A Primer on Real Estate Investing

 

First, of course, the legal disclaimer

 

Please note that the information in this guide is not to be used as consulting, accounting, or legal advice. The following information is provided with the understanding that this article is not a substitute for professional advice, and is merely for informational purposes. TheFinanceResource.com is not responsible for the use of any information contained below or for the factual accuracy of any statements made below.

 

The Article

 

Real estate is a very complicated world. You may be familiar with late night advertisers hawking “no money, no credit, no problem” schemes that seem almost too good to be true. In fact, an over familiarity with Carleton Sheets is a common sign of insomnia (just kidding). The truth is that those programs are extremely high risk investments that prey on those that want to get rich quick. True real estate investing is a slow way to become wealthy. It can be an extremely rewarding venture provided that the investments are done in a safe manner. One of the best aspects of real estate is that you can safely leverage your investment so that the final payoff will be several times the down payment. Additionally, a constant stream of income can be provided as well. While the rewards of real estate are wonderful, the risks can be extremely high. If you read other books/articles about real estate investing, they will tend to play up the benefits of the asset vehicle without properly examining the risks. This part of the text is devoted to the financing of real estate and alternatives to the outright purchase of properties. If you decide to build a real estate portfolio then you should consult several professionals and texts before any serious investment plans are implemented as this article is just a brief primer on the complexities of real estate financing.

 

When you purchase an apartment complex, home, or commercial building, the chance that you will only put down a portion of the overall cost is extremely high. Banks and finance companies love lending money to real estate investors because the collateral (the building itself) is easily sold in the event of a default. Unlike a business loan, where the lender can lose all of their investment, real estate is tangible. In a typical real estate scenario, you will be required to put down at least 10%-20% of the net cost of the building. No money down purchases are completed by having the owner of the building provide the down payment for the property in the form of a second mortgage. This increases the risk dramatically because now there are two mortgages to pay. The owner held mortgage usually carries a much higher interest rate than the traditional bank loan because in the event of default, the previous owner is second on the list of creditors to be repaid.

 

In certain exceptions, the lender may extend more credit than the usual 80%-90%. These loans are generally used to rehabilitate old, broken down homes that are going to be sold once the building is renovated. “Rehabbing” a building has significant risks. This type of investment scenario is the most commonly hawked product on late night infomercials. Wealthy borrowers with exceptional credit may be able to receive higher leverage ability because of their overall financial resources.

 

There are several types of financing methods available for purchasing real estate. The route that you chose will depend on what type of real estate transactions that you will engage. Real estate finance can be quiet complicated, but it can also be the most creative aspect to finance that you will encounter. As you engage in larger real estate deals, the financial aspect will become exponentially harder. It is important to work with a lending institution that understands the needs of real estate investors. Some lenders tend to frown upon furious acquisitions of property regardless of the cash flow produced from the tenants.

 

Local banks tend to be the first stop among novice real estate investors because it seems to be the most convenient. It is important to shop for the best rate before you accept a loan from a loan officer. Mortgage brokers offer a wide range of loan products. The benefit of using a broker versus a banker is that they are not bound by any lending institution. A mortgage broker works for you, and not a bank. There has always been a debate as to whether or not a mortgage broker is more expensive than a direct lender. Typically, the fees associated with using a mortgage broker are in line with what you would pay at a bank or with an independent mortgage banker. Brokers receive discounts on the mortgages that they originate and then add a certain fee to the overall cost. These fees are known as points, and are charged against the overall amount of the loan. For example, two points on a $100,000 mortgage is $2,000. The drawback to the broker is that they do not fund their own loans and nor do they make the decision to lend money to you. Mortgage brokers simply act as your liaison among several lending institutions.

They will pull your credit report, negotiate the interest rate and loan covenants, and close the deal on the behalf of the lending institution. Mortgage bankers are independent lending institutions that originate loans and then sell them to a group of investors. Unlike a mortgage broker, a mortgage banking company directly lends money to you to purchase real estate. Similarly, the mortgage banker will add a fee to the loan that you will pay at closing. Mortgage bankers that sell their loans make additional money upon the sale of the loan to an investor. If you are planning to do a lot of real estate business then it would be in your better interest to retain a good mortgage broker. Brokers may be able to solicit equity and bridge financing when needed, which is not usually done by mortgage bankers.

 

Real estate investment trusts (REITs) are another way to enjoy the benefits of the asset without exposing yourself to the risks of borrowing or the hassle of managing properties.

