The affordability of American homes has never been greater. Low home prices and low interest rates make buying a home cheaper than renting in many markets. So why do nearly a third of Americans choose to rent? For many people, financing can be a barrier. On CNBC.com’s Realty Check, real estate reporter Diana Olick writes, “The days of free-wheeling lending are over, and credit-worthiness is king. There are low down payment options, like the FHA, but too many potential buyers don’t meet the credit qualifications either for the great low rates or for the loan itself.”1
Homebuyers and sellers and investors on either side of a transaction have found viable alternatives in the form of creative financing. In three types of creative seller financing—installment sales, seller carryback loans, and wraparound mortgages—the seller becomes the lender and accepts payments from the buyer over an agreed upon period of time. This is particularly lucrative for the seller because the payments are amortized; they include interest resulting in greater cash flow. Along with the higher returns, however, comes risk as the seller assumes the burden of dealing with default. It’s always best to consult with an attorney to minimize the risk and also to ensure legal compliance.
In another type of creative financing, called a lease option, the interested buyer rents the home with the option to buy at the end of the lease. The seller becomes a landlord and charges a higher rent, a portion of which will go toward the down payment. The lease agreement includes a nonrefundable deposit that will also go toward the down payment. If the renter decides not to buy at the end of the lease, however, the seller keeps the deposit and extra rent paid. Investor organizations believe that less than 20 percent of all lease options result in a closed transaction.
Creative financing can be a great option on the buying side, too. Many investors who purchase fixer-uppers with the intent to renovate them and resell them for profit use private or “hard-money” lenders. Hard-money lenders, as opposed to traditional lenders, will loan on properties needing minor and/or major repairs and have quicker turnaround times. The downside to using hard-money, of course, is the high interest rate. The interest on a loan from a hard-money lender can be three to four times higher than the interest on a traditional loan. But if an investor is able to turn a property around within the term of his loan, he’ll be in good shape and will likely make a fantastic return on his investment in a very short period of time.
Whether buying or selling, knowing the options available to you as a new—or even experienced—real estate investor can open doors to new opportunities and put more money in your pocket. Creative financing can be a useful tool in executing an investment transaction. Be sure to consult with a qualified attorney; you don’t want to let an unlawful contract ruin a great deal.
The real estate market has been heating up nationwide, and it’s only getting hotter. On CNBC.com’s Realty Check, real estate reporter Diana Olick writes, “It’s no secret that investors have been inhaling foreclosed properties at a breakneck pace, trying to cash in on an increasingly hot rental market.”1
Recently Bloomberg reported that Blackstone Group, the biggest buyer of U.S. commercial real estate, “is turning to residential real estate after a 34 percent plunge in prices since the 2006 peak. The New York-based company is the biggest investor seeking to enter the single-family leasing market as rents climb and the U.S. homeownership rate sits at a 15-year low.”2
In some markets—Oakland, California, for example—rents are often higher than mortgage payments. SFGate.com reported, “In neighborhoods hit hard by the housing crisis, it would be cheaper for many families to buy a foreclosed home than rent an apartment. The average price of a house in those neighborhoods is less than $150,000. Monthly payments on most 30-year mortgages at that price are usually less than $1,000, while rents on many West Oakland properties are around $2,000.”3
Real estate investors have the added advantage of record-low interest rates. According to Freddie Mac’s Weekly Primary Mortgage Market Survey, the 30-year fixed-rate mortgage for the first half of 2012 averaged 3.86%, while the 15-year fixed-rate mortgage averaged 3.12%!4 Even investors who have the cash are locking in these incredible rates.
So who are the buyers making up this heat wave of investing? Surprisingly, the typical real estate investor isn’t wealthy and middle-aged like you might imagine. The reality is that the median income of the real estate investor is $86,100. It’s not much higher than the median income of the primary residence buyer: $72,400. And nearly 40% of investors made less than $75,000 in 2011.5Today’s real estate investor is really just the average American homebuyer.
When you consider today’s market conditions, it’s not surprising that investors are popping up everywhere. But not all discounted properties are good investments, no matter how low the price and interest rate may be. Several factors affect a property’s return on investment, and they all need to be carefully considered. For example, experienced investors know to invest for cash flow—a property’s return on investment in the form of monthly rent. It’s immediate, steady, and can build wealth over time. Many new investors tend to think in terms of appreciation, but intelligent investors know that investing for cash flow helps ensure a profitable investment regardless of appreciation.
5 2012 National Association of Realtors (NAR) Investment and Vacation Home Buyers Survey
If you’ve been considering buying real estate as an investment, you’re in good company! Existing home sales are up in January for the third month in a row. One out of every four buyers were investors. The difference between them and you? They took action!
