Chapter 2
IN THIS CHAPTER
Keeping your investments close to home
Looking at residential properties
Getting to know commercial real estate
Studying undeveloped land
If you lack substantial experience investing in real estate, you should avoid more esoteric and complicated properties and strategies. In this chapter, we discuss the more accessible and easy-to-master income-producing property options. In particular, residential income property, which we discuss in the next section, can be an attractive real estate investment for many people.
Residential housing is easier to understand, purchase, and manage than most other types of income property, such as office, industrial, and retail property. If you’re a homeowner, you already have experience locating, purchasing, and maintaining residential property.
In addition to discussing the pros and cons of investing in residential income property, we add insights as to which may be the most appropriate and profitable for you and touch on the topics of investing in commercial property as well as undeveloped land.
The first (and one of the best) real estate investments for many people is a home in which to live. In this section, we cover the investment possibilities inherent in buying a home for your own use, including potential profit to be had from converting your home to a rental or fixing it up and selling it. We also give you some pointers on how to profit from owning your own vacation home.
During your adult life, you’re going to need a roof over your head for many decades. And real estate is the only investment that you can live in or rent out to produce income. A stock, bond, or mutual fund doesn’t work too well as a roof over your head!
Under current tax law, you can also pocket substantial tax-free profits when you sell your home for more than you originally paid plus the money you sunk into improvements during your ownership. Specifically, single taxpayers can realize up to a $250,000 tax-free capital gain; married couples filing jointly get up to $500,000. In order to qualify for this homeowner’s gains tax exemption, you (or your spouse if you’re married) must have owned the home and used it as your primary residence for a minimum of 24 months out of the past 60 months. The 24 months don’t have to be continuous. Additionally, this tax break allows for pro-rata (proportionate) credit based on hardship or change of employment. Also note that the full exemption amounts are reduced proportionately for the length of time you rented out your home over the five-year period referenced above.
Some commentators have stated that your home isn’t an investment, because you’re not renting it out. We respectfully disagree: Consider the fact that some people move to a less costly home when they retire (because it’s smaller and/or because it’s in a lower-cost area). Trading down to a lower-priced property in retirement frees up equity that has built up over many years of homeownership. This money can be used to supplement your retirement income and for any other purpose your heart desires. Your home is an investment because it can appreciate in value over the years, and you can use that money toward your financial or personal goals. The most recent version of Home Buying For Dummies (Wiley), which Eric cowrote with residential real estate expert Ray Brown, can help you make terrific home buying decisions.
Turning your current home into a rental property when you move is a simple way to buy and own more properties. You can do this multiple times (as you move out of homes you own over the years), and you can do this strategy of acquiring rental properties not only with a house, but also with a duplex or other small multi-unit rental property where you reside in one of the units. This approach is an option if you’re already considering investing in real estate (either now or in the future), and you can afford to own two or more properties. Holding onto your current home when you’re buying a new one is more advisable if you’re moving within the same area so that you’re close by to manage the property. This approach presents a number of positives:
Turning your home into a short-term rental, however, is usually a bad move because
Serial home selling is a variation on the tried-and-true real estate investment strategy of investing in well-located fixer-upper homes where you can invest your time, sweat equity, and materials to make improvements that add more value than they cost. The only catch is that you must actually move into the fixer-upper for at least 24 months to earn the full homeowner’s capital gains exemption of up to $250,000 for single taxpayers and $500,000 for married couples filing jointly (as we cover in the “Buying a place of your own” section earlier in this chapter).
Here’s a simple example to illustrate the potentially significant benefits of this strategy. You purchase a fixer-upper for $275,000 that becomes your principal residence, and then over the next 24 months you invest $25,000 in improvements (paint, repairs, landscaping, appliances, decorator items, and so on), and you also invest the amount of sweat equity that suits your skills and wallet. You now have one of the nicer homes in the neighborhood, and you can sell this home for a net price of $400,000 after your transaction costs. With your total investment of $300,000 ($275,000 plus $25,000), your efforts have earned you a $100,000 profit completely tax-free. Thus, you’ve earned an average of $50,000 per year, which isn’t bad for a tax-exempt second income without strict office hours. (Note that many states also allow you to avoid state income taxes on the sale of your personal residence, using many of the same requirements as the federal tax laws.)
Many people of means expand their real estate holdings by purchasing a vacation home — a home in an area where they enjoy taking pleasure trips. For most people, buying a vacation home is more of a consumption decision than it is an investment decision. That’s not to say that you can’t make a profit from owning a second home. However, potential investment returns shouldn’t be the main reason you buy a second home.
