Q: I am planning to start investing in real estate. I have read your past columns about how to manage rental property. I agree with the two points you made, the first being that this will be a part time job for me and the second is the importance of finding a good tenant. Now that I’m ready to get started. Can you give me some information regarding the initial purchase? I am learning some basic rules of thumb, but I want to feel very comfortable that I am not gambling.
A: First of all, there’s an old saying in real estate that you make your profit when you BUY, not when you sell. In other words, you have to buy the property at a low enough price so that you are certain to make a profit when you sell. If you count on appreciation to raise the value of your property and generate a profit, then you really are gambling.
Every time the housing market gets hot — as it is now throughout most of the Puget Sound region — the “get-rich-quick” gurus come out of the woodwork telling you to buying real estate for “no money down,” hang on for a year or two, and then sell for a big profit. In fact, the latest “get-rich-quick” scheme is buy houses and immediately re-sell them at a higher price. This is called “flipping” and I addressed that in a recent column.
Your question deals with buy-and-hold property, so I will focus on that strategy in this column. If you buy a rental property with little or no down payment, it will be virtually impossible to generate enough rental income to cover the high monthly mortgage payments – not to mention the typical maintenance and repair costs. You would have a negative cash flow, which means that you would be paying money out of your pocket every month just to hang onto the property. Real estate investors call this an “alligator” because it will eat you alive. Your only hope of turning a profit is that property values will go up faster than you are losing money in monthly carrying costs. In my opinion, that’s a risky bet.
Now, I know that you may be looking at the skyrocketing real estate values in your neighborhood and think this is a “can’t lose” investment. But trust me, the housing boom will not last — it never does. That last time I saw the local housing market this hot was back in 1990. Housing prices zoomed up about 20 percent from January to March, when the market peaked. Over the next few months the prices came back down to January levels. People who bought homes before the 1990 “bubble” did just fine. People who bought after the bubble also did fine. But about 50,000 people in King and Snohomish counties bought homes at the top of the market and they ended up taking a loss if they had to sell their home in the next few years. Of course, the housing market took off again in the late 1990’s and surpassed the peak housing values set in 1990. The people who were not forced to sell during the early 90’s downturn did fine. The moral of the story is that you can make money with appreciation, but it is not guaranteed. If you are not financially capable of holding the property for at five to seven years, you may be forced to sell in a down market and lose some or all of your cash investment.
So the best way to minimize your risk is to try to buy a property below market value so that will not lose money if you are forced to sell sooner than expected. Frankly, that is very difficult to do in today’s hot housing market. So the next best strategy is to concentrate in lower priced housing areas where there are homes that are affordable to first time home buyers. Even when the housing market slows, there are always people looking to buy their first home. So don’t limit your search to your local neighborhood. For example, I bought a rental house during the housing boom of 1990 and I had to go all the way to Tacoma to find a house that I could buy at a low enough price to make it a viable investment because prices were far too high in the greater Seattle area. I paid full market value for the house at that time and I still own the house today.
Try to find a property that you buy at a low enough price, and with low enough mortgage payments, to at least break-even with your monthly rent income. That probably means making a fairly big down payment of 10 to 20 percent and shopping very hard to find a decent deal. If possible, try to stay within a 30-45 minute drive from your home in order to make it easier to rent and manage the property. However, you may have to go farther out if you live in a fairly expensive housing area. Don’t rush, take your time and make sure you buy right.
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