Main Real Estate Investing 101: From Finding Properties and Securing Mortgage Terms to REITs and...
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Thank you for downloading this Simon & Schuster ebook. Get a FREE ebook when you join our mailing list. Plus, get updates on new releases, deals, recommended reads, and more from Simon & Schuster. Click below to sign up and see terms and conditions. CLICK HERE TO SIGN UP Already a subscriber? Provide your email again so we can register this ebook and send you more of what you like to read. You will continue to receive exclusive offers in your inbox. INTRODUCTION Compared to other types of investments, real estate ranks as one of the most profitable, least risky, and most stable choices (but if part of the fun for you is rollercoaster-like risk, there are real estate investments for you too). No matter what’s going on in the world, people need a place to live and somewhere to work, and that means real estate will always be in demand, making it a perfect piece of every portfolio. When you hear the phrase real estate investing, the first thing to come to your mind may be renting properties to tenants. Or you may think of house flipping, something becoming increasingly popular. It’s true that these are types of real estate investing, but they’re far from the only ones. Among the kinds of real estate investing to choose from are: • Real estate mutual funds • Real estate investment trusts (REITs) • Exchange-traded funds (ETFs) • Crowdfunded real estate In this book, you’ll learn about all these and more. You’ll discover how to take advantage of special tax breaks, choose the most profitable properties, and even ways to start investing in real estate with as little as $50. With so many ways to get started, it’s easier than ever to begin building your own real estate empire—a proven path to accumulating serious wealth without taking on bank-breaking risk. Whether you’re a novice in the art of real estate investing or you’ve had some experience and want to learn more, this book will be a reliable guide. You may want to become a full-time investor, flipping houses or managing properties. ; Or you may want to just dip your toes to make some money on the side. Either way, you need the advice offered in these pages. Welcome to Real Estate Investing 101. CHAPTER 1 THE WORLD OF REAL ESTATE INVESTING Most people think of real estate investing as owning property to either rent out or flip. They’re right, but real estate investing includes much more, from those physical money-making properties to real estate–related stocks to real estate investment clubs. For people who prefer a hands-off approach, investing in real estate mutual funds, real estate investment trusts (REITs), and crowdfunded real estate provides the opportunity to reap rewards without the work and for much smaller investments. All it takes to get started is a little bit of money, some research, and a desire to build wealth. WHAT REAL ESTATE IS Land and Buildings For most people the words real estate probably conjure up houses, but real estate is much more than that. There are dozens of types of real estate, and even more options when you turn to real estate investing. At the heart, though, real estate is made up of land and the buildings on it, as well as anything growing on the land or found underground (such as oil). Unlike personal property, real property can’t be moved, so its value is tied to its geography. Who Owns America? * * * According to The Washington Post, 80 percent of Americans live on just 3 percent of the total available land in the United States. The federal government is the single biggest landowner, holding 28.7 percent. That’s followed by the one hundred biggest private landowners, who together own about 40.2 million acres—nearly the size of New England. * * * RESIDENTIAL REAL ESTATE Most people are familiar with residential real estate—it’s where we all live. Residential real estate is controlled by zoning laws. These regulations define the number and types of homes that can be built in a specific area and may also control things like noise, pets, and whether business may be conducted from a home. Underneath the residential umbrella, real estate is split into existing homes (also called resale homes) and new construction (never been lived in before). While single-family homes are the most common property in this category, they’re still just one option out of many. Other types of residential real estate include: • Condominiums: privately owned units within a larger structure that is collectively owned • Cooperatives: where individuals own shares of the building and the right to live in their own units • Townhomes: attached houses that may have condominium-style common areas • Multi-family homes: which can hold anywhere from one to four individual units The two ways to invest directly in residential real estate are renting property (a long-term investment) or flipping property (a short-term investment). You can also invest in these properties indirectly through real estate investment trusts (REITs) and crowdfunded residential rental properties. You May Already Be a Real Estate Investor * * * If you own a home, whatever kind it is, you’re already a real estate investor. For most homeowners, it’s the biggest asset they have. As with other investment assets, you expect your home to increase in value over time; and given enough time, it will. * * * LAND The most basic type of real estate is land, but even “land” encompasses more than just undeveloped vacant housing lots. In this category, you’ll also find working land, which refers to properties such as: • Farms • Cattle ranches • Timberland Land also includes anything natural found on the property, such as trees, streams, oil, or minerals (for mining). Unimproved Land Raw, unimproved land refers to property that has no basic services. That means there’s no gas, electricity, water, phone service, and sometimes even no roads. This type of property may be very remote and hard to access. These parcels may also be found in rural areas, such as old farmland that hasn’t yet been transformed to support housing or commercial buildings. Use caution when buying unimproved properties. For one thing, it can be hard to obtain a clear title (proof of ownership). Also, if you are planning on developing the property, you need to make sure that you can get (or that there is) an easement (the right to use property in a certain way) that will let you bring utilities onto the land. And though they’re usually pretty low, be aware that many state and local governments assess property taxes even on unimproved land. In Development Land that’s in the process of being improved gets its own category. This includes things like improved (meaning it has access to roads and utilities) but undeveloped tracts of land, land in early development stages, subdivisions, and land being transformed for reuse (such as a former military base turning into a townhome community). The most common way to invest in this type of property is through individual builder stocks or through funds that invest in an entire basket of construction-related stocks. COMMERCIAL REAL ESTATE Commercial real estate includes a wide variety of property types, such as: • Shopping centers • Hospitals and medical buildings • Office parks • Hotels and casinos • Educational centers Most investors (and some hold-all investments such as mutual funds and ETFs) categorize apartment buildings with more than five tenants as commercial real estate, even though they’re technically residential real estate. From a strictly investment perspective, commercial real estate has several benefits over residential real estate: • More stable cash flow • Longer leases (usually five to ten years) • More opportunity for cash flow (more rental units than even a multi-family home) • Economies of scale (lower per-unit costs, like buying in bulk) Because it takes a lot of up-front cash to invest in commercial real estate directly, most beginners start investing here through REITs or crowdfunded real estate platforms. INDUSTRIAL REAL ESTATE Manufacturing plants, warehouses, distribution centers, and self-storage facilities fall under the category of industrial real estate. Though it’s not the most interesting, this category is a rising star for real estate investors, largely due to the skyrocketing popularity of e-commerce. As more people shop online—and demand same- or next-day delivery—warehouses are cropping up all over the place to facilitate that service. At the same time, manufacturing activity has been resurging, which also holds promise for investors looking to hold industrial real estate in their portfolio. Cheaper to Operate Compared to commercial real estate such as office buildings and hotels, industrial real estate usually costs much less to buy and maintain. Examples of lower expenses (compared to other categories of investment property) include: • Less cleanup and fix-up between tenants • Cheaper vacancy costs (insurance, property taxes, heat) • Less turnover Those lower costs can translate into higher profits for investors. Predictable Investment Income Stream Industrial real estate comes with long-term lease commitments, and that means steady, stable cash flow for investors. Plus, these types of properties house the backbone of the economy: virtually everything we use has to be made, stored, and shipped. In addition, it’s easy to bring in different types of tenants (as long as zoning laws are followed) because industrial space lends itself to flexibility. For example, a warehouse could be rejiggered to be a warehouse with office space. Best of all, this type of property offers the most income potential, due in part to its lower costs and locked-in leases. Industrial real estate also tends to have lower vacancy rates than other property types, so there’s less time (if any) when it’s not supplying income. FIVE REASONS TO INVEST IN REAL ESTATE Build Your Fortune There are five key reasons to invest in real estate, and one potential disadvantage. That drawback is limited liquidity, which means you can’t transform your investment into cash immediately (and sometimes not for an extremely long time). While that’s true about direct real estate investing (buying a property to rent, hold, or flip), there are many ways to invest in real estate that eliminate that issue and still offer you all of the plusses of this resilient asset class. IT’S REAL Unlike the most popular investments—stocks, bonds, and mutual funds—real estate is tangible. You can see it, touch it, and stand on it. It’s not an idea like bitcoin or stock options, and it doesn’t exist only on a financial statement or an exchange: it’s real. That means you have something of value even if the current market value falls to zero, unlike a stock or bond that would be worthless in a crash. You can use your real estate even if the market considers it valueless. You can live there or turn it into productive space (using it to grow food, for example). And even indirect real estate investments are largely based on physical assets, which allow them to hold a more stable value even in a volatile market. Limited Supply There’s a finite amount of usable land in the world, a limited supply. People need places to live and work, and as the population continues to grow, the demand for space grows right along with it. On top of that, we need land to produce food and deliver natural resources, from timber to oil to the elements that power our laptops. Other investment assets are not finite. Corporations can issue more shares of stock. Governments and corporations can create more bonds to sell. And while land can be transformed to serve a new purpose, it can’t be created from thin air. More Control When you own real property, you have more control over your investment than if you owned stock (a small portion of a company) or other paper-based assets. For example, you can do things to make your property more valuable, like spring for a new roof. You can affect the income by catering to more financially solid tenants and raising the rent. The flip side of that is your investment requires more active management. You have to maintain and repair it, or pay someone else to do so. REAL ESTATE DIVERSIFIES YOUR PORTFOLIO Diversification is a crucial part of successful wealth building. By combining many different types of investments in a portfolio, the risk of the total portfolio losing value is greatly minimized. That’s especially true if your portfolio includes investments that don’t act in the same ways as each other. In