5 Smart Moves a First-Time Buyer Should Consider

As a first-time real estate buyer, you probably have no idea how the overall purchasing process works or how to make sure you’re making a smart decision to purchase. And you’ll probably be very surprised to learn how much work it really is just to buy a home. To get you started in the right direction, and this is just a start, here are a few tips that you should consider.

Get lender-qualified and find a good real estate agent

To start off, you should get qualified by a lender to see what price range you can realistically afford and interview some real estate agents to find the right person to represent you in your transaction.

5-smart-moves-for-first-time-homebuyersOnce you’re qualified and have your price range estimate in hand, you’ll be able to spend your time shopping in neighborhoods that you can afford. But remember: Just because the bank says you can qualify for a certain amount, that doesn’t mean you should spend that amount. Make sure you can actually afford the monthly payment, along with all your other bills.

For real estate sales professionals, you should get referrals for a full-time agent or broker who sells at least five or more properties per year and is well-educated on the process and location where you plan to live. You should call references, check that the agent’s state sales license is up to date and interview them to make sure you’ll be comfortable working with them.

Make sure you plan to be a long-term owner

Once you know your price range and have looked at some properties, it’s time to make sure that you believe you can find a property that you will own for a minimum of five years. If your price range doesn’t match where you want to live, you’d be better off staying a renter and saving some additional money until you can afford where you want to live. This is because an owner really doesn’t earn any equity, on average, in a property for at least five years. That’s the general breakeven point, and you really need to shoot for longer than that as an ownership strategy. The truth is, long-term real estate ownership can be a great way to earn wealth, but short-term ownership usually will diminish your wealth.

Educate yourself

Buying property is probably the most complex, riskiest and expensive thing you will ever do. Do your homework: Talk to real estate owners, go to first-time buyer seminars, check out online material and read some books to learn what to avoid in the buying process. The more you educate yourself, the better the chances that when things go wrong — and they will go wrong — they will only be minor issues, not major headaches.

Find a nice affordable property

The real gems in real estate are the nice, decent shape, moderately priced, boring houses, town homes and condominiums that are within your budget. Most buyers stretch to purchase the most expensive property they can afford. What if you lose your job? How about saving some of your money for retirement? You want your home to be an asset you can afford, not a liability that leaves you with no additional funds over the cost of homeownership. Also, skip the fixers, prize properties or anything that sounds too good to be true: Those always end up having issues, and owners realize, after the fact, that the deal they thought they were getting really was just too good to be true!

Take your time

Realistically it should take you six months or longer to buy a nice quality property that will add to your long-term wealth. Make sure you have a full understanding of what the marketplace has to offer in your price range and that you know what you’re doing.

Those are a few tips to get you started in the right direction. Real estate is buyer beware, so try to make sure you’re one of the buyers who is “aware” of how to make quality wealth-building real estate decisions. Down the road you’ll pat yourself on the back when things work out well.

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Is a Personal Residence an Investment?

If you’re going to use your hard-earned money to buy a home, you might wonder if that home is an investment. And without doubt, for the vast majority of buyers, a home is an investment.

However, just because it IS an investment doesn’t mean the house you’re interested in purchasing is agood investment — an asset. It could be a really bad investment — a liability. That’s what you should try to determine before you make the decision on whether to buy property.

What is an investment?

When you buy a home, you’re taking down payment money from your financial assets (bank account, mutual funds, stocks, bonds) where you’re earning a rate of return on your money. If you’re going to take the cash from your financial assets and invest it into another asset — a home — where you’re taking risk, and in this purchase you hope it will go up in value, then it’s an investment.

The definition of investment is “taking risk with capital in expectation of earning a profit.” Think about this: If you were guaranteed the house would go down in value, would you buy it? No, you’d rent someone else’s house and leave your money in financial assets that would better improve your wealth.

So, because you’re taking risk, and you’re expecting it to go up in value, there’s no doubt, a personal residence is an investment.