Still not convinced? Here’s what Warren Buffett recently had to say about residential real estate: “I think it’s about as attractive an investment you can make.”
Are you really going to let this incredible opportunity pass you by while others are building their wealth through real estate?
Just consider these four reasons to buy real estate now—before it’s too late!
Historically Low Interest Rates
Why are low mortgage rates (below 4% for 2012) so important? Low interest rates mean lower payments; lower payments mean more possible cash flow.
Cash flow for a real estate investor is what he or she earns after paying all the expenses related to the property. For example, if expenses are $1,000 per month (mortgage payment, insurance, taxes, repairs, etc.) and rent is $1,500, there’s cash flow of $500/month ($1,500-$1,000=$500).
For an investor, cash flow means more immediate return on the original investment, which means a greater return overall because these funds can be reinvested immediately or saved for future real estate purchases.
Low Prices and Rising Rents
Along with great challenges come great opportunities, and this couldn’t be truer in today’s housing market. Due to excess distressed inventory and more demand on rental housing, prices have plummeted and rents have soared 24% over the last four years, creating the perfect atmosphere for investing in real estate.
A Lower Risk Investment
A long-standing debate has raged over whether real estate or the stock market is the smartest investment strategy. Building a portfolio with a mix of different types of investments is always smart, but what if you have a finite amount of money to invest and still want a high return without a lot of risk?
To add more perspective, examine the real estate and stock markets side-to-side over the last decade. Real estate values increased by 19.2 percent between January 1, 2000 , and December 31, 2011. Over the same time period, stocks in the S&P 500 decreased by 14.4 percent.
Even during one of the worst performing real estate markets for appreciation, real estate is a more reliable, stable investment than the stock market. And that’s only half the story. Remember cash flow? Most stocks don’t pay a cash dividend at all. If purchased correctly, real estate always cash flows.
Appreciation should always be looked at as a bonus in a real estate investment. Over the last 40 years, real estate appreciation has averaged 5% per year (in addition to monthly cash flow)--one of the reasons Buffett called single-family homes a “very attractive” asset class. Buffett: “If anybody is thinking about buying a single-family home … it’s a very attractive asset class now.”
Investors in your market are cashing in on the opportunity now. Why aren’t you?
A new trend in real estate investment is emerging: parents investing in real estate to fund their children’s college education.
With the decline of the stock market in the past decade, more parents are seeking to invest for their children’s future through other assets, including real estate. These parents believe that the time is right to purchase real estate because of low prices and mortgage rates, and a strong belief that real estate prices will show considerable appreciation by the time their children are in college.
The idea is to purchase a house as an investment property when a child is born or very young. Ideally, a 15-year fixed rate mortgage is used for a property that cash flows in the first year. By the time the child has reached college age the property is paid for and the parents can sell the asset and use the gain to fund college. Not only has the equity in the property grown over 18 years, they’ve benefitted from the yearly cash flow as well.
Here’s how the scenario might play out:
Let’s say our fictional parents purchase a $100,000 house with $20,000 as a down payment. They take out a 15-year mortgage for the balance at 6.75 percent interest. Their mortgage payments are roughly $8,945 for the year (or $708 per month).
If they rent the house out for $1,200 a month and have around $325 per month in expenses (taxes, insurance, repairs), they should see about $2,005 in cash per year from rental income for the first 15 years. From years 16-18, the expense of the mortgage is eliminated, yielding them $10,500 in cash flow annually. Over 18 years the total cash flow equates to $61,575. Note that this conservative estimate does not include potential rent increases that will increase cash flow and will help offset additional property taxes. Nor does it include interest earned if the parents decide to reinvest cash flow.
In 18 years the property will have appreciated, too. The standard rate of appreciation for real estate nationally over the past 40 years has been 3 percent. At that rate the $100,000 property they bought would be worth $170,243 at the time of sale.
The initial $20,000 investment would have earned $150,243 over 18 years - a return of over 13%. Including cash flow, the return is 15%!
While it is difficult to determine what future tuition will be—increases in tuition have spiked dramatically in recent years—a $230,000 ($170,000 sales price + $60,000 in cash flow) cushion should be enough to soften the tuition blow.
Investors aren’t limited to purchasing real estate to fund college; many choose to purchase property during the college years to provide their children with a home and save on room and board.
In a survey of Coldwell Banker agents, 64 percent saw significant number of parents investing in college-town real estate for their children. With increased room and board and the high demand for rental property in college towns, the strategy makes sense.
San Francisco-based parents Katie and Dale have purchased a house with multiple bedrooms for their children, leasing the other bedrooms to other students. Because of the high demand, the rent helps pay the mortgage on the property and the parents plan to sell when their children no longer need the house.
In the long run, these savvy parents are saving money and helping to provide their children with a stable place to live during their college careers.
