Real Estate
Evaluate Real Estate As If You Were Running A Business
Many investors who are looking to diversify their portfolios or are weary of the stock market often consider adding real estate to their holdings. While it is true that real estate as an investment can be profitable and an appropriate fit for many portfolios, it is not the sure-thing, get-rich-quick investment that many books and seminars would have you believe.
Investing in individual real estate is far more complex and time consuming than investing in mutual funds. Bear in mind that by investment real estate we mean housing that you will rent out to others for an income stream, not your residence or vacation home. Market values are only part of the data that you should use to evaluate a potential investment. In addition, you must realistically estimate the income and expenses of holding a piece of real estate and evaluate the attractiveness of that investment in comparison to alternatives. In short, if you want to invest in real property, it is best to approach it as if you were running a business.
Many clients ask if residential real estate would be a good investment as part of their overall investment portfolio. Our reply is that to properly evaluate the investment aspects of real estate, you must ‘run the numbers' and be realistic about the projected results. When considering real estate for investment purposes, you should approach the purchase in much the same way a businessperson would evaluate the merits of purchasing a business. Your investment return will be the result of the profit or loss from that rental business.
There are two primary components to consider when investing in real estate. One is cash flow; the other is the change in the value of the investment (appreciation). Cash flow, which is composed of rental income and expenses, can usually be forecast with some certainty. On the other hand, a forecast of appreciation, or the future value of the property, at any given point in time will be an estimation and will probably result in a fairly wide range of possibilities, and therefore not a good indication of the quality of a property as an investment. Many people see the rising property values in their communities and place their emphasis on the future value, but this is a mistake. If you are focusing only on the increasing price, you are speculating on real estate prices, which can be dangerous. It is the cash flow analysis that will help you to determine whether the property is an appropriate investment vehicle for you, and therefore we emphasize cash flow in our discussion.
Cash (flow) is King
While we wouldn't go so far as to claim that cash flow is everything, it is the largest element to consider when evaluating a potential investment. Real estate transactions typically include many inflows and outflows of cash, and you should put on your businessperson's hat to carefully evaluate those transactions. At the basic level, you have an income stream (rent) coming to you monthly, tax benefits coming to you annually, property taxes and insurance expenses flowing out, and maintenance and management expenses also flowing out.
But most landlords will tell you that things get even more complicated than this. There are many hidden costs to real estate investing. Beyond the down payment, you must think about closing costs and the ongoing costs of property taxes, insurance, and maintenance. Periods of vacancy reduce average income. Costs that seem manageable when viewed separately add up when taken collectively. Additionally, many would-be investors are surprised to discover that mortgage rates are higher for non-owner-occupied property, and higher minimum down payments (often 20-25%) are usually required.
Know Your Limits
If you are considering investment real estate, you should also ask yourself the hard questions beyond whether or not the numbers work. Do you have the skills and time to do the maintenance work and how much is your time worth? If not, what are realistic costs to hire trades people like plumbers and electricians? If you plan to manage the property yourself (collect rent, find and evaluate new renters), how much time will that take and what is that time worth? If you plan to contract out, what do management companies charge?
Ask any landlord and they will tell you the job is very time intensive, even if you do hire outside management (who will, of course, take a percentage of your income every month). You should be honest with yourself about your ability and desire to be a landlord. Do you have the time to commit? Would you be able to evict a problem tenant? Are you prepared for calls at 9 P.M. on a Friday evening about a burst pipe? If you travel a lot, who would handle management tasks while you are away?
Understand the Risks
Even if the numbers are in your favor, be sure that you are able to commit your money long-term. Real estate is illiquid as compared to most other securities. It takes time and money to sell a property. If you are going to venture into the investment real estate waters, you should consider real estate to be a long-term investment. Transaction costs as a percentage of the investment are quite high, so frequent buying and selling could easily wipe out a large portion of your return.
Be realistic. Real estate is not guaranteed to be a steadily increasing asset, as demonstrated all too often of late. Local, geographical dips in value can and have occurred. Rental vacancies can place a strain on your personal finances.
Also keep in mind that ownership of property will usually result in concentrated investment risk. Your income stream is dependent upon a single location and is not diversified by geography, style, or many other factors present in a well-diversified portfolio.
Taking the Plunge
You've weighed all of the pros and cons and have decided investment real estate is right for you. Now you just need to find the right property. If you are committed to adding investment real estate to your holdings, make sure that you thoroughly evaluate the potential investment and understand its place and impact on your entire investment portfolio.
