Are You Wasting Money Renting?

are-you-wasting-money-rentingPeople generally buy property in hopes that they will be better off financially down the road than if they did not buy property. However, for many people, it’s better to skip property ownership and stay a renter – at least for a while.

If you find yourself in any of the following scenarios, you may be someone who is better off as a renter than a homeowner.

Scenario 1:

Whether you buy or sell a home, real estate has significant transaction costs. If you want to come out ahead financially, the value increase of the property you buy has to be more than the total transaction cost of the deal.

The chart below shows a two-year ownership scenario with the property going up in value 3.5% per year – a healthy projected increase in value – and then taking out typical costs on the buy and sell. Notice how the owner put in $35,000 to buy and is left with only $25,440 in the bank after two years. Look at all those transaction costs, $5,000 + $8,560 is $13,560 or 13.5% of the $100,000 purchase price.

It is clear to see that this person would be better off financially after a couple of years if they stayed a renter.

This doesn’t even account for all the money this owner may have paid for upgrades such as new flooring, landscaping, and appliances — things that will not add much value to the property. The current owner will never get to enjoy them, but the next owner certainly will.

Who should avoid ownership? A few groups that should really think hard before they buy are military people and professional athletes. Both of these groups move often and in general would most likely be much better off to stay renters until they are settled in a city where they are sure they will be staying for a long period of time. Additionally, parents considering buying properties for their college students to live in during school will be probably end up being a short-term ownership situation – skip the hassle!

Five years is typically the break-even point where it probably is better to own over renting, but again depends on the difference between the cost of renting and the cost of owning.

Scenario 2:

On a monthly basis, it is almost always more expensive to own, but let’s just talk about when it’s expensive to own on yearly basis, which is most often the case in areas where there is plenty of nearby land to build upon. This is common in revitalizing downtown areas where cities construct  luxury condominium projects, and there are still many lots available for building additional properties, as well as a glut of vacant or rental properties.

It probably makes sense to consider staying a renter in those areas, because rentals are widely available and most likely more affordable. You might be paying an extra $750 per month or $9,000 per year for the “pride of ownership.” Year two as an owner may still have $8,750 more in costs than if you rented, year three could cost $8,500 more to be an owner – and these costs add up each year! You could be in the “red” for ten years, adding up to $60,000 to $70,000 or more to your costs. Your hope would be that the appreciation in value would compensate for these huge cumulative annual negative amounts – but the odds are against you.

Staying a renter is the best choice for many people, and for many, renting does not equate to throwing money away. If you want to purchase real estate, consider the surrounding area and rentals, and make sure you own the property for at least five years or more to recoup costs.

Your best chance of increasing your wealth through real estate ownership is buying property that suits your wants and needs and to hold it for a long, long time — the longer the better!

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Do You Understand Income Tax Considerations of Rental Properties?

A rental property can generate “taxable losses” that can be used to reduce your normal salary income, hence the federal income taxes you pay.

Do-You-Understand-Income-Tax-Considerations-of-Rental-PropertiesIt’s difficult for most people to understand how taxes work, and even more confusing once we get into the realm of rental properties and taxes. Note that understanding how taxes impact personal residences are a completely different topic, as those are governed by totally separate tax codes and go elsewhere on your 1040 form.

Below are some of the basics to understanding rental properties and federal income taxes.

Often I hear people saying that they want to buy some real estate to save money on income taxes. However, depending on your tax situation, owning real estate might not save you a dime on taxes. It wholly depends on your specific tax picture and the IRS rules about Passive Activity Loss Limitations.

First and foremost you should never make real estate investment decisions based solely on tax considerations. The first order of business is do your due diligence and determine if an investment makes sense based on cash flows, cash on cash returns, renovation costs, rental income, financing, and the risk of any particular property. Once you believe it makes sense in every other sense, then you can contemplate the tax effects.

Important note: Always have a CPA, attorney or licensed tax professional guide you through your individual tax picture — this article is an illustration of one scenario but your scenario can be very different based on your financial picture.

To better understand, let’s first quickly discuss the IRS 1040 form.

