulia or other MLS services, getting deals from wholesalers, or finding them yourself. The purchase price is actually the most straightforward number you’ll be working with, although there is an art to submitting and negotiating offers below the price being asked by the seller. This can often lead to huge reductions and savings off the original asking price.

We’ll jump ahead for a moment to the final stage – selling. The value of a residential house is established based on what the other houses in the area are selling for. Based on the square footage, type of house, number of rooms and the condition of the house, you try to “comp” or compare the house to other houses in the area and estimate its ARV – after rehab value. This is something a good investor-focused agent can help you with.

So now you’ve got the beginning – asking price, and end – ARV. Now the biggest variable, and the one that’s the hardest to calculate, is the middle – the renovation. This is because generally you will not be doing all the work yourself, but will need to rely on a whole list of other professionals to bring out the full value of your house.  At any point, any of these individuals can bail on you, perform shoddy work, or otherwise scam you, leading to increased costs. And even if they all perform professionally, there is still the chance the unexpected issues will arise with the property itself.

It’s therefore  important to include large contingencies into your rehab budget, and to constantly work to find trustworthy professionals to do your work for you. There are many lessons in this area that usually need to be learned d through trial and error, and over time investors get better at getting a feel for how much a renovation will actually cost.

Once you have the beginning, middle and end of your process mapped out, you can perform the calculations of whether a property is a good deal or not. One final note: generally, the quality of work, and therefore expense, required to make a house rental ready is usually lower than what is required to actually resell it to another buyer. People are more picky when they are putting down tens of thousands of dollars to buy a home for themselves, and it’s important to keep this in mind if you plan on flipping your property.

 

6. Pitfalls

The two biggest issues most real estate investors make is by miscalculating their property’s expenses, as well as the cost of rehabbing the house.

When it comes to calculating a property’s expenses, most people just think about the mortgage and property tax. If the rent is more than that, they think they’ll be getting a monthly cashflow from the property. Not so, young grasshopper.

In addition to those obvious costs, there are the costs of all the things that break in the house – the small things that need to be fixed, like a burst pipe, and the heftier “cap ex” expenses that eventually come up like replacing a roof or furnace. In addition, rentals usually experience some vacancy which means you won’t be making a profit during those months, and in fact, every turnover usually means you’ll need to pour some money back into the property to fix it up for the next renter.

So as a conservative rule of thumb, investors recommend ascribing to the 50% rule: assume that 50% of the rent will actually go to expenses other than your mortgage. Woah.  This means your monthly debt servicing and profit need to come from the other 50%, which generally means you’ll be cashflowing less than you think every month – and which forces you to be more conservative and to look for even better deals.

Rehabbing, as described above,  is another area where people are likely to mess up, and here, a certain amount of trial and error is inevitable. It’s important to include large contingencies into the budget to try to mitigate these issues, it’s better to be conservative with your estimates, especially in the beginning.

There’s another helpful rule of thumb that investors have that relates to this: the 70% rule. This states that you should not spend more than 70% of a house’s total after rehab value (ARV) when purchasing and renovating it. This will give you some more leeway in case you mess up a bit with your numbers, and conveniently is the approximate amount that banks will pay for you to refinance out of your short-term financing options.

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