What is a good investment?

Over time, most real estate should appreciate in value, which will cause you to earn wealth from your gained equity. And that’s a good thing. However, could you have done much better financially by taking another course of action, or purchasing a different home?

For a good personal residence investment, the most important factor is that you own the property for a long time. Short-term ownership, with transaction and other costs, rarely adds net wealth to your financial picture. So go long, and that’s a minimum of five years! If you’re not 99 percent positive you will own the property for at least that long, skip it and stay a renter. You’ll most likely be better off financially.

You should also buy a property that is in good physical shape, with a fixed-rate mortgage and a homeowners association in good financial, legal and operational shape (if the property is in a common interest development). Keeping the proper type and amount of insurance in place is vital, and of course make sure to verify that there are no title issues — before you close escrow.

Oh, and don’t forget to make sure you can comfortably afford the payments — if you cannot, it’s going to end up a liability.

What is a bad investment?

Bad investments are ones where the probability of the residence adding to your net wealth is low. Examples include fixer-uppers and prize properties, which cost significantly more to own than a similar property would cost to rent; condominiums with HOAs that are a disaster; or any funky real estate purchase or personal residence investment that may have extreme financial risk issues (rent-to-own, wrap-around mortgages, short-term financing, etc.).

Real estate, every parcel, is extremely high risk — whether the condition, the financial aspects of ownership or a myriad of other issues. Owning long term can compensate for many of these issues, but making smart choices upfront is the way to reduce or mitigate the chances of making a bad investment.

As we all know, real estate is “buyer beware,” so try to know what to “beware of” before you buy, and hopefully the home you purchase will be a net addition to your wealth.

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Is Land a Good Investment?

If you bought land in California in the 1970s, you’d probably opine that land is a good investment. If you bought it in 2006, and now it’s worth a fraction of what you paid, your opinion would probably differ. Most knowledgeable real estate investors will agree that buying land is not a good idea, and this includes buying small parcels of land and/or potentially investing in a large land deal. There’s just way too much risk.

Land is speculative

Here is the issue with land: It’s a 100 percent speculative investment. You are 100 percent hoping that the value will go up to provide you a fair rate of return. And it might. But will it go up enough to provide you a fair rate of return for the extreme risk that you are taking holding that land?

Here’s the risk

Let’s say you buy $100,000 worth of land, and you pay cash. It’s still going to cost you money each month to cover property taxes and insurance. And, here’s the kicker: It’s also costing you the opportunity cost of capital.

You probably took $100,000 out of your mutual fund account, or other financial asset, to buy the land. And when that money was in the financial account, it was probably earning interest — let’s say 5 percent — but now it’s not earning anything because you took it out of your account to buy some dirt. So you’re really effectively losing 5 percent in wealth each year because you’re not earning that return. Unless, of course, the land goes up that much in value plus compensating for property taxes, insurance and other annual costs.

As an example, if you have $100,000 and put it into a mutual fund, you’d earn 5 percent, or $5,000, per year. That’s cash in the bank that you can reinvest to earn even more money. After 10 years you’d have your original $100,000, plus $50,000 to $70,000 additional cash/financial asset earnings.

On the other hand, if you bought land, you’d earn no interest or dividends, and after 10 years you’d have a piece of dirt that you’ve been paying taxes on. Will your land have gone up enough in value to match the returns you would have earned on a financial asset?

In addition to those significant financial issues, land also can be contaminated, undevelopable or have significant development restrictions, among other issues.

Who might consider land?

Land may be a good investment for home building companies and long-term corporate land investors with extensive development and entitlement skills and experience, and significantly diversified portfolios of land to reduce their overall risk. But for small investors, it’s a high-risk gamble with little chance of earning a fair rate of return. There are much better investment opportunities, such as stocks, bonds, mutual funds, rental properties or, quite frankly, heading to Las Vegas for the weekend (where, by the way, many an investor has learned some tough land investment lessons in the past decade!).

