Being aware of too-good-to-be-true results

Maybe you’ve seen signs like this on busy streets in your town: “Real Estate Investor seeks intern. Earn $10K per month.” Feel free to call and check it out for yourself. It is possible that you will be that one in a million who finds the person putting out those signs to be legit, but the reality is you are being tempted with promises of unrealistic earnings to buy “training materials” or be the latest shill in a multi-level marketing enterprise that likely isn’t actually actively buying real estate.

Or — and actually better, but not by much — you will be calling a wannabe real estate investor who wants you to do all of his legwork and will pay you for every great deal you bring him. The problem is that great deals aren’t easy to find, and you could spend countless hours doing the time-consuming and backbreaking work of looking for that needle in a haystack that your “boss” will actually end up acquiring. Sorry, but neither scenario would be one we would endorse.

We do favor learning about real estate investing from experts, and that may be a reason why you bought this book. But, you will see in all of our real estate books that we share not only our successes but the failures and lessons learned along the way. We also have followed every single piece of advice ourselves over the last 30+ years and have started from the ground up with no rich uncles or large inheritance. So we know it isn’t easy, but with a good plan, a lot of hard work, and a large dose of patience, you can do this on your own.

Understanding why we recommend skipping these investments

The concept of buying real estate without using any of your own money is clearly dependent on finding an extremely motivated seller. A motivated seller is one who faces circumstances that don’t allow him the flexibility to achieve full market value for his property. For sure, a certain number of motivated sellers exist in any market.

The late 2000s/early 2010s downturn in the real estate market and its aftermath may have seemed a perfect opportunity to explore the benefits of putting less money down to purchase a property. The reality was that most lenders were no longer in the creative financing business after being burned by the stated income or “no doc” and similar subprime loans in which the buyers had no equity or “skin in the game” and were essentially gambling and counting on unsustainable appreciation to create equity.

There were also fewer sellers with significant equity in their properties, so the margin for seller financing was diminished. Low money down and/or installment sales are much more likely and feasible when you have a seller with plenty of equity. However, many of the most motivated current sellers are owners of properties in which they owe as much as or more than the property’s current market value.

The stock market is a relatively liquid market where buyers and sellers can enter or leave the market quickly with broad knowledge of current pricing. In contrast, real estate assets are illiquid — it can take a relatively long time to enter or leave the real estate market. Real estate is also unique: A share of your favorite stock always represents the same investment; not so with real estate. This creates the opportunity to profit from pricing inefficiencies from one property to another. Also, the ability to complete a real estate transaction quickly provides an additional factor that can affect the price.

The following are examples of motivated sellers who may be willing to accept a no-money-down real estate offer:

• A seller who’s relocating and needs to sell in a hurry: An owner who’s leaving the area may need to quickly sell his home so he can buy a replacement home in his new location. In order to complete the sale in a timely manner, he may be willing to lower the price to slightly below the full market value (the price he could have received if he were not in such a hurry).

  Finding a seller in a hurry is one of the most reliable ways to buy real estate with little or no money down.

• A seller who’s desperate to sell and exasperated by the effort: The owner of a property that has been vacant for an extended time period or that requires extensive renovation may be eager to sell. The property may have a deadbeat tenant, or maybe it’s vacant after being destroyed by the last tenant and the owner lacks the cash to make the significant required investment in repairs. This type of seller may be willing to offer generous seller financing terms or even pay you to remove him from his liability.
• An owner that is burnt out on self-managing his rental property: Many real estate investors acquire properties gradually over time and choose to do their own management. Nothing wrong with that. But after many years — either due to their age or desire to simplify their lives, or because their local market suffers due to some negative event or their current tenants are stressing them out — they simply want to “retire” and may entertain a below market offer.
• The current owner may have challenges in his life with his health, relationships, or job: Managing rental properties is time consuming and at times draining, both emotionally and financially, especially when something major — such as replacing a roof or repairing the damage from a burst pressurized water supply line — needs to be done. Also, any reason that the current owner no longer has other sources of income that can support rental properties with negative cash flow can be an opening for you. Most owners have mortgages with monthly payments due, and if the property isn’t generating enough income to cover the mortgage and operating expenses, the owner has to come up with the additional cash from other sources.

We have no problem with buying real estate at a great price, but we cannot endorse many of the “No or low money down” concepts that essentially are taking advantage of another person’s tragic circumstances. Our experience has been that you can make good deals and buy at below market prices while still being ethical and treating people fairly (and even sleep comfortably every night).

But even when sellers find themselves in such positions, who will stamp “Desperate to Sell” on their forehead? Trying to determine a seller’s motivation takes effort and investigation. Check out Chapter 13 for more on the subject.

