Real Estate Investing for Dummies by Eric Tyson (Author), Robert S. Griswold (Author)

Introduction

Part I: Stacking Real Estate Up Against Other Investments

• Chapter 1: Evaluating Real Estate as an Investment
• Chapter 2: Covering Common Real Estate Investments
• Chapter 3: Considering Foreclosures, REOs, Probate Sales, and More
• Chapter 4: Taking the Passive Approach
• Chapter 5: Fast Money: Small Down Payments and Property Flips
• Chapter 6: Building Your Team

Part II: How to Get the Money: Raising Capital and Financing

• Chapter 7: Sources of Capital
• Chapter 8: Financing Your Property Purchases
• Chapter 9: Securing the Best Mortgage Terms

Part III: Finding and Evaluating Properties

• Chapter 10: Location, Location, Value
• Chapter 11: Understanding Leases and Property Valuation
• Chapter 12: Valuing Property through Number Crunching
• Chapter 13: Preparing and Making an Offer
• Chapter 14: Due Diligence, Property Inspections, and Closing

Part IV: Operating the Property

• Chapter 15: Landlording 101
• Chapter 16: Protecting Your Investment: Insurance and Risk Management
• Chapter 17: Recordkeeping and Accounting
• Chapter 18: Tax Considerations and Exit Strategies

Part V: The Part of Tens

• Chapter 19: Ten (Plus) Ways to Increase a Property’s Return
• Chapter 20: Ten Steps to Real Estate Investing Success

Appendix: Sample Purchase Agreement

Index

Excerpts (partial)

(front section)

ERIC AND ROBERT’S PRINCIPLES FOR SUCCESS

Although many people can succeed investing in real estate, rental property investing isn’t for everyone

Are you comfortable troubleshooting problems or hiring a property manager?

Make sure you’re financially fit before investing in rental properties. Pay particular attention to your monthly budget and make sure that you have adequate insurance coverage.

Your first (and often one of the best) real estate investment is buying a home to live in

Focus on residential properties in the beginning

Among residential property options, our top recommendations are small apartment buildings and single-family homes. Attached housing makes more sense for investors who don’t want to deal with building maintenance and security issues.

Have your real estate team in place before you begin your serious property searching. Line up a real estate agent, loan officer, tax advisor, lawyer, and so on early because the real estate investor with the best resources can identify the properties to ignore and those worthy of careful consideration. Move quickly — the speed at which you can close a transaction is an advantage in any type of market.

Look for properties in the path of progress

The best real estate investment properties are ones that are well located and physically sound but cosmetically challenged and poorly managed.

For low entry costs, consider real estate investment trusts (REITs) and lease options.

We prefer the adage of “Location, location, value.

Make real estate investments close by. Buy property within two hours away by your favorite mode of transportation. Venture farther only when you really know another real estate market and regularly find yourself there for other reasons or you’ve found an excellent property manager

Any decision about where to invest starts with an evaluation of the overall region’s economic trends

You’re purchasing a future income stream or cash flow when you buy an investment property

The key is identifying which properties sellers have underpriced.

Don’t rely on the seller’s numbers when evaluating a property’s potential

Introduction

Throughout this book, we emphasize three fundamental cornerstones that we believe to be true:

Although you should make money over the long term investing in good real estate properties, you can lose money, especially in the short term

About This Book

how to invest in single-family homes; detached and attached condominiums; small apartments including duplexes, triplexes, fourplexes, and multiple-family residential properties up to 20 to 30 units

Foolish Assumptions

particular audience in mind.

Beyond This Book

type “Real Estate Investing For Dummies Cheat Sheet” in the search box to find additional tips for investing.

Where to Go from Here

you may also choose to read selected portions

Recognizing the Caveats of Real Estate Investing

Few home runs

Upfront operating profit challenges: Unless you make a large down payment, your monthly operating profit may be small, nonexistent, or negative in the early years of rental property ownership. During soft periods in the local economy, rents may rise more slowly than your expenses or they may even fall

Ups and downs: You’re not going to earn an 8 to 9 percent return every year. Although you have the potential for significant profits, owning real estate isn’t like owning a printing press at the U.S. Treasury.