For example, we know a family that lived in Pennsylvania and didn’t particularly like the hot and humid summer weather. They enjoyed taking trips and staying in various spots in northern New England and eventually bought a small home in New Hampshire. Their situation highlights the pros and cons that many people face with vacation or second homes. The obvious advantage this family enjoyed in having a vacation home is that they no longer had the hassle of securing accommodations when they wanted to enjoy some downtime. Also, after they arrived at their home away from home, they were, well, home! Things were just as they expected — with no surprises, unless squirrels had taken up residence on their porch.
Before we close out this section on vacation homes, we want to share a few tax tips, as found in the current tax code:
Before you buy a second home, weigh all the pros and cons. If you have a partner with whom you’re buying the property, have a candid discussion. Also consult with your tax advisor for other tax-saving strategies for your second home or vacation home. And please see Chapter 18 for more tax-related information on rental properties.
Timeshares, a concept created in the 1960s, are a form of ownership or right to use a property. A more recent trend in real estate investing is condo hotels, which in many ways are simply a new angle on the old concept of timeshares. A condo hotel looks and operates just like any other first-class hotel, with the difference that each room is separately owned. The hotel guests (renters) have no idea who owns their room.
Both timeshares and condo hotels typically involve luxury resort locations with amenities such as golf or spas. The difference between the traditional timeshare and condo hotel is the interval that the unit is available — condo hotels are operated on a day-to-day availability, and timeshares typically rent in fixed intervals such as weeks.
Some of the most popular projects have been the branded condo hotels such as Ritz Carlton, Four Seasons, Trump, W, Westin, and Hilton located in high-profile vacation destinations like Hawaii, Las Vegas, New York, Chicago, and Miami. You can also find many foreign condo hotel properties in the Caribbean and Mexico, and the concept is expanding to Europe, the Middle East, and Asia.
Two types of individuals are attracted to investing in condo hotels and timeshares. One group is investors who believe that the property will appreciate like any other investment. The other group is people who use the condo hotel or timeshare for personal use and offset some of their costs.
We don’t see timeshares or condo hotels as worthy real estate investments as they don’t appreciate and they don’t generate income. But they are often presented as a viable alternative real estate investment and millions have been purchased. You will likely be solicited to consider this opportunity during an upcoming vacation, so we want to share our concerns.
Timeshares are offered as deeded and non-deeded timeshares. With deeded timeshares you own a permanent or fee simple interest, and with non-deeded timeshares you have a right to use the property, but there is an expiration date. (See the sidebar “Still interested in a timeshare? Read on.” for more info on the types of timeshare ownership.) The most popular timeshares are deeded, and they can be sold or transferred just like any other interest in real estate, assuming there is demand.
Many investors’ first experiences with timeshares are tempting offers of a free meal, a great discount offer to a theme park, or even a free one- or two-night stay at the resort, with the catch that they have to spend some time listening to an informational presentation. These offers usually come from individuals contacting you in known tourist locations or when you check into a hotel that just happens to offer condos as well. Robert remembers his first exposure to timeshares was as a child in the early ’70s on a family vacation to Florida, when his parents got a free camera just for attending a seminar on timeshares near Orlando. Even as a teenager, Robert didn’t like the obvious pressure sales tactics he observed.
From an investment standpoint, the fundamental problem with timeshares is that they’re overpriced, and like a condominium, you own no land (which is what generally appreciates well over time). For example, suppose that a particular unit would cost $150,000 to buy. When this unit is carved up into weekly ownership units, the total cost of all those units can easily approach four to five times that amount! (Now you understand why timeshare developers and promoters can give you “free stuff” if you will listen to their sales pitch—their profit margins are very high on every sale!)
To add insult to injury, investors find that another problem with timeshares is the high management fees or service fees and almost guaranteed rising annual maintenance fees over time. As the property gets older, the annual maintenance costs, which you are required to pay to retain ownership of your timeshare interval, continue to increase and can even exceed what you would pay for a comparable stay at a nearby non-timeshare. Is it worth buying a slice of real estate at a 400 to 500 percent premium to its fair market value and paying high ongoing maintenance fees on top of that? We don’t think so.
Many owners of timeshares find that they want to vacation at a different location or time of year than what they originally purchased. To meet this need, several companies offer to broker or sell or “trade” timeshare slots for a fee. However, timeshare availability and desirability have so many variables — including location, time of year, amenities, and quality of the particular resort — that it has been difficult to fairly value and trade timeshares. For a given resort, it can be difficult online to determine which of two identical floorplan units has the prime location, versus a less desirable one. As a result, resort rating systems have been developed (Resorts Condominiums International [RCI] and Interval International are two of the most well known) to compare resort location, amenities, and quality.
The timeshare cancellation strategies often involve either selling your timeshare (almost always at a significant or even a complete loss), attempting to rescind the timeshare (virtually impossible unless you just bought it while on vacation early this week and are still within the “cooling off” or rescission period!), asking the developer to just take it back (most won’t, but rarely one actually will), renting out or gifting your interval, or hiring an attorney who may be able to find a legitimate way to challenge the disclosures or the validity of the timeshare contract.
