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Real estate investing: The full breakdown

At a glance:

A savvy investor once noted why he thought real estate was a good investment: "They're not making any more of it." Of course, new construction happens all the time, but that kernel of wisdom is largely true. In good times and bad, regardless of what's happening in the financial markets, people will always need a place to live.

At a minimum, real estate provides a great way to diversify your investment assets. Moreover, from Donald Trump to your neighbor who rents out a beach house, tens of thousands of us have built fortunes, or at least increased our financial security, in real estate.

Real estate sold sign in San Ramon, California, in 2019. (Photo: Smith Collection/Gado/Getty Images)
Real estate sold sign in San Ramon, California, in 2019. (Photo: Smith Collection/Gado/Getty Images)

How to start real estate investing

To get started with investing in real estate, you must first choose your strategy. There are a lot of ways to play the real estate game. We'll focus on the two predominant ones: "fix and flip" and "hold and rent."

Fix and flip

With the "fix and flip" approach, you find a "handyman's special" or "fixer-upper" and buy at a low-enough price to allow you to do the necessary repairs and sell at a profit. Sometimes significant discounts are available on houses that need only minor or cosmetic improvements. On the other end of the spectrum are houses that require major renovation. It is essential to determine where on the scale your target property lies, and whether you have the time and money necessary to put the house into marketable condition.

Hold and rent

If you intend to "hold and rent," you will always want an acceptable positive annual cash flow, exclusive of any profit upon resale. Until you become more experienced, it is probably wiser to buy toward the lower end of the market in a desirable neighborhood. The kind of renters you'll want will be looking for a safe neighborhood, and folks with kids will want a good school district.

It is also very important to screen your tenants carefully rather than accept the first warm body that responds to your ad. A tenant who doesn't respect your property can eat up a year's worth of profit—or far worse. You should consult a lawyer to obtain a basic lease agreement, which you can reuse. Feel free to add a page with any additional terms and conditions you feel are appropriate.

Finding property

To find your first property, ask around to find a real estate professional who is investment-oriented. He or she will have access to the Multiple Listing Service (MLS). The MLS is a database—a computerized catalog of all properties listed for sale by brokers. The MLS provides much of the information you'll need to know about a house: neighborhood, number of bedrooms and bathrooms, asking price, and a great deal more. Your real estate agent can use it to ferret out a list of only those properties that meet whatever criteria you specify—e.g., price range.

How to evaluate a real estate deal

The simple but crucial figure to accurately estimate with regard to investing in real estate is your "return on investment" (ROI).

The formula for ROI is this: Return on investment (%) = Net profit ($) / Investment ($)

Fix and flip

If the property is a "fix and flip," the net profit will be the estimated amount with which you'll walk away from the closing table upon resale. The investment will simply be the down payment you'll have to put up, plus all the fix-up and other costs you estimate will be incurred prior to buying the property.

Hold and rent

If the property is a "hold and rent," the net profit will be the estimated amount of rental income you'll net each year after your mortgage payment (which will usually include taxes and insurance), cost of advertising for tenants, routine maintenance, and contributions to a reserve fund for large, longer-term expenses (e.g., a new roof).

Remember that it's probably a mistake to figure on a full twelve months of occupancy. To play it safe, it's wise to make an allowance for several weeks of vacancy in estimating your gross annual rental income. Your investment will simply be the down payment you'll have to put up, plus any fix-up and other costs you estimate will be incurred prior to landing your first tenant.

Get it appraised

No matter which strategy you use, you will want a formal property appraisal. If you are using a mortgage lender, they will insist on one. The appraiser is a trained professional who will carefully examine your property and compare it to similar properties in the same neighborhood to make an estimate of its value. No matter how much a house might appeal to you emotionally, it will very seldom make financial sense to pay any more than the appraised value.

Get an inspection

You will also want to get an inspection from a qualified home inspector. The appraisal looks at the big picture and does not take the place of a detailed inspection. The standard home inspector's report will cover the condition of the home's heating system, central air conditioning system, interior plumbing, electrical system, the roof, attic and visible insulation, walls, ceilings, floors, windows and doors, the foundation, basement and structural components. The inspector will provide you with information you'll want in order to avoid costly surprises.

The importance of annual cash flow

If you're buying the property as a long-term rental, you will always want a positive annual cash flow—an acceptable annual ROI, exclusive of any profit upon resale. Very likely, of course, you hope to eventually sell the property for a capital gain, which will add to your ROI. But the date and price of the resale will be unknown when you are evaluating the deal. So you should probably look at the capital gain when you finally sell as "gravy."

The importance of square footage

If you intend to fix and flip, before making an offer to buy, determine how much the property in the neighborhood is selling for per square foot, to help estimate a realistic target sales price. Use that price to work backward in order to calculate whether you can do the necessary renovation work and still make a profit. Likewise, if you intend to rent, you should know in advance what rent the property will command. Square footage is less important in evaluating the appropriate rent because renters care more about bedrooms than square footage. So find out what the average rent is for the number of bedrooms you'll have.

Keep in mind that these numbers—your resale price or your monthly rent—are absolutely critical, so don't use off-the-cuff estimates. Do your homework carefully.

Be conservative and have cash on hand

When evaluating how a deal will play out—whether a fix and flip or hold and rent—be reasonable about your costs and timeframe. Don't ever assume the best case scenario in any calculation or estimate. Be conservative and cautious; expect the unexpected—delays, greater than anticipated costs, etc.

