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Last Updated: May 14th, 2012 - 22:24:01 |
For some people, the biggest obstacle to successful real estate investing isn’t a meltdown in property values or tenants who wreck an apartment or don’t pay their rent. It’s overconfidence. If you’re expecting to cash in on the 21st century’s first gold rush without breaking a sweat, think again! The margin of error for making money in real estate is closing fast.
It’s not surprising that real estate tempts so many Americans. Over the past five years, home prices have soared and rags-to-riches tales abound. But so much real estate has become so expensive that Real Estate Research Corp., in Chicago, reports that many real estate pros say now is a better time to sell than buy. Some say that today’s buyers are like “lambs being shorn.”
That doesn’t mean all deals are doomed to fail. But it does mean that it’s time for would-be investors to pay more attention to the perils of owning property, not just the potential profits.
Watch your cash flow
The most common entrée into real estate investing is the single-family house. Investors bought almost one-fourth of all homes sold in 2004, according to the National Association of Realtors. If you’re one of those buyers and your income from that property (after taxes) exceeds your expenses by $100 or $200 a month, you’re in good shape.
But because prices and property taxes are so high in many areas and there’s so much competition for attractive rental properties, it’s increasingly difficult to find deals that generate enough income to more than cover expenses. N areas such as the leafy suburbs of New York City and Boston, where a modest three-bedroom house can cost $600,000, there’s no way you can collect enough rent to cover steep property taxes and payments on a $500,000 mortgage. Figure monthly out-of-pocket expenses of more than $3,000, if not $4,000. The pool of renters who will pay that much is small.
So be ready to set your sights lower and to get your hands dirty. Instead of a well-located home in pristine condition, look for a fixer-upper off the beaten track for about $150,000 that you can rent for $1,000 a month. The numbers work if you’re willing to spend weekends, say, painting the walls and, if you’re capable, making repairs that would otherwise require professional help. He hidden profit from home improvements is why “ugly real estate often makes more money than the nice stuff”.
Mind the cap
You can quickly figure out whether a house or condo is likely to generate positive cash flow. For more complex properties, such as a small office building or retail space, check the cap rate, a single number that can tell you if you’re overpaying.
The cap rate – cap is short for capitalization – is a property’s net operating income as a percentage of its price. The figure is real estate’s version of a bond yield. If a property sells for $500,000 and generates net income of $50,000 (rents minus expenses), the cap rate is 50,000 divided by 500,000, or 10%. The lower the cap rate, the more you pay for each dollar of annual income.
In 2000, the average cap rate on commercial property in the U.S. was 10%. Since then, because of relentless price appreciation, the average cap rate has sunk to 8%. That alone suggests that wringing further gains out of commercial property is unlikely.
If you want to invest in a commercial property, aim for a purchase price that results in a 10% cap rate. But remember that the cap rate also depends on how much you collect in rent. Ask the broker for details about the tenants’ leases, including how rents compare with those of other nearby properties and when the leases are up for renewal. The property should come with an information packet that is more like a stock prospectus than a real estate agent’s fact sheet on a single-family house. If necessary, hire a property inspector. Then take all the information to a lawyer who specializes in real estate. If you have any doubts about the property, walk away.
Don’t be in a rush
With so many people hungry to invest, you may think real estate is a race to the swift. Joice Bone knows better. A 37-year-old businesswoman and investor has learned the hard way. “I allowed myself to be rushed,” she recalls, “If the seller is trying to get you to hurry and close, someone is hiding an ugly truth.”
In 2001, Bone was driving on a busy highway near her home when her 6-year-old son, thinking about free fun on Mom’s nickel, shouted, “The Putt-Putt’s for sale!” Bone saw the four-acre site as a perfect location for a few storefronts and some townhouses. She recruited a partner, put up $250,000 in cash and bought a 50% interest in the property.
The details are complicated but, as Bone explains, one problem let to another. There were zoning roadblocks and the headaches of running the miniature-golf course before it could be demolished, and the other investor turned out to be more trouble than he was worth. In 2004, Bone gave up and sold at a loss. The misadventure taught her to think twice before her next purchase.
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