theory, diversification helps smooth out the ups and downs of the markets and increase income potential. When one type of asset is drowning, another could be soaring, and that balance helps keep your overall portfolio steadier. The Correlation Factor Real estate doesn’t act like other investments, and that holds true even if the real estate investment gets bought and sold like stock. That’s because real estate has a low or negative correlation to many major types of investments. When you add real estate into a portfolio, it helps balance the ups and downs (called volatility in the investment world), which lowers your risk of total loss. Here’s how that works: say real estate has a low correlation to other assets in your portfolio. If those other asset values plummet, real estate will just dip slightly; if the other assets skyrocket, real estate will take a few steps up. It won’t be as dramatic, and it won’t be as heartbreaking. Correlation * * * Correlation measures how two different investments move in comparison with each other. A perfect positive correlation means two investments rise and fall exactly alike, so if one tanks so does the other. A perfect negative correlation means that they move in opposite directions, so if one tanks, the other soars. Low correlation means they move the same way, but not at the same rate. * * * When real estate has a negative correlation with the rest of your portfolio, it moves in the opposite direction. If your other assets take a nosedive, your real estate investments will gain value. Different Kinds of Real Estate Investments Investing in real estate doesn’t mean you have to own property, though that’s what jumps into most people’s minds when they think about it. There are several different ways to invest in real estate to help you build wealth, including owning any of the following: • Residential rental properties • Commercial properties • Real estate industry–related stocks • Mortgage-backed securities • Mortgage debt funds • Real estate investment trusts (REITs) • Real estate mutual funds and exchange-traded funds (ETFs) Inside each of those categories you’ll find even more choices. For example, commercial real estate could be anything from a shopping mall to an office park to a hospital. Residential rental properties include single-family homes, apartment buildings, and retirement communities. So even within the real estate portion of your portfolio you can hold diverse investments. Different Areas In addition to diversifying among different types of real estate, you can also spread out risk by investing in several geographical areas. That way if one area gets hit hard by wildfires, storms, or a toxic chemical spill, you’ll still have income-producing assets in other places that remain unaffected. INFLATION CUSHION Back in 1980, the median rent across the United States was $243 a month. Ten years later, that expense jumped to $447 per month. Fast-forward to 2015, and median monthly rent had risen to $942 per month. That’s inflation: paying more money for the exact same thing. That’s bad for tenants, but great for landlords and other real estate investors who can shield themselves from the inflation effect by passing it on to their tenants. Inflation happens over time, with most prices tending to go up steadily. When that happens, your purchasing power decreases: $100 today buys more than it will twenty years from now. So for your money to really work for you, it has to earn at least as much as the inflation rate—but more is better. The Inflation Rate * * * In the US, inflation typically runs at about 2 percent to 3 percent every year. Some years, though, inflation has been negative (that’s called deflation). Other years, the rate has been much higher or lower than the norm: the inflation rate in 2015 averaged just 0.1 percent, while in 1990 it hit 6.0 percent. * * * Appreciation In virtually all cases, real estate values appreciate (rise) over time. The longer you hold on to a piece of property, the more it will be worth. That makes real estate investing a natural foil for inflation. Throughout the United States, residential real estate values have increased (on average) around 3.4 percent every year since 1991, and commercial property values typically increase 2 percent to 3 percent annually. Local markets, though, can see much bigger swings (in both directions). For example, according to ATTOM Data, home prices in the Seattle area are increasing more rapidly than in most of the US. In addition, with real estate investments you have some control of your property value. You can make repairs, renovations, or additions that increase how much the property is worth. Pass It Along As mentioned earlier, investing in rental real estate can protect you from the effects of inflation: rising costs get passed through to tenants in the form of rent increases. This benefit works especially well when the property was bought with cash or with a fixed-rate loan. That means at least some of your costs will not increase even as you’re able to charge more rent, helping further to protect your purchasing power. This holds true with investments in commercial and industrial properties as well, something which surprises many novice real estate investors. Though these types of properties typically work with long-term leases, those agreements almost always come with “elevator” (also called “rent escalation”) clauses, meaning the rent will increase over time. Sometimes that’s at the landlord’s discretion, and other times it’s based on a formula. In either case, when property costs rise due to inflation, rents on these properties increase as well. STEADY RETURNS, REDUCED RISK Real estate investing offers multiple paths for earning income, some that deliver monthly and others that pay off over decades. Real estate assets are productive, bringing in regular cash (mostly from rents but possibly from other sources, such as timber sales, for example). They also gain value over time, whether through market appreciation or more hands-on methods (such as renovation). That’s how investors can use real estate to balance their portfolios, to stabilize returns with steady income, and to reduce their overall risk by adding a safer asset class without sacrificing long-term growth. Most stock investors are looking to capture rapid growth, a highly risky proposition. Bond investors are often looking for low-risk, reliable income, without the prospect for explosive growth. Real estate investors get the best of both: stable current income and proven long-term growth potential. The Volatility Factor Real estate prices move around slowly, while stock prices move around at rocket speed. That slow movement leads to less volatility in real estate than the constant heart-wrenching ups and downs of the stock market (think canoeing on a lake versus whitewater rafting). That’s why comparing returns on real estate investments and stocks is like comparing apples to soufflés; they belong together under the same general umbrella of assets, but they aren’t alike in most other ways. To make it a more useful comparison, experts look at risk-adjusted returns—and that’s where real estate investments outshine many other asset classes. Risk-Adjusted Returns * * * When you invest money, you’re taking a risk (that you’ll lose your money) to earn a return (more money). Riskier investments (such as stocks) usually promise higher returns to entice investors; after all, if the dollar returns were equal, people would pick the safer bet. Risk-adjusted returns take that into account, by looking at the real rate of return relative to its risk factor. * * * Stable Income Streams Steady cash flows are a staple of most forms of real estate investing. Rental properties, whether you own them directly or through a fund, generate positive cash flow: rent payments cover property expenses with cash left over. That strategy works whether you have one rental property or invest in funds that hold thousands of them. Even better, real estate investing offers passive income, meaning you just sit back and collect money rather than trading your time for money (as with a traditional job). That frees up your time for whatever you want to do with it, whether that’s delving into other money-making ventures or traveling the world. REAL ESTATE CREATES WEALTH Building true wealth takes time—it doesn’t happen overnight; in fact, in some cases, it takes generations. Many of America’s wealthiest families have built their fortunes on a foundation of real estate. This sturdy asset class ranks among the top choices for members of the “three comma club” (billionaires) according to CNBC. The Path to Wealth Real estate is a proven wealth generator, providing all the ingredients needed to build a secure, income-generating nest egg. This single asset class offers investors a steady cash inflow (through rents), growth (through property value appreciation), and the opportunity to transform relatively small amounts of capital into much larger assets (through the use of leverage). Consider this: if you have $20,000 to invest, you can either buy $20,000 of stocks or bonds, or put a $20,000 down payment on a $100,000 property. Which seems like the most direct path toward wealth? Holding On to Your Money Real estate investing offers unmatched tax advantages that help you keep more of your earnings than you would with other types of investments. That brings the double benefit of increasing your net worth and leaving you with more cash to acquire more income-producing assets. Examples of these unique tax benefits include (see Chapter 6 for full details): • Depreciation (to reduce income taxes) • Deferred capital gains opportunities through 1031 exchanges • Tax-free cash flow through leverage • No FICA taxes on rental income These are just a few of the ways the tax code specifically benefits real estate investors, and these key advantages build up over time, giving you more capital to invest. FOUR FACTORS AFFECT REAL ESTATE INVESTING These Issues Influence Your Interests Like every other type of investing, real estate investing is affected by a variety of factors. Some of these have a direct and obvious effect; for example, rising interest rates lead to lower property values. Others, such as changing demographics, have a less focused impact that affects values over time. The Normal Cycle * * * The economy has a normal cycle, rising and falling in a predictable order (though not at predictable times). Every cycle has four phases: expansion, peak, contraction, and trough. If you know which stage the economy is in, you’ll know what’s coming next and be able to manage your investments appropriately. * * * These factors matter most when you’re buying and selling real estate investments, less when you’re holding on to existing investments. The main exceptions: trading-based investments like real estate–related stocks (such as construction companies) or real estate mutual funds and ETFs (exchange-traded funds), because they’re also subject to stock market forces in addition to the factors that affect real estate. THE ECONOMY The overall state of the economy can have an enormous impact on real estate investing, but the type of effect depends on the type of investment. In general, real estate values will flourish in a robust economy and shrink in a sluggish economy. Real estate investments, though, can thrive in any kind of economy, and some do even better when the economy is down. How a Slow Economy Affects Real Estate Investments Different sectors within the real estate investment world aren’t impacted the same way by changes in the economy. Some types of investment real estate are greatly affected during an economic slowdown; therefore REITs and funds specializing in these areas could see big price drops. Well-managed funds could snap up distressed commercial properties for a song, holding them in anticipation of the inevitable economic resurgence. Specific types of real estate that tend to buckle in a slow economy include: • Hotels • New home construction • Shopping centers Other types of real estate investments thrive in a down economy. For example, discount retailers see an uptick in sales as people adjust their budgets. Sin industries, which include casinos, also flourish as the economy worsens. Other recession-resistant property types are self-storage facilities and mobile home parks. INTEREST RATES Interest rates may be the biggest driver of the real estate market, because they directly impact the ability to buy property. That’s especially true in the residential real estate market, important to landlords and house