The 1040 form you fill out each year does two things:

  1. Calculates the amount of federal income taxes you owe for the year based on how much you earned in salary, income, wages, profits and distributions — LESS all the deductions (tax “shields”/subtractions) to those totals in the form of losses, deductions and exemptions to get to your Taxable income on Line 43. Then, look at the IRS Tax Tables and determine how much you owe in taxes based on your tax filing status (Single, Married Filing Jointly, etc.) and your Taxable Income.
  2. Second, it reconciles the amount you owe from #1 above against the amount you have already paid during the year. This is commonly called “withholdings” from your salary, or if you are self-employed, you probably paid quarterly estimated income tax amounts to the IRS during the year.
  • If you paid more in #2 than you owe in #1, you get a tax refund!
  • If you paid less in #2 than you owe in #1, you write the IRS an additional check!

Tax Considerations of Rental Properties

Rental properties generally show taxable losses for the first many years. That taxable loss is essentially another “deduction” that lowers your taxable income — noted in #1 above — and hence lowers your income taxes.

This chart below shows an example of how a loss would be calculated. For example, this property might show a ($7,500) loss. That loss would filter through your IRS 1040 form, reducing your taxable income, and hence reducing your taxes.

This is how you might save money on taxes by owning rental properties — using losses on your rental real estate to reduce your taxable income, which allows you to pay less in federal income taxes.

How much it reduces your taxes depends on your income and filing status. It is a little complicated and can get very complicated depending on your situation.

There are also limits on how much of a loss on rental property any particular taxpayer can use to “shield” their income. These limits are called Passive Activity Loss Limitations. If your losses are over $25,000 and/or your Adjusted Gross Income is over $100,000, you may not be able to use all of the losses. You may have losses, but you are not allowed to reduce your income with them based on the IRS rules. Consult a professional.

Have questions? Just leave me a comment below and I’m happy to help you!

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Should You Buy a House with Seller Financing?

So, you want to buy a home with the seller financing the deal.

Generally, this is not a good idea for many reasons. Mainly, if there is anything we have learned in this ongoing recession, it is that contrary to the thinking of past years, people do often lose money in real estate. To avoid that, people should buy the RIGHT property that fits all the RIGHT reasons that they want to own real estate and a particular property.

Why It’s Not a Good Idea to Buy a Seller-Financed Home:

Should-You-Buy-a-House-with-Seller-Financing1. Not credit-worthy — Buyers who are interested in seller financing are often people who cannot get traditional long-term, low-interest financing because they have some credit issues. For these people, the bank is telling them that they are not currently creditworthy. These people should generally avoid making large, risky purchases like real estate where they may get in over their head. They should instead work hard over the next few years to get into a creditworthy position where traditional financing is available.

2. Not the right property — To add to issues for buyers, seller-financed houses make up a very very small percentage of the overall real estate market. There might be 1-3 seller-financed houses for every 100 for sale. With those odds, the chances of a seller-financed house being the RIGHT property for a particular buyer for all the RIGHT reasons is very low. So don’t buy, just to buy!

3. Not a good deal — In addition, many seller-financed deals are properties bought for cash by investors who are selling them to inexperienced and non-creditworthy buyers at either above-market prices, or above-market financing rates on short-term loans, or both. And that is a recipe for getting the buyer into deeper financial problems and losing the property just a few years down the road.

When You Add Up 1 + 2 + 3 You Have a Buyer Who:

  1. Isn’t really in the financial position to buy real estate,
  2. Is going to buy a house that probably doesn’t really match what they want and need
  3. Is possibly paying an above-market price and above-market interest rate on short-term financing.

Even a first grader can add up those numbers and realize it’s simply not a good idea.

Traditional Sellers/Owners with Mortgages

There are also seller-financed deals called “all-inclusive trust deeds” and “wrap-around financing.” Both of these are basically sales where the existing mortgage stays in place and the seller offers some additional financing behind the first trust mortgage deed. In almost all cases, this violates the existing mortgage agreement’s “due on sale” clause. While many people have done this, it just isn’t a good idea for a buyer to get involved in one of these situations. The buyer is taking on a lot of additional risk and potential problems down the road.

What If You Are the Seller?

For a traditional owner trying to sell a property, or a less experienced investor, you are selling a property to someone who the bank has deemed not financially able to buy real estate. Remember the term “subprime mortgage?”  We do not hear that term any longer because banks were burned badly on subprime loans and they are no longer issued. A seller needs to understand that there might be a little additional risk in trying this strategy.

