Real estate investing (REI) has become a mainstream topic with the fantastic increases we have seen in property values over the last couple of years. Millionaires have been created seemingly overnight and everyone from high-school dropouts to retirees are part-taking in the current frenzy of real estate investing.

For the purposes of this article, I have divided the rest of it into two sections. I have found that most novice investors want to either resell properties (short term) or rent out properties (long term.)

Property reselling ("Flipping",foreclosures/fix up and sell/buy low sell high etc)

It is possible to make a lot of money in a short time investing in real estate in an up-market as we  currently see in this area (Washington D.C.) and in other metropolitan areas around the country. Especially prevalent the last couple of years have been flipping. Flipping, in general, is buying a property for the purpose of reselling it within a relatively short time period.

Do not confuse the flipping discussed here with the illegal flipping schemes that has been in the media lately. In those schemes, a combination of mortgage and appraisal fraud took place to inflate the appraised value of a property and then pass the property on to a consumer. Flipping in this article is just another word for resale.

To make money in any kind of transaction, you have to add value to the transaction. The value you add by flipping is taking away risk from a builder or owner and assuming that risk yourself. You are betting on a price increase from when you purchase a property to when you sell it, leaving you with a profit (preferably a huge one!)

With new construction, you are counting on general price appreciation from the purchase date to the completion date. The builder may also give incentives for using their lender that would add to your profit.

With existing construction you are counting on a rebate (i.e. a distressed seller), a possible general appreciation (buy and hold for a limited time) and/or the value added by making improvements to the property.

With existing property flipping you often need relatively large amounts of cash for a down payment,  deposits and so on. Generally, with conventional financing, a 20% down payment is necessary. Many investors use Home Equity loans on properties they already own to finance the down-payment of other properties, also called leveraging.

With new construction you may sometimes be able to get a builders contract and the control of a property for a small down payment. For example, you may get control of a $300,000 town home by paying a $5000 deposit to the builder. However, you will in most cases still need to get a loan, pay closing cost and a down-payment before reselling. As construction usually takes time, by the completion time maybe a year later, the appreciation may give a good return if you are in an up-market. Click here(pdf) to see a spreadsheet sample of  how a $63,500 initial investment gave an after tax return of about 130%.

Flipping generally incorporate one or more of the following concepts:

1. "Buy a property from a distressed seller at a low price then resell it at a high price"
   
   Premise and assumptions
   Owners of properties become distressed for many reasons. Nobody starts out distressed. Sickness, job loss, divorce and death are common causes; none of which are happy circumstances. If money is tight and/or your life is falling apart around you, most people like to simplify their life and get rid of external distractions to better deal with their pain. High mortgage payments, threat of foreclosure, no income and so on will result in a owner needing money fast. Selling a house with a real estate agent could take months. A savvy investor can purchase a house in days, hence there is a market for people that quickly can  exchange a property for hard needed cash. There is a fine line between helping out distressed owners and taking advantage of people that has hit a rough patch in their lives - don't cross that line.
   
   What creates value/justifies your profit?
   • Your time working with the sellers to help them avoid bankruptcy etc
   • Your ability to act fast and solve a problem before it gets out of hand.
   • Using your own money to make payments on a property for the owner while trying to find another buyer to resell to.

   Pros/Cons

   • You will have to pay taxes on the profit you make (holding a property with the intent to resell would in most/all cases disqualify the transaction from a 1031 Exchange.)
   • Deals can be complex if you are doing subject-to, wraparounds and so on. Mortgage companies may not like what you are doing, and if they find out may call the loan balance due. Have a backup source of financing to reduce risk.
   • You can make quite a bit of money with minimal investment.
   • It will take a lot of prospecting, patience and perseverance to find and complete these deals.
      
2. "Buy a dilapidated, underdeveloped or abandoned property cheap, fix it up, sell it for more"
   
   Premise and Assumptions
   A property is unattractive to a buyer for many reasons. One may be turned off simply by a worn out carpet that would cost less than a grand to replace while another buyer may not like the closed floor plan or small room size you often find in older homes. Most homebuyers are picky, so there is plenty of opportunities for eager rehabbers to renovate and fix up older homes to better suit today's taste.  You may be adding a bathroom or two to a 4br/1ba house or you may add an additional bedroom to the loft of a 1950's 2br/1ba rancher and open up a modernized kitchen to the living room.
   
   What creates value/justifies your profit?
   • You creativity has value. By envisioning not what is but what could be, you increased the desirability and marketability of the property.
   • You spending your own money and time fixing up and modifying the property.
   • You taking the risk that the repairs and improvements will give you a return on the investment.