Did you know you could use your nest egg to purchase an investment property and increase its value through cash flow? You can roll your traditional IRA or 401k into a self-directed IRA (SD IRA) and—as the name implies—have direct control over where your funds are invested, namely a cash flow-producing rental property.
Traditional IRAs, in most cases, are distributed among stocks, bonds, and mutual funds at the discretion of the bank or financial institution by which they’re managed. The financial institution acts as the trustee or custodian of the IRA; it distributes, receives, and holds the account funds for the investor. In most cases, the investor is out of touch with his or her investment activity and just hopes for the best.
While approximately 97% of all retirement account assets are invested with banks, brokerage firms, mutual fund companies, and insurance companies, many people don’t know there are other retirement investment options available and that many of these options have greater return capabilities.1 Real estate, limited liability companies, private companies, and joint ventures are just a handful of possibilities. These investments require that you first roll your IRA into a self-directed IRA to allow you to direct its activity. Because self-directed IRAs are less profitable for financial institutions than traditional IRAs, and because fewer institutions are proficient at handling them, they’re more reluctant to communicate this option to investors.2
There’s no penalty for rolling your retirement funds into an SD IRA, but like a traditional IRA, it requires an account custodian. The difference is your ability to tell your custodian where to invest your funds. For example, you can have your custodian purchase real estate with your SD IRA, then hold the property as a rental investment and have the cash flow go back into your SD IRA. As a bonus, the fees associated with SD IRA custodians can be lower than traditional IRA fees.3
It’s much simpler than most people think. The first step is to find an SD IRA custodian. Not all banks and brokerages handle this type of account, and you’ll want to find one that specializes in SD IRAs. And be aware, rolling your IRA into an SD IRA typically takes six to eight weeks.
Once you have your SD IRA all set up, you can make an offer on a selected investment property in the name of your SD IRA. After negotiating a deal, your custodian executes the contract. There’s extra paperwork involved when going this route, but your custodian can help guide you through the process.
If you’re interested in boosting your retirement and diversifying your investments, using an SD IRA to invest in real estate is a great strategy. You’ll want to consult with your accountant and find a custodian who is experienced with SD IRAs. This method is certainly more proactive and lucrative than leaving your retirement funds in the hands of someone else and simply hoping for the best.
1 Allen, Matthew M. Leverage Your IRA: Maximize Your Profits with Real Estate, Scottsdale: LIFESUCCESS PUBLISHING, 2010.
New real estate investors can sometimes get caught up in common pitfalls that end up costing them time and money and, ultimately, turning an investment into a bad deal. But not all of these pitfalls are self-evident. Being aware of the potential risks and knowing how to prevent them will help keep you from falling into these traps.
Pitfall 1: Emotion vs. Logic: Buying on emotion, not math.
Most business transactions and investment decisions are based on numbers and whether they make logical sense. Buying a home, however, is an emotional experience—it’s where lives are lived, families are raised, and memories are created. It’s natural for us to hold great emotional value in our dwellings, and we look for homes that are a good fit emotionally. When purchasing a home as an investment, however, it’s important to treat it as such and keep emotions at bay. To be successful in real estate investing, it’s best to think of the purchase as a business transaction or investment—focus on the returns. Calculating the numbers, such as the cash-on-cash return, for example, and determining if a property overall is a logical investment are the most important factors to consider.
Pitfall 2: Dealitis: Thinking that every property is a good deal
There are plenty of inexpensive properties in the current market. Home prices have dropped drastically since 2007. Just because a home is significantly underpriced doesn’t mean it’s a good investment. You need to take the same cautionary steps to evaluate the value of a property listed at $40,000 as you do for a property listed at $400,000. A low-priced property could have serious structural issues, the relative property values in the area could be low, or the property’s expenses could be too high to provide cash flow. Many people wanting to take advantage of the current market’s low home prices have been burned because they didn’t do their homework and acted too quickly. It pays to consider all elements of a real estate investment property. The return will dictate whether the price is right for you.
Pitfall 3: Analysis Paralysis: Spending too much time analyzing and missing opportunities.
The flip side of Dealitis is Analysis Paralysis. Doing your due diligence is important, but you don’t want to take too long to make a decision. With a properly written contract, you’re allowed adequate time to back out if you decide the deal isn’t right. This is what contingency/ inspection periods are for—a thorough inspection and analysis. If you hesitate too long, you might miss a good opportunity.
Even experienced investors can fall into these traps, which is why it can be helpful to work with an agent who specializes in investment properties. There are risks involved with all types of investments, and real estate is no different. But being aware of these pitfalls and having a knowledgeable real estate agent on your side, along with his or her team of professional advisors, will help keep you safe.
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