Final Word:

This is not to say all seller-financed deals will fail. It just means chances are slim that it is going to be a fair deal for the buyer and a safe deal for the seller. In most cases, there are better courses of action for all parties.

If you are going to do one of these, make sure to get adequate legal advice. The rules, laws and disclosures on financing are extensive and if you do not properly dot your I’s and cross your T’s it could become major trouble down the road.

As always, spend your time finding the RIGHT property that works for you for ALL the reasons you want to own property and that particular property. And for the long term.

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Homeowner’s Insurance: Do You Have the Right Type and Amount of Coverage?

With all the hurricanes, forest fires, even an earthquake on the East Coast in the recent past, now is a good time to start paying a little more attention to the homeowner’s insurance coverage you carry on your property.

Most people select their homeowner’s insurance policy when they buy property and just pay the bill each year, giving little thought to keeping the proper coverage in place. Rarely do they understand, or even look at, their coverage in following years. And as long as they don’t have a loss, they don’t even notice. The problem is once you have a loss, it’s too late!

do-you-have-the-right-type-and-amount-of-coverageConsidering that your residence is probably your largest and riskiest investment, it really makes sense to better understand how insurance works to ensure you have the right type and enough coverage in place for your specific situation.

The objective of insurance coverage is to try to assist policy holders in avoiding major financial issues and disruptions to their lives if they have a loss. Insurance companies know that losses are generally predictable in total relative to a population of properties, but they are not foreseeable as to which specific property will incur the loss. You have insurance so that when that specific loss happens to you, the coverage will help ease the financial burden.

That loss could be a variety of different issues: a tree falls through your roof, a broken water line could cause a flood, or your playful golden retriever mistakenly bites a neighbor’s child.

Reviewing your homeowners policy, or renter’s insurance, is something you should do each year  to make sure you are adequately and properly covered.

How Much and What is Covered by Your Policy?

A standard policy has a single page noted as “Coverage Limits” with the maximum amount an insurer will pay out on each category of risk you have in being a property owner. Here are the more important ones:

Dwelling/Structure – This covers the main building structure, walls, roof, doors, windows, kitchen, etc. My house of 1,250 square feet is valued at $560,000 but I only have $205/per square footage worth of coverage, or $256,250 maximum loss payout. That is because the rest of the value in my property relates to land (about $264,000), which typically doesn’t need insurance. Rule of thumb: If you have a big fancy house, you need more coverage.

It’s important to talk to your insurance professional each year and make sure that the current coverage maximum dollar limit for your dwelling is enough to pay to rebuild your house in case it is destroyed. Other dwelling coverages to discuss are “Extended Replacement” and “Building Ordinance” coverage — so as to make sure you are fully protected.

Personal Property – Your insurance also covers your personal items (i.e., clothing, computers, couches, flatware, etc.). Make sure you have enough coverage as personal property costs more than you think. Special expensive items like jewelry, and artwork should be discussed with your agent for the proper separate insurance.

Liability and Lawsuit Protection – Homeowners insurance also typically covers you if you get sued. Some examples would be if your child hits a baseball that hurts another child, or a slip and fall accident occurs on your property. Typical liability coverage is $300,000 and you need to discuss your net worth with your insurance agent to see if that is sufficient. If your net worth is high, it is smart to consider an “Umbrella” policy to increase liability coverage to $1 million+. Talk to your insurance agent to determine the premium cost increase.

Want a lower premium? Raise your deductible! When a loss occurs, you are required to pay for the first few hundred or thousand dollars of a claim out of pocket. This is called your deductible amount and you can select the amount. The reason to have a higher deductible is to get a lower premium.

Realize. however, that you will pay more out of pocket when a loss occurs. It’s wise to discuss this with your insurance professional.

What Isn’t Covered and What to Consider Adding

You also need to understand that a typical homeowners policy does NOT cover many perils like earthquakes, floods, business activities and other specialty occurrences. Other policies may cover these and your insurance professional can help.

HO-6 Policy for Condos: For townhouse and condominium owners, it’s wise to have an HO-6 policy in place. HO-6 refers to the form used for a condominium/townhouse insurance policy. An HO-6 policy typically covers the interior of the unit, personal property and personal liability from the “studs in.” Many people are under the impression that the condo association’s master policy protects interior unit coverage, but most times it does not.