   Pros/Cons

   • You need to be handy yourself to make necessary repairs and upgrades, or work closely with a contractor that can get things done quickly. For most renovations, we are talking 2-6 months for the house to be renovated and sold.
   • Financing may be an issue unless you can do some kind of creative financing. You will have to pay for mortgage payments, taxes, permits, insurance and for the renovations.
   • Unexpected items (read expenses) can and will pop up during the process and eat away at your profit.
   • Getting an appraiser to see that your upgrades and repairs are worth the necessary increase in assessed value may be a challenge.
   • There is a lot of competition in this market from contractors that are experts in this field. If you have no construction expertise available, you may be more successful in some other type of REI.
   • Knowing what improvements will give a positive return is as an art and a science.
   • Buying a trashed place and turning it into a jewel can be a very satisfying and profitable experience.
   • Great cash potential - risk varies depending upon your expertise and the people you work with.
      
3. "Buy a property at pre-construction sales, then resell it"
   
   Premise and Assumptions
   Generally, home prices rise over time. The last couple of years home prices has increased 10-20% per year in some markets. With new construction sometimes taking a year or more to complete, and pre-construction sometimes starting well before the developer has even broken ground, there is a great potential to make money in pre-construction sales. The profit assumes an increase in home values, the completion of the development, and the continued desirability of the development.

   Even though it may seem like prices will continue with the current 10-20% annual appreciation forever (Northern Virginia), this is an unrealistic expectation. There has been times with stagnating and falling prices in the not too distant past. Speculate at your own risk! 

   What creates value/justifies your profit?

   • You taking the risk away from the builder that the unit will sell and that the market price at completion will be higher than what you paid.

   Pros/Cons

   • The market may change by the time the property is completed.
   • Sales commissions, closing costs, carrying cost after settlement and taxes will eat away at your profit.
   • Your deposit with the builder could be locked up for a long time. The builder could also go broke and you could loose your deposit.
   • You will in nearly all cases have to settle on the property before reselling it. This  means you will have to acquire financing unless you have all cash.
   • Hostile developers and builder may make it difficult to put up signs and directional signs to your property. They typically aren't too excited about the competition with their own higher priced and still available units.
   • Some developers may not sell to investors at all or may require a large deposit.
   • You will have to pay short-term capital gains on the profits and may be considered a "dealer" by the IRS for income tax purposes if you purchase the property with the intent to resell it.
   • Great cash potential at great risk.

Possible Tax implications of reselling
As most reselling of properties take place over a short period, and for the purpose of resale, you will  more than likely have to pay short-term capital gains tax on anything you make.  

Few books deal with the tax implications of owning and flipping investment properties. Most of them give general information and then refer you to your "Tax Advisor". Well, my experience has been that very few beginning investors have or want a tax advisor. Even if they do find one, finding one that has any real expertise in real estate investing is difficult and may be expensive.

Before you get into real estate, you should equip yourself with a real understanding of taxes and real estate. Many first-time investors count on tax breaks that they in the end are not eligible for, or forget to count in taxes owed when selling property. Real estate investing involves a lot of money changing hands - every time this happen you may owe or be owed taxes.

Tip: Buy the book "The Real Estate Investor's Tax Guide" by Vernon Hoven. It is a great book that will answer most or all of your real-estate related tax questions .

Property Rentals
This class of investment property is probably what most people associate with "investment properties." The basic premise is that you purchase a property (or move out of your Primary Residence and turn that property into a rental property), find a tenant, and then rent the property to that tenant for a monthly fee (rent). With the rent you will try to cover the property expenses, and hopefully get some regular income. Over the long term you will also build equity as part of the rent income will be used to pay down the principal on any outstanding mortgage. 

Rental properties is a more long-term investment than reselling properties. On the other hand, over the long term, it is more stable and the risk often less. Over the long term, odds are that you will make money owning rental properties.

Types of Rentals

1. Condo
   
   Pros
   • Low maintenance cost. Common elements as the roof, windows, landscaping and HVAC are covered by the homeowner association.
   • Insurance is usually included in condo maintenance fee (may or may not be sufficient.)
   • Low cost per unit.
   • A larger pool of potential renters as the cost per bedroom typically is lower.
   • In-house maintenance to take care of minor repairs.
   • Usually controlled access.
   • Handicap accessible in many cases with elevators and ramps.

