I started investing in foreclosed properties in 1996. I can still remember the very first investment property I ever purchased. It was at a live auction of HUD homes located in the Inland Empire of Southern California. I had spent weeks investigating about 300 properties for sale and had narrowed my list to about 25 homes that I would buy if the price was right. I was 25 years old and in debt up to my eyeballs so I could afford the 25% down payment required for investors. I was planning on using credit cards to pay for improvements and make the house payment until I could repair and sell the property. But that didn't worry me because I was young, smart and going to be the next Donald Trump...
As it turns the auction was an incredibly intimidating place and I was scared to death. There were amped up auctioneers running around, pointing at people and shouting at the top of their lungs. I thought twice about bidding because I didn't want one of those sharks to come running over and hover near me. When the first of my 25 homes came up for bid, I was thinking of holding back and that maybe I was getting in over my head.
5 minutes later I was being ushered into an escrow room to sign paperwork for the $57,000 house I had just bought. I was young, inexperienced, and leveraged to the gills. But I was lucky, and in spite of many mistakes, I still managed to earn a small profit on that first house.
Today after years of investing in real estate I have learned much. And although markets change, there are certain universal truths about investing in real estate that don't. I have struggled explaining this during the recent boom years, when it seemed that I was always "raining on the parade" of potential investors seeking to earn easy money in a hot market. But today is a new world, and opportunity abounds for those willing to invest intelligently.
For those that are thinking of taking the plunge, here is my advice for investing in residential real estate; particularly foreclosures:
- The "real" value of real estate is set by the marketplace. Unless you are sticking a gun to someone's head, chances are the price you pay for a home is close to what the house is worth in its present condition. Do not be fooled into thinking it is worth substantially more than what you are paying because if it was, somebody else would be buying the home for a higher price. And most definitely don't pay attention to what the home sold for 3 years ago. If I had a dime for every time a Realtor told a client "This foreclosure is a steal at $200,000...just 3 years ago it sold for $500,000!" Yeah and 3 years ago I was 20 pounds lighter, didn't have any grey hair, and thought owning stock in Fannie Mae and Lehman Brothers was a good idea. The point is to be realistic about the potential value of a home; especially if you are thinking of flipping for a quick profit.
- Never buy a home with a net negative cash flow. EVER. And make sure you get your numbers right. Evaluate local rents so you are absolutely certain of the amount you can lease the property for. Assume that 25% of your gross rents will be eaten up by vacancy, maintenance and general tenant neglect. Don't forget to include debt service, insurance, taxes, association and management fees when adding up your costs. I've never understood why some investors are willing to lose money in the short term in order to gamble on long term appreciation! Would you buy a stock that required YOU to pay a dividend each month to hold on to it???
- Stick to single family detached homes, with a minimum of 3 bedrooms, 1.5 bathrooms, and 1000-1200 sq ft. Avoid condos, townhomes, planned unit developments or anything with shared walls. There are three reasons for this. One, single family homes historically appreciate faster/hold their value better as a result of a larger pool of buyers who prefer a detached home. Two, condos and townhomes typically come with greater operational costs in the form of HOA dues lowering net cash flow. And three, investors are more at the mercy of the decisions of others when it comes to their investment. <<shiver>>
- Unless you are a licensed contractor, or Tim "Tool Time" Taylor, avoid major renovation projects. I know, you've seen all of those shows on Bravo and HGTV and think you can do the major repair and flip deals. But let me tell you from past experience that it just takes one big mistake about the cost to cure a property to empty your pocket book. Besides, in most markets today you don't need to deal with major renovation projects in order to find a solid investment opportunity.
- Buy the worst house in the best neighborhood.
So what exactly is my idea of a good investment opportunity in today's environment?
In the local markets I serve, Litchfield Park, Goodyear, Avondale, Surprise and Glendale, Arizona, we have an abundance of banked owned, government owned and short sale homes. A large number of them were built between 2000-2005, are located in newer communities, have relatively minor cosmetic repairs needed and can be rented for positive cash flow. An investor could purchase a home in these areas today for under $60K cash and rent the property for $800-$900/month. Or the investor could leverage, put 25% down, and still achieve a similar "cash on cash" return. Do the math. That's a 13+% annual return with below market rents! Hell, even if the tenant skipped every other month's rent payment (50% vacancy) the investor would still earn 6-7%. And that's without any appreciation in the value of the property.
I know there are a lot of "stung" investors out there who rode the recent real estate boom only to lose a large amount of money in the last 2 years. And I know that rising unemployment and general economic problems are scaring away many would be investors. But I can tell you from personal experience, now really is the time to acquire property in a sensible way that can offer exceptional returns. The market has finally shifted back in favor of the conservative investor...
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