What Real Estate Investing Opportunity Is Right for You?
Part 3 of an ongoing series on Investing & Rehab
So where is the Investing Opportunity in today's lively mix of foreclosing lenders, stressed home owners and highly competitive real estate speculators? Where do you and I fit in?
There are at least four advantages or "niche opportunities" available to us as relative newcomers to this quickly evolving, dynamic real estate marketplace. And the Good News is the market is not so much changing as it is growing. At least for a while longer...
The first of these opportunities has always been here for us. It was the case when I came into the business decades ago; it was the case a hundred years ago. We know that landlords have been economic players in housing since ancient times; we’ve found correspondence between landlords and tenants about when the rent was going to be paid written on clay tablets in cuneiform over 5000 years ago. Medieval Europe ran on a system of rents collected by landowners from those who tilled the soil. There’s nothing new about that.
And given the very passage of time and hard use properties may or may not, depending on any number of circumstances, become distressed or “functionally obsolete”. They come in every category–
Opportunity #1 – "Adaptive Re-Use"
Take, for example, industrial “loft buildings” (a favorite category for me as I've worked with loft buildings). In the upper Midwest and the eastern part of this country such buildings, contrary to modern standards, tend to be multistory brick and timber structures, with column placements on twelve and sixteen foot centers. Vast expanses of glass provide abundant natural light but little protection from summer heat and winter cold (energy was cheap in the old days).
Such buildings became more and more difficult to use by today’s modern production or warehousing standards and over time fell into disuse, derelict. The buildings became both physically and functionally obsolete: their very function is no longer useful as originally intended.
In any event ownership was compromised: physical conditions are antiquated, and the historical user of that property no longer is interested in it. Obsolete and at best underutilized, such buildings are arguably distressed.
As we have seen, a distressed property is sold at a discount because of its situation or special circumstance. To a buyer who has both the initiative and the genius to put that property into service, it represents an extraordinary business opportunity.
Buying functionally obsolete real estate can be a fast track to wealth. Buying and changing (adapting to a new use) distressed real estate is proactive and offers great opportunity for innovation and profit for those who take initiative. Again, the properties are distressed for a reason. But for the astute entrepreneur, the savvy investor, distressed property represents a problem that you can fix to your own benefit and that of the community as a whole. That’s a “win-win” in any book.
The Secret Is To Restore Value
An entrepreneur who buys a derelict loft building and goes to the considerable expense of subdividing floors and doing all the construction necessary to create individual residential units, is creating new value because a $multi-million sell-off of 12 or 14 “custom lofts” may well prove profitable. But only at considerable risk and expense.
The business model more appropriate for most investors in terms of both efficiency and limited risk, is to simply restore value. And by that, I mean a 3 bedroom 1 ½ bath single family home is identified, acquired (at a discount due to its distressed condition) and rehabilitated. At the end of the day, this once distressed board-up is returned to the community as a refurbished 3-bedroom 1½ bath home. Can one do more? Say, add a second full bath? Sure. It simply takes longer and costs more.
Keeping It Simple
The approach I recommend to those interested in Fast-Track Wealth Building is to keep it simple. If it’s a three bedroom 1½ bath board-up, make it a clean, wholesome three bedroom 1½ bath home. If it housed a family, you will benefit most by simply putting it back in service as a clean, wholesome environment for a new family.
You will have the opportunity because you bought it right and because of the skills you have that reward efficiency and sound project management. You will also have the opportunity to profitably resell the house if you choose, perhaps at a discount for quick sale. For that community, your “product” may constitute affordable housing and serve as a real contribution to that community’s housing choices. We’ll talk more about Affordable Housing as we go along.
Engage The Market At Any Level
It is possible to enter this distressed real estate marketplace at any level. For example–at one extreme–you might join in or compete with the bulk buyers who buy 150 units at a time. If you have the resources, I won’t discourage you, except that I strongly suggest that you have your investor/buyers lined up before you make your move.
The risk is you may find yourself sitting on properties and looking around to see if you have any buyers after the fact. In this case you’ve simply stepped into the shoes of the foreclosing lenders, with too much inventory. This isn’t the proverbial Catbird Seat. Rather, your situation will only serve to invite the kind of bare-knuckled negotiations that will cut your margins.
On the other hand it is also possible that, working on your own or working with an agent, you just go out and buy a house (OK, maybe two or three).
Then get about the business of fixing it, put a tenant in there, and refinance the property as an income-producing investment. Then go do it again. This can be done at very modest risk. You may be the fortunate buyer of the one bad house on a given block, and so you will be considered a local hero in that neighborhood. You’ll be supported for it. Your values are out there for all to see. And whether in the end you rent the property or sell it, you should have a ready market for your property. So it is possible to benefit from this unique market at a very modest level, but the benefits will be very real.