flippers: when rates are low, it costs less to take on a mortgage so people are more likely to buy, and that increased demand can drive up real estate prices. When rates begin to rise, mortgage costs go up, and that makes prospective homeowners less likely to buy, which can eventually lower real estate prices. That can be a double bonus for landlords, because any extra mortgage costs can be passed right through to tenants in the form of higher rent. Rates also affect other types of real estate investments. REITs (real estate investment trusts), for example, offer a steady yield (sort of like interest on a bond). When interest rates drop, it makes those yields look better, so demand for REITs increases and their prices increase too. On the flip side, when interest rates rise, they can outpace that yield, making REITs look less attractive and lowering their market value. Those price fluctuations matter more if you’re buying or selling—not if you’re just sitting back and collecting the income from your REIT investments. DEMOGRAPHICS When it comes to real estate, people matter, and that’s what demographics are all about. Essentially, demographics are statistics about the population and its subgroups that help describe group behaviors. Demographic factors include things like: • Age • Income level • Marital status • Occupation • Family size Real estate investors use demographic data to make decisions about things such as which types of properties to buy, which geographical areas to focus on, and how to make proactive investment choices based on upcoming population trends. Big shifts in demographics can impact real estate trends for years, especially when it comes to residential rental properties. For example, as baby boomers move toward retirement, they could spark big changes in the real estate market. Baby boomers own about 40 percent of homes in the US; that could lead to a sell-off of larger family homes as they downsize to maintenance-friendly condo-style properties, increasing the number of single-family homes for sale. More homes on the market could lead to a sharp decline in home prices—bad for homeowners but a benefit for real estate investors looking to snap up residential properties. Southbound * * * According to ATTOM Data, 62 percent of the growth in the real estate market will be heading south. Thanks to warmer weather, more affordable housing, and job availability, they predict more people will be moving to states like Texas, Georgia, and Arizona. * * * Other boomer-related trends could include shifts away from colder climates to more temperate areas, an increased demand for independent living communities, and a swing toward more convenient urban-style areas—all important factors for real estate investors to consider. GOVERNMENT ACTIONS Federal, state, and local governments can have a measurable impact on both demand for real estate and property values. They can boost demand in an area by offering tax deductions, tax credits, and subsidies to drive investor interest. They can steer policy and legislation for specific effect, like the introduction of the first-time homebuyer credit in 2009, which encouraged home sales in a sagging real estate market. SALT Tax Deduction The 2017 Tax Cuts and Jobs Act (TCJA) capped the total tax deduction for state and local taxes (SALT) to $10,000; that includes state and local income taxes and property taxes. The new cap could have a chilling effect on new homeownership, but it could also greatly benefit direct and indirect residential rental property owners. Plus, the SALT cap doesn’t affect real estate investors, who can still deduct the full amount of taxes paid to support rental properties. Opportunity Zones The TCJA also created tax-advantaged Opportunity Zones to attract long-term investment in distressed areas and spur development and job creation. There are designated OZs in every state and five US territories. Investments must be made through Qualified Opportunity Funds (QOFs), which are basically holding companies set up to allow investment in eligible properties. Potential tax benefits include: • Defer tax on prior gains until 2026. That means if someone sells stock and makes a $100,000 profit, then puts that money in a QOF, they don’t have to pay taxes on the profit now. • Exclude 10 percent of that prior gain forever if they hold the OZ property for at least five years, and 15 percent if they hold it for seven years. • Investors who hold QOF investments for at least ten years won’t have to pay any capital gains tax on profits when they sell. As you might imagine, OZs have real estate investors across the US very excited—but the rules are brand-new, and no one has actually tested them out yet. Proceed with caution. You can learn more about Opportunity Zones on the IRS website (www.irs.gov). REAL ESTATE INVESTING IS IDEAL Model Homes Investing in real estate offers you a set of key advantages that you won’t get with any other asset class. They’re what make real estate investing IDEAL (an acronym that’s been floating around for at least twenty-five years). IDEAL refers to the different ways real estate investing can help you accumulate profits and build wealth: • Income • Depreciation • Equity • Appreciation • Leverage Any one of these would make real estate holdings a valuable addition to any portfolio, and all five in one shot offers you accelerated wealth-building potential. INCOME Investing in real estate is one of the best ways to add a steady stream of income to your budget, whether you own physical properties or REIT (real estate investment trust) shares. Historically, real estate assets tend to generate constant, reliable income, largely due to rent payments. For people looking toward retirement, this secure income stream can eventually replace salary; other commonly held retirement investments (such as stocks) don’t hold the same promise. Building a portfolio of real estate investments can bring in cash flow from multiple sources, reducing your risk of falling short should any single investment run into problems. How It Stacks Up * * * How does real estate–based income (not including growth or appreciation) compare to other types of investments? Consider this: as of December 2018, the dividend yield on the S&P 500 was 1.9 percent. The yield on a twenty-year Treasury bond was 3.01 percent. Yields on REITs easily topped 5 percent, with some ranging as high as 8 percent. * * * Rental Properties If you own a couple of multi-family rental properties or office buildings, each individual unit sends income your way every month. Once you acquire enough properties and stable tenants, you’ll build up a big enough income flow to replace the income from a regular job, so you can retire (no matter how old you are) whenever you want to. On top of that, you’re also amassing a huge source of untapped wealth. Should you need a large cash infusion for any reason (to pay for unexpected medical bills or to take an around-the-world vacation, for example), each rental property represents a virtual ATM: you can borrow against the equity or sell a property to get the cash you want. REITs and Funds REITs (real estate investment trusts) give investors the opportunity to take part in huge commercial, industrial, and residential real estate deals. Because of their special tax-advantaged structure, REITs are required to pay out the lion’s share of their profits as dividends to shareholders—a guaranteed income stream. Real estate mutual funds and exchange-traded funds typically hold shares in REITs, and often pass at least a portion of those dividends along to shareholders. With funds, you’ll typically have the choice of reinvesting those dividends to buy up more shares or receiving them as cash payouts. DEPRECIATION Depreciation is a special accounting expense that tracks the decline in asset value for things like wear and tear. For most assets, this makes sense: cars lose value as soon as they drive off the lot; machines in use for ten years start to break down. Most assets don’t last forever. But for real estate, where the value of properties can just as easily increase, depreciation offers a rare beneficial disconnect: an expense on paper that transforms into real-life cash. Not only does it reduce the taxable profits on your real estate investment asset, it may also offset a portion of your other income (this is a tricky tax area, so work with a qualified CPA to take full advantage). For example, if you had one property that ended up with a tax loss due to depreciation, and another property that produced taxable income, the loss from the first property could be used to decrease the profit from the second property. Plus, in specific cases (more on these in Chapter 6), you might actually be able to use that tax loss to reduce other types of income (like salary). This tax jackpot works for indirect real estate investing (funds and REITs, for example) as well, though not in quite the same way for the investor. For example, because depreciation is not a cash expense, REITs appear to pay out more income than they earn, a boon to investors. The Only Asset That Doesn’t Depreciate * * * In the world of accounting, every asset depreciates except land. Therefore, with real estate investment properties, only the buildings on the land count toward depreciation expense. For accounting and tax purposes, the value of the land and the value of the buildings are kept separate. An experienced CPA can figure all of that out for you at tax time. * * * How It Works Depreciation reduces income annually for tax and accounting purposes but unlike most other expenses it has nothing to do with actually spending money. This paper expense is based on the “useful life” of your investment property, which the IRS has determined as twenty-seven-and-a-half years. During that time, a portion (determined by IRS depreciation tables) of the property gets deducted from rental income, reducing the income tax bill. That translates into more available cash for the investor. Here’s a simplified example: say you had taxable rental profits of $100,000 this year, depreciation expenses of $10,000, and the applicable income tax rate was 20 percent. Without depreciation, you’d pay $20,000 in taxes (20 percent × $100,000). After deducting the depreciation expenses, the taxable income would be $90,000, and you’d owe $18,000 in taxes (20 percent × $90,000), a cash savings of $2,000. Other types of real estate investments, including mutual funds and REITs, also get the benefit of depreciation expense. They pass that tax savings along to investors either through higher dividends or increased value. The Recapture Trap The depreciation advantage comes with a catch: when you sell the property, you have to “recapture” the depreciation expense you took. This can lead to a substantial tax bill in the year you sell. In addition to any regular capital gains taxes on the sale, you’d also have to pay your regular income tax rate (almost always higher) on the depreciation recapture. So if you had a gain on the sale of your investment property (your property sold for more than you paid), you’d pay tax on that at the lower capital gains rate. On top of that, you’d also pay tax at your regular income tax rate (which topped out at 37 percent in 2018) on the total depreciation deductions you’d taken over the years. Luckily, there are ways to skirt that recapture, so you don’t end up with a cash loss on the profitable sale of your investment property. (You’ll find more information about all of this in Chapter 6.) EQUITY Equity refers to the portion of property that you own fully; it’s the value of your property minus any outstanding mortgage debt. As you pay down the mortgage loan, your equity (your ownership percentage) increases. At the same time, property values tend to rise (at least over the long haul), which also adds to your equity. As your equity increases, you can use it to build even more wealth. For example, you can borrow against existing equity to create a down payment for your next investment property. While that temporarily decreases your ownership stake in the original property, you still have the same total equity—but now you have two income-producing properties to show for it. This also holds true for the underlying properties in indirect real estate investments like REITs. The holding company can use these methods strategically to maximize the value of its holdings and your investment. Increase Value There are two ways property values climb: one you can’t control, the other you can. The housing market, both generally and in your property area, rises