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Why Prize Investment Properties Are No Prize

Here’s a little real estate investing secret that few rental property investors know: The fancier and more prize location of a property, the worse the cash flow. In fact, most “prize” properties are going to have negative cash flows. And that’s not a smart way to invest your hard earned cash equity dollars.

Consider the options

Let’s look at an example. You want to buy about $500,000 worth of real estate, and with a 25 percent down payment plus costs, you’ll need about $150,000 in cash to close the deal. You have two choices:

  1. A swanky downtown San Diego condominium for $500,000, or
  2. Three nice moderately priced boring suburban $165,000 condominiums.

Now most people would think location, location, location and want to buy the prize downtown. That’s because their only investment criteria is that they want to buy real estate in hopes that it will go up in value. And the problem with that strategy is that they are totally missing the most important piece of rental property investing — the cash flows the property can produce.

Immediate cash flow

In reality, moderately priced cash flow positive condominiums are the best location, location, location, and here’s why.

A $500,000 downtown San Diego condo would probably generate negative cash flows of about $1,000 per month. That’s $12,000 per year — ouch — on a $150,000 cash investment or negative 8 percent return on the investment.

A moderately priced $165,000 suburban San Diego condo would probably generate positive cash flows of about positive $250 per month. Multiplied by three condominiums — so apples to apples on the $500,000 investment — is positive $750 per month. That’s positive $9,000 per year on a $150,000 cash investment, or positive 6 percent return on the investment.

See the difference? You can allocate your hard-earned $150,000 of equity into either a fancy prize property with negative cash flows of $12,000 per year, or into moderately priced properties with positive cash flows of $9,000 per year. That’s a difference of $21,000 per year on $150,000 equity investment into $500,000 of real estate.

Building wealth

If you’re hoping appreciation in value will make up the difference on your negative cash flow property, good luck with that. To be fair, over long periods of time, most real estate should appreciate in value about the same percentage each year. But as you can see, cash flows can be very different, and that’s where you earn your wealth!

You might assume that because rents increase and mortgages stay constant, the fancy prize property would turn positive one day. This is true, but it would take about 40 years until the fancy prize condominium owner really got their first dime of positive cash flow.

Think that through and pencil out your real estate deal before you take the plunge. Some properties are just much better wealth-building investments than others, primarily due to the cash flows.

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First Steps for First-Time Landlords

So you’ve got a property under contract, and you’re excited that you are going to become a landlord. While it can be a financially and personally rewarding investment, there are lots of things to do in preparation for your new career.

Pre-closing homework

First up, at the home inspection make sure to really take a hard look at what will need to be repaired or replaced once you take ownership of the property. Possible tasks include changing out the toilets to low-flow models, strapping the water heater, changing the door locks, fixing broken doors or windows, repairing damaged drywall and probably just a good old-fashioned scrubbing of the entire property.

Even before you close escrow, you should start making a list of the above items and others that need to be fixed. This will allow you to go home improvement store shopping to figure out a better budget than you previously estimated. (Don’t forget to check popular home improvement store websites for coupons, military discounts and other promotions.) It should also assist you in determining who will be doing the work and getting bids for projects.

Also, if there’s a good tenant already in place, you’ve done yourself a huge favor because you’ll get a security deposit and pro-rated rent at closing. So you possibly don’t have to go in and fix a bunch of items. Make sure to get an estoppel certificate signed by the current landlord and tenant verifying the tenant’s rent and other lease information once you go into escrow.

Essential upgrades

Once you take ownership of your new property, chances are you’ll need to make changes in these three areas:

Water: Because water issues are prevalent in rentals, it’s a good idea to have a plumber change out all the water valves, hose bibs, water supply hoses, washing machine hoses, dishwasher hoses, etc. In most rentals, it’s probably time to replace them, and doing so before a leak occurs — especially because the property will be occupied then — is just a good move. So put $250-$750 into your budget for this.

