WHAT STOCK INVESTORS NEED TO KNOW BEFORE INVESTING IN REAL ESTATE

 Many stock investors have become frustrated with the stock market and are buying real estate. They want a growing investment that can produce predictable, controllable results.  I began buying real estate aggressively after the stock market crash in the early 70’s. For thirty years I have studied how to make money with real estate, and continue to share what I learn with students and subscribers.

Real estate and stocks are very different investments. Some try to directly compare the two. A recent article compared home prices to stock prices using a price to earnings (P/E) ratio.

 There is a relationship between the price that a consumer can rent a house for and the price that they are willing to pay for that house. However, it's not as simple as a stock PE ratio (which is based on a cash purchase of the stock), because the cost and availability of credit have a tremendous influence on the potential homebuyer.

When a buyer can acquire a home with a nominal down payment and finance the balance of the purchase price with a 6.5%, thirty year loan, they are willing to pay a higher than market price, as long as they can afford the payments. If they had to pay all cash, as when buying a stock (disregarding margin loans), then they would be willing to pay far less.

If interest rates rise and the credit market tightens, house prices will stop going up. Overpriced housing will retreat to its real value, and today much housing is overpriced.

If you are starting today with a relative small amount, say $10,000 and you want to obtain a million dollars in the next ten to fifteen years, real estate is a better bet than the stock market. Today you have the ability to buy property with a low down payment that will pay for itself and grow in value. Make the effort to learn how to buy, finance and manage property and you will make more money and avoid the disasters that befall some beginning investors.

NOT ALL REAL ESTATE INVESTORS MAKE MONEY

 Profiting from real estate requires a different mindset and different skills than investing in stocks. Although real estate prices are rising, not every real estate investor is making money. Avoid these critical mistakes:

1.      Do not pay a retail price, betting on a quick profit. Although property in most towns appreciates, you make your profit when you buy property. If you pay a retail price, and then decide to resell quickly, you may take a loss. ”Flipping” or speculating in real estate is higher risk and produces far less in profit than buying and holding.

 2.      Never borrow on terms that cause the property to lose money while you hold it. Borrow only an amount that the tenants can afford to repay.

 3.      Avoid hard to manage properties.  Some properties attract troublesome tenants. Better properties attract easier to manage tenants. Buy properties that will attract tenants that you can relate to. Buy properties that you would live in yourself.

 SELECTING THE TYPE OF PROPERTY THAT WILL MAKE YOU THE MOST MONEY WITH THE LEAST AMOUNT OF WORK AND RISK

    Like stocks, some real estate is income producing and other property, such as land, produces its profits only in growth. Improved property, such as houses or apartments can easily produce an 8% net income when bought and managed well. This income is important, especially if you finance the property. Borrow the right amount on good terms and your tenants can repay your loans.

     The right house in a good neighborhood produces both income and appreciation, and it is easier to rent or sell than other property. Lenders prefer houses as collateral, and will loan a very high percentage on a house purchase price to a buyer. This makes houses the most liquid of all real estate investments. Good tenants usually prefer a house to an apartment, because of the privacy, better neighborhood, parking, and the extra space. Houses tend to attract tenants who have more stuff, kids and pets. The good news is they hate to move and tend to stay longer. Tenants who stay a long time and take care of your property make you a lot of money. I have had tenants stay twenty years. They paid my entire loan.

 REITS AND REAL ESTATE PARTNERSHIPS

   You can buy into existing investment entities that own and manage real estate. This is similar to buying a mutual fund that buys stocks. You can hire and trust management to make your investment decisions and pay you a fair return. Unfortunately, just because an entity chooses real estate for its source of income, does not guarantee that you will profit from these investments. These entities employ executives who pay themselves first and well, whether or not they make you any money.

    Making your own investment decisions, and managing your own money are keys to your success. No one will think more about your money or work as hard to make it grow, as you will.