and falls and your property’s value will probably ride right along with it. With the luxury of time, you can ride out the down trends until the market is ready for another upswing—and with real estate, it’s only a matter of time before that happens. The second way is to improve your property. Whether the changes you make are substantive, minor, or cosmetic, sprucing up the property will generally increase its market value, and possibly also its income-producing abilities. For example, you can add on more rentable space or make smart renovations that will allow you to increase the sales price and still attract plenty of buyers. Decrease Debt Debt is the other side of the equity coin, reducing your ownership stake. You can accelerate debt paydown by making extra principal payments. Not only will that immediately add to your equity, it will also reduce the interest portion of payments moving forward (interest is calculated based on the outstanding loan balance, so a lower balance means less interest). When a bigger portion of every payment is going toward principal, your equity will grow faster. With rental properties, the income you receive from tenants will cover the mortgage—so those tenants are paying to increase your ownership stake. APPRECIATION Appreciation, where the value of an asset increases over time, is the opposite of depreciation. Real estate is one of the few physical assets that appreciates, which is one of the main factors making it a desirable investment. There’s only so much habitable land on the planet. Because land is a finite asset, demand will naturally outstrip supply; when demand outweighs supply, prices increase—it’s basic economics. That doesn’t mean property values increase in a straight line; as we saw back in 2008, they can decline dramatically along with a troubled economy. Property values in different areas rise and fall in their own time. But overall, real estate values in the United States tend to appreciate, and that means tax-free growth for you (you don’t pay taxes on appreciation until you sell, and never if you don’t sell). Property Trends Supply and demand play a key role in real estate value: when end-user demand (more people want to buy houses) is higher than supply (houses for sale), market values rise, and the opposite holds true as well. Changes in an area can also drive demand, such as the arrival of new employers and shopping areas or changes in zoning laws. Real estate investors can track these trends using websites like Realtor.com (www.realtor.com), giving them a clearer picture of what’s up-and-coming and which areas are cooling off. Inflation Inflation is a key factor that plays a role in real estate appreciation. Over time, inflation pushes up the cost of almost everything. That includes the materials needed to build, renovate, and repair homes or develop land, and real estate values as well. Over the long run, real estate values have at least kept up with inflation, often outpacing it (depending on the specific area). LEVERAGE One of the biggest advantages of real estate investing is the ability to use leverage: putting in only a little of your money and borrowing the rest to buy property. By coming up with a down payment and taking out a mortgage for the balance, you can invest in real estate for as little as 3.5 percent of the purchase price—a fraction of the cost. That means only a small amount of your money is tied up, but you still benefit as if you owned the whole property outright. You keep all of the income (like rent) the property generates. You claim all of the tax write-offs. You reap the rewards of soaring real estate prices. You gain all those advantages with just a small investment, which leaves the rest of your money free to invest elsewhere. It’s an important part of building significant wealth: using leverage to buy income-producing real estate assets. Using Leverage to Create Cash Flow Unlike other types of investments, direct investment in real estate (other than quick flips) gives you access to tax-free funds when you need to increase cash flow (money coming in) but not income. Here’s how it works (and it works especially well with rental properties): you borrow money against the equity in your property, giving you access to the amount of cash you need. Because it’s a rental property, the interest portion of loan payments is tax-deductible, lowering your overall tax bill. At the same time, rent paid by your tenants covers the loan payments over time. This works especially well with: • Properties that are completely or mostly paid off • Rental properties that have stable tenants in long-term leases • Fixed-rate loans As long as the rental income (and your cash reserves) remains strong enough to cover the loan payments, you have access to tax-free cash flow when you need it. CHAPTER 2 HOW TO PROFIT FROM RESIDENTIAL RENTAL PROPERTIES Rental properties are one of the most stable ways to build wealth over time. By combining an asset with strong appreciation potential with a steady income stream, this investment offers both current financial security and long-term growth. Once you’ve got the knack, you’ll be able to turn a single rental property into a real estate empire. The idea of buying a property, getting it rental ready, and finding tenants can seem daunting. Taking it one step at a time can make the process flow more smoothly. Surrounding yourself with helpful professionals, familiarizing yourself with landlord legal issues, and carefully choosing the property and the renters will help ensure that your first dip into residential rental property is a profitable one. PROTECT YOUR ASSETS Work with a Safety Net The first and most important rule of physical real estate investing—meaning you buy property—is to never purchase property in your own name. While there are a few different reasons for this, the most important involves personal asset protection, making sure that no lawsuits can touch anything you own personally (like your house, car, or bank accounts). Other reasons for the “separate entity” rule (creating a holding company to own any investment property) may include: • Special tax advantages • Easier bookkeeping • Simpler transfers to heirs Next on the list for asset protection: insurance, and plenty of it. A lot can go wrong with residential rental properties, and proper insurance coverage is your first line of defense when expensive problems crop up. The combination of a separate business and ample insurance offers the strongest protection against any of the many liabilities that could crop up, from tenant slip-and-falls to severe weather damage. THE HOLDING COMPANY One of the strongest tools in a real estate investor’s kit is the holding company, a special legal structure that shields your personal assets (your house, car, bank accounts, etc.) from any problems having to do with your investment properties. Two common types of business entities used for this purpose are limited liability companies (LLCs) and limited partnerships (LPs); in some cases, a combination of the two can offer an extra level of protection. Both entities offer maximum flexibility and pass-through taxation (the company doesn’t pay income taxes itself; the income “passes through” to the owners’ personal income tax returns). Which structure would work best for your situation depends on your circumstances, but both offer legal liability protection when set up properly. In order for this strategy to work the way it’s supposed to, you have to keep business and personal finances completely separate. That means, for example, you never make a rental property mortgage payment from your personal checking account, and you never deposit rent checks directly into your own bank account. If you need to move money around between the two, you have to do it officially—make a formal contribution to the company so it can pay the mortgage, or write yourself a check from the company after it deposits the rent checks. You also have to run the business professionally, keeping up-to-date records and following all the state regulations to lock in that liability protection. LLC (Limited Liability Company) LLCs are special business entities designed to protect the members’ (the official name for LLC owners) personal assets from company-related lawsuits, and they’ve become very popular among real estate investors. You can form an LLC whether you’re going it alone (a single-member LLC) or have partners. The company is formed according to state law and governed by a legal operating agreement, which is even more important for multi-member LLCs. Any LLC member can take part in the day-to-day operations of the company unless the operating agreement specifically forbids it. That agreement also dictates how income is distributed. Although there are state forms to fill out and fees to pay, LLCs require much less time, money, and paperwork than corporations but still offer their members solid personal liability protection. LP (Limited Partnership) Unlike an LLC, an LP requires at least two participants: one general partner and one limited partner, which can’t be the same person (although a general partner can also be a limited partner if there’s at least one other person involved). Only the general partners can be directly involved in running the business; limited partners are strictly forbidden from taking part in any of the day-to-day activities (which is why they’re often called silent partners). Basically, limited partners put up the money, and general partners run the company. General partners are 100 percent personally liable for any business obligations, which is why many LPs are set up with another company (often an LLC) as the general partner. Limited partners can’t lose more than the money they contributed to the company, which can work well for a group of real estate investors who want to pool their money to buy properties without dealing with property management issues. The LP is formed according to state law and governed by a partnership agreement, which spells out specifics such as the general partner’s responsibilities, ownership percentages, and how income will be distributed. The Downsides of Holding Companies Forming a holding company for your real estate investments offers solid legal protection, but it does come with some drawbacks. First, it costs money to set up and maintain, and even more if you have an experienced real estate lawyer handle the paperwork. And to make sure your protection is as strong as possible, you want a legal expert on your side. This is one of the times that it’s not better to DIY. In addition to having a lawyer set up your company (which can run anywhere from $300 to $2,000 depending on which state you’re in and the lawyer you hire), there are ongoing state fees and taxes to contend with. Second, you may need a CPA to handle the extra tax prep, depending on the type of holding company you form. Third, it can be hard to get financing in the company name when you’re just getting started. That means you may have to personally guarantee or co-sign for loans (which leaves you personally on the hook for mortgage payments). As soon as you form the company, apply for a credit card or line of credit in the company name and tax ID number. Even though you’ll probably have to personally guarantee this credit initially, it will help the company begin to build its own credit rating for future loans. DON’T SKIMP ON INSURANCE A separate company protects your personal assets from being attacked, but it doesn’t shield your rental properties from loss. The best way to do that is with the right insurance policies and enough coverage to make sure your company and your properties are protected against disaster. The trick is to strike the right balance between the premiums you’re paying and the benefits you’re getting: too much coverage will shrink your profits and leave you cash poor, too little coverage could leave you financially devastated. You also want to make sure you have the right kinds of insurance for your investment. Every property is different, and its unique features will determine the specific coverage you need. For example, a beachfront property calls for different insurance than a ski chalet. That said, there’s some coverage that all landlords should have. Big picture: you’ll need to make sure you have both property and liability coverage. Specifically, rental property investors should purchase these policies (some companies may combine them): • Liability insurance (for both the property and the company) • Fire and hazard insurance • Sewer/septic backup insurance • Personal property