Relatively high transaction costs: If you buy a property and then want out a year or two later, you may find that even though the property has appreciated in value, much (if not all) of your profit has been wiped away by the high transaction costs

8 to 12 percent of the purchase price of a property

Tax implications: Last, but not least, when you make a positive net return or profit on your real estate investment, the federal and state governments are waiting with open hands for their share. Throughout this book, we highlight ways to improve your after-tax returns

Chapter 1: Evaluating Real Estate as an Investment

Comparing Real Estate to Other Investments

Our research and experience suggest that total real estate investment returns are comparable to those from stocks — about 8 to 9 percent on average, annually

And you can earn long-term returns that average 10+ percent per year if you select excellent properties in the best areas, hold them for several years, and manage them well

Chapter 2: Covering Common Real Estate Investments

Seeing the Various Ways to Invest in Residential Income Property

The first (and one of the best) real estate investments for many people is a home in which to live. In this section, we cover the investment possibilities inherent in buying a home for your own use, including potential profit to be had from converting your home to a rental or fixing it up and selling it. We also give you some pointers on how to profit from owning your own vacation home.

Converting your home to a rental

Turning your current home into a rental property when you move is a simple way to buy and own more properties

acquiring rental properties not only with a house but also with a duplex or other small multi-unit rental property where you reside in one of the units

Turning your home into a short-term rental, however, is usually a bad move because

• You may not want the responsibilities of being a landlord, yet you force yourself into the landlord business when you convert your home into a rental.
• You owe tax on the sale’s profit (and recaptured depreciation) if your property is classified for tax purposes as a rental when you sell it and you don’t buy another rental property.

Investing and living in well-situated fixer-uppers

you must actually move into the fixer-upper for at least 24 months to earn the full homeowner’s capital gains exemption of up to $250,000 for single taxpayers and $500,000 for married couples

In our experience, this strategy is not likely to work well for you if any of the following apply:

• You’re unwilling or reluctant to live through redecorating, minor remodeling, or major construction.

Purchasing a vacation home

potential investment returns shouldn’t be the main reason you buy a second home.

Paying for timeshares and condo hotels

We don’t see timeshares or condo hotels as worthy real estate investments as they don’t appreciate and they don’t generate income

Surveying the Types of Residential Properties You Can Buy

in addition to single-family homes, you can choose from numerous types of attached or shared housing including duplexes, triplexes, apartment buildings, condominiums, townhomes, and co-operatives

From an investment perspective, our top recommendations are (whole) apartment buildings and single-family homes. We generally don’t recommend attached-housing units, which have associations and shared common areas. If you can afford a smaller single-family home or apartment building rather than a shared-housing unit, buy the single-family home or apartments

always allow for unexpected vacancy or capital improvements like flooring and window coverings, appliances, and/or the water heater.

Single-family homes

single-family homes tend to outperform other housing types for the following reasons:

Single-family homes tend to attract more potential buyers

Attached or shared housing is less expensive and easier to build and to overbuild; because of this surplus potential, such property tends to appreciate less.

Because so many people prefer to live in detached, single-family homes, market prices for such dwellings can often become inflated beyond what’s justified by the rental income these homes can produce

To discover whether you’re buying in such a market, compare the monthly cost (after tax) of owning a home to the monthly rent for that same property. Focus on markets where the rent exceeds or comes close to equaling the cost of owning and shun areas where the ownership costs exceed rents.

Single-family homes that require just one tenant are simpler to deal with than a multi-unit apartment building that requires the management and maintenance of multiple renters and units. Single-family homes in some markets are also currently exempt from rent control laws as long as other conditions are met. The downside, though, is that a vacancy means you have no income coming in. Look at the effect of 0 percent occupancy for a couple of months on your projected income and expense statement! By contrast, one vacancy in a four-unit apartment building (each with the same rents) means that you’re still taking in 75 percent of the gross potential (maximum total) rent.

Attached housing

Shared housing makes more sense for investors who don’t want to deal with building maintenance and security issues.