     THREE WAYS YOU CAN CONSISTENTLY MAKE MONEY

 You can consistently lock in real estate profits by following these three rules:

1)      Make your profit when you buy. Always buy at least 10% below the market. There are always sellers who are willing to make you a good deal. This is your minimum profit target. As you learn more, you will be able to buy further below the market.

2)      Buy the highest quality property that you can afford. Higher quality property will enjoy more appreciation, and will attract easier to manage tenants. My favorite investment is a three bedroom, two bath single-family home in a neighborhood with few, if any, rentals.

3)      Borrow carefully. Most people go broke because they cannot repay money that they borrowed. You should be able to make your payment with the net income the property produces. Avoid short-term loans and variable interest rate loans. Real estate is a long-term investment and you should finance it for the long term with fixed rate loans.

     Each property is unique; the way you make money with each property is unique. Even if you buy three identical houses in a row, you may buy one cheaper. One may appreciate a little more because of a better design, view, or even a better neighbor. Another may produce more net rent because it is better built and costs less to operate.

     Each seller is unique. Well-informed investors make significant bargains, 20%, 30% and even 40% below the real market value when they find a seller willing to take a discount for a quick sale. The illiquidity and uniqueness of real estate works against anyone who has to sell in a hurry.

    It is important to note that timing when buying is not as important in real estate as it is when buying stocks. Because the real estate market is not a market where buyers and sellers can easily find each other, when a seller needs to sell in a hurry he will have to accept a below market price. This happens even in a good market. There are always opportunities to buy below the market.

     I bought a newer house in a great neighborhood that the owner was anxious to sell. It was appraised for $325,000 and I bought it for $225,000. The housing market was strong, yet this seller could not find a buyer for his house. Each house and each seller is unique. This creates opportunity for a buyer who knows what to look for.

    The market in my town has been hot for several years, yet there are houses that have been on the market for more than a year. Some are overpriced, and others are just not well advertised, designed or well decorated.  Expensive houses typically sell slower; as there are fewer buyers and they are more discriminating. Conversely, cheap houses are hard to sell, because anyone who would live there cannot afford to buy one. Study the market in your town to determine which price houses sell the fastest, and target that price range. Any informed Realtor can furnish you this information.

 KNOWING THE VALUE OF PROPERTY BEFORE YOU BUY

    Before you can make a good deal, you need to know what a property is worth. When buying a real estate investment, you need first hand information about the values, income and expenses of a property. To establish value you can hire an appraiser, or you can do the same research yourself.

    An appraiser looks for other comparable property that has sold recently, and then compares the values to the subject property. He will make adjustments for size, location, quality and quantity of income, quality of construction and building age and design. With smaller investment properties, such as houses, duplexes, and apartments, this research is not beyond the ability of an average buyer.

 THE DANGER OF USING A RULE OF THUMB TO ESTABLISH VALUE OR RENT

     Many real estate investors will share with you their rules of thumb for buying property. They may tell you that if you buy a property for eight times the gross income, that it’s a good buy. While there is a relationship between income and value, it differs radically in different types of property and in different locations.

    For example, a duplex in my town rents for $850 per month per side or $1700 per month or $20,400 a year. Using the 8 times rule you would pay approximately $160,000 for this duplex, although if you really studied the values of other duplexes that have sold in the area, you would find them selling for between $90,000 and $100,000.  The reason that these duplexes sell for considerably less than the local “rule of thumb” is that they require intense management, have high expenses, and have little history or potential for appreciation.

     Another rule of thumb is to rent a house for 1% per month of your purchase price. This may work with less expensive houses, but does not work well with the better houses that I recommend. I own a house that rents for $1200 a month or $14,400 a year.  The house is actually worth between $180,000 and $200,000 because of the rapid appreciation it has enjoyed. If I tried to rent it for $1800 a month, it would sit empty for a long time.

    The total return on your investment when you buy a house is the combination of the cash flow the rents produce, the appreciation that the house enjoys, and the amount of discount you negotiate when you buy. I have bought houses that produced 1% a month in rent based on the price I paid. However, that price was well below the fair market value.