Policy Binder – Your insurance company will mail you a policy binder that has all the coverage items, maximum limits, terms and conditions outlining your coverage with the insurance company. While this document is lengthy, it is your money at risk if you have a loss and are not covered.

To lower your risk and potential financial disruptions in life, make sure you have the right type and amount of insurance in place. Any loss will most likely be devastating, but by properly preparing yourself with sufficient insurance the loss should be a lot less painful!

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Is Now a Good Time to Buy Real Estate?

People always ask, “Is it a good time to buy real estate?” The answer is always, “Yes, but it depends.” In order to make that determination for you, we first must understand the three most important words in real estate:

Long-Term Ownership

is-now-a-good-time-to-buy-real-estateWe buy property, whether a personal residence or for investment, in hopes that we are financially better off down the road than we are today. The chance of that occurring is very low if one does not own real estate for at least five or more years. The reason is that transaction costs, repairs, monthly ownership costs higher than comparable rent, and ownership hassles dictate that it is better to invest your money elsewhere and stay as a renter if you are not sure you will own long term.

Therefore, since you are going to be a long-term holder (the longer the better) you really should not be that concerned with short-term current market price fluctuations because ten years from now the home’s value will be more than it is today.

What you should be concerned about is finding a house that you “love”— one that fits all the right reasons you want to own that particular property for a long time!

That could almost be the end of this article…but there are a few more issues to consider to make sure it is a good time for you to buy property. If you fail any of the below tests, you should think through the issue(s) and whether or not it really is a good time for you personally to buy.

1. You are planning to be a long term holder, 5+ years of course

2. For owner occupants – payments are affordable and you have a steady job

3. It isn’t significantly more expensive to own over renting – this very important.

4. For investors – It makes cash flow sense, 4-5 percent-plus cash on cash. The higher the better but watch out for returns that appear too good to be true.

5. It is the RIGHT property for you for all the right reasons; you “love” it!

6. It is fairly priced relative to the recent comparable market sales in the immediate area for similar properties

7. You plan to own it for a long long long time!

8. Vacancy isn’t too high in the area. This is very important whether an owner occupant or investor. Empty unstable neighborhoods or communities have a higher risk of vandalism and risk downward price spirals.

9. It is in decent shape and doesn’t need much fixing-up. Skip the junkers, the ones with foundation issues, or anything labeled as “needs a little TLC” in the listing, as that means it is a wreck. Leave the fixers for the contractors. And doing it yourself doesn’t usually save you much money.

10. It is not near a big vacant parcel, non-residential zoned parcel, empty or retail/industrial/religious site where you are not 100 percent sure what is going to be built or in use there. A new use of that land could impact your “quiet enjoyment” of your residential unit.

11. You complete the proper due diligence steps to reduce your risk as much as possible. Mind your contract terms and contingencies, pencil out your deal, get a couple of bids on financing and dissect your GFE, review the HOA condition, review the property condition, make sure you have the right type and amount of property insurance in place, make sure you adequately review the title abstract and title policy and everything else you need to do to lower your risk.

12. And you plan to own it a long long time!

Those Three Important Words? I laughed when someone once said “location, location, location” were the three most important words in real estate. Not only is that actually only one word but we pay a handsome premium for “location” and is that premium worth it? It may or may not be, but “long-term ownership” are by far and away the three most important words in real estate.

To summarize: Subject to the above issues, it is always a great time to buy real estate but:

  • Not for everyone,
  • Not at any price, and
  • Not just any property.

Find a house you love or rental property that makes sense, that you will own for a long time, is in decent shape, lock in a long-term mortgage and sleep well.

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Risks of Buying into an HOA Community – Buyer Beware!

Zillow blogger Brendon DeSimone wrote an article called “Three Ways an HOA Can Screw Up the Sale of a Condo” which discussed some of the red flags a seller should learn and items they should clear to help get their property ready for sale. In addition, it’s necessary for a buyer to do an in-depth analysis of the HOA to better protect themselves when purchasing a property.

Researching an HOA is a time consuming process and very few buyers have any idea what they should be looking into when purchasing. Yet your time and effort is worth it as it is your money at risk!

risks-of-buying-into-an-hoa-communityEach one of these items is a significant risk issue and should be reviewed and understood, no matter how difficult it is to get the proper documentation. Some states are not helpful with requiring things like reserve studies, and some communities don’t even have or prepare what is needed. But if you understand the issues, that will help you reduce your real estate risk.

