Where The Real Estate Profits Are
Throughout this Real Estate Topic we discuss methods and ideas that you can use to make money from your real estate investments. Some of the ideas and methods on this page are a clarification of areas already discussed, and some are new. As you open up your mind to the many ways an income producing property can make you money, you just might begin to see opportunity where you only saw problems before. Then you will have found your road to wealth.
Profit First When You Buy It!
Negotiate! You make your first profit when you buy the property. Every dollar you pay under the market price for a property is net worth to you on your financial statement. Buy based on the properties current economic value, or the property's current "as is" condition value. Improve the net operating income, or the property's condition, to improve the overall value.
Make your offer subject to someone inspecting the property or subject to satisfactory remodeling estimates, etc. What you are looking for is a reason to re-negotiate the price after the deal is accepted just in case you discover something later that needs fixing. On a commercial deal this is called due diligence, but in residential contracts you may need to add a clause.
The clause I use is:
"This contract is subject to the buyer receiving an acceptable repair estimate from (repair company name)." This clause lets you tie up the property and you can renegotiate the price if the cost comes in high. (I have a friend's name I fill in so that I am not tied to one contractor or person.)
Key Point: Every dollar you save at the time of purchase is worth three times that amount if you consider interest paid over thirty years. You make your first profit when you make the purchase. This is also the time to get the terms that will allow you the most future flexibility.
Sweat Equity
Always get your repair estimates from a general contractor. You negotiate the purchase price based on having a contractor do the repairs. If you then subcontract out the repairs, or do the repairs yourself, you make the profit the contractor would have made. See improvements that pay.
Interest Rate Profits
There are several ways to make or save money on interest rates.
1. Negotiate and shop the rate. The Internet makes this easy to do.
2. After you are quoted a rate, ask for a lower one. The institution may come back with a lower offer with different terms. 50% of the time I get a slightly better deal.
3. Assume any old loans at low rates.
4. If the owner is financing the deal, offer a rate that is 2 or 3 points over bank CD rates, which are usually lower than mortgage rates.
5. Avoid due-on-sale clauses, or early payment penalty clauses. Avoiding them will give you a chance to sell the house on a wrap around mortgage at a higher interest rate than you are paying and you can make the interest spread. This is easier to do with owner financing.
6. Refinance if rates drop two or more percentage points. This is your chance to get cash out, lower your payment, or shorten your loan term. Check the total cost first.
Cash Flow
If you buy right, you should have a positive cash flow each month on your purchases.
Cash flow is determined by taking all the rent payments, subtract the cost of maintenance, the principal and interest payments.
Example: A two unit duplex, rented at $500 per side per month. Cost $100,000 with $10,000 down and a mortgage of $90,000 at 7% for 30 years.
$ 500 x 2 units x 12 months = $12,000 gross income per year
Less cost $1,250 taxes
400 insurance
250 repairs
200 Miscellaneous
Total Cost $ 2,100
Less interest on mortgage
$ 6,800 ( $90,000 at 7%)
Total cost one year
$2,100 cost
6,800 interest
Total cost $ 8,900
Profit $ 3,100 ($12,000 gross income minus $8,900 total cost)
Payments of $598.77 per month x 12 Months = $7185.24
Subtract the Interest of $6,800
This leaves a principal payment of $1,185.24
Subtract the $1,185.24 from the profit of $3,100 and you have a positive cash flow of $1914.76
The return on the down payment cash invested was 19%
The return on the cash down payment with principle payment and cash flow is 31%
Wrap Around Mortgage Magic
A wrap around mortgage is a mortgage where you sell a property and carry the note at a higher interest rate than you are paying, for a longer term, or both. You collect from your buyer each month and pay your underlying mortgage with their payment to you, pocketing the difference. I do this with a contract for deed until my underlying mortgage is paid off.
There are some creative things being done with wrap around mortgages. Here is one way to use them to make money. You buy a house at a good price with owner financing and no due-on-sale clause. You spruce it up. You then sell the house for a higher price with a low down payment at a higher interest rate than you are paying. For example; you buy an owner-financed house for $40,000 at 7% for 20 years. After a little sprucing up, you sell the house for $48,000 with a small down payment and you owner finance the house at 12% for 30 years. You make money several ways.
1. You make money from the equity increase from the difference in price.
2. The longer finance terms you gave your buyer, means more of each payment you receive will be interest.
3. The longer-term note will keep paying you long after your underlying note is paid off.
4. The higher interest rate you are charging allows you a profit from the interest rate spread.
I am assuming that the down payments cancel each other out and that you can cover the sprucing up cost out of pocket. Also, if your buyer pays you off early, some of your gains will go away. You can delay that time by putting in the contract a penalty clause for early payoff during the first five years.
These deals are being done everyday, and you can do them to. There are buyers out there who cannot qualify for a conventional mortgage that would love for you to do a deal like this. There are sellers who want a quick sale without repairs, who will carry the note.
Key Point: If you want to do these deals you must always be looking for them and you lay the groundwork when you buy the house by leaving your options open. You must avoid a due-on-sale clause when you buy. You want a twenty-year mortgage and a low interest rate. You lock in the profits when you sell by including a due-on-sale clause, charging a higher interest rate than you are paying, and sell with a thirty year mortgage including an early pay off penalty.
