Investing in real estate in today’s market is not for the faint of heart. Whether you plan to dive into the rental market, or to start flipping properties you must understand that there are risks involved. However, it is possible to manage those risks with adequate planning. Before making your first purchase, it is important to secure financing, decide on a purchase strategy, assemble a team of professionals, and choose a market.
If you are not using cash for your investment, you will need to secure financing. There are three primary ways to do so. The first is to take the conventional route, but be prepared for a down payment of at least 20 percent with excellent credit. Interest rates will be higher than buying a primary residence, but generally cheaper than other types of financing. Conventional financing will work better for those investors entering the rental market, but not unheard of for property flippers. If you are looking to flip a house that requires extensive work, you may run into problems getting the final approval from the lender. Therefore before making an offer on any property have a long discussion with your lender about underwriting rules pertaining to the condition of the house.
Real estate investors can also get hard money loans, but these types of loans are designed for house flippers. Many investors have successfully used hard money loans, but know that these loans are expensive, and can prove costly if you cannot flip the property within the lender’s designated time, usually just a few months. Interest rates and closing costs tend to be very steep, but you will recoup those costs with a successful flip.
The last possibility is to secure private financing by asking friends and family. This is harder to do but many investors have successfully done so by presenting a good business model. Make sure you give them a breakdown of the numbers and be clear and transparent on how your “lender” will also profit from your venture.
There are a couple different ways to purchase a property. The conventional route would be to use a Realtor. If you are not too familiar with the market, this might be the best option for you, but it does have its limitations. You are less likely to get a steep discount on the purchase price because these types of properties tend to sell closer to market value. However, many investors (particularly those interested in the rental market) have used Realtors to buy their properties so it is possible, but work with a Realtor experienced with investment properties.
You can also buy a property at a foreclosure auction. Upcoming sales are usually listed in the local newspaper. The downside of this strategy is that you will not be able to view the property from the inside, but you are more likely to get a much better deal. Also the sale announcements will not give you much information regarding the property itself so you will have to become very familiar with the neighborhoods you are targeting to identify a good address.
An alternative would also be to develop a marketing strategy to attract distressed sales. Some investors do this by placing multiple signs in neighborhoods they are targeting such as “we buy ugly houses” or approach owners directly if they see evidence of distress such as an unkempt lawn or boarded-up windows. You can also use online marketing. The benefit of this strategy is that you cut out the middle man. The downside is that you may potentially spend a significant amount in advertising costs.
A winning team
Putting together a great team is essential before purchasing your first property. Even if you can do a lot of the work yourself, at some point in the process you will need the help of professionals. A bad contractor, or a bad Realtor can cost you your profit or worse yet, lead to losses. Once you have determined what you can do yourself, identify those individuals that you will need on your team. Get recommendations from friends, family, fellow investors and interview several candidates. Obtain references and check their business licenses. If you are hiring a contractor, ask to see some of their work and get estimates for different types of remodeling projects such as a kitchen or a bathroom. These estimates will help you determine costs once you identify a property to buy, but more importantly it will help you compare contractors based on their prices.
Find your market
If you are entering the rental market, focus on geographic areas where the rental income is typically higher than the mortgage. Because today’s economic conditions have kept many potential buyers from purchasing homes, it has placed a greater demand on rental units forcing rental prices to rise. That in turn has caused the rent to be higher than a mortgage in many geographic areas. Those are the markets that will be most profitable for you.
If you are flipping your first home, target areas where sales are on the rise, but have not yet peaked. Rookie mistakes in a stagnant market will cause your recently remodeled home to sit on the market for months. Conversely, trying to find a home to flip in a “hot” market can leave you frustrated as you compete with numerous investors for a good property. This is where a Realtor with investor experience can come in handy to point you in the right direction.
Avoid luxury or high priced areas. Yes, the profit margin can be greater, but losses can also be devastating. Therefore, begin at the lower end of the scale, mistakes are less costly and any mistakes in the resale value calculations are less likely since comparable sales tend to be more numerous.
Finally, find the ugliest homes in nice neighborhoods that need mostly cosmetic work. As a first-timer avoid any homes that appear to have structural issues or that require large scale renovations. And outdated home with bad curb appeal in a generally well maintained neighborhood is the best candidate.
Ready to make an offer
Once you have made a decision on financing, chosen a purchase strategy, put together a team, and decided on a target market, you are then ready to make an offer. Whether you are buying a rental property or planning to flip a property for a short term gain, with both types of investments, the key to a profitable venture will be the purchase price. Deciding on an offer price will require that either you or if you are enlisting the help of a Realtor, that the Realtor is very knowledgeable with after-renovation values (ARVs). Whereas a comparable market analysis (CMA) determines the current market value of a property, the ARV will determine the value post renovations. The ARV will be your starting point when determining an offer amount and therefore an investment will quickly go sour if the ARV is highly inaccurate.
If you are flipping the property and you have identified a property for purchase you want to make sure that the ARV minus the construction/sales costs equals your desired profit margin. Include all costs in your calculation such as Realtor commissions and taxes/insurance paid while holding the property. Your offer for the purchase will therefore be determined by subtracting the constructions/sales costs and the profit margin from the ARV.
ARV – (Construction/Sales Costs + Profit Margin) = Desired Purchase Price
If you are buying a rental property, you will need to determine the post-renovation rental income as your starting point. You want the mortgage plus the maintenance costs (HOA/condo fees, property management fees, advertisement fees) to be less than the rental income. Also plan to have funds set aside to cover the costs of the property for periods of vacancy.
Mortgage + Maintenance Fees < Rental Income
If the numbers do not add up, walk away. An emotional buy will eat away at your profit margin or lead to serious losses.
Remember, proper planning is the key to successful real estate investing. Do your homework first before purchasing your first property. Account for all potential costs associated with each property and always leave a margin for error when calculating construction costs. It is inevitable that you will make some mistakes along the way, but you are more likely to recover from those mistakes if you have a well-thought-out plan.