In this section, we discuss the investment merits of three forms of attached housing: condominiums, townhomes, and co-ops.

Condos

When you purchase a condominium, you’re actually purchasing the interior of a specific unit as well as a proportionate, undivided (meaning, you don’t directly own a portion) interest in the common areas

One advantage to a condo as an investment property is that of all the attached housing options, condos are generally the lowest-maintenance properties (from the perspective of unit owners) because most condominium or homeowners’ associations deal with issues such as roofing, landscaping, and so on for the entire building and receive the benefits of quantity purchasing

Although condos may be somewhat easier to keep up, they tend to appreciate less than single-family homes or apartment buildings unless the condo is located in a desirable urban area.

Be wary of apartments that have been converted to condominiums

Our experience is that these converted apartments are typically older properties with a cosmetic makeover (new floors, new appliances, solid surface countertops, new landscaping, and a fresh coat of paint). However, be forewarned: The cosmetic makeover may look good at first glance, but the property probably still boasts 40-year-old plumbing, heating/cooling, and electrical systems; poor soundproofing; and a host of economic and functional obsolescence

You may then find the property is predominantly renter-occupied and has a volunteer board of directors unwilling to levy the monthly assessments necessary to properly maintain the aging structure. Alternatively, old buildings may have high unit assessments to deal with myriad costly problems. Within 10 to 15 years of the conversion, these properties may well be the worst in the neighborhood.

Townhomes

Townhomes are essentially attached or row homes

As with condominiums, you absolutely must review the governing documents before you purchase the property to see exactly what you legally own.

Co-ops

Co-operatives are a type of shared housing that has elements in common with apartments and condos

Unlike a condo, you generally need to get approval from the co-operative association if you want to remodel or rent your unit to a tenant. In some co-ops, you must even gain approval from the association for the sale of your unit to a proposed buyer.

we highly recommend that you avoid co-ops for investment purposes.

Apartments

Not only do apartment buildings generally enjoy healthy long-term appreciation potential, but they also often produce positive cash flow (rental income minus expenses) in the early years of ownership. But as with a single-family home, the buck stops with you for maintenance of an apartment building

 In the real estate financing world, apartment buildings are divided into two groups based on the number of units:

Four or fewer units: You can obtain more favorable financing options and terms for apartment buildings that have four or fewer units because they’re treated as residential property.

Five or more units: Complexes with five or more units are treated as commercial property and don’t enjoy the extremely favorable loan terms of the one- to four-unit properties.

Chapter 4: Taking the Passive Approach

Using Real Estate Investment Trusts

Real estate investment trusts (REITs) are for-profit companies that own and generally operate different types of property. The options for REIT investments are extremely broad and cover virtually every type of real estate. You can choose your favorite REIT from the following income property types:

Office

Residential

Retail

Industrial

Hospitality

Healthcare

Self-storage

Cell towers:

Other rental income properties, even timberlands

REITs can be a good way to invest in real estate for people who don’t want the hassles and headaches that come with directly owning and managing rental property

Distinguishing between public and private REITs

asking for full disclosure of the relationship between the REIT, its advisors, and the management companies. REITs often involve conflicts of interest that aren’t clearly disclosed or pay significant above-market fees to directly or indirectly related entities or affiliates that ultimately lower the cash flow and return

Public REITs are traded on the major stock exchanges and thus must meet strict SEC reporting requirements:

Liquidity

Independent board of directors

Financial reporting

We recommend that you stay away from private REITs unless you’re a sophisticated, experienced real estate investor

Taking a look at performance

Over the long term, REITs have produced total returns comparable to stocks in general. In fact, REIT returns historically have been comparable to stock returns

One final attribute of REITs we want to highlight is the fairly substantial dividends that REITs usually pay. Because these dividends are generally fully taxable (and thus not eligible for the lower stock dividend tax rate), you should generally avoid holding REITs outside of retirement accounts if you’re in a high tax bracket

Investing in REIT funds

You can research and purchase shares in individual REITs, which trade as securities on the major stock exchanges. An even better approach is to buy a mutual fund or exchange-traded fund that invests in a diversified mixture of REITs. Some of the best REIT mutual funds charge 1 percent per year or less in management fees, and have long-term track records of success while taking modest risks. Vanguard’s Real Estate Index Fund charges just 0.13 percent per year in fees and has produced average annual returns of about 8.8 percent since its inception in 2001.