Door locks: You should change out the door locks when you take possession of the property and after each tenant moves out. Kwikset’s SmartKey system allows you to rekey the door knobs in place every time a new tenant arrives and is priced similar to normal door locks/knobs.

Flooring: If you need to change out the carpets, take a look at laminate wood flooring as an alternative. It will cost more upfront but should last 10 years or longer. Many laminates are literally tough as nails and look awesome. Plus laminate will save you the hassle of having carpets cleaned during turnover, arguing with past tenants over the cost and having new tenants complain about stains.

Leasing documents

You’ll need to get a lease application and lease agreement. Your real estate agent can provide the standard documents for your state, but be sure to add any terms or clauses that are important to you. Once you find a prospective tenant, you’ll need to pull their credit report and conduct a criminal check. Your agent may be able to run credit reports.

Finding a tenant

You can post your rental listings for free on Zillow, and if you join the Zillow Rental Network, you’ll get access to a suite of free tools including online rental applications and Craigslist AdHelper.

If your listing doesn’t get inquiries, you’re probably asking too much for rent. Interview people who respond to your ad on the phone before agreeing to meet with them at the property. This will avoid wasting everyone’s time if they don’t meet your credit, job or rental history requirements.

Once you find a good tenant, move quickly to get a lease signed so you don’t lose them to another landlord’s property.

And finally, realize that being a landlord is a business, and your tenant is your customer. Just like any other business, the better you treat your customer, the more likely you will have a successful business venture.

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Investing? 6 Types of Properties to Pursue

If you’re interested in improving your lot in life — no pun intended — by becoming a property mogul and investing your hard-earned capital into income-producing properties, there are some general guiding principles that should increase your chances of earning wealth.

One of the better ways to improve your wealth is to reduce your risk on the properties you purchase. This will allow you to buy lower-risk real estate, which hopefully will earn a fair amount of wealth for you over time. Go for these:

Properties in very good shape

Too many people buy fixer-uppers thinking they’ll add value by doing a renovation. Then they get mired in a much more expensive and time consuming property than they ever expected. More money into the property means lower investment returns for you and less wealth-building than you expected. Skip fixers and instead buy properties that are in as good shape as possible, which should get those rental checks coming into your bank account in as short a period as possible.

Properties in moderately priced areas with good cash flows

Real estate is all about location, location, location! The properties in the best locations (think beach areas, downtown, wealthy enclaves) generally have very negative cash flows, so those are the location, location, locations you want to avoid. The moderately priced properties in working-class areas are the real gems; they generally have the boring locations, but much better cash flows. Of course pencil out any deal with conservative rents and expenses, and go for beginning year cash on cash return of at least 4 to 6 percent, based on your conservative estimates.

Communities with HOAs in good financial, legal, operational shape

There are many, many landmines in buying properties in common interest developments. And you aren’t just buying your property; you’re buying into a larger entity called the homeowners association (HOA). And if it is in financial, legal or operational trouble, you pay the bills. Make sure to do your due diligence on this — and it’s a lot of hard work to do it properly. Learn what you need to look at way before you go into escrow.

Properties that come with decent credit quality tenants in place

There is nothing better than buying a property with a decent tenant already in place. You get the security deposit and pro-rated rent, and you don’t have to go in and clean, paint, update or fix too many things in the unit. If you buy properties in areas that have decent credit quality tenants, that’s hopefully the type of tenant you will inherit. Also take a look at the current tenant’s lease, credit application andcredit report, if you can, before you make the decision to purchase the property.

Properties in low vacancy areas

Vacant units get robbed, incur vandalism and don’t have any rent coming in to cover the bills. If you buy in places with really high vacancy, it might be months or years before you get the property rented out at a fair rental rate. So really think through buying properties in areas with many unoccupied units. Drive around at dinner time: No lights in a lot of neighborhood houses means no one is residing there, and you shouldn’t, either.