coverage (for any contents, such as furniture or appliances, owned by the landlord) • Loss-of-income insurance (to cover lost rental income if the home becomes uninhabitable) • Workers compensation insurance (if there are employees such as a building super or maintenance workers on-site) • Umbrella insurance (to cover anything that slips through the cracks) Some companies may lump these policies together in one big landlord policy, but make sure it includes all the coverage you want. Depending on where the property is located, you may also want to consider flood insurance. Technically, that’s only required if it’s in a designated flood zone, but if the property is at the bottom of a hill or in an area that gets battered by heavy rains and hurricanes, consider adding this on. Floods caused by outside sources, rather than things like burst pipes or a leaking water heater, aren’t covered by standard hazard policies. If you aren’t sure what kind of insurance your investment property needs, work with a professional who can walk you through the process. Visit the National Association of Insurance Commissioners at www.naic.org for advice and help finding a reputable agent. PICKING PROPERTIES WITH STRONG PROFIT POTENTIAL Reap Rewards with the Right Real Estate Real estate investors are in it to make money. Reaching that goal starts with picking the right property, which can be tricky when you’re new to the game. Before you buy, take the time to figure out what type of rental property you want, make a thorough rental budget, and scout out potential locations. You’ll need to do your homework to select a property that meets your requirements and has all the features that most renters look for, like access to jobs and plenty of conveniences nearby. WHICH TYPE OF PROPERTY? Single-family homes are taking the residential rental industry by storm, but they’re not the only (or necessarily the best) choice for a first-time landlord. Multi-Family versus Single-Family One of the first decisions you’ll have to make is whether you want to invest in a single-family or multi-family property. Like the names state, single-family properties have one rental unit; multi-family properties have more than one unit. Both come with distinct benefits and drawbacks, and both make good choices for rental properties. Benefits of single-family properties include: • Usually easier to get financing • Less maintenance • No hassles between tenants • Easier to sell With a multi-family property, you can consolidate some of your expenses (because there’s one roof and one yard, for example). They can be easier to manage than having several separate single-family properties, especially if the latter aren’t near each other. It can be harder to get financing for a multi-family property, but a good down payment and a strong credit score may eliminate that issue. And if your main investment goal is maximizing cash flow, a multi-family property offers more opportunity for a stronger income stream. House Hacking * * * Live in one of the units of a multi-family rental property, and your tenants will be paying your “rent.” This setup also makes it easier and less expensive to get financing, which will increase your cash flow and your profits. * * * House versus Condo For new real estate investors, condominiums can be a better way to wade in than single- or multi-family homes. Condos make good starter properties because you’ll only have to deal with internal maintenance and repair issues, and the condo association will deal with everything else. That takes a lot off your plate, including: • Trash pickup • Landscaping • Snow removal On the condo con side, these smaller dwellings will bring in less rent and don’t offer as much in the way of investment appreciation. They’re also less likely to attract long-term tenants. Single people and new couples tend to rent condos. They’re likely to change jobs and move more frequently, leading to shorter stays. Single-family homes will attract families, who tend to stay longer, especially when there are school-age children. Families tend to also be more financially stable, making them better tenants (especially when it comes to paying rent) than single people. On the single-family home con side, they tend to cost more to buy, which means bigger down payments, loans, interest payments, and closing costs. They also require more upkeep than condos because you’re responsible for the whole property, inside and out. KNOW THE MARKET Before starting any kind of business, smart entrepreneurs—and that includes rental real estate investors—take the time to do comprehensive market research. Even if you already have a particular neighborhood in mind, look at others to see if there’s more profit potential somewhere else. Look at properties in and slightly out of your price range to get a full picture of the local market. Rentability You can pick the greatest property in the perfect neighborhood, but it won’t matter if you can’t rent it for enough to cover your costs and leave you with a tidy profit. Some common reasons a property will be tough to rent include: • Lots of competition, which may force you to lower the rent • Wrong kind of property for your target renter • Needing to charge higher rent than the neighborhood normally bears • A high (or growing) number of vacancies in the immediate area You can increase your chances to get tenants in by offering incentives, like a free month’s rent or utilities included. Cash Sales Indicator * * * One clue to a good rental market: properties being snatched up for cash, which indicates investors. You can do a search at the local courthouse (part of the public record) to find out whether homes in the area have been selling for cash. * * * Rent Levels The amount of rent you can charge will be determined by the area, and it has to be enough to cover all of your expenses and your desired profit to make the investment worthwhile. If the average local rent doesn’t meet those criteria, you’ll need to find a property somewhere else. You’ll also want to find out limits on rent increases, to make sure those can keep up with ever-rising expenses. If the neighborhood is up-and-coming, you can expect property taxes and other costs to increase quickly, and you’ll need the rent to do the same. KNOW THE NEIGHBORHOOD To attract the type of tenants you want and have a near-zero vacancy rate, find a property in a high-quality, desirable neighborhood. The neighborhood may also dictate the type of renters you attract. For example, if the property is in a college town, your potential tenant pool will be heavy on students, which means high turnover. Schools Matter If you’re planning on renting to families, you’ll want to make sure your property is in a highly ranked school district. The best property in an undesirable school district won’t attract the tenants you’re looking for, and it can also be harder to resell when you’re ready to move on. Check the Crime Stats You wouldn’t want to live in a high-crime area, and neither will most prospective tenants (no matter how low the rent is). You’ll want to specifically look into rates for vandalism (defacing property), petty crimes (like kids stealing things out of cars), and serious crimes (house break-ins, violent crimes), as well as whether those rates have been going up or down. Check in with the local precinct to find the inside scoop on neighborhood crime. Expensive Areas Some neighborhoods are more expensive than others and that means most things will cost more there. That’s fine, as long as you can bring in enough rent to support the higher expenses you’ll face. When you’re deciding where to buy your rental property, look at all of your cost factors to make sure they don’t outpace your rental income. While it’s good to run a rental property at a loss for tax purposes, you want to make actual profits, bringing in enough cash to cover the property expenses and leave you with money left over. Property Taxes Property taxes can vary widely among neighborhoods and within neighborhoods. One thing you can count on: they’re likely to increase every year. According to WalletHub (https://wallethub.com) the average American pays $2,197 per year in property taxes—but that number is misleading. Effective real estate rates range from 0.27 percent in Hawaii to 2.40 percent in New Jersey (according to WalletHub). So in high-rate states, property taxes could severely eat into your rental property profits—another factor to consider when you’re choosing an area. UNDERSTANDING THE MORTGAGE PROCESS The ABCs of Real Estate Loans If you’ve ever taken out a home mortgage, you know how complicated it can be. In addition to compiling and filling out tons of paperwork, you also have to make key decisions about the loan itself. When you’re taking out a mortgage for a rental property, the process is even more involved. Your goal here is to borrow as little money as possible, which can substantially increase your rental profits and keep you from going under if you have a hard time finding a tenant. The less you borrow, the better loan terms you’ll get, and the less interest you’ll pay over the life of the loan, potentially saving you tens of thousands of dollars—and that savings can be used to invest in another income-providing property. To that end, you’ll want to carefully research all of your loan options to find the best mortgage for your investment property. You can find reliable calculators online to help you compare rates and terms for different lenders. WHAT YOU NEED FOR TRADITIONAL FINANCING The cheapest way to finance your property is through traditional lending: a bank or credit union that does mortgage loans. But that savings comes with much higher requirements you’ll have to meet, including a bigger down payment and a better credit score. Before providing you with this kind of financing, the lender will want to know you’re a good risk. That means you’ll have to be prepared with a budget and a plan in place to cover potential problems (such as not being able to find a tenant right away). The lender will probably also want to see substantial cash reserves, so sock away as much money as you can before you start looking for loans. A Big Down Payment The amount of cash you’ll need to bring to the table depends in part on your investment strategy—house hacking or straight landlord. Properties bought strictly for investment, non-owner occupied (NOO), call for down payments starting at 20 percent, and may be as high as 30 percent depending on the lender. Owner occupied (OO) properties face lower down payment requirements (in some cases as little as 3.5 percent of the purchase price), but that doesn’t mean you shouldn’t aim to put down at least 20 percent on your rental property. You’ll also need enough cash to cover closing costs, which can come to 10 percent (or more) of the purchase price. The OO versus NOO Difference * * * Say you find a multi-family property for $350,000. If you plan to live in one of the units, the down payment could be as small as $12,250. But if the property will be NOO, you could have to pony up as much as $105,000 for the down payment. * * * You Need Stellar Credit to Start Before you start contacting lenders, check your credit report. To get the best deals, you need gold-star credit. Not only have lending standards gotten tighter (at least from the most reputable sources), investment-property loans are considered higher risk than live-in mortgages. From your perspective, better credit means lower interest rates on the mortgages for your investment properties. That could translate into thousands of dollars of savings on every property, leaving you more room for profits. HARD MONEY LOANS If you’re having trouble securing financing through traditional mortgage lenders, take a look at your hard money options. These deals are collateral-based, so they focus more on the property itself than on you, which can be especially beneficial for investors without perfect credit scores. In addition, because hard money lenders are so property focused, these deals can move much more quickly than the traditional thirty- to sixty-day closing timeframes common with traditional lenders. They’re also more prepared to seize the property and sell it than a regular bank would be. The Pros This loan process is much simpler because you don’t have to put together all of your tax and income information for a hard money lender. Typically, they’ll look at your credit score but won’t ask for any other documentation (such as proof of steady income). Instead, they’ll focus virtually all of their attention on the property value