REITs offer an additional advantage that traditional rental real estate doesn’t. You can easily invest in REITs through a retirement account such as an IRA.

If you really have your heart set on becoming the next Warren Buffett and you enjoy the challenge of selecting your own stocks, you can research and choose your own REITs to invest in.

Chapter 6: Building Your Team

IN THIS CHAPTER  Assembling your team from the get-go*  Hiring tax and financial advisors*  Seeking lending professionals*  Finding top real estate agents and brokers*  Adding appraisers and attorneys*

for most real estate investors, real estate investing is hands-on and complicated enough to require the services and knowledge of a team of professionals. Although you may be skilled in your chosen field, it’s unlikely that you possess all the varied and detailed skills and knowledge necessary to initiate and close a good real estate transaction.

You should understand the economic climate and potential for growth, the current physical and economic condition of the property, the tenants, and the value of the property in the marketplace. Then you should ensure that you’ve got a solid negotiating strategy to orchestrate a deal, that the financing comes through without surprises, and that the transfer of real estate is handled properly. This requires a team approach.

Knowing When to Establish Your Team

We recommend that you have your team in place before you begin your serious property searching, for two reasons:

You can move quickly. The speed at which you can close a transaction is an advantage in any type of market

You can effectively research the property before making an offer.

you really need to perform due diligence even before making an offer. You don’t want to waste time or money on a property that can’t meet your goals.

We recommend only making offers when you have done enough due diligence to feel comfortable that your further, thorough physical inspection and financial review of the property interiors and books probably won’t reveal any surprises that will lead to canceling the purchase.

The most effective research is done with the assistance of real estate professionals to give you the advice and information you need to make an intelligent decision

You may invest time and several hundred to several thousand dollars to perform the necessary due diligence

Adding a Tax Advisor

Seek a knowledgeable advisor who has many years of experience and has worked through the real estate cycles and understands that markets can go up and down, and that real estate financing can be reasonable and easy to obtain as well as expensive and elusive

We cover the ins and outs of real estate accounting and taxation in Chapters 17 and 18.)

You need specific feedback and ideas from a tax expert regarding your unique financial situation and which types of real estate investments work best for you.

whether your best real estate investment is the direct ownership of properties or perhaps owning triple net leased properties with lower returns but fewer management headaches. Accountants can inform their

meet the active participation required for certain tax benefits while hiring a property management company to handle the bulk of the day-to-day tenant/landlord issues.

Finding a Financial Advisor

many financial consultants sell investment and insurance products that provide them with commissions or manage money for an ongoing percentage in stocks, bonds, mutual and exchange-traded funds, and the like. Such salespeople and money managers can’t provide objective, holistic advice, especially on real estate transactions

Lining Up a Lender or Mortgage Broker

Postpone making an appointment to look at investment properties until after you examine the loans available.

You have two resources to consult:

A lender is any firm, public or private, that directly loans you the cash you need to purchase your property. This type of lender is often referred to as a direct lender. Most often, your list of possible lenders includes banks, credit unions, and private lenders (including property sellers).

A mortgage broker is a service provider that presents your request for a loan to a variety of different lenders in order to find the best financing for your particular needs.

On the upside, we’ve found that lenders can also serve a valuable role by preventing you from making serious mistakes. Particularly in overheated seller’s markets where prices are irrationally climbing with insufficient fundamental economic support, your lender and the required appraisal from a competent, independent, professional appraiser can keep you from getting caught up in a buy-at-any-price frenzy.

Lenders require collateral to protect them if the borrower doesn’t make the debt service payments as required. Collateral is the real or personal property that’s pledged to secure a loan or mortgage

Typically, the property being purchased is the pledged collateral for real estate loans or mortgages.

