6 August 2007 3 Comments Print This Post  Email This Post

Real estate investors and as well as wanna-be investors made a ton of money during the real estate boom a few years ago. Just about anyone and their dogs were “investing” in real estate by leveraging their residence, buying a second or third home, then reselling them in as little as a year at a profit. It was easy to do because banks want to lend you money so they can make money. Houses are easy to buy because they generally cost less than multifamily or commercial properties. The ones who got in too late with this craze got burned, myself included. I can deal with the situation effectively while others aren’t so lucky. Many people now find themselves upside down on their loans, meaning they owe more than the property is worth. This sudden market correction, along with the adjustments of interest rates in adjustable rate mortgages (ARMs) are forcing many people into foreclosure and horrible financial circumstances. The reason they are suffering is because they invested in real estate the wrong way.

What is True Real Estate Investing?

True real estate investing is a long term commitment to quality income producing properties, such as multifamily or commercial buildings. You put up money in hopes of earning a return, just like in any other type of investment vehicle. In commercial and multifamily real estate, that return is based on income, appreciation and added value for the most part. You can estimate your  future cashflow on your investment by looking at past rental income and expenses. You can then estimate appreciation because the valuation of income producing properties is based on their income. The capitalization rate is the net income per year divided by the properties selling price. For example, a $100,000 property that has a net income of $7,000 a year has a 7% capitalization rate. If rental income increases due to improvements or scheduled rent increases, your property value more than likely goes up as well using the same cap rate whereas the appreciation of single family homes are based solely on supply and demand of all the homes in the area.

The biggest problem with what happened as of late, and is still happening today is that people are buying single family homes as investments where the rental income does not nearly meet the total expenses of the house. This is known as ‘feeding the alligator’, where every month you have to come out of pocket just to cover your expenses. Am I missing something? If you buy a house and have to pay out every month to keep it, how is that investing? Sounds to me like an added liability.

When there is a negative cashflow situation, all you have to rely on is hope; hope that the property will appreciate. You can’t see or feel the appreciation, but you can sit there and pray that the property in question is appreciating. When you are in this situation, it is no longer real estate investing, it is purely real estate speculation. Speculation has high rewards but a long with that comes with high risks. Speculation can ruin lives, like what we see now.

Higher Risk Higher Reward

The counterargument to investing a higher down payment would be that if you put little or nothing down, you are leveraging the bank’s money and thereby allowing yourself to earn enormous returns on your investment. This logic is what a lot of so called experts perpetuate. It is true that in terms of percentage, you’ll earn more return on your investment if the market does what you hope it will do. Financial leverage works as a dual edge sword because if you win, you win big but if you lose, you lose big. If you put nothing down on a house and it appreciates 5% in a year, you’re getting an almost infinite return on investment since you put nothing down. However if the property depreciates 5% in a year and you cannot afford to feed the alligator any longer, you are liable to the bank tens of thousands of dollars plus the selling and closing costs when you sell the home. At that point, label yourself screwed.

If you are flipping or rehabbing homes, or buying foreclosures, you’re still putting yourself at risk if you’re in a negative cashflow position. Of course you can estimate what the property will sell for after work has been done, but just remember that there are still risks involved. A market shift can happen in the middle of a remodel, it happened to me in 2005.

Do It Right

If you are going to invest in real estate, do it right. It’s not worth the potentially higher returns to speculate. Anyone who buys houses with no cashflow is speculating, or just down right gambling. If you don’t have the capital to invest, save up until you do. Although there is money to be made in speculation, don’t do it until you are a far more experienced investor and you actually have a speculation fund that you can afford to lose.