BUYING OUT OF TOWN PROPERTY

We have seen that it is hard to judge a property’s value, simply from the numbers. Looking only at an appraisal, or a pretty picture, without applying the common sense necessary to make money

with real estate has snookered many out of town real estate buyers.

My advice to you is not to buy a property out of your town. If you break this rule, at least go and see the property before you buy it. Don’t let some smooth talking salesman sell you property based on an appraisal and a picture. If you won’t invest the time and money to go see it, don’t buy it.

     When a salesman tells you he has another buyer if you don’t commit now, tell him to try to sell it to the other buyer, and to call you back if he can’t. If he calls back, you can buy it cheaper.

If you buy out of town, know before you buy how you will handle the management. Beware of the salesman who says management is not a problem, or that he will arrange or guarantee management. Management is always a problem, and good managers are far harder to find than good properties.

     I have owned property in ten states, and my experiences have taught me that I always make more money when I invest in my town than I do when I buy out of town property. In my town I can manage the property myself, eliminating fees and inefficiency. I know my market and when I sell, I can get the highest price.

 MANAGEMENT – ATTRACTING AND TRAINING GOOD TENANTS

     The one reason most investors avoid real estate is the prospect of dealing with tenants. You have probably heard stories of midnight toilet stoppages, or tenants who will not pay and will not leave. Opportunistic tenants sometimes hoodwink unskilled landlords, but you don’t have to be part of this group. You can be in charge and not work nights or weekends. In 30 years of managing my own property, I have never talked to a tenant except during weekday office hours.

    I manage all of my own properties, and I do it in one or two hours a week. I will share with you a few of my secrets for attracting tenants who will take care of your property, pay on time, and who won’t call you on weekends.

     First, different types of properties attract different types of tenants. Office and commercial tenants will pay higher rents per square foot than residential tenants, and will often sign longer-term leases, but these tenants ability to pay rent is subject to swings in the economy. The vacancy rates in office and commercial properties are much higher than in residential properties. During downswings in the economy, entire office buildings sit empty for years at a time. You may have a twenty-year, triple net lease with Enron, but if they cannot pay the rent, you have a big problem. Unless you can afford to diversify in many such properties so that you can survive a major long-term vacancy, you should avoid these properties.

 HOUSES MAKE A GREAT FIRST INVESTMENT

Residential properties produce less cash flow, but they have lower vacancy rates. Their cash flows are more dependable. During a recession, some even move their businesses into their homes.  Beginning investors should start small and keep it simple. The best first investment is something you already know about: a simple house.

Apartments and duplexes have higher gross cash flow than houses, but their net cash flow is lower. A typical apartment or duplex tenant moves more often than a typical house tenant. Every time

a tenant moves, it costs the landlord money in lost rent, repairs and advertising. A key to reducing your work as a landlord is to increase the length of time a tenant stays. Another key is to collect an ample large security deposit so that the tenant has the incentive to leave your property clean and in good condition.

House tenants tend to be families who need more room for possessions, kids and pets.

They tend to stay longer as it is more work to move. Often they have long-term jobs, kids in school, and other ties to the community. My typical house tenant stays more than five years.

     Attracting and training good tenants is a skill that successful landlords develop. It is 80% common sense and 20% knowledge of your local laws. If a prospective tenant starts quoting you the law in your state, that is a sign that he knows the law too well because of a conflict with another landlord. Be sure and get a reference from both the current landlord and employer before you make your decision.

            Use a rental contract that clearly states what you expect from your tenant and enforce it. My six-page agreement has been carefully honed over thirty years of use. I give my tenants a discount for paying early and taking care of the all the maintenance. If they pay late or need maintenance one month, they lose their discount.

