Chapter 3
Other Considerations in Investing
Every part of real estate involves the law. There are many complicated legal pieces and many different people are involved in any real estate transaction.
First and foremost, the contract is most important part of buying and selling property. The primary purpose of a contract is to show mutual assent – the agreement by both parties to the exchange- in writing. Verbal agreements are not binding. To be valid a contract, it must include the following:
There are checks-and-balances to protect people in every situation and to protect the overall system. Appraisals are used to ensure that the property is worth what the lender and seller have purported. The appraisal prevents shady deals being stuck between investors and mortgage brokers. Commercial property has its own laws regarding use and sale. If there are tenants living in the property, there are specific laws to protect the landlord and tenants. Lenders are held to the law by how much they can loan, what documents and insurance are required, and even how they market their financing programs.
It’s important to know about tax law, or get advice from a professional, since it greatly impacts your success in real estate investing. Mistakes are costly, and by protecting yourself you can make decisions that will help your bottom line rather than take away your profits.
Before covering the subject of real estate tax law, understand that the following should not be thought of as legal advice. Seek legal advice from your attorney or accountant when making any legal or tax decisions.
Each area has its own tax codes, but here are a few general tips to consider that apply in most locations:
Since the tax law is so complicated, it’s best to seek professional assistance anytime you are in a situation that’s out of the ordinary. The amount you pay for their services will be saved tenfold by their expertise in the field.
The Pros and Cons of Rural vs. Urban Investments
One real estate trend is the shift of buyers from populated urban locations to less populated rural places. Unique properties like vineyards, Bed & Breakfasts, horse farms, and agricultural farms, have realized increased property values thanks in part to aging, financially secure, baby boomers. Although these locations are desirable when investing in real estate, there are some challenges associated with rural properties.
Finding a property can be a challenge. With the increased popularity of people working from home, and more retirees looking for rural retreats, it can be difficult to find an investment property at a bargain price.
Finding reliable and qualified contractors that are affordable often presents a challenge in rural locations. You may need to pay a premium for skilled labor, even if the average income in the area is lower than in the city.
When property is unique, it’s difficult to appraise. Many rural properties don’t have realistic comps, so the value is essentially guessed. Lenders are aware of this type of situation, so they might to be less willing to finance a loan for a one- of-a-kind property. This usually isn’t a problem if the buyer has solid credit and can provide a more substantial down payment.
When it comes time to sell a rural investment property, you will need to market your property over a larger area to pull together a group of interested, and qualified, potential buyers.
Investing in Real Estate Foreclosures
While some foreclosures may look appealing to the real estate investor, it’s essential to consider many factors before you enter into a deal involving a foreclosed property.
What is foreclosure? It’s a legal process that occurs when a mortgage holder takes back a property when payments are not current.
By buying a foreclosed property, you are entering into a legal mess. Some foreclosure situations allow for the ‘right of redemption’. This means that the property owner can make back payments and take back the title. Obviously, you want to stay away from this. When considering a foreclosure, look for situations where, at minimum, a Notice of Default has been given.
A unique point about foreclosures is that the property is sold “as is”. There are no warranties and no title insurance. Have a professional inspection beforehand, and never make an offer without looking at the property personally. If there are problems with the property but you are looking for a house to fix, reduce your offer appropriately. Before buying, conduct a thorough title search.
Two other types of foreclosure are REO and ‘short sale’ deals. REO stands for “real estate owned”. This is when the lender owns the property because it was auctioned, but no one bought it. You can find a REO bargain, but be very careful. The property usually wasn’t bought for a reason. Short sale deals happen when a lender will take less money than remains on the existing loan.
Investing in Commercial Property
Commercial real estate investment (CREI) accounts for a fraction of all real estate investments, with residential property being the largest segment. Just because it is a small piece of the pie doesn’t mean it’s less complicated.
Commercial property is most often bought for business purposes as an investment. Even if it’s an apartment building with several apartments, it’s considered commercial.