Timeshare laws vary greatly from state to state, so you want to find a timeshare cancellation company or attorney that specializes in canceling timeshares in the state where your timeshare is located. While you will take a large financial hit when you sell or cancel your timeshare, you need to consider that the benefits of cutting your future losses (maintenance fees) may make such a tough decision the right one.
The developers and operators of condo hotels love the concept because one of the most consistently successful principles of real estate is increasing value by fractionalizing interests in real estate. As with timeshares, the developers are able to sell each individual hotel room for much more than they could get for the entire project.
Condo hotel operators are able to generate additional revenue from service and maintenance fees to cover their costs of operations. Often the owners’ use of their own rooms doesn’t negatively impact the overall revenues of the property because the rooms would have sometimes been vacant anyway. Condo hotels allow their owners to stay in their units but often impose limits on the amount of personal usage. There may also be resort fees, parking fees, or other amenity costs as well.
The purchaser of the condo hotel unit sees this type of investment as an option to direct ownership of a second home and likes the ability to generate income. The professional management is another one of the attractions to investors. The owners don’t pay a management fee to the hotel operator unless their room is rented, and then the collected revenue is split, typically in the 50-50 range, and the operator has complete control over the rental rate as well as which units are rented each day.
These properties are often hyped, and the expectations of the condo hotel investor are often much greater than the reality. Investors are lured to condo hotels by the potential for appreciation and cash flow as well as professional management. Many investors find themselves being pressured into pre-sale offering presentations even before the units are built. These events can be tempting, but savvy investors need to do their own due diligence. So when you hear a sales pitch indicating that your proposed investment in a condo hotel unit will provide significant income from hotel rentals and cover most or all of your mortgage and carrying costs, that’s the time to grab your wallet and find the nearest exit.
If you’ve been in the market for a home, you know that in addition to single-family homes, you can choose from numerous types of attached or shared housing including duplexes, triplexes, apartment buildings, condominiums, townhomes, and co-operatives. In this section, we provide an overview of each of these properties and show how they may make an attractive real estate investment for you.
As an investment, single-family, detached homes generally perform better in the long run than attached or shared housing. In a good real estate market, most housing appreciates, but single-family homes tend to outperform other housing types for the following reasons:
Single-family homes that require just one tenant are simpler to deal with than a multi-unit apartment building that requires the management and maintenance of multiple renters and units. The downside, though, is that a vacancy means you have no income coming in. Look at the effect of 0 percent occupancy for a couple of months on your projected income and expense statement! By contrast, one vacancy in a four-unit apartment building (each with the same rents) means that you’re still taking in 75 percent of the gross potential (maximum total) rent.
With a single-family home, you’re responsible for all repairs and maintenance. You can hire someone to do the work, but you still have to find the contractors and coordinate and oversee the work. Also recognize that if you purchase a single-family home with many fine features and amenities, you may find it more stressful and difficult to have tenants living in your property who don’t treat it with the same tender loving care that you may yourself.
As the cost of land has climbed over the decades in many areas, packing more housing units that are attached into a given plot of land keeps housing somewhat more affordable. Shared housing makes more sense for investors who don’t want to deal with building maintenance and security issues.
In this section, we discuss the investment merits of three forms of attached housing: condominiums, townhomes, and co-ops.
Condominiums are typically apartment-style units stacked on top of and/or beside one another and sold to individual owners. When you purchase a condominium, you’re actually purchasing the interior of a specific unit as well as a proportionate, undivided (meaning, you don’t directly own a portion) interest in the common areas — the pool, tennis courts, grounds, hallways, laundry room, and so on. Although you (and your tenants) have full use and enjoyment of the common areas, remember that the homeowners’ association actually owns and maintains the common areas as well as the building structures themselves (which typically include the foundation, exterior walls, roof, plumbing, electrical, and other major building systems).
One advantage to a condo as an investment property is that of all the attached housing options, condos are generally the lowest-maintenance properties (from the perspective of unit owners) because most condominium or homeowners’ associations deal with issues such as roofing, landscaping, and so on for the entire building and receive the benefits of quantity purchasing. Note that you’re still responsible for necessary maintenance inside your unit, such as servicing appliances, floor and window coverings, interior painting, and so on.
Although condos may be somewhat easier to keep up, they tend to appreciate less than single-family homes or apartment buildings unless the condo is located in a desirable urban area.
Condominium buildings may start out in life as condos or as apartment complexes that are then converted into condominiums.
Within a few years, most of the owner-occupants move on to the traditional single-family home and rent out their condos. You may then find the property is predominantly renter-occupied and has a volunteer board of directors unwilling to levy the monthly assessments necessary to properly maintain the aging structure. Within 10 to 15 years of the conversion, these properties may well be the worst in the neighborhood.