and base your loan approval on that. Plus, because hard lenders are usually individuals or small companies, they have more flexibility for working out deals than behemoth banks and mortgage lenders. For example, they may offer relaxed payment schedules or ramped-up payments depending on the particular situation, instead of being locked into cookie-cutter contracts. The Cons The biggest downside to hard money loans: higher interest rates, sometimes significantly higher. These loans also typically come with much shorter terms, often less than five years before the full balance of the loan comes due. They also often call for bigger down payments for an LTV (loan-to-value) ratio. Whereas a traditional lender might be willing to finance 80 percent of a property, hard money lenders are more likely to finance only 50 percent to 70 percent. WORKING WITH A PROPERTY MANAGER Hand Off the Headaches When asking rental real estate investors about their biggest newbie mistakes, the answer that comes back most often is, “I wish I’d gotten a property manager sooner.” Hiring a property manager will make your landlord tasks a snap as long as you choose the right one. That takes some time, so start this process before the first tenants move in. WHAT THE PROPERTY MANAGER DOES Property managers handle all the heavy lifting and day-to-day tasks of being a landlord so you don’t have to. Specific responsibilities will vary depending on the type of property you own but they tend to fall into the same categories: • Dealing with tenants • Handling the property finances • Maintaining the property Managing Tenants Your rental property can’t turn into a gold mine without tenants. A good property manager will find, screen, and select the best tenants for your property. They’ll take over handling background and credit checks and verifying references. With experience on their side, many property managers have an instinct for selecting long-term, reliable tenants who don’t cause problems. Once they’ve chosen tenants, the property manager will handle the lease signing and security deposit. After tenants move in, the property manager will hear and deal with complaints, maintenance requests, and emergencies (such as burst pipes). They’ll handle problems between tenants (in multi-family dwellings). When the lease is up and not renewed, the manager will deal with all of the move out issues, from damage assessment to deposit return. In the case of a tenant who refuses to vacate, the manager will know exactly how to handle an eviction. Setting and Collecting Rent Experienced property managers know the score when it comes to setting rent. They know the area, the property type, your budget, and the prospective tenant pools. With that information, they can come up with appropriate rent that won’t scare away tenants and still leave you with profits—a skill that could take you years to develop. They can also adjust the rent up or down as the situation calls for; they know the rules about rent increases (which may be strictly controlled by state or local law), and they can adapt rent to changing economic circumstances to make sure your property stays occupied. Once you have tenants in, the property manager deals with collecting rent, and that includes making sure tenants pay in full and on time. They set dates, grace periods, and late fees—and strictly enforce those rules so you don’t get stuck in a cash flow situation. Property Maintenance Once you hire a good property manager, it’s their responsibility to make sure the building is safe and regularly maintained. Whether they have in-house taskers or hire out, they’ll make sure everything necessary gets done in a timely and cost-effective fashion. This includes things like: • Landscaping • Snow removal • Trash pickup • Pest control • Repairs Even with an OOP * * * You can use a property manager even if you live in one of the units (an owner-occupied property). In fact, that can make your living situation easier because other tenants will call the manager—and not you—when things go wrong. * * * FINDING POTENTIAL PROPERTY MANAGERS Once you’ve decided to hire a property manager, it’s crucial to find the right one. This person (or company) will be a long-term partner and will have an enormous impact on your investment success (and peace of mind). Take your time with this decision: do research, conduct interviews, and do a little snooping. After all, you’ll probably be partnered up with your property manager for a long time, so you want someone who clicks with you personally and professionally. Read the Agreement * * * Once you sign a property management contract, you’re locked in for the term of the agreement. Because this will impact every aspect of your investment success (from happy tenants to solid profits), make sure you read and understand everything in the contract. If anything seems unclear, talk to your attorney before signing. * * * Check These Sources First stop: your real estate agent. They can offer you a list of property managers they and their clients have worked with successfully. From there, talk to other landlords you know in the area, and ask who they use to handle their properties. Make sure to ask what they like (and don’t like) about this manager, and what kinds of problems they’ve had. If you get the same take on a management company from several different sources, chances are it’s true. You can also search online for property management companies in your area, but be wary of online reviews. Check the Better Business Bureau for any company that sparks your interest to see if any complaints have been filed against them. Like any other professional, property managers have specialties, and you’ll want to find one who specializes in the type of rental property you own; someone who runs apartment complexes isn’t the best choice for your single-family home. Check Their Work One of the best ways to see how a property manager works is to see how they’re handling other properties. For example, look at the “for rent” ads they’re placing for your competitors to see if they look professional. Look at a couple of properties they manage to see if they look well kept. Even more important, talk with tenants. You’re hiring the property manager to make your life easier, and that includes keeping your tenants happy. Steer clear of any property managers where: • Complaints and repairs aren’t addressed promptly. • The manager is hard to reach. • Tenants aren’t renewing their leases because of the management. Eleven Questions to Ask During your interview with any prospective property manager, make sure to cover all of these key questions: 1. How long have you been managing properties? 2. What types of properties do you manage? 3. What licenses and certifications do you hold? 4. Do you have a thorough understanding of landlord-tenant law, including fair housing practices, eviction procedures, and safety codes? 5. How long does it typically take you to fill a vacancy? 6. How do you vet prospective tenants? 7. How many tenants have you evicted in the past six months? 8. What services do you provide? 9. What are your fees and how are they charged? 10. Where are the property funds held and how are they handled? 11. How often do you perform property inspections and do preventive maintenance? These are the minimum questions you need to have answered before selecting a property manager. You can find a more thorough list on the BiggerPockets website (www.biggerpockets.com). Check Certifications Many states require property managers to hold some type of license of certification (usually to be allowed to show rental properties). Check that any prospective property managers hold the specific documentation required by law (you can do this on the state licensing website). Find out whether they belong to a reputable trade organization that requires training, certification, and continuing education. Applicable organizations include the National Association of Residential Property Managers (www.narpm.org) and the Institute of Real Estate Management (www.irem.org). WORK WITH A TEAM TO MAXIMIZE SUCCESS The Building Bunch Investing in residential rental real estate is a team sport, so don’t go it alone. Assemble a group of professionals who can fill in any knowledge, skill, or experience gaps. That will help ensure that you don’t get in over your head and get stuck with problems you don’t know how to solve—it’s always more expensive to call someone in after there’s a problem than to get a pro to help you avoid problems in the first place. Start developing relationships with key professionals before you buy your first property. They can help you navigate the investment from start to finish and handle everything that comes up in between. Long-term relationships with real estate agents, lenders, and other experts will serve you in several ways, from increasing your profitability to connecting you with the resources you need to remain successful. Real Estate Agent A real estate agent who works with investors (and not just homeowners) can be the centerpiece of your team. In addition to helping you with property selection (the foundation for your success), the real estate agent can also help you find suitable tenants. They’ll also have contacts with lenders, lawyers, and management companies—anyone you might need to help make your investment successful. Real estate agents know neighborhoods. They know what prospective tenants are looking for, which areas have the fiercest competition, and what properties are ripe for profits. Lender Once you’ve decided to invest in rental real estate, you’ll want to start developing relationships with potential lenders. The process works differently than when you’re getting a regular home loan, so you don’t turn to your home mortgage broker unless he also has substantial experience working with real estate investors. For your investment properties, you’ll want to connect with a lender who regularly works with investors and will help you grow your real estate portfolio…as well as offering you the lowest possible interest rates. If you have no existing connections, you can start your search online using a rate comparison tool (like the one at Bankrate, www.bankrate.com). Be aware that many lenders limit the number of investment loans, so you’ll want to ask how many loans you could carry if you plan on expanding your real estate empire. ROUND OUT YOUR TEAM WITH THESE PROFESSIONALS In addition to your A-team and property manager, you’ll want to connect with other professionals to provide key skills. Make sure anyone you hire has experience working with residential rental properties; you want experts who really know what they’re doing to make up for any gaps not covered by you or the rest of your team. At the very least, you’ll want to find a lawyer, an accountant, and a handyman (yes, even if you’re using a property manager) on whom you can depend when you need them. Lawyer Landlord and tenant laws can be complicated, and having a competent rental real estate attorney on your side can help you avoid potentially costly lawsuits. Your attorney can also help: • Set up your holding company correctly • Draft leases • Deal with property closings and title issues • Navigate federal, state, and local laws • Review and revise the property management contract CPA Find a CPA with rental property experience (even better, one who owns residential rental property); not all accountants know the ins and outs of this business, and the difference could end up costing you thousands in taxes. Most people go to the accountant at the end, when it’s time to deal with taxes—that’s a mistake. Connecting with the accountant before you buy a property can vastly improve the project profitability and help you avoid costly mistakes that could eliminate potential tax breaks. Your CPA can help you: • Create a property budget • Deal with estimated tax payments • Set up and manage retirement accounts • Analyze complicated financing options • Handle all the tax returns Handyman Things go wrong with properties all the time. If you don’t have the time or background to deal with repairs, find a competent general handyman to work with. He’ll handle a wide variety of issues, from hanging fixtures to winterizing to basic repairs. Some handymen can also take care of basic plumbing and electrical issues, but don’t use them instead of licensed professionals for big jobs. It can be hard to find a reliable and reasonably priced handyman, so start your search early. TENANTS AND LEASES Landlord Rules To be a successful landlord, you need reliable tenants who always pay their