Building relationships with lenders

Chapter 11: Understanding Leases and Property Valuation

Establishing Value Benchmarks

they’re only quick and simple indicators of value. Don’t make investment decisions without calculating the Net Operating Income (NOI), which we cover in detail in Chapter 12.

Gross Rent Multiplier (GRM): GRM is most commonly used for residential income properties

As we discuss in Chapter 12, the operating and capital expense levels can make a tremendous difference in the overall cash flow and the value of the property

Like the GRM calculation, the price per unit does have its limitations

The price per square foot is a widely used yet simple calculation most often associated with commercial, industrial, and retail properties (and sometimes used for residential properties).

Chapter 14: Due Diligence, Property Inspections, and Closing

Determining How to Hold Title

Maintaining your privacy, minimizing your tax burden, and protecting your assets from claims and creditors are critical elements to most real estate investors

Sole proprietorship

advantages include the following:

Exclusive rights of ownership

Minimal legal costs to establish

Simple recordkeeping

also has its downsides, including the following:

Unlimited liabilities: You have no legal protections against lawsuits or other claims

No real tax advantages: Sole proprietorships offer no real advantages in the area of death and taxes!

Joint tenancy

Joint tenancy is only available to individuals (not legal corporate entities) because a unique feature of holding title in a joint tenancy is the right of survivorship. Upon the death of one of the joint tenants, the entire ownership automatically vests in equal shares to the surviving individual

unique advantage to joint tenancy, besides the right of survivorship, is that you get a stepped-up basis on your deceased joint tenant’s portion of the property.

 Although marriage isn’t a requirement to use this method of holding title, traditionally, joint tenancy has been the most common way for married couples to hold title to investment properties. One of the primary advantages of joint tenancy is that the death of one spouse can result in a complete step-up in basis to the fair market value at the time of death rather than just a step-up for the portion owned by the deceased joint tenant.

Tenancy in common

One of the most common forms of co-ownership is tenancy in common (also known as tenants in common or TIC). A tenancy in common is the ownership of real property in which several owners each own a stated portion or share of the entire property

each owner can own a different percentage

 Tenancy in common is a popular way to hold title for real estate investors but can be a problem unless there are clear understandings, preferably in writing, as to the asset and property management decisions of operating the property. But even then, problems and challenges are possible:

Death of an owner

Sale by an owner

Financial problems of an owner

Different plans

Income and expenses from operations of the property are reported on the individual’s tax return, but a problem with tenants in common is that new investors acquiring a TIC interest may not qualify for the tax-deferral benefits generally associated with a 1031 like-kind exchange

Partnerships

business enterprise in which two or more persons join together to pool their capital and talent to purchase, manage, and ultimately sell real estate

Limited liability company

LLC is a hybrid form of doing business that combines characteristics of a partnership and a corporation. This setup is an unbeatable combination for many real estate investors and a great way to hold title to real estate holdings.

LLCs have essentially replaced corporations and partnerships as the most common way to hold title to real estate because they offer the advantages of allowing each member to have a say in the management while extending limited liability to all members, without the burden of double taxation that occurs with corporations

An LLC is a separate entity like a corporation and therefore carries liability protection for all of its members, but it can be structured like a partnership so that the taxation flows through to each member individually. This feature simply requires the LLC to declare itself a joint venture with the IRS and indicate how it wants to allocate the taxation of income and expenses. Like a partnership, an LLC is required to prepare and file an IRS Form 1065, Partnership Tax Return, unless it makes the joint venture election.

Check with your own tax advisor, but many advisors recommend that their clients use a limited liability company because it offers the best of both worlds

Have an attorney prepare the articles of organization and an operating agreement (which are usually filed with the secretary of state

a husband and wife are considered two members when forming an LLC.

 Despite all these advantages, seek the counsel of an attorney who specializes in the formation of LLCs to help you with the following issues:

IRS limitations

Costs: The costs can be much greater than for other forms of ownership. Be sure to consult with a local tax advisor for details on the typical costs for operating an LLC in your state. Currently, the highest base cost for an LLC is found in California: a minimum franchise tax fee of $800 per year plus additional taxes based on gross receipts.

Corporations

Part IV: Operating the Property

Chapter 15: Landlording 101