While you may be familiar with basic due diligence for HOAs, there are additional risks a buyer needs to understand to protect themselves when purchasing a home for sale in a common interest development community:

Unfunded or seriously underfunded reserve and replacement accounts: In this case, there are long-term repairs and replacements that will be needed in the future, like roofs, private streets, mechanical equipment, but the HOA has not saved anywhere near enough money to pay for these.

HOA in litigation: The HOA could spend a lot of money filing or fighting litigation and most lenders will not lend money on a project that is in litigation. This also means that you may have trouble selling your unit until the litigation is ended – which could be years – and possibly beyond that date.

Water and mold issues: Potential large dollar uninsured repairs that were not anticipated – so potential regular or emergency special assessments in large amounts.

Too many rental units: You many have trouble obtaining a mortgage or it may be more expensive (i.e. a higher interest rate) and the project may not be as well taken care of, thus making it harder to sell.

New project, few owners:  Less than a majority percentage of the units are sold and the developer is in financial trouble. You need to determine who will be paying the HOA fees on the unsold units to cover the property expenses to keep the lights on, elevators working, maintenance, etc.

Insurance: This involves not being properly insured for the inherent risks you potentially incur on the interior part of the unit you own, or the exterior. Cash buyers be especially aware here.

Is the building on a ground lease? Or does the HOA own the pool, parking lots, clubhouse, streets? This may seem extreme but in some rare instances the HOA may be leasing common areas because the original developer made them separate and kept ownership. You better know for sure before you invest.

One owner controls multiple units: If the original developer or a subsequent owner has control over more than 10.0% of the units this may be an issue with financing and other issues.

CC&Rs (Covenants, Conditions and Restrictions): CC&Rs are the governing documents or rules that the HOA’s abide by. It is necessary to read them, and the bylaws, as well as the Board of Directors meetings minutes and notes. If you don’t, you run the risk of being in the dark about a possible special assessment and could be charged the week after you close escrow. I know one incidence in which a woman closed three days before a $7,500 special assessment that had been noted in the BOD minutes that she got via escrow but did not read.

Lender Condo Certification (Condo Cert) – Did your lender do one? Did you ask for it and get a copy? Did you read it and made sure you understood the items on it? If you are paying cash, you don’t have the lender watching out for you, how are you going to mitigate that risk?

Banks will not finance it, just pay cash! If a bank will not finance a unit, they are telling you something! I often hear investors say, “well, I’ll just pay cash.” What you must consider however, is that the bank, with decades of experience losing money on loans in these communities, is signifying a problem by not approving the loan. Don’t just pay cash because you have it; I suggest that you listen to the banker.

Those are the issues, and if you plan to buy into an HOA-governed community, you need to fully understand these items and how to mitigate these risks.

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Investing in Real Estate – What is a “Good Deal?”

Let’s look at a tried and true way to measure rental property investment returns and what we as buyers should be looking for in our purchases. Total investment returns in real estate are really comprised of two pieces: operating positive cash flows and long-term appreciation. In today’s world, even though it probably will come, we cannot count upon and should not consider long term appreciation. That leaves positive operating cash flows as our primary source of investment return. Let’s call this: “earning money the old fashioned way.”

So how do we calculate our returns and how do they compare to other investments where we could place our hard earned cash equity dollars? It is quite straightforward to calculate our investment returns, unfortunately few people do this leaving many a buyer to make poor real estate choices.

Most Important – “Cash on Cash return” is the most important measurement. So while the price is important, one’s actual cash equity investment is the vital issue. So for every dollar invested what is our percentage yield return on our equity cash investment. CDs offer 1.5%, Bonds 4.5%, stocks 7.5% and real estate is generally high risk, so we want fairly high returns to compensate for the risk.

If one is buying a $200,000 investment property they probably put down 25% or $50,000 plus another 5% or $10,000 for closing costs, loan fees and rehab costs. So the mortgage is $150,000 and a buyer’s cash equity is $60,000 from the start. Again: The property price of $200,000 is important too, but how much cash equity one invests is much much more important.

investing-in-real-estateSee Chart – Using a conservative estimate, depending on the local market, that property might generate $1,800 per month in rent and have 33.3% operating expenses ($600) leaving net operating income of $1,200. Then subtracting the monthly mortgage payment of $900 leaves $300 of monthly cash flow or $3,600 per year.