   Cons

   • Condominium fees eat away at your profit. Especially when capital reserves have not been sufficient in the past and major things like elevators, boilers and piping start to need replacement.
   • You may be forced to pay for "required" common elements like landscaping, swimming pools, tennis courts as part of a condo fee. Your tenants may not care about those amenities but you will still be paying for them.
   • Potential for high move-in fees that will have to be paid by your tenants (or you.) High move-in fees is a tactic utilized by condominium associations to discourage rentals.
   • Limitations as to what kind of alterations and renovations can be done, how many people can stay in the unit (may be a plus, depends), pets etc. Grilling may not be allowed on veranda etc.
   • Prices of condominiums fluctuate and are more volatile than for a town-home or single family house.
   • If the ratio of rental units in the complex goes above a certain percentage, resale of your unit will be very difficult as lenders will stop making loans for the complex.
   • Parking may be an issue.
   • Noise to and from neighbors may make your tenants unhappy - or get you complaints from the surrounding units.
   • You will in most cases need some sort of limited insurance to cover water damage to units below yours. This is usually is not covered by the master insurance.
      
2. Town home/Row house

   Pros

   • Possibility for a yard, great if you allow pets and it allows for grilling and gardening.
   • Families love town homes and may stay for a long time.
   • Closer proximity to car makes unloading of groceries easier.
   • Keeps their value better than condominiums.
   • Usually you do not pay for a lot of common elements as a part of your HOA fee.

   Cons

   • In most cases you are responsible for maintenance of yard, roof, HVAC, siding and so on. To pay for this, you will have to budget 10%-20% of the rent for this on average towards a capital expenditure reserve.
   • Town homes sometimes have narrow stairs. More damage to walls and staircase during move-in and move-out. More wear and tear.
   • No in-house maintenance that can take care of small things going wrong.
   • You will have to ensure seasonal maintenance takes place like gutter-cleaning, water spigot winterizing, tree trimming, yard maintenance etc.
      
3. Single Family

   Pros

   • Similar to Town House.

   Cons

   • Similar to Town House.
      
4. Multi Family Properties

   Pros

   • Huge income potential
   • Multiple units in one location instead of spread all over town.
   • Can be efficiently managed by a management company.
   • Can possibly be converted to condos at some point.

   Cons

   • Larger expenditures for items like elevators, roofs etc
   • Extra cost in form of onsite management for daily operations. Must "manage" the management company for maximum profit.
   • Unique challenges as opposed to single-unit ownership.

   Other

   • Value of property is determined by the income potential.
   • Out of reach for most part-time investors.

Possible tax implications when owning rental properties
To most people there are tax benefits to owning a rental property. To some people this is the main reason they have rental properties. Apart from mortgage and taxes, the largest tax deduction is usually depreciation.

Depreciation allows you to deduct the full value of the property over a 27.5 year period. It is not a tax break - it is a tax deferral. When you sell the property (unless you do a 1031 Exchange or similar) you will have to "pay back" the depreciation to IRS. But, as $100 today is worth more than $100 in 10 years, this is a great way to use deferred money to make you more money today.

The other tax deductions are the mortgage, tax and general expenses you have on the property. Some are deductible in the year the cost is incurred, others must be deducted over time. There are maximum amounts that can be deducted. For example, if you earn above $100,000 (2004 rules), the amount you can deduct against your income is limited. If you earn above $150,000(combine with your spouse, if filing a joint tax return), none of the losses (including depreciation) from your rental properties can be deducted against your regular income (with a few exceptions.)

However, the losses can (even if you make above $150,000) be deducted against any income you have from your rental activities (rent received), and can be carried forward from year to year.

If you have a management company manage the rentals for you, what you can deduct may be limited and any surplus could be counted as regular income. Read up on Active Participation in IRS Publication 527. (pdf)

Real estate Terminology

• No Money Down loans *do exist*. But you probably don't want them for an investment property. They often have up-front costs of 1%-2% in "points", or have a high interest rate, or have a prepayment penalty or have mortgage insurance or similar. Lenders take a large risk lending you 100% of the value of the property (you have shown them no commitment as you are not using any of your own money.) Banks are in the business to make money - they will be compensated in one way or another for the risk they are taking. Also, as we are talking about "investment properties", getting a loan with anything less than 20% down will be difficult and expensive. Getting a loan for an "owner occupied" unit is very different from getting one for an "investment property" that you do not intend to occupy.

  Don't waste your time trying to get a 100% investor loan. If you need money towards the 20% down of a typical investor loan, take out a HELOC (Home Equity Line of Credit)  on your primary residence (or another rental property.) You can typically get a line of credit up to 70% or 80% of appraised value on an investment property and up to 90% of the value on your primary residence.

