Buy Real Estate?

realestateicon Whether or not now is a good time to buy [tag]real estate[/tag] depends, as most things do in finance, on time and amount. For example, if you have been renting for the last year or two and have saved up 20% for a down payment and you just found the house of your dreams, then yes, now is a great time to buy real estate. But what about people looking for a good investment? Is now the right time?

When it comes to investing in real estate the key to success is understanding what kind of real estate investing you are doing, and how that affects what you do today and tomorrow.

Real Estate Investment Strategies

The three most common real estate investment strategies are:

1) [tag]Fix and Flip[/tag]

2) Buy & Hold (Capital Appreciation)

3) Collect Income (Buy and Rent)

Fix and Flip

The strategy for fixing and flipping a home sounds simple on paper. You buy a house that is currently in need of some sort of update or renovation for a certain price. Then, you do (or hire someone to do) those updates and then you put the house back on the market for a higher price. Profitability then can be measured by:

New Selling Price – (Original Selling Price + Renovation Expense + Interest Expense + Transaction Costs)

The keys to profitability are the speed with which the house can be resold (minimizing Interest Expense), the spread between the Original Selling Price and New Selling Price (maximizing raw profit), and minimizing Renovation Expense. In a market like the one we are currently in, the rough part is maximizing the spread. Even if everything else goes to plan, the market assumes that prices are not rising and that this is currently a buyers market. That being the case, when someone sees that you paid $350,000 for the house just two months ago, and now you want $450,000 for it, there will be more resistance than usual. In order for this strategy to work in this market, you will need to ADD things that are tangible. Simply making the place look better won’t work in this market. A buyer might be willing to pay the higher price if they can see the additions — a new bathroom, a new deck, a new master suite are all the kinds of things that may make this strategy work. New carpet, new cabinets, new paint, are the kinds of things that will not work in this market.

Consider the Fix and Flip Strategy to be much tougher now.

Buy & Hold (Capital Appreciation)

This is the one that has people’s wheels turning. The key to this strategy is full understanding. Yes, if you buy a house today chances are it will be worth more in ten years assuming that the neighborhood does not become a bad one. So, how do you make money? The most important thing about this kind of real estate investing is the concept of [tag]leverage[/tag]. Assuming you won’t be paying cash for the full purchase price, there is going to be a loan involved. In the stock market, this concept would be known as “the margin” or a margin loan. It is using a [tag]loan[/tag] to buy and investment. In real estate, that loan is a [tag]mortgage[/tag], and thanks to the fact that real estate is hard collateral, you can get a loan for a higher amount of the cost of your investment. Let’s say that your investment property is a $300,000 home. If you put down 10%, then you get a loan for 90% (easy math eh?). Now, the way the leverage works is this. If the $300,000 appreciates to $360,000 then you have made a $60,000 profit (assuming no costs) or a 20% return. So far, nothing special. But, because of leverage, you profit is actually much higher. Your original investment was only $30,000 not $300,000 (you borrowed $270,000 remember?). A $60,000 profit on $30,000 is a 200% return! Now we’re talking. Of course, this ignores the fact that you will have paid interest on the loan, taxes on the home, and whatever other expenses occurred along the way. Still, this example demonstrates the power of leverage. So is now a good time? The answer is all about your time frame. If you are looking to sell next year, then this would be an extremely risky investment, and frankly probably a bad one. Two years isn’t necessarily much better. Keep in mind the real estate markets move much slower than the various exchanged based markets. There is no such thing as a 3% up day in real estate.

So, how about a five year time frame? This is the number I’m telling people right now. You have to have a MINIMUM time frame of five years to even think about this kind of investment right now, and even that will be fairly risky. It is possible that real estate recovery will take much longer. Keep in mind that unlike other investments real estate investing incurs costs along the way. If you hold for five years, you’ve got five years worth of taxes, interest, and upkeep.

So is it a good time? Yes, IF AND ONLY IF you have EXTRA CASH to handle the investment. If you have a $30,000 nest egg and that is it, then no, no, no. If you are putting 15% into your 401(k), have six months worth of expenses in your emergency reserve fund, have fully funded your children’s education, and you still have $100,000 sitting in a brokerage account that you have no foreseeable plans for, then yes, now is a great time. Is it the best? No. Home prices tend to stagnate and drop come the fall. Considering no one is predicting a blow out year for real estate prices, you can be fairly certain that there will not be big increases in prices over the summer, therefore your better spot will be October or November when the people who couldn’t sell over the summer drop their prices to sell before the holidays.

Now is NOT the time to be buying in distressed areas. Real estate recoveries happen from top-down, so the nice areas will recover first, then the nice but not great, then the average, then the below-average and so on.

Collect Income

The buy and rent strategy is probably the least understood and the most wrongly used by the casual real estate investor and probably the most profitably used and least risky strategy used by the professional real estate investor. If you are looking to buy real estate and rent it out UNTIL YOU THE PRICE IS HIGHER, then you are talking about the strategy above, and it is different. If you are looking to generate monthly cash flow and you may or MAY NOT sell the property someday in the future depending upon market conditions then we are in the right place. This strategy is the right one to be playing in this market. With home prices coming down, you can get great properties in good neighborhoods, exactly the kinds of places that people will want to rent. Your best bet right now are properties with good schools that are not easily accessible in other ways. So, that great new school that everyone wants their kids in is surrounded by pricey homes, then perfect. As people who got in over their heads sell their homes, they will need somewhere else to live. They will want that somewhere else to live to be as close to their old quality of life as possible. Those people are your renters, and they are increasing in number.

As always, good quantitative [tag]analysis[/tag] is the key to the rental strategy. Do not get into to something with negative cash flow at this time. Although the number of renters will be increasing, their level of distress is increasing as well which means although demand will rise, rates will not be able to rise much with that demand. In other words, renting the place out is going to get easier, but raising the rent is not.

Summary

So, in this market, Fix and Flip probably not a good strategy. Buy and Hold is fine if you have both the liquidity and the LONG time frame. Buy and Rent, this is the good times. Get in there.

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