Properties you will own a long time

The most important factor in real estate investment property is to own it for a long time — in fact, forever is the optimal ownership horizon. So do your due diligence and buy quality properties that you really like for all the right reasons, and plan to own them for good. That’s your best bet to earn wealth on real estate.

If you buy properties with ALL the above characteristics, that will greatly increase the chances you will add wealth to your nest egg from your real estate ownership. So try to acquire properties that have as many of the above good qualities as possible, and skip the ones that don’t make the cut!

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Is a Second Home a Good Investment?

You may believe that a second home can be a great place to vacation and retire, that you can earn some equity over time and that it’s a good deal because property is a physical asset that can’t go away. While those statements may be true, it’s unlikely that buying a second home will be a very good financial move.

Here’s the unbiased reality: You may be able to earn some long-term wealth from a second home, but you probably would have earned a lot more wealth keeping your money in a well-diversified pool of financial assets or buying rental properties.

Cash out, no cash in

You see second homes, and land, have one very unappealing quality when you are looking to earn wealth: They don’t pay interest, dividends or net rental income. In fact, all they do is take money from your bank account for property taxes, insurance, maintenance, renovations, and, oh, that mortgage payment — all money going out the door, with no money coming in the door. So you are 100 percent speculating that the property will go up in value over time to compensate for all the negative cash flows that accumulate each year. And how are you covering those negative cash flows? You are taking money out your financial assets — stocks, bonds, mutual funds — to pay the bills that cause those negative cash flows.

And by the way, weren’t you earning interest and dividends on those financial assets? So you would have been earning 5-7 percent annual returns on a well-diversified pool of financial assets, but instead you are earning nothing — that’s termed the lost opportunity cost of capital.

Long-term impact

Over the long term, all those negative cash flows and the lost opportunity to earn a rate of return on financial assets are really going to add up. If on a $100,000 property you spend $10,000 per year (inflated by CPI 3 percent per year) to carry that second home, with cumulative lost opportunity cost of capital, that could be $450,000 to $500,000 after 20 years that you would have had in financial assets. Of course if the value of the property goes up 8-9 percent per year for those two decades, so it’s worth $500,000, then you might just break even. Note: Housing appreciates about 3 percent per year over long periods of time.

So if you are buying a second home in hopes of earning wealth, you might earn it. But keep in mind that there probably are much better investments out there, and you should really think it through if you are simply hoping the value of the property will increase enough to provide a fair rate of return.

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Should You Add Real Estate to Your Investment Portfolio?

money-houseAs the national real estate market is in the news each week, and there is talk everywhere about cheap foreclosures, short sales and other incredible opportunities and deals, you might wonder whether investment real estate is right for you.

Real estate is not like other investments: Ownership takes time, energy and effort to manage, and it can be a real hassle. Remember when your kid overflowed the bathtub? Tenants’ kids do that, too! And you, as the landlord, have to deal with, fix and be involved with the issue or it won’t get resolved properly. And if it isn’t handled properly, it can become a bigger, more expensive problem.

And even if you have a property manager, you ultimately will have to be pretty involved and deal with the property if you want it to be a wealth building asset. The less you are involved, the higher the chances it won’t be a profitable experience. And that starts even before you purchase it by your doing the proper homework, research and analysis to find the properties that are good investments.

Is real estate right for you?

Since owning real estate is hard work, just like any other job, you need to ask yourself: Do I have the desire and time to manage my property? If you are one of those people who believes real estate will be easy money with little work, ask around. Water leaks, tenant issues, neighbors, etc., all come along with rental properties, and you, as the owner, will probably have to be involved. So does that sound appealing to you?

Is it the right property?

In order to find a fair deal on an investment, you need to educate yourself on what is a good deal. Far too many people buy property and just hope it will go up in value. Hoping something will go up in value isn’t a very sound — nor likely to be successful — investment strategy. Experienced property owners avoid even considering any appreciation in value and know that the good investments pay positive cash flow to you each month. And many properties are not very good investments — fancy downtown condos, beach houses, prime locations, etc. Some of those might be negative cash flow for several decades before you see, or more likely your grandkids see, the property’s first penny of positive cash flow.