Equity Build Up
This is my favorite way that real estate makes you money. Every time you buy a property and rent it out, you create a cash flow to pay the mortgage payments with. You are paying for your property with other peoples money, thus making yourself a little richer every month. That is a very powerful statement. And no income tax is due on this mortgage reduction until you sell the property, if then. The more rental properties you have, the richer you get each month. Think about it, re-read this paragraph!
The problem the average person has when trying to get rich is that they only have twenty four hours a day in which they can sell their services to make money. In order to get rich, you have to solve this problem. One way to do that is to start a company and hire people to work for you. Hopefully you can make a profit on their labors. It works, but has a high failure rate. Another way to solve the problem is to buy rental properties on credit and pay the loans off with other peoples labor paid to you in the form of monthly rent. That is a much lower risk way of getting rich.
Taxes
The tax laws changes that occurred in 1986 had a large effect on real estate investing. The main effect was that you can no longer shelter all your earned income* from taxes by taking real estate losses.
You can still shelter some of your earned income using the income tax deduction from the interest paid on mortgages, property repair expenses, as well as all the operating expenses, all of which are deductible against the properties income at tax time. The buildings and improvements to them may be depreciated to further reduce your income tax liability. The mileage you drive to find the properties or to visit the properties after you buy them provides a nice tax deduction. The profit from increasing prices and equity build up are taxable only when you sell the property and may not be taxable even then. You can exchange the property rather than sell it to delay the taxes even longer and if you pass the properties on to your estate the taxes may never have to be paid.
I do recommend that you request an read the IRS tax bulletin on real estate and the tax laws.
* If you make over $150,000 per year, see your accountant as you may not be able to take full advantage of the tax savings from your real estate investments.
Property Value Appreciation Bonus
This is where the bonus money comes from. Many things can affect the value of real estate such as schools, the neighborhood, crime rates, street improvements, inflation, a new development near by, etc.
Let us assume you buy a house and two years later the city repaves your street, puts in new side walks & curbs, and you get a new driveway entrance at no or little cost. The elementary school builds a new building. A new grocery store and movie theater open up less than a mile away. Inflation is only 2% per year yet your house goes up 12% in value because of all these other positive events that make your neighborhood more desirable. You do not get this money until you sell but you can get a form of it when the leases expire and you raise the rent, or you refinance the house to take out cash. The more homes you own, the more the chance you have to get these extra bonuses.
An actual example:
A friend of mine had a piece of commercial property and was thinking of selling it for about $250,000. He put up a sign that said "Available - 1 acre, Sale / Lease / Build to suit". He priced it at $275,000, leaving a little room to negotiate. Instead of selling the property, which would create a tax liability, he leased it giving the lessee an option to buy at $300,000 any time during the next five years.
By not selling the property my friend got $50,000 richer than he was before leasing it. What did the lease accomplish? He had a monthly income to cover the note he owed the bank. The lessee is paying the taxes and maintenance cost. He does not owe capital gains taxes because he didn't sell the property thus all of the equity is still at work. He got a higher price than a sale would have produced thus getting $50,000 richer. He saved the real estate sales commission as the lessee has the option to buy at a set price. The property value increased because the value is now the economic value of the lease rather than the area's property value comparisons. He can borrow money if need be based on the property's new economic value backed up by the lease. The bank will be more inclined to make a loan taking the property as collateral because the property's value is declared, the lease can be assigned to the bank, the property has income to pay back the loan in addition to the owner's guarantee. The bank will have three ways that they can get re-paid. All of which makes the loan more secure.
The lessee gets to control the property's use without a large down payment and has a set purchase price that won't increase. The purchase option also protects the value of the lessee's property improvements. Because the lessee plans on improving the property, when he is ready to buy he will have the equity needed to get the bank loan as the improvements will increase the appraised value of the property compared to the fixed price of his purchase option. This is a win-win deal.
Improvement Profits
You can make money on some improvements. You must do your homework and be certain that the cost of the improvement will be offset by higher rents and improved value. The two questions are: Will the next buyer be willing to pay as much, or more, than I paid for this improvement? Will the tenant pay more per month if I do this improvement?
A few weeks ago I visited my daughter at her new apartment. The apartment complex had detached garages and storage rooms. When I commented on them she informed me that the garages were $50 extra per month, and the storage rooms were $25 per month extra. What could you do to improve your property and/or increase the income? Carports? Storage? Convert a garage to an apartment? Add an apartment over the garage? Think!
Rent Increases
You profit from rent increases two ways. First your cash flow improves and second the higher the property's net income the more an investor will pay for a property when you sell it. You should check the rental rates every six months for similar properties to yours and increase the rents as needed. When you are buying, you want to find landlords who have not kept up with the market rents and when you are selling, you want to sell based on the highest possible market rents.
Highest Use and Best Use
Once you own a property you should consider if a change in the properties use would increase the income and thus the value. Some properties are what they are and there is nothing better to do with them. Others will have potential and you should review any properties you own to see if there is a better, more profitable use. Some ideas are given below to get your imagination started.
1. Adding a garage apt.
2. Making the house a duplex.
3. Changing the zoning.
4. Changing the type of tenant.
5. Converting from monthly rentals to leases.
6. Adding another building on the same land.