About “Affordable Housing”
Another prospect here, another advantage of this market situation, is need for “affordable housing”. In many communities, during the peak of the bubble, houses were being built at a great rate that fewer and fewer people could afford, particularly the new homes built in more established neighborhoods and subdivisions. In the event of foreclosure, the typical home buyer is seldom the likely candidate to purchase that now distressed property.
Often this is not even related to the inherent savings in the reduced price. The distressed, "real-estate-owned" sellers typically put very aggressive conditions in place (such as "all cash", "as is, where is,"etc.) that discourage all but the most hardy buyer. Physical conditions of the property may prove daunting.
Unlike thirty and forty years ago, few people today are truly interested in buying a “fixer-upper.” There’s an aversion to the “novelty” of working with contractors, and little experience in doing serious work themselves; such skill-sets are fast disappearing from American urban culture. In spite of popular interest in “fix-this-house” television programming, most folks today are unwilling to forfeit spare time to work on their home, preferring to spend available time and money pursuing recreation, or career development or other lifestyle “enhancements”.
The experienced investor, on the other hand, has cultivated a fundamental understanding of what is needed, can arrange for contractors and, because there’s so little competition for the property, will negotiate a relatively advantageous price. Given that advantage, there is certainly opportunity to resell the house immediately, refurbished and in first rate condition–certainly no longer distressed. The “newness” of the property will compete favorably with other properties on the market, though there should be no certainty of getting top dollar.
That said, the potentially reduced price of the improved property can still be a very good deal for an investor, primarily because it was the bank that took the hit. Costs to fix are efficiently and cost-effectively “micro managed’ (far better than could the bank) and, as a result, the dealer or rehabber is in position to pass–or better “share”–the savings in the form of a reduced price to the eventual buyer.
The happy result is that that neighborhood, at that moment in time, has the opportunity for someone to buy a home that at the peak of the bubble they could not afford. For that community this recycled housing may prove to be an Affordable Housing opportunity.
THE CASE FOR AFFORDABLE HOUSING
The demand for affordable housing will never go away if communities continue neglecting the housing needs of school teachers, health workers and mechanics who are actually employed within that community. It is generally known that such individuals, because of their career choices, simply cannot afford to live within the communities they serve.
Analysts, financial advisors, and most lenders, for years have recommended that households commit no more than 30-35% of household income to housing; call it an “affordability index” if you will. In affluent communities that index serves to drive up home prices. Those who make more can simply afford more house.
But what of the teacher, the cop and the barber? Do we insist they commute from elsewhere, or integrate them into the communities they serve by supporting or creating housing they can afford and having them as neighbors as they should be?
The housing that the investor might create within that community by focusing on acquiring and restoring distressed properties for resale becomes a true opportunity to provide affordable housing.
What About Competing With New Construction?
My remarks concerning townhouse development (see footnote) are nevertheless appropriate. Because the investor or the investor/rehabber who focuses attention on existing housing will always have a pricing advantage over the cost of new construction.
In the Chicago metropolitan area, the only way affordable housing is truly developed today, and for the last 50 years in Chicago, is through heavily subsidized new construction, subsidized in such a way that the price of the housing can be brought down within affordable housing standards. In Chicago, this is a range of $140,000 to $160,000. (In other areas it’s simply not possible, according to today’s new construction protocols, to build a viable home at that price point.)
Meanwhile, two blocks away, on a free-standing 25-foot Chicago lot, is a sixty or seventy-year-old bungalow that has fifty percent more square footage and a full basement, that may have a garage in back, with a nice garden, that can be acquired and fixed for something on the order of 70% of the market value of neighboring “used” housing (say $140,000 to $150,000). And it’s on its own lot!
Given today’s new construction costs, I don’t see the economic advantage inherent in recycling existing housing changing any time soon. The investor/rehabber is in the best position to create a fine housing product for their customers, with built in cost advantages over new construction.
Real Estate As A Conservative Investment
When compared with other investment opportunities, historically real estate has been a conservative investment. Precious metals, gems and fine art are bought by those who are affluent and feeling flush. Not really investments, gold and gems are merely an alternative to cash and may serve as a hedge against inflation. Commodities and futures contracts can be fun, but generally amount to pure speculation with no real intention of owning anything other than the paper contract (perish the thought one should end up owning the corn!).
The thing about housing is that housing everywhere is a basic human need, like food and clothing. It’s not trendy. The demand never goes away, good times or bad.
Profiting As A Real Estate Investor 4 Times Over!