• Foreclosures *do exist*. Nowadays they often end up being sold close to market price. You usually need all the money in cash to pay for it, and, depending of the type of foreclosure, there may be no promises made as to the condition, outstanding creditors and liens, current occupants (sometimes hostile tenants) and so on. Also, the original owner may have the right to buy back the property within a certain time period.
• Distressed sellers *do exist*. Many distressed sellers are smart enough to get near market price for their property, but you may be able to make some money in return for helping an unfortunate owner out of a bad situation.
• Tax Auctions *do exist*. Yes, you may get a lien position to a property for say $300 or so. But the original owner do have a lot of rights. So do all the other creditors that probably wait for their fair share.
• Assumable Mortgages *does not exist*. The loan papers may say a loan is "assumable", but if you read the little writing it says that the new borrower must qualify, interest rate may be adjusted to current rate, loan term may be reset or something similar to that. The reason a person want an assumable mortgage is to not have to qualify, lower settlement cost or to get a lower rate than the market rate - today's "assumable" loans very rarely allows for this.
• Creative Financing usually refers to some way for the purchaser to get a loan/control of a property without the use of a typical bank. Could be as easy as $10,000 cash-out from a credit card (not very creative, but with a 0% promo offer could be very useful as a short term tool) or a loan from the seller of the house (also called a "purchase money mortgage" or "carry back a note"). You could also do a "Wrap-Around-Mortgage" that is a way to get a loan from the owner of a property without touching the original mortgage. Getting one of these to work assumes the original owner trusts you to make the mortgage payment. If you default, he'll default...Also, the original lender may have something to say if they find out.
• Subject To Financing is the action of purchasing a property with the existing non-assumable mortgage in place. As lenders rarely check up on loans as long as they are being paid, investors often try to purchase a property leaving the original mortgages in place. The original owner will still have his or her name on the mortgage - relying upon the new owner to make the scheduled payments. If a lender finds out that the property has changed hands, they will usually exercise their due-on-sale clause, and demand the full mortgage amount paid back.
• Realtors will lend you money from their commission. *Not true*. Some "get rich" schemes claim Realtors will lend you money against their future commission on a property you are buying. This is nonsense - realtors don't do this. But, if you give a realtor repeat business, he or she may give you a break in the commission rate when buying and selling (I sure do.)
• Transaction Cost is the expenses related to the transfer of the property from the original owner to you, and then from you to the new owner. Settlement costs, commissions, loan fees, mortgage and taxes and so on are examples of this. Transaction fees can end up reducing your profit in a "flip" and should therefore be minimized.
• Leveraging means to use the equity in one property to purchase another one. This is usually done with a Home Equity Loan Of Credit (HELOC). In an up-market an investor can take out as much as 10% of the value per year from a property via a HELOC and amass numerous rental properties in a short time.
• Cash Flow
  Cash flow is used in reference to rental properties. The cash flow in question is the difference between all expenses and all income from one or more properties. For example, if a property has total monthly expenses (mortgages, insurance, taxes etc) of $800 and the monthly rent is $1,000, the property is said to have a positive cash flow of $200. If the monthly rent on the other hand was only $600, the property would have a negative cash flow of $200. Some investors talk about short term and long term cash flow. For long term cash flow, expenses such as contributions to a capital expenses reserve fund (maybe 10% of rental income) and loss for vacancies (maybe 8% of income) is deducted from the cash flow.
• Depreciation is *not income* and does not increase the overall profit from a rental property.  Depreciation is deferment of taxes and allows you to depreciate the value of a home over 27.5 years for a residential property. That means, in general, that you each year can deduct 1/27.5th of the basis (usually same as purchase price) on your tax return as a passive loss. So, for example, on a $300,000 rental unit you could (depreciation will assumed, whether you take it or not) deduct $10,909 yearly on your tax return to offset against things as rental income etc. The depreciation will be recaptured at the time of the sale of the unit at whatever tax rate is applicable at that time. However, as $1 today is worth more than $1 in 20 years, depreciation is a great way to get you more money to invest. It is sort of like pre-tax money from a 401-k plan.
• Equity Buildup is the increase of equity in a property resulting from the payment of a mortgage. With a rental property, given enough time, the tenants will pay off the mortgage and the rent income will be pure profit (less taxes and other expenses.)  
• 1031 Exchange is a way to defer paying tax on the sale of an investment property. You do this by using the proceeds from the sale to purchase another investment property. The exchange is subject to numerous rules that must be followed to avoid taxes.
• Trading Up means to move at regular intervals from one property to another, renting out your former residence as you move to a more expensive one. By moving every couple of years to a new property, you can get favorable owner occupied financing and need a lower down payment. You will as a result accumulate a real estate portfolio as you go along.

  Plan to stay for a while. When moving your intent has to be to stay in your new residence for a reasonable time, if not it would be fraud. Also, lenders like to see that you "move up" in size of the property. They may have a hard time believing you are moving from a 3500 sq/ft single family to a 100 sq/ft condo unless you have a good reason to do so. The more units you own, the more scrutinizing the lender will become, so you cannot repeat this strategy forever.

If you have comments on anything in this article please send me an email - any suggestions will be considered (and duly credited if used.)

(C) Are Andresen 2004. All Rights Reserved.
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