Townhomes are essentially attached or row homes — a hybrid between a typical airspace-only condominium and a single-family house. Like condominiums, townhomes are generally attached, typically sharing walls and a continuous roof. But townhomes are often two-story buildings that come with a small yard and offer more privacy than a condominium because you don’t have someone living on top of your unit.
Co-operatives are a type of shared housing that has elements in common with apartments and condos. When you buy a cooperative, you own a stock certificate that represents your share of the entire building, including usage rights to a specific living space per a separate written occupancy agreement. Unlike a condo, you generally need to get approval from the co-operative association if you want to remodel or rent your unit to a tenant. In some co-ops, you must even gain approval from the association for the sale of your unit to a proposed buyer.
Not only do apartment buildings generally enjoy healthy long-term appreciation potential, but they also often produce positive cash flow (rental income – expenses) in the early years of ownership. But as with a single-family home, the buck stops with you for maintenance of an apartment building. You may hire a property manager to assist you, but you still have oversight responsibilities (and additional expenses).
Apartment buildings, particularly those with more units, generally produce a small positive cash flow, even in the early years of rental ownership (unless you’re in an overpriced market where it may take two to four years before you break even on a before-tax basis).
Commercial real estate is a generic term that includes properties used for office, retail, and industrial purposes. You can also include self-storage and hospitality (hotels and motels) properties in this category as well as special purpose properties (e.g., mobile home parks, amusement parks, etc.). If you’re a knowledgeable real estate investor and you like a challenge, you need to know two good reasons to invest in commercial real estate:
With commercial real estate, when tenants move out, new tenants nearly always require extensive and costly improvements to customize the space to meet their particular planned usage of the property. And you usually have to pay for the majority of the associated costs in order to compete with other building owners. Fortunes can quickly change — small companies can go under, get too big for a space, and so on. Change is the order of the day in commercial real estate, and especially in the small business world where you’re most likely to find your tenants.
So how do you evaluate the state of your local commercial real estate market? You must check out the supply and demand statistics for recent years. How much total space (sublease and vacant space) is available for rent, and how has that changed in recent months or years? What’s the vacancy rate for comparable space, and how has that changed over time? Also, examine the rental rates, usually quoted as a price per square foot. We help you cover this ground in Chapter 12.
For prospective real estate investors who feel tenants and building maintenance are ongoing headaches, buying undeveloped land may appear attractive. If you buy land in an area that’s expected to experience expanding demand in the years ahead, you should be able to make a tidy return on your investment. This is called buying in the path of progress, but of course the trick is to buy before everybody realizes that new development is moving in your direction. (Check out Chapter 10 for a full discussion on the path of progress.)
You may even hit a home run if you can identify land that others don’t currently see the future value in holding. However, identifying many years in advance which communities will experience rapid population and job growth isn’t easy. Land prices in areas that people believe will be the next hot spot likely already sell at a premium price. That’s what happened in most major cities with new sports facilities or transportation corridors (especially because these decisions often are disclosed well in advance of the municipality leadership vote or the ballot initiative). You don’t have much opportunity to get ahead of the curve — or if you guess wrong, you may own land that falls in value!
On the income side, some properties may be able to be used for parking, storage income, or maybe even growing Christmas trees in the Northwest or grain in the Midwest! (After you make sure you’ve complied with local zoning restrictions and have the proper insurance in place, that is.)
Determine what improvements the land may need. Engineering fees; subdivision map and permit costs; environmental studies; stormwater control; running utility, water, and sewer lines; building roads; curbs and gutters; landscaping; and so on, all cost money. If you plan to develop and build on the land that you purchase, research these costs. Make sure you don’t make these estimates with your rose-tinted sunglasses on — improvements almost always cost more than you expect them to. (You need to check with the planning or building department for their list of requirements.)
Also make sure that you have access to the land or the right to enter and leave through a public right-of-way or another’s property (known as ingress and egress). Some people foolishly invest in landlocked properties. When they discover the fact later, they think that they can easily get an easement (legal permission to use someone else’s property). Wrong!
Understand the zoning and environmental issues. The value of land is heavily dependent on what you can develop on it. Never purchase land without thoroughly understanding its zoning status and what you can and can’t build on it. This advice also applies to environmental limitations that may be in place or that may come into effect without warning, diminishing the potential of your property (with no compensation).
This potential for surprise is why you must research the disposition of the planning department and nearby communities. Attend the meetings of local planning groups, if any, because some areas that are antigrowth and antidevelopment are less likely to be good places for you to buy land, especially if you need permission to do the type of project that you have in mind. Through the empowerment of local residents who sit on community boards and can influence local government officials, zoning can suddenly change for the worse — sometimes you may find that your property has been downzoned — a zoning alteration that can significantly reduce what you can develop on a property and therefore the property’s value.
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