There are many different tools that you can use to evaluate a potential investment. We will discuss only a few of them here.
Cash Flow Diagrams
A cash flow diagram is a picture of a financial problem that shows all cash inflows and outflows plotted along a horizontal time line. It can help you to visualize a financial problem, in this case expense outflows (taxes, maintenance, mortgage payments) and income inflows (rent, tax breaks).
The time line is a horizontal line divided into equal periods such as months or years. Each cash flow, such as a payment or receipt, is plotted along this line at the beginning or end of the period in which it occurs. Funds that you pay out such as mortgage payments, taxes or maintenance expenses are negative cash flows that are represented by arrows that extend downward the time line with their bases at the appropriate positions along the line. Funds that you receive, such as rental income, are positive cash flows, represented by arrows extending upward from the line.
Spreadsheet
A spreadsheet could be organized similar to the cash flow diagram. Each column could represent months or years, and each row would contain a different income or expense item. The after-tax cash flow should then be analyzed to determine the potential investment value of the real estate property.
Additional tools
Calculating the price-to-rent ratio for a particular market (median home price divided by rent for a three-bedroom house) can tell you a lot about the market in a potential property's area. The bigger the number, the less likely you are to make money. You can find the information you need to calculate this ratio on realtor.org and huduser.org. Currently, for the state of California overall the price-to-rent ratio is the highest in the nation.
Experienced investors say that looking for annual rental revenues of 15-25% of a property's value should help you to weed out potentially poor properties. In many coastal areas, this type of revenue stream is highly improbable. While a lower rental revenue stream does not automatically indicate that a property is an unsuitable investment, it should alert you to look carefully at the other numbers.
Part of any full evaluation of a possible real estate investment is an analysis of both current market conditions and future markets for the sale and rental of your potential property. Even though you are focusing mainly on cash flow, it would be wise to familiarize yourself with historical cycles of contraction and expansion in real estate markets you are considering.
It is also important to do a market analysis for the area in which you want to buy. What are the demographics for the buyers and renters in the area? Who are the main employers in the area? Are they in industries that are growing or contracting? Has there been population growth in the area?
Planning For Success
Once you have found the property whose numbers work for you, your preparation is not over. Just as in business, you now have to watch your costs and plan for success.
It is critical that you have money available to cover unexpected expenses and vacancies. Water damage, earthquakes, renter damage, and other perils are always possibilities. Such occurrences may result in significant cash outflows, and possibly even costs to help your tenants find temporary housing. Even barring acts of nature, vacancies will happen. Not having the funds available to get you through times of negative cash flow can wreak havoc with your bottom line, and may even put the ownership of your property in peril.
Have a list of contracting professionals that you might need before you actually need their services. Building relationships with local professionals can benefit you both by potential reduction in costs and quicker response time. At the very least, you don't want to be fumbling through the yellow pages when one of your tenants calls at midnight with an emergency.
Screen tenants carefully. Nothing can throw a wrench into your cash flow faster than deadbeat tenants. The eviction process is long (and often expensive). During that process you may not be collecting any rent from your deadbeat tenant. Make sure that you run a thorough background and credit check on would-be renters. Call old landlords, not just the tenant's current one. Less scrupulous current landlords may want to get rid of their problems tenants by foisting them onto you, and therefore may be less than forthcoming. Be thorough. It is far easier to be meticulous before renting out a unit than it is to evict a tenant after the fact.
Make sure you take advantage of all tax breaks. There are many tax benefits that result from the ownership of investment property. If you prepare your own taxes, make sure that you understand all of these so as not to miss out on any deductions for which you would be eligible.
Protect Yourself and Your Assets
Investing in rental real estate exposes you and your assets to potential lawsuits. Make it a priority to protect yourself as best as you can. Know the law. It is important that you know not only how the law protects you, but also how it protects your tenants. Some cities are known for more stringently protecting tenants' rights under the law than others. Violating one of these laws, even inadvertently, could be costly.
In order to mitigate the risks to you, make sure that you adequately protect your other assets. At the very least, buy an umbrella insurance policy that covers you for a minimum of one million dollars.
At Pleasanton Financial Advisors, we can help if you are considering a real-estate purchase. We have experience in evaluating investment opportunities from the perspective of a business owner and in evaluating the appropriateness of investment real estate to your portfolio and your needs.