Interestingly, among the advantages to be found in today's foreclosure marketplace is the opportunity to profit four times. We’ve talked about each of these– First of all, you get the initial bump in value when the property purchased at a discounted price. The investor gets it at a low price because it needs fixing. The lender took a look at how much it would cost to fix the property by today’s construction and contracting standards, and rightly concluded that the property had to be fixed in order to merely maintain the value, let alone achieve a profit. Most rehabbers can accomplish that work for thirty to forty percent less cost because of their active involvement in the process.
So there are reasons for the pricing, some competitive, some based on the sheer volume of properties out there. The consequence of this over-supply is one piece of establishing pricing. The other is simply the “cost to fix”. All of this must be measured against prevailing values in the particular neighborhood, given the reduction in value that has taken place over the last several years. You as an investor or rehabber are positioned to profit where the foreclosing lender cannot.
Thus the benefit to be derived is a profit – on the books, not immediately in your pocket – of the restored value measured against what you paid for the property and what it cost you to fix it. So there is a bump in value right there.
If you maintain personal financial statements, and you certainly should, your wealth just went up by that differential, by that positive increase in value. That’s increased market value from simply bringing the property back into service. And you have yet to pay a nickel in taxes!
Secondly, because your primary costs of ownership are reduced, your mortgage, and perhaps even taxes and insurance, will similarly be twenty to thirty percent less than had you bought that same property six or seven years ago at the top of the market.
Meanwhile, the demand for rental housing has gone up because of displacement resulting from these foreclosures. So, while rents are holding reasonably firm, your holding costs will be less, which means you’re going to enjoy generous rental income as long as you own the property.
Thirdly, because we are still in a swing period, what I believe to be a temporary (2-5 year) recovery in real estate values, you will find that as this situation progresses, as remaining foreclosures are absorbed by the marketplace, however they’re absorbed–by investors or by first-time home buyers. Most experts agree that market values will increasingly recover.
That could be a jump of twenty, thirty, forty percent over your “cost basis” (the amount you actually invested). This is extraordinary appreciation by any measure when compared to the 3% annual increases experienced historically (since the 1920s). Thus you have unusual opportunity for extraordinary appreciation in the near term.
And fourth, there are important tax benefits available to those who choose to hold their properties. Folks who promote the concept of “flip this house” and getting in and getting out never really focus on the fact that when you buy and sell within less than a year, or buy and sell as a primary business activity, the IRS will treat you as a Dealer.
We talked earlier about how a Speculator is inherently a Dealer in the short term. What does that mean? It means every nickel, every bit of profit on the quick resale of your property is taxed at ordinary income tax rates. Under today’s tax laws, personal tax rates are generally in the range of thirty to forty percent; when state taxes are taken into account, they can be even higher.
On the other hand, when a property is held for “investment purposes” (think of the stock market and your securities) and held for a year or longer, then the profit is measured at capital gains rates. Taxes on capital gains are today capped at fifteen percent for most investors. Compared to thirty-five percent, fifteen percent is money in your pocket as an investor, adding to your working capital, added to your wealth, just by virtue of reduced taxes. Real dollars.
These are important advantages for real estate investors. Compared to other investment and savings vehicles, they are extraordinary advantages. Just stepping up, first of all, and buying a distressed property because you have in hand a system to quickly and efficiently restore value has always been a fast track to wealth-building in real estate.
Secondly, when this process restores value rather than creating value, that is a very conservative objective and readily realized. Third is the fact that this market is accessible at any level. Of course my recommendation would be, if you’ve not done it before, start with one property. Don’t start with ten. I’ve seen people do that, and they’ve simply become mired in too many projects, too many contractors, and too many responsibilities in a single period of time.
The fact that the demand for affordable housing is undiminished and growing provides a market both for sale and for rent. And the comparative cost advantage if you plan to be an investor or rehabber, as opposed to a builder, is that so-called “used” housing will always give you a pricing advantage, a cost advantage, over both existing homes and new construction.
Finally, if you’re going to choose a marketplace to play in, and if you are approaching it as an investor, real estate is best understood as a “conservative” investment: Housing is a commodity which will always be in demand.
You have choices, “niches within niches”. One may choose to specialize in penthouse apartments on the boulevard, or bungalows in working class neighborhoods. The opportunity for acquiring discounted multi-unit apartment buildings is attractive for the same reasons and certainly not to be ignored.
All things considered, today’s market provides for us an unprecedented opportunity.
The potential for multiple profit centers is there for the taking: There are: (1) profits from the initial restored value– just by bringing a property up to today’s pricing; (2) the generous rental income that’s available, the enhanced cash flow; (3) rapid appreciation as markets recover; and (4) important tax benefits which, in a sense, serve to subsidize our continuing investments.
This “perfect storm” combination of benefits and profits available to us today in fact represents an extraordinary opportunity.
Which is why we do what we do. #
Next time: "How Risky Are Foreclosures?" (Part 4)