That's why it's important to have adequate cash reserves. You can hold out for a higher sales price. You can leave a property vacant for a few months in a pinch, rather than accept an unqualified tenant. You're able to maintain the property and make necessary repairs before it deteriorates. Conversely, having inadequate cash reserves puts pressure on you to compromise your business decisions and act from a position of weakness.

Taxes and real estate investments: The basics

Tax considerations are important to the real estate investor. Consult IRS Publication 527, "Residential Rental Property," available at www.irs.gov. It is also advisable to consult a tax professional to ensure that you are complying with the law, while maximizing allowable deductions and minimizing your overall tax.

Reporting your tax information

In most cases, you will use Schedule E with Form 1040 and include as gross income all amounts you receive as rent. If you hold the property for rental, you recover the cost of the property through yearly tax deductions. You do this by depreciating the property. In other words, you deduct some of the cost each year on your tax return. (Use Form 4562 to claim depreciation.) The depreciation deduction is in addition to your actual out of pocket maintenance and repair expenses.

The result is an increase in cash flow—the amount of money you get to keep after taxes. The depreciation period for residential real estate is 27.5 years. This means your depreciation deduction will be 3.636 percent of your "basis" in the rental property (the building only, not the land) each year for 27.5 years. Typically, your basis is the amount you paid for the property, plus the value of any structural improvements (e.g., a new roof or furnace).

What about capital gains?

Upon selling a property, you will realize (hopefully) a capital gain—the difference between the amount you sell it for and your basis, which is usually what you paid for it (plus any structural improvements), minus the amount you have claimed as depreciation deductions since purchasing the property.

Capital gains are classified as long-term or short-term. If you hold the property more than one year, your capital gain or loss is long-term. If you hold it one year or less, the gain is short-term. Long-term capital gains are taxed at 0–20%, while short-term capital gains are taxed at your ordinary income tax rate.

How to finance real estate purchases

For rental property

Loans for rental property will be long-term notes, usually for 30 years, as with owner-occupied home loans. The application process for rental property is similar to that of an owner-occupied mortgage, but you should understand that the mortgage interest rates you hear and read about don't apply to you as an investor. Lenders consider investment (i.e., non-owner-occupied) property a riskier loan and will charge a higher interest rate and perhaps higher fees or "points" than for a traditional mortgage loan on an owner-occupied house.

Additionally, be aware that the minimum down payment for non-owner-occupied real estate loans is generally higher than for owner-occupied financing. Depending on how much you put down and your personal credit rating, expect to pay from 1.5–2.5% more than the going rate for owner-occupied mortgages. Typical closing costs are about 3% of the sales price, and this can either be paid for by the seller or wrapped into the loan.

For fixing and flipping

The financing for renovating and reselling houses is different. These are short-term loans, generally no longer than a year—enough time to complete the renovations and sell the property. The down payments will vary by the deal and will depend, in large part, on how much work needs to be done on the house. The loans on rehabs will vary based on the Prime Rate, with fees and points in the 1–3% range, depending on your financial strength. Your experience in residential renovations may also be important.

If you plan to renovate your property, a "purchase and renovate" loan is probably the best option for you. This type of loan combines the cost of the improvement work and the purchase of money funds so you have few out-of-pocket costs. The lender will probably require an estimate from a general contractor.

You may also qualify for a Fannie Mae long-term rehab program called the HomeStyle Renovation Mortgage loan, which provides a convenient way for borrowers to make renovations, repairs, or improvements totaling up to 50% of the as-completed value of the property. The funds can be used for any repairs or renovations that are permanently affixed and add value to the property. Investors are eligible borrowers for this loan, which will be offered at a rate not too much higher than a regular mortgage loan.

Where to find loan information?

To find the best terms on loan interest rates and closing costs, call around to check out what your local banks or credit union are offering. Alternatively, you can ask your real estate agent to recommend a mortgage broker. The function of a mortgage broker is to work as a middleman between a borrower and a mortgage lender.

A mortgage broker will have connections with real estate lenders, which means that they are better able to help you get a good deal on mortgage loans. They can help you assess your individual situation and provide you with customized home loan options to choose from. Mortgage brokers allow you to effectively comparison shop for mortgages while they handle the legwork.

The median age of home buyers has risen since 1981. (Graphic: David Foster/Cashay)
The median age of home buyers has risen since 1981. (Graphic: David Foster/Cashay)

While the convenience that is involved with using mortgage brokers is definitely an advantage, it comes at a price. A typical mortgage broker works on a commission basis. In some cases, you pay the commission, and in others, the lender pays the mortgage broker a commission fee. It's also possible for both you and the lender to have to pay the broker fees. It's important to take the time to shop around for a mortgage broker and understand the different fees you may be charged.

Using your own home

Finally, another option is to use the equity in your own home to secure a credit line. That will give you maximum flexibility and the least amount of hassle. Of course, to get a home equity loan or line of credit, you have to convince the lender you can handle the debt, which means you need pretty good credit and income.

Summary of real estate investing

Real estate is a time-tested means of diversifying your investment assets and protecting them from the ups and downs of the financial markets. The two principal approaches to real estate are "fix and flip" and long-term rental.

Of course, either approach is a far more "hands on" investment technique than traditional financial vehicles. But with the extra effort comes the opportunity for good long-term income and/or hefty capital appreciation, along with tax advantages.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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