Although, clearly, such real estate owners exist, they’re not as common as some of the real estate investment gurus would have you believe. There are always amazing anecdotal success stories, but there are many more untold stories of cocky novice real estate investors who found out the hard way that you get what you pay for. One of Robert’s favorite idioms combines two well-known adages: “There is no free lunch as you get what you paid for.”

Finding no-money-down opportunities (if you insist)

No-money-down sellers are in greater abundance in a weak real estate market (or buyer’s market) because sellers have fewer options. The target market for no-money-down deals is a real estate market environment with highly motivated sellers facing dire consequences (including foreclosure, which we discuss in Chapter 3) unless they dispose of their property. Usually, sellers who need to sell quickly are in one of the following situations:

• A seller who has had some unfortunate circumstances such as an illness, disability, a death in the family, a divorce, a job loss, or a significant loss of income such that she can no longer afford to make the payments and handle the ongoing expenses of the property — this situation is often the one that leads to a no-money-down offer. Because of her compromised situation, such a property seller may not readily qualify for new or additional loans that would allow her to handle the cash flow dilemma she faces. Although home equity loans may be available in these circumstances, the owner may be so financially overwhelmed that she prefers to sell her property and downsize her financial obligations to a more manageable level.

• A seller with significant equity but limited options to tap that equity is likely to have cash flow problems, but the overall equity in the property can allow her to act as a lender to you (see Chapter 8 for seller-financing strategies).

  The two most common good candidates (as opposed to the classic definition of owners who would be flexible out of desperation) for no-money-down scenarios are

  • Folks at or approaching retirement age who would prefer a steady income stream to a lump sum
  • Individuals who inherited the property and are looking for monthly income without the hassles of being a landlord

In order to know whether the candidates you’re considering fall into one of the preceding scenarios, you need to assess their motives. Chapter 13 helps you do that.

The buy-and-flip strategy

The buy-and-flip strategy can also work with existing homes that the investor can purchase from a motivated seller at a wholesale price that is below the market value. The investor may not even have to close escrow before finding a buyer willing to pay a retail price. There may be some minor cosmetic work or simple improvements needed before reselling, but typically, buy-and-flip investors really make their money when they buy at a discount and then locate a buyer at full market value.

You generally can only do work on a property that you have closed upon and own. Even if a seller allowed you to do work on it before closing, you’re taking a huge risk (loss of your money and time spent) doing it in the event that the deal ends up falling apart for some reason (such as you don’t get financing, an inspection finds something concerning, and so on).

This high-risk strategy requires a rapidly rising real estate market with higher-than-normal appreciation rates to allow for profits on short-term investments. Not only do you have to have excessive demand driving up the prices of real estate, but you also have to cover all the costs of real estate. With online stock trading firms, you can buy shares of your favorite company in minutes with relatively low transaction costs. But with real estate, the costs of buying, holding, and selling a property are much higher and unknown, and generally include

• Acquisition costs: Due diligence and inspection fees plus loan fees/costs and points
• Transaction costs: Closing and escrow fees
• Repair or upgrade costs: Costs and contingencies to renovate or fix property to make it more desirable and generate the highest resale price (unless the property is brand-new)
• Holding costs: Property taxes, insurance, association dues, and any negative cash flow while the property sits vacant or if the rental income doesn’t cover the carrying costs
• Sales costs: Commissions and title insurance from the sale of the property

Even during the weak real estate market in the late 2000s/early 2010s, you saw late-night infomercials promoting the flipping strategy, but they often cited examples with just limited information. These ads featured an average Joe who invests his excess income in a fixer-upper down the street — he pays $150,000 for it and then sells it for $200,000 after replumbing the property and installing all new flooring, window coverings, and appliances. The infomercials imply that he just made a quick and effortless $50,000.

But what they don’t say is that he has $3,000 in acquisition costs, $2,000 more in transaction costs, $15,000 in repairs and upgrades, and $10,000 in sales costs for a total of $30,000. That brings the theoretical profit down to $20,000 before factoring in holding costs. Even if everything works out well for Joe, his property likely sits empty for at least six months while he renovates it, puts it on the market, and shows it to prospective buyers. So by the time Joe has completed this investment cycle, he’s quite possibly spent another $6,000 in mortgage interest payments, plus $2,000 in property taxes, insurance, association dues, and utilities. His pre-tax profit is now $12,000 if everything goes well. But wait — there’s more. Because he only held this investment for less than one year, he pays income tax at his nominal ordinary earned income tax rate of, say, 30 percent, which brings his realized profit down to a measly $8,400.