 BUYING JUST ONE HOUSE A YEAR CAN MAKE YOU RICH

             While I won’t try to define rich for you, I will tell you that you can accumulate a net worth of well over a million dollars by simply buying one house a year, renting it to good tenants, and then holding onto it until you’ve paid off the loan. If you live in an expensive area, you can buy a house every other year, or buy half-interest in a house with another investor and you will still get your million dollars. The combination of the increasing value and rents and the decreasing debt give you a tremendous return on your investment.

             If you buy houses and finance them with thirty-year loans, how long will it take you to get them free and clear?  The answer is thirty years if you make the same payment each month for thirty years.  However, by increasing your payment as you increase your rents, you can pay the loan off in less than fifteen years. This is far safer than borrowing with a fifteen-year loan, as you have the option, but not the requirement of making a bigger payment. If the house is vacant, you can drop back to your lower payment.

            The houses you buy today can be free and clear in fifteen years. If you live in a market that is appreciating, your houses will eventually double in value. If you buy a house with a 20% down payment today, your $30,000 investment would grow to $300,000, not including any cash flow.

             If you would accumulate 10 houses in your town in the next ten years, what would your net worth be?  It’s impossible to project it correctly. However, we can make an assumption, and then make a guestimate. Assume that the first house you buy will double in value in ten years. If you buy a house worth $150,000 today, it will be worth $300,000 in ten years. If you continue to buy houses in that same price range, in ten years you will own ten houses worth about $300,000 each, or $3,000,000 worth of property.

             You would have at least $150,000 equity (the value less your loan balance) in your first house, as it is worth $300,000 and you paid only $150,000. If you made a down payment and your loan paid down, you would have a higher equity. The last house you bought you would have equity equal to your down payment, plus whatever discount you were able to negotiate. As you learn more about negotiation you will become a better buyer, and make a better deal with every new purchase.

To be conservative, your average equity per house would be at least $75,000 (half of $150,000). Ten houses would then have at least equity of $750,000.  Even if you are off by a bit, it is obvious that acquiring one good house a year can produce rewards well worth the time and effort. It is predictable, and anyone willing to learn how to buy and manage can do it.

 TAX SHELTERED INCOME AND TAX FREE PROFITS

     Income produced by real estate can be offset with depreciation. If you sell the property, you will have to repay this depreciation, but you can offset income today at ordinary income rates, and pay it back later at capital gain rates. If the property loses money after depreciation, you may be able to use this loss to offset your other income.

    Stock investors often hold onto a stock too long because they do not want to sell and pay the taxes. Real estate investors can sell and avoid paying taxes. This gives real estate investors the opportunity to change investments when they think one has peaked out and another is an opportunity.

     Any investment property can be sold and the proceeds reinvested into another investment property tax-free under Internal Revenue Code Section 1031. You can sell a rental house and buy a rental condominium, or a parcel of land, or an office building without paying taxes on your gain. To complete a 1031 exchange, you must follow the rules spelled out in the code. Well informed CPAs and attorneys can help you with these transactions.

    If you invest in houses, there is another way to avoid or reduce your taxes. Internal Revenue Code Section 121 allows you to take tax free the first $250,000 in profit if you are single or the first $500,000 in profit if you are married, when you sell a house you have lived in two out of the last five years. House investors are using this law to avoid paying taxes, by simply moving into one of their investment houses. You can use this every two years. With good planning and good buying, you can take out $500,000 every two years, tax-free.

 I WANT TO HELP YOU MEET YOUR FINANCIAL GOALS

             Real estate can produce predictable results, when you take the time to learn how to buy, finance and manage. In the past thirty years I have made many mistakes, but I have learned from every one. I continue to write and teach so that you can learn from my mistakes and avoid making them yourself.  

To help you,  I have recorded home study courses, which will teach you step by step how to buy, finance, manage and sell property. You will learn how to buy good houses at below market prices, how to finance them on good terms, and then how to rent them to tenants that will take care of your property and pay on time. These courses are available on both tapes and cd's and come with an unqualified money back guarantee. For more information, see my website www.johnschaub.com or call 800-237-9222 and we will mail you a brochure.