Divide that $3,600 by the $60,000 of cash equity and this property has a first year cash on cash return of 6.0%. And it should increase a little each year as rental income increases, as do general expenses, but the mortgage stays constant.

That 6.0% is a pretty fair return for real estate and of course there hopefully will be some long term appreciation, tax benefits and a little more yield from the mortgage balance pay down via amortization of the loan.

Be Smarter – It is stunning how many real estate buyers fail to do this simple calculation and buy properties with minimal or negative cash on cash returns – to their own financial detriment. Let’s be a little bit smarter and make sure we take a good look and a conservative approach to real estate investing for our own long term benefit.

Go for the Cash Flow! – As a final note, buyers will find prize properties, like at the beach or fancy condos, generally have very low or negative returns. Skip those! It is the moderately priced units that have decent cash on cash returns. Hence… “prize” properties are NO prize…moderately priced cash flowing properties are the real prizes! Then you will have to figure out where to invest all that positive cashflow….

To help you do better analysis, you can download my simple and straightforward spreadsheet for free when you join my email list. Sign up below!

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5 Signs a Foreclosure is a Good Deal

If you want to take advantage of the market and try to pick up a great deal on a foreclosure, and yes, you have enough credit or cash, there are few things you should know before making a purchase.

5-signs-a-foreclosure-is-a-good-dealFirst of all, what is a foreclosure? It’s a bank-owned property, commonly called real estate owned (REO). For whatever reason, the original owner stopped paying their mortgage so the lender (e.g., Bank of America, Wells Fargo, Fannie Mae, etc.) legally repossessed the property and took ownership.

Next, it will be listed for sale by a local real estate sales professional in the Multiple Listing Service (MLS) along with listings of traditional sales and short sales. We are not talking about properties sold via a foreclosure auction at the county courthouse; those make up a very very small percentage of bona fide real estate sales to third-party buyers like you. Plus, they are extremely high risk, so let’s leave those to the pros who take huge risks.

When Foreclosure is Not a Good Deal

Let’s first talk about what foreclosure is not a great deal. A great deal is not necessarily the lowest-priced property on the block. Or, if it is the lowest priced, it’s because it needs lots of repairs. A great deal won’t be a property where there are several other properties for sale, or many vacant properties in the area. And a good deal on a foreclosure won’t be a home that is really run-down — unless you’re a professional — or a condo or house in a new subdivision that is only half sold out or one that can only be purchased by “cash” buyers because no bank will finance the purchase.

The fact is there are many things that can go wrong with a real estate purchase. You may think you are going to get some unbelievable deal, but the truth is there is usually a reason for a property to be really low priced. Most often, you won’t figure out that reason until after you close escrow, and at that point it’s too late.

What Makes a Foreclosure a Good Deal

When you are about to purchase a foreclosure, consider these 5 things:

1.    “I love the property” is what you say after you’ve viewed it, driven the neighborhood, and investigated the property fundamentals. You love it because it is very close to exactly what you were hoping for in becoming a homeowner, or rental property owner.
2.    “I plan to own it a long time” is what you say when asked. Regardless of how great a deal you think you are getting, the break-even point in ownership is really about five years. If you aren’t going to own it that long, you are most likely better off staying a renter. Remember the three most important words in real estate: long-term ownership
3.    “It’s in pretty good shape” is what you say when your friends ask about the physical condition of the property. The vast majority of buyers have wildly low expectations of how much it costs to renovate a property. Renovations usually cost a lot more and take a lot longer than one believes, so let the contractors buy the fixer-uppers.
4.    “The price is in line with comparable recent sales in the neighborhood” is what you find out when you do a comparable market analysis of nearby properties. Remember, if it sounds too good to be true, it probably is.
5.    “Most of the nearby houses are occupied” by owners, or at least renters in the area. Neighborhoods with many empty houses can go into downward spirals that can become very bad areas with very low home values. Avoid that type of risk.

Confirm Your Suspicions

To further help you ascertain and confirm that the foreclosure is a “great deal,”  you need to do the proper due diligence during your buying process. This is especially true since bank-owned properties generally do not come with the traditional seller disclosures of any material issues wrong with the property.