rent in full and on time. That calls for careful and thorough screening, and a painstakingly clear rental agreement—the lease—that spells out exactly what you and your tenants expect from each other. Before you start screening tenants, come up with a list of questions that you’ll ask everyone, and make sure none of your questions are illegal (for example, “Where do your kids go to school?” is an illegal question). Next, you’ll move to the formal rental application, and follow up by verifying everything on there. You’ll choose your best candidate—and hope they choose your property. From there, it’s time to sign the carefully crafted lease and let your tenant move in. KNOW THE LAW As a landlord, you must be careful to treat every prospective tenant equally; it’s the law. The rules are laid out in the federal Fair Housing Act, which was created to help ensure that landlords don’t discriminate against people simply based on specific factors, including: • Race or color • Religion • Sex • National origin • Disability • Familial status You can find all the details of the Act by visiting the US Department of Housing and Urban Development (HUD) website at www.hud.gov. Follow State Law Too In addition to the federal law, many states (and some smaller localities) have their own fair housing rules that landlords must follow. Before you create a lease agreement or begin interviewing potential tenants, make sure you’re fully aware of the state and local rules and regulations for rental properties. A Word About Eviction Laws Though you hope it will never happen, there may come a time when you’re forced to evict a tenant. Each state has its own specific rules and procedures that landlords must follow in order to terminate a rental agreement. Those rules differ based on the reason for eviction: either nonpayment of rent or violating something in the lease (for example, having a dog in a no-pets-allowed apartment or subletting without permission). The rules about eviction for late or unpaid rent vary pretty widely but cover four basic topics: 1. When you can send a “pay rent or quit” notice (quit means “move out” here) 2. How you have to serve the notice (usually either in person or by mail) 3. How long the tenant has to come up with the rent or be evicted 4. Your options if it’s not the first time this has happened Most states give the tenant a window of time (usually somewhere between three and thirty days) to try and fix or stop their lease violation or move out before the landlord officially evicts them. Some states let landlords terminate the agreement right away without giving the tenant a chance to fix the problem. TAKE TIME CHOOSING TENANTS Good tenants can make your landlord experience smooth and profitable; bad tenants can destroy property, skip out on rent, and make you wish you’d invested in the stock market instead. The key to zeroing in on the best tenants is research. You want to look for tenants with a proven track record of both financial responsibility and personal responsibility. People who’ve changed jobs frequently or moved around a lot probably won’t make good tenants; when you’re looking for stability, past commitment history tells you what you can expect going forward. To gather the basic information you need, create a comprehensive rental application for each tenant to complete (if more than one person will be named on the lease, have each fill out a separate application). Then take the time to follow up and verify that information before you settle on a tenant. And always trust your gut: even when a tenant looks great on paper, if your instinct says something feels off, move on. The Rental Application A thorough rental application can act as a great tenant-screening tool. It helps you organize and evaluate the information you collect on prospective tenants and provides the data and permission you need to run credit and background checks. To cover the costs of those checks, most states allow you to charge application fees, though some limit how much you can charge. A basic rental application asks for information such as: • Name and Social Security number • Complete contact details • Employment history (company name, salary, dates of employment, full reference information) • Rental history (at least three years, including landlord contact information and reason for leaving) • Basic screening questions (such as, “Have you ever declared bankruptcy?” or “Do you smoke?”) • Signature that explicitly (a) verifies the information on the application is true and (b) gives permission for credit, background, and reference checks Keep every rental application, even for the people who don’t become your tenants. Then if a rejected applicant tries to sue you (usually under the Fair Housing Act), you’ll have a solid paper trail of protection that spells out why someone else was a better candidate. To streamline this process (and make things much easier for you), consider using an online rental application tool. These can help you stay organized, allow applicants to upload documents (like W-2s for income verification), and save on paper storage space. Websites such as Zillow (www.zillow.com) offer free screening and rental application services for landlords. Verify Everything Once a prospective tenant fills out a rental application, it’s your job to verify that information. Call the employer to confirm the prospective tenant’s job status, earnings, and how long she or he has worked there. Contact prior landlords (ideally, at least two) to see what kind of tenant he or she was. If the tenant is including alimony or child support in her income, ask to see the court order and six months of bank statements showing that money was received regularly. (In many states you can’t discriminate based on source of income—but you don’t have to rent to someone who can’t prove he or she is actually receiving that income.) No matter how much you like a prospective tenant, do your homework. Verifying the information will save you a lot of hassle (and potentially eviction proceedings) down the line. Run a Credit Check Before you rent to anyone, you need to know that he or she can and will pay the rent. The best way to find that out is by running a credit check. You can either do that on your own (which is inexpensive or sometimes free) or hire a service (which costs more but usually includes a thorough background check as well). To DIY the tenant credit check, contact at least one of the three major credit bureaus (Experian, TransUnion, and Equifax) and request a credit report. Experian (www.experian.com) offers free tenant screening credit reports to landlords. TransUnion (www.mysmartmove.com) offers tenant screening services starting at $25 each. Equifax (www.equifax.com) tenant screening reports start at $15.95. Before you can order credit reports, you need explicit permission from every tenant who’s at least eighteen—and you should check this for all adult tenants. To pull the report, you’ll need basic information from the tenant’s application, including his or her full name, birthdate, and Social Security number. Also, all adults who will be living there should be named on the lease, even if they’re not technically responsible for the rent; i.e., occupants rather than tenants. Do a Criminal Background Check Criminal history is a matter of public record, for even minor offenses. You’ll want to look into this thoroughly for the safety of your property, your other tenants, your maintenance workers, and yourself. A complete background check calls for looking at several sources, including: • Criminal court records searches at the local, state, and federal level • An “offender search” through the Department of Corrections • The sexual offender database Some of those searches are free; others may cost between $10 and $30 (on average). Since there’s not a nationwide criminal database, running a thorough check can be tricky—especially because criminals may lie on their rental applications. Consider Going with a Pro * * * It’s tough, time-consuming, and potentially expensive to do a thorough background check, especially if the prospective tenant has lived in several different states. Make your life easier by using a full screening service like SmartMove (www.mysmartmove.com) or MyRental (www.myrental.com). * * * LEARN LEASING LINGO Once you’ve selected the perfect tenant, it’s time to bring out the lease (here, the word lease also includes rental agreements). This is a binding legal document that sets out the rules that you and your tenants agree to follow, and it should include plenty of details, from the monthly rent amount to exactly how long the tenant can live in the property. You can make the lease as long or short as you like, but make sure that it includes at least the following information: • The full names and signatures of all adult tenants • The time period of the tenancy • Rules of occupancy (who’s allowed to live there, which protects you against subletters and permanent guests) • The rent amount, including when it’s due and how it should be paid • Fees and deposits • Landlord entry, including advance notice rules • Repairs and maintenance, including which responsibilities fall to the tenant • Restrictions on illegal activity • Pet policy • Any additional restrictions, like no smoking or rules about home businesses • Rules about common areas, like parking lots or swimming pools Make sure your lease completely complies with state and federal law. If you don’t want to deal with the hassle of drafting your own lease, you can find templates online at websites like Nolo (www.nolo.com) and LegalZoom (www.legalzoom.com). Lease versus Rental Agreement * * * What’s the difference between a lease and a rental agreement? Time. Rental agreements typically go month-to-month, renewing automatically until you or your tenant terminates it. Leases usually come with a term of at least one year. * * * Security Deposits You’ll collect and hold a security deposit to make sure the rent gets paid and to help ensure the tenant (or their kids, friends, or pets) doesn’t damage the property—or to cover the damages they cause. Every state has different rules for how much you can charge, where that money has to be kept, how you can use the money, and when you have to return the deposit (or what’s left of it after reasonable deductions). Those rules vary pretty widely: Arizona, for example, caps security deposits at one-and-a-half times rent and gives the landlord only fourteen days to return the deposit after the lease is up; Maryland allows for security deposits of twice the rent, and requires that the deposit be returned in forty-five days. Some states require landlords to hold security deposits in interest-bearing accounts and that interest goes to the tenant. These rules are very strict, so make sure you check the state law where the property is to avoid potential legal hassles. Should You Allow Pets? Many new landlords jump to a “no pet” policy. Before you decide, consider all the pros (yes, there are pros!) and cons of allowing pets. Here are some ways you could benefit from a pet-friendly rental property: • Charge higher rent. If the area is flooded with no-pets-allowed properties, you might be able to charge higher rent (sometimes hundreds of dollars more) by allowing pets. • Bigger tenant pool. According to the American Pet Products Association, 68 percent of US households have pets. A study by Firepaw.org found that only about half of all landlords allow pets. The math is clear: allowing pets gives you access to more tenants. • High-quality tenants. Several surveys show that pet owners tend to make more money than people with no pets. Pet owners typically stay in a rental longer because it can be difficult to find another pet-friendly property. Both of those are big plusses for landlords. • Avoids sneak-ins. Allowing pets lowers the chance that people will sneak in unapproved pets (and they do). Having it all up front lets you know what pets will be on the property, and lets you charge a pet deposit or monthly pet fees (depending on state law) to protect you from any animal damage. That’s the biggest downside, animal damage, but it’s not the only con to consider: • Damage. Scratched-up floors, chewed-up molding, pee stains—all of these are common issues with pets, and they can be very costly to repair. • Noise. Animals make noise, sometimes very loud noise (like incessant barking). They also run around, sometimes in the middle of the night, which can disturb other tenants. That could lead to lost tenants if those pets are too disruptive. • Liability. If you allow pets—especially