But what if there are some additional problems with the property when Joe opens up the walls to replumb his new investment gem? Maybe there are termites or roof leaks or problems with the foundation. What if the demand for this property diminishes and he has to hold the property for 12 months? (Some folks got burned in the late 2000s/early 2010s when the demand for housing suddenly evaporated.) Even in the best scenario, where Joe has accurately estimated the repair and upgrade costs and there are no surprises, he finds that just owning the property for six months longer than he expected doubles the holding costs from $8,000 to $16,000, reducing the pre-tax profit to $4,000. By the time he is done paying 30 percent of that in taxes, Joe has just $2,800 to show for all his efforts, or less than Joe would have earned with even a minimum wage part-time job.

You probably know people who are addicted to those reality “buy and flip” shows on your favorite cable network. Robert travels a lot, and with free entertainment now a feature on most airlines, he frequently sees people or couples who seem to be obsessed with these shows. But, as you hopefully know, not even one of these acquisitions of the “worst home in the neighborhood” is miraculously renovated and resold in record time for a handsome profit. Often the true costs of labor and the investment capital, as well as utilities and property taxes, don’t find their way into the “profit analysis.” Also, be suspicious if your favorite flavor of this formulaic get-rich-quick strategy always has a happy and profitable ending.

You may be located in a market that has experienced rapid housing price increases, but be careful. If there is too much excess demand for new housing in the area, real estate speculators — not long-term investors or homeowners — can make up the majority of the purchasers. This tendency can be dangerous when the majority of buyers in the market are looking for a quick profit rather than a long-term, stable real estate investment. When enough of these speculators head for the exits (as happened in some areas in the late-2000s/early 2010s real estate market decline) and don’t return, prices can quickly turn down. The speculators are then forced to mitigate their losses by renting out their properties (sometimes for years) until the real estate market rebounds and they’re able to sell the property to break even.

For example, the greater Las Vegas area in the early to mid-2000s became known as a place where investors could make quick cash. The large number of new home tracts and increased demand and rising new home prices over a relatively short time frame created an opportunity for aggressive investors to place small cash deposits on new homes that were going to be built. Typically, each new phase of a developer’s project would see price increases (annualized at 10 to 20 percent in many cases), so these savvy investors would sell their holding at a profit to a buyer just about the time the new home was completed for a nice return on their investment. Las Vegas wasn’t the only part of the country that experienced this real estate investment strategy, but it was the most prevalent with an estimated 40,000 to 60,000 of investor-owned homes (many of them vacant with no demand from buyers) after the financial and real estate markets collapsed starting in mid-to-late 2007.

But we’re pragmatists — we know that lightning may strike and you may run into a property that turns out to be a buy-and-flip candidate. So in Chapter 13, we detail how to keep this possibility open by using an assignment clause when completing a purchase agreement. And we also cover possible tax drawbacks of losing the advantages of lower capital gains taxes in Chapter 18.

Another recent trend in major metropolitan areas entails construction or real estate investing companies seeking sellers with significant equity in an older, tired home or condo. They aren’t looking to buy the property but instead offer to develop a complete renovation plan to modernize and upgrade the property and will even cover all of the expenses. They then will market and sell the property, getting back all of their upfront renovation costs plus all of their markups or operating margins, and then they will “split the profit,” which is the theoretical difference between the market value of the unrenovated property and the actual sales price of the fully renovated property. While there is nothing wrong with this concept, one needs to make sure that the “before” and “after” market values used to calculate profit, as well as the cost and overhead of the renovation work, are fair and reasonable.

The buy, fix, and refinance strategy

With the buy, fix, and refinance strategy, you invest in properties where value can be added to the property through repairs, upgrades, and improvements that take a distressed property and turn it into a solid and well-maintained property with a good stable tenant. Over the years, with increased equity in the property and as long as interest rates are attractive, you could refinance the property if you so choose and use some of your equity toward other real estate investments.

We strongly prefer this method because it has proven throughout the years and decades to be the lowest risk, highest probability way to make money in real estate. You can think of it as the tortoise in the old tortoise-and-the-hare story, where the hare is the fast-money, high-risk, high-return strategy. The tortoise may be slow and steady, but he ends up winning in the long run. As an example, Robert is a conservative person by nature, yet he has acquired a significant real estate portfolio by simply purchasing well-located but often distressed and poorly managed properties and renovating, filling them, and then refinancing and holding them for the long run. You will find that physically distressed or abundant deferred maintenance is a cornerstone of rental properties that are poorly managed. So, your best acquisition target should be a “twofer” where you can address the physical and fiscal/mismanagement deficiencies at the same time.