When investing in commercial property, you have to invest more money, which requires excellent credit. By putting more money down, you have exposed yourself to greater risk. Commercial investors also need to determine their capitalization rate (cap rate) and Gross Rent Multiplier (GRM) to decide if an investment is a good decision.
The cap rate and GRM are useful calculations when investing. The cap rate formula is: Annual Net Operating Income/Purchase Price. Usually, a sound investment has an 8-10% cap rate. The lower the percentage, the higher the risk and the lower the anticipated profit. The formula used to calculate the GRM is: Purchase Price/Monthly Gross Operating Income.
You should also consider the property comps, appraisal vs. assessment, income and replacement costs when considering if a deal is worth it.
Commercial properties are also tricky because the economic conditions of an area often dictate the occupancy of commercial property.
When buying commercial property, you’ll need to first educate yourself on area zoning, leasing rules, commercial law, building maintenance, and other legal issues. Since the property will most likely be rented, you’ll need to consider fire safety, internet and telephone capabilities, more complex plumbing and electrical needs, security systems, and more. Only when a landlord has a triple-net lease – where the tenant pays for and coordinates all maintenance, repairs, and insurance- will the involvement be less.
Of course a profit can be made from CREI. Although there are more risks, the potential profit is often higher.
The Pros and Cons of Renting Property
Sometimes investors hold onto property with the hopes of making a profit through rental, while benefiting from the capital appreciation and beneficial tax code.
When deciding whether to hold or sell a property, calculate out your estimated taxes if you keep the property, versus selling it. Hypothesize about future sales prices are going based on interest rates, trends, and the current market.
If you’ve decided to become a landlord, keep the following in mind:
Alternative Real Estate Investment Instruments
There are ways to invest in real estate without ever having to deal with the nitty gritty parts of the business – no inspection, appraisal, or marketing. Real Estate Financial Trusts (REITs), Mortgage-Backed Securities (MBS), and Self-Directed IRAs are all ways of investing in real estate on paper alone.
Real Estate Financial Trusts (REITs) are mutual funds that focus on real estate; investments are made in both physical property and mortgage portfolios. It’s handled like other securities and has special tax situations. REITs often have better yields and provide easier access to cash than traditional property investment.
There are Mortgage, Equity, and Hybrid REITs. Mortgage REITs invest in mortgages, with revenue coming from the mortgage interest. Equity REITs own and invest in actual real estate, with most of the revenue coming from rental income. Hybrid REITs are a combination of both.
Just like other mutual funds, once purchased they can’t be cashed in through the fund, but have to be sold to another investor through a broker.
REITs can be considered high yield, since dividends are paid out to shareholders at 90% or more of taxable earnings. Dividends plus appreciation equals the total return, and REITs are comparable to small-cap stock in that about 66% of the return comes from the dividends. As a result, REITs are impacted by changes in interest rates. When interest rates increase, the price of REITs usually decline.
Mortgage-Back Securities are bonds backed by a group of mortgage loans. Just like other type of bonds, you earn a coupon rate of interest. Unlike other bonds, however, investors get repayments of the principle in small parts, over the duration of the MBS, as the mortgage loans that back the MBS are paid off, instead of in one lump sum when the security matures.
One of the reasons that the MBS is a stable investment is because there are so many loans in the pool; the few loans that default or pay off early do not eliminate the investor’s profit.
When choosing between closed MBS and pre-payable MBS, determine if interest rates are likely to rise or fall. Mortgage holders can pre-pay their mortgages, and if interest rates drop people will refinance to take advantage of better rates, both scenarios will negatively impact the MBS investor. If interest rates are expected to drop, a closed MBS is the better option.
A Self-Directed Individual Retirement Account (IRA) can hold assets such as land, single family residences, and commercial property instead of just cash.
Before you invest in any real estate investment, contact a financial professional and do your own research to make the best decision for you.