Before you sign, review comparable market sales, get contractor estimates, compare mortgage rates, and view at least 10 other properties so you know what the market has to offer. You should also review the HOA financial and legal condition and your title insurance policy for any issues as well as keep the proper amount and type of dwelling and liability insurance in place.

Taking those steps to reduce your risk is key to making sure what you bought was really a “good deal.”

Overall, when buying a foreclosure (or short sale, or even traditional sale for that matter), the first order of business is to buy a good quality property in a good area that you will own for a long time and will make you happy. It’s better to pay more for a better quality, lower risk property. This is the largest and riskiest purchase you will ever make, so make a smart purchase.

Finally, the prices these days on residential real estate are generally very fair, as is the financing, so it truly is a good time to buy – subject to the above due diligence tasks. But avoid the “I’m going to get the steal of a lifetime deal” mentality. Go for something that fits what you want, for all the right reasons, and for the long term, all of which are vastly more important issues than price.

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Demystifying HOA Fees and Special Assessments

If the property you’re looking to buy has home owners association (HOA) fees, it’s essential that you understand where those fees are coming from, as well as their risk of increasing every year before you buy.

Formulation of the Fees

HOA-fees-and-special-assessmentsEvery year, a home owners association (HOA) board of directors (BOD) prepares a community budget. That budget includes what the BOD will set as the current year total HOA fee per month, per unit. The composition of that fee is the first thing you’ll need to comprehend before you better understand fees increasing each year as well as the much loathed “special assessment.”

The monthly HOA fee has two parts to it, so for the sake of this exercise, let’s assume the total HOA fee is $300 per month per unit for a 100-unit community. Here are the calculations:

Current Year Operations Portion – $200 per month

The HOA collects fees from each of its units to pay for all the current year operations such as gardening, water, insurance, property management. The BOD forecasts forward that this year it will cost $240,000 to pay for all current year operating expenses. Since there are 100 units, we divide the $240,000 by 100 units to get $2,400 per year per unit or $200 per unit per month for operations.

Current Year Reserves Portion for Long Capital Items – $100 per month

The HOA also has to save money over time for long-term repairs and replacements, such as roofs, roads and parking lots. To understand how much they have to save, they have, or should have, an outside expert do a “reserve study.” The reserve study expert makes a 20-year +/- schedule of when HOA assets will need to be repaired and how much they will cost.

The reserve expert calculates an annual amount needed for those long-term repairs. Therefore, through the HOA fee, owners are putting money away each year to pay for those repairs. This money accumulates into “reserves” so that the HOA can pay cash for large-item repairs when they come due. This helps avoid special assessments because the HOA has the money on hand to pay for these capital items.

In our example, the reserve study specialist determined that owners should be putting away an additional $120,000 per year going forward or $1,200 per unit per year or $100 per month per unit owner.

Thus, $200 for current year operations and $100 to put away additional funds, totaling the $300 HOA fee per month, per unit.

As long as the HOA board makes perfect predictions, and the reserve study expert’s estimates are 100 percent accurate, the HOA will pay all the current year bills and be in great shape for paying for long term capital item repairs. However, this rarely happens.

Not an exact science

Calculating unfortunate budgeting expenses, long-term reserves, and unanticipated repairs is not an exact science. Usually, operating expenses are higher than budgeted, or some people do not pay their HOA fees, and the HOA gets drained of cash covering expense overruns. If the BOD spends extra on operations, they won’t be able to save the recommended cash for long-term repairs. Thus, the BOD increases HOA fees next year to catch up the amount they should have saved this year for their reserves.

If they don’t increase fees to make up for that balance, perhaps because owners protested higher HOA fees, when they need $240,000 to paint the building, the BOD uses a special assessment — an additional fee levied at homeowners— so the HOA can pay for the needed repairs.

The main takeaway…

At the end of the day, all the bills — current year, capital repairs and replacements — will have to be paid by you and the other owners in the community one way or another.

The BOD usually does their best to financially manage the community well, but due to a number of factors above, it is a challenging assignment. All the owners have to live within the HOA finances, but note, it’s better to increase fees as you go to avoid special assessments.

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Buying an Investment Property? Use This Checklist to Avoid Surprises

You are ready to make the largest financial decision of your life by buying a home or rental property. But, you are concerned because of all the issues that people who bought in recent years have encountered. Perhaps properties are underwater, or the rental income doesn’t cover all the expenses, or mortgage payments have become unaffordable.