Is the return sufficient for the risk you are taking?

You can earn a very low-risk long-term yield on corporate bonds or securities of 4-6 percent average per year. So even if the real estate has positive cash flow, does a 1 percent investment yield sound appealing in a very illiquid asset?  You need to buy properties with better cash flow yields, and that’s harder to do than you think.

What’s the plan?

If you plan to only own real estate for 3-6 years, skip it. The chances of your earning a fair return from short-term ownership are pretty low. Sometimes people get lucky … but that lucky person most likely will not be you! If you have a short-term time horizon, it’s likely you will do better financially by skipping real estate ownership.

So if you are interested in adding real estate to your portfolio, and you can do the proper research, buy nice cash flow properties, manage those properties and own them a long, long time … then real estate may be a good addition to your investment portfolio.

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Income Tax Tips for ‘Accidental Landlords’

House-on-tax-formsSo you’ve just joined the world of being an “accidental landlord.” Maybe you had to relocate, or perhaps you had to downsize. Now you’re renting out your personal residence or second home instead of selling it.

This makes you a landlord in the eyes of the IRS, which means you’ll have to report the rental property on your federal income taxes.

So what’s a landlord to do?

Fortunately, most rental property ownership will initially generate taxable losses for you, which may,that’s may, save you some money on your taxes. These savings come from shielding, or deducting, losses against part of your regular taxable income. But keep in mind, taxable losses are different from positive or negative cash flows (and that’s a story for another day).

For our purposes, we’re just going to discuss what you need to do as a newbie landlord to get your taxes heading in the right direction.

Income and expenses

Next April you’ll add an IRS 1040 Form Schedule E (Supplemental Income and Loss From Real Estate) when you file your taxes.

On the Schedule E, you’ll record all the rental income your received for the prior year. Then you will record all the cash expenses related to the property: mortgage interest, property taxes, HOA fees — which are now deductible because it is a rental property instead of a personal residence — maintenance and repairs, gardening costs and any other expenses, such as depreciation (described below) that are related to the operation of  your “business.”

The net rental income, less all those expenses, will provide an income or loss figure that will be calculated on Schedule E and flow to your IRS 1040 Form, Line 17. So if rental income is $15,000 and expenses are $17,000, you have a $2,000 loss for tax purposes.

Depreciation

One favorable expense deduction that you can take against rental income is called depreciation. It is usually a large amount and can help you greatly decrease the taxes you pay. To figure out this amount, first you need to determine the tax basis and depreciable basis of your rental property. The tax basis will generally be what you originally paid for the property, plus any capital improvements you’ve made over the years. So if you paid $200,000 and put in a $25,000 addition, your taxable basis is $225,000.

You’ll then split that basis into land value and building value, which is your depreciable basis. Divide that building value by 27.5 years to get your depreciation deduction, which goes on your Schedule E just like any other expense. Make sure to have a tax preparer help you with this calculation.

Adding it up

Now let’s look at how the Schedule E income or loss flows to your main 1040 form. You would take your net income or loss on the Schedule E form and transfer it to your 1040. If it’s a loss, you save money on taxes. If it’s positive income, you pay additional taxes.

Note: On losses there are some “Passive Activity Loss” limitations on using losses to shield income. The net maximum loss you can use to shield income is $25,000, and the ability to use any losses phases out starting at $100,000 adjusted gross income. Real estate professionals, however, may be able to use unlimited losses. Talk to a tax professional on all these issues.

Even though your new landlording career may be an accident, being smart about the relevant income tax deductions shouldn’t be. Do some Internet research, talk to your tax professional, look at the Schedule E form, save all those receipts and make sure you maximize your deductions, especially depreciation, so you get the largest possible tax savings the IRS code allows.

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