dogs—there’s the risk that they’ll bite someone, including you, another tenant, or a maintenance worker. Make sure your insurance covers this potential liability and whether the policy contains limitations (like where the bite occurs) or exclusions (like a “dangerous breeds” list). DON’T UNDERESTIMATE RENTAL EXPENSES Counting Costs The vast number of expenses associated with rental properties can shock new landlords. Many jump in thinking that as long as the rent covers the mortgage payment and property taxes, they’ll be reeling in profits. That can lead to huge financial issues, even bankruptcy, because they aren’t prepared for all the costs they’re going to face. Taking the time to make a complete rental budget that accounts for regular and extraordinary expenses will help you make sure you don’t get caught short, and that your property will earn profits. On top of that, your rental properties count as a business for tax purposes. No matter how they’ve been set up, at the end of the year you’ll need to report their income (or loss) on a tax return. Include All Rental Income * * * Seems like a no-brainer: the money your tenants pay every month counts as rental income. That’s true, but it’s not the only thing that could count toward income. For example, if you have an arrangement with your tenant that he or she does yard work in exchange for a rent reduction, the value of that yard work counts as part of your rental income (even though there’s no actual money involved). * * * DEDUCT EVERY EXPENSE YOU CAN Most new landlords don’t realize the wealth of expenses linked to rental properties; they assume the expenses are limited to what they can deduct on their own homes. But one of the biggest benefits of owning rental properties is the combination of real-world cash profits and on-paper tax losses. That means you could end up with positive cash flow every month without having to pay taxes on it. At every stage of the game, you’ll have certain guaranteed expenses, including mortgage interest (if you borrowed money), property taxes, insurance, and property maintenance. Most other expenses will change based on whether or not the property is rented. Getting the Rental Ready To attract high-value tenants and get a lease signed as quickly as possible, your property needs to make a good first impression. That means boosting its “curb appeal,” which can include things like planting flowers, trimming trees, painting rooms, and refinishing floors. It also means making sure all plumbing, wiring, and appliances are in perfect working order, and possibly even updating older equipment before it gives out. In addition to the sprucing-up costs, you’ll also be able to deduct things like insurance, utilities, taxes, and other ongoing expenses even before your property is ready to be rented. Finally, this category also includes the fees for any permits, licenses, or certifications required before the property can be rented. Before It’s Rented Just because you have a tenant-ready apartment doesn’t mean it will be rented as soon as you list it; some properties sit on the market for weeks or months before a tenant moves in. All the money you spend to get a tenant into the property goes into your expense list. That can include things like the cost of: • Paid listings (in newspapers or online) • Hiring a property manager • Researching the local rental market • Advertising (such as signs or flyers) • Real estate agents As long as your property is available for rent, all of those expenses will flow into your financial statements and your tax return. Once You Have a Tenant After a tenant has signed a lease and moved in, you’ll have new (or higher) expenses to deal with: • Repairs • Wi-Fi (if included with the rent) • Water bills • Utility bills (if included with the rent) • Maintenance (new light bulbs, HVAC filters, etc.) • Trash and recycling removal That’s for tenants who don’t cause any issues. Expenses may be higher with problem tenants who consistently clog toilets, leave food out (attracting bugs or rats), or actively cause damage. A CLOSER LOOK AT DEPRECIATION Real estate investors have access to a special expense that reduces income on paper without actually costing any money. Depreciation is an accounting expense based on the idea that any kind of physical property (except land) loses value to wear and tear over time. It has nothing to do with changing market values, lousy tenants, or superior handymen; depreciation is all about time. Here’s the basic idea: instead of taking the entire property as an expense all at once (the same way you’d count an electric bill as an expense), you divide it up over time. That way, you take a portion of the property as an expense every year over its “useful life.” Rules to Depreciate As you’d expect, the IRS has pretty strict rules surrounding depreciation deductions, and you have to meet all of them to qualify. In order to legally deduct depreciation: • You own the property (loans are okay). • The property is being used to make money (even if it’s not making money now). • The property has a “measurable” life (which all buildings do). As long as you meet all three requirements, you can reap the enormous tax benefits of depreciation expense. The Math To calculate depreciation, you need to know your basis in the property. Basis means the total cost to acquire the rental property, which typically includes the full purchase price (even if you borrowed some of it) and most closing costs. From that, you have to subtract the value of the land (because land does not depreciate for IRS purposes) to get the basis for the building. If you make any permanent improvements to the property (putting on a new roof, for example, is considered permanent; repainting rooms is not), those get added on to the basis. The IRS timeframe for depreciating residential rental property is twenty-seven-and-a-half years, but it doesn’t happen evenly over time; it starts high and gets lower every year. The agency provides depreciation tables that help you figure out what portion of your property can be expensed every year. Even though your accountant will be taking care of this, it’s still important to understand how depreciation works so you’ll know why it looks like your investment is losing money even though you have positive cash flow. CHAPTER 3 BUILD WEALTH FLIPPING HOUSES House flipping skyrocketed after 2008, when millions of homes went into foreclosure and investors scooped them up for pennies on the dollar. Then, within a few years, came the resurgence of the TV shows (there are dozens of them now) where a house was bought, fixed, and flipped in under an hour—or so it seemed. Those shows sparked flip excitement, and suddenly everyone who’d done some puttering around the house was looking for property to flip in the hopes of scoring huge profits. Most of them lost money and got out. Some people stuck around, learned a lot, and slowly became successful real estate investors. With lessons learned, you can start investing in flip houses the right—and profitable—way from the start. THE ART OF FLIPPING As Seen on TV It looks super easy on TV: buy a house, slap on some new paint, and sell it right away for a huge profit. They make it look fun and stress-free, but that’s TV; the real-life version is very different. TWO WAYS TO FLIP There are two basic types of house flipping: 1. Fix-and-flip: You buy a low-priced fixer-upper, make some key improvements, and sell it for a profit. 2. Live-in and flip: You buy an underpriced property in good structural shape, spruce it up over time while you live there, and sell when the property value has increased. Most investors go for the straight fix-and-flip—it’s what all the shows are about—and this chapter will focus mainly on this strategy. This is not an arena to enter casually (especially with gargantuan dogs like Zillow joining in), but it is possible to collect big profits with the right approach. If you’re not in a rush, and the property you choose doesn’t have any issues that make it uninhabitable, the live-in and flip strategy may work better for you. Both strategies come with profit and loss potential, but you can tilt the odds in your favor by doing your homework before you buy. The Hold and Flip * * * There’s a third way to invest in flip properties, but it’s less popular because you have significantly less control over the outcome. With a hold and flip investment, you buy an underpriced property in an expected up-and-coming neighborhood and hold it until property values increase. Without the time to wait or the means to write it off if the increase never materializes, this would not be a good investment strategy. * * * Why Fix-and-Flip? If you’re handy around the house and love DIY home projects, a fix-and-flip investment could be perfect for you. These projects need to move quickly to be profitable and require a major time commitment (even when you don’t plan to do most of the work yourself). If you love a challenge, have good credit and a pile of cash, and know your way around tools, this could be an ideal investment opportunity for you. Expect your first flip to be a learning experience rather than a profit bonanza (practically no one makes a lot of money on their initial flip). Pick up as many skills and make as many connections as you can to make your second flip a winning investment. Why Live-In and Flip? With this strategy, you buy a house to flip, and live in it while doing the repairs. This can be a great way to get your feet wet in the house-flipping space because it gives you more time to get things done. Plus, when you plan to live in the house, it transforms a lot of the finances normally associated with house flipping. For example, you can get a regular home mortgage and use regular homeowners insurance, both of which can be much less expensive than if you were doing a standard fix-and-flip. Plus, if you live in a home for at least two years, then capital gains from the sale may be completely excluded from taxation. That means taxes won’t eat a huge chunk of your profits, leaving you with more cash to buy your next hold-fix-flip. BUY LOW, SELL HIGH The idea behind profiting from house flipping is the same as with other types of investments: sell it for more than you paid, and pocket the difference as profit. According to ATTOM Data, the average house-flipping gross profit (before any expenses were taken into account) for the second quarter of 2018 across the US was $65,520. That sounds like a lot, but it’s down about $4,000 from earlier in the year, and the numbers vary widely depending on where you are. Keep in mind that a lot of people lose money or break even when they flip a house, and (again) that’s before taking their expenses into account. There are a lot of factors that play into this, but the most important is choosing the right property, followed closely by having an accurate flip budget. The 70 Percent Rule To limit the financial downside while maximizing your profit potential when you flip a house, you need to know your costs before you buy a property. To start, you need to know how much the property is really worth so you don’t end up overpaying. Then, you need a realistic estimate of the repairs and renovations the property needs to be attractive for buyers. Armed with that information, you can calculate the perfect price for your flip property by using the 70 percent rule. The 70 percent rule is a guideline to help real estate investors make the best deals. According to this rule, the purchase price shouldn’t be more than 70 percent of the after-repair value (ARV, how much the house should sell for after all the repairs are made) minus the total cost of those repairs. The Need for Speed One key to maximizing profits involves what happens in between the purchase and the sale and how long that takes. In house flipping, speed is your friend on the selling side. The longer you hold the property, the smaller your profits will be. That’s because you’ll still be paying all the costs associated with holding the property, which could include: • Mortgage interest • Property taxes • Homeowners association fees • Utilities • Insurance The sooner you sell, the sooner you shed all of the costs that are eating into your profits. And the longer the house is on the market, the more likely you’ll have to drop the asking price, which deals another blow to your profits. FOUR RULES FOR A SUCCESSFUL FIX-AND-FLIP Do This for a Fun Flip House flips are more likely to fail (be unprofitable) than succeed, especially for beginners. Renovations always take longer to complete and cost more than expec