Buying-an-Investment-PropertyYou are not alone if you have some of these reservations about buying a home. While those issues are just a few of the inherent risks that are present when buying real estate, there are many more. Although these issues have been around forever, only recently have typical buyers been getting better about doing their due diligence and taking the time, energy and effort to work hard to significantly lower their risk on real estate.

The process is not overly complicated, but, it is time-consuming. We’ve put together a list of categories that should be on your due diligence list. You should learn these items, tasks, procedures and how to analyze property so you can make great choices.

Here’s how to lessen the chances of something going wrong with your purchase:

1. Understand the Purchasing Process

Buyers should have a full understanding of the purchasing process from the start. Early on review the contract you will be signing, understand how to shop for the right property and know about making an offer, contingencies, appraisals, mortgage financing, and when your earnest money deposit becomes “at risk.”

2. Does This Make Financial Sense?

• Buying Investment Property – Start by penciling out the deal. You should determine the total cash you will invest and what “cash on cash” rate of return you project to earn. Bank CDs pay 1.0 percent, Bonds 5.0 percent, but real estate is riskier – so what should you earn? Five percent is suggested. Value appreciation may come down the road and certainly will help, but let’s count our cash first!

• Personal Residence Rent vs. Own – There are some simple guidelines to follow here. If you plan to own for less than five years, you should remain a renter. You are not throwing away money renting and you avoid a lot of stress. Buying for the long term is your best move. And, don’t buy just to buy something – buy the property you “love” and that will make you happy.

3. Shop Smart

Hoping to snag a once-in-a-lifetime deal on a foreclosure or short sale? If you’re trying to chase some “great” deal like at the courthouse auction, or through a distress sale, it only wastes your time and energy with little chance at success. Be prepared. These options are complex and can often fall through the cracks.  Skip the get-rich-quick schemes. A more conservative approach is to shop for a traditional sale on listing websites.

4. Real Estate and Income Taxes

Buying to save money on your taxes? Most couples buying residences under $300,000 get little in net tax savings. People with higher incomes and more expensive homes get the biggest tax benefit. Surprised? Meet with your CPA to determine what, if any, tax benefits you will earn.

5. Mortgage Financing – Getting a Fair Deal

If you can get financing, it has become easier to get a “fair deal” because of new federal regulations. Regardless, you should understand your Good Faith Estimate (GFE) and how to dissect it to make sure you get that fair deal. Mortgages are for the long term, so take some time to interview a couple of lenders and understand your mortgage so you can make a good decision.

6. Homeowners Association (HOA) Condition

This is one of those items that most buyers do not even know to review. The finances and operations of an HOA are becoming a huge risk issue nowadays. If you do not understand and review them, you may get a surprise in the form of sharply higher fees or special assessments in the years to come. Meet with a knowledgeable person to help you decipher them. The goal is to avoid a community where the association is in really bad shape.

7. Home Inspection/Fix Up Costs

Having a home inspection is one of the most important things you can do as a buyer. During the inspection you should be putting together a list of what needs to be repaired and replaced. Then you can take your list to a home improvement store to get a feel for the total costs to bring the property up to the standards you desire. This should help you negotiate any seller’s credits and/or terminate the deal if the costs are too much.

8. Property and Liability Insurance

Insurance policies cover certain risks and have a maximum payout on any loss related to those risks. It is up to you to determine the maximum policy amount you want based on construction quality, cost to rebuild and your risk tolerance. The top issue – failing to increase coverage amounts over time as the cost of rebuilding increases. It is not difficult to understand and have the right coverage – we suggest getting with your agent and have a once a year checkup!

9. Title Insurance, Title Issues, and Lot Lines

This is another purchasing task that few people review. And while the risk of an issue is very low, the potential losses are huge. Taking fifteen minutes to review your title abstract/history and the plat or a survey of the parcel, then walk the property. It could save you endless headaches and financial stress down the road.

10. Other Investments

Fixer uppers, flipping, vacation rentals, second homes, apartment buildings, condohotels, land or building a home also have significant risk issues that should be evaluated carefully, before you make the decision to take on one of these investments.

Buyer Beware!

By taking the time to learn the risk issues and do the proper due diligence before you buy, you can significantly reduce your risk of something going wrong. And while it’s hard work, it is much easier than straightening out a “predicament” after you close escrow.

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