REIT’s are traded on the stock exchanges, or they can be purchased privately through certain broker-dealers. When you purchase a REIT, you are obtaining a piece of many properties that are usually high quality Class A real estate. Other REIT’s specialize in the origination, sale, and investment in mortgage notes. These funds are similar to bonds because they payout the money received from debtors. When interest rates rise, mortgage and property REIT investments tend to do poorly. This is especially true for investment companies that purchase mortgages. When a REIT lends money to purchase a building, they are not lending their own money. Usually, these businesses borrow money in the form of very large lines of credit. The interest earned on the mortgage goes toward paying the interest expense on the line of credit. These borrowing facilities (formally called mortgage repurchase facilities) are typically tied to a floating interest rate such as a treasury yield. Interest rate hikes make the spread between the cost of borrowing and the interest received from debtors to narrow, which causes lower profitability. If the debtor has a fixed rate mortgage, the investment company can lose money should the market interest rate increase past the rate on the fixed mortgage loan. The prospectus of each REIT will discuss in length the risks associated with their holdings. Sometimes, REIT managers will use interest rate derivatives to obtain the same income regardless of the interest rate environment.

 

The rates of return on REITs tend to be less than what you would receive for purchasing properties outright. This is because the expenses of maintaining high end real estate are much higher than a local apartment complex. Also, these management companies tend to hire seasoned experts to manage financing, appraisal, and tenant relations in order to have stable occupancy rates. Part of the reason that the returns are lower is because the risk associated with REIT is significantly lower than purchasing real estate outright. Additionally, the leverage normally used in real estate is not used. Debt to equity ratios are much lower for publicly traded REITs. There are complicated tax implications created by real estate investment trusts. Investment trusts are required to pay out 90%- 95% of their total earned income so that they can avoid the double taxation of dividends. Your tax specialist will be able to determine whether or not the dividend paid to you from the management company is a qualified dividend.

 

Real estate limited partnerships are another way of gaining entry into the real estate world without having to manage the property. These partnerships also offer limited liability from banks and lenders should the properties default. One of the aspects of a limited partnership is that the depreciation and gains/losses are passed directly to your income statement. There is not a double taxation provision, and in some instances you may be able to credit the depreciation and gains/losses against your ordinary income. However, the tax code has changed significantly over the last few years and a law that has separated passive income from ordinary income now exists. As always, a tax advisor will show you what deductions and taxes are associated with limited partnership investing. The minimum required investment for these partnerships can vary from $25,000 to millions of dollars. Higher end partnerships incorporate a plethora of managers and expertise. Unlike securities based hedge funds, real estate partnerships may be unregistered investment vehicles that do accept non accredited investors. Real estate management companies may not fall under the provisions of the Securities Act of 1933. When dealing with investment partnership agreements, you should consult a lawyer and accountant about the language used in these documents. Partnership agreements tend to be very complicated documents, and a real estate lawyer will help you understand the language used in these agreements. A real estate limited partnership operates in a similar way to a hedge fund. A managing partner handles all of the day to day operations of the business and then passes the profits or losses to the individual partners.

 

Your success in real estate will also depend on your ability to negotiate a deal. This type of investing is complicated because there are no definitive rules or strategies that can make your real estate successful. Unlike a stock exchange where prices are determined by a market price, real estate investments are difficult to value. Additionally, real estate agents have a conflict of interest as they do not work on your behalf. They are paid on a commission basis, and it is in their best interest that you pay a high price for the property. Later in the article we will look at conflicts of interest in real estate investing. When determining a building’s value, make sure that you have a licensed appraiser help you in determining fair worth. It is important to also check on the prices of homes that are comparable in the same neighborhood, area, etc.

 

Time is a very important element in real estate. Investments in brokerage accounts work automatically after you’ve implemented your strategy. Real estate is different. You may have to deal with nonpaying tenants, lackluster property management firms, taxes, contractors, etc. If you are overwhelmed with other activities in life then it may be in your best interest to purchase REIT vehicles versus actual buildings. An alternative to managing your own properties is to allow a property management company to do the work for you. A property management firm will handle all of the aspects of your building for a fee. This fee can be as high as 10% of the gross rent collected. If you do not have the time to manage a property effectively then a property management company is a must.

 

The other element to real estate is the people. Real estate people can be pushy as their income depends mostly on commission income. There are very few rules to making real estate deals, and this can make things rather complex. This industry is a jungle, and it is not for the faint of heart. Unlike the securities industry where advisors, investors, and traders are bound by a seemingly endless amount of rules, real estate investors have very few legal restrictions in the methods of which they can deal. For instance, it is not illegal to trade on inside information with respect to real estate deals whereas it is a very serious offense to profit from inside knowledge of a stock transaction.

 

One of the problems with real estate investing is that a lot of the people that operate in real estate have conflicts of interest. Real estate agents are the worst offenders. When purchasing a property, it is in the real estate agents best interest for you to pay a higher price as they are paid on a commission basis. Typically, there are two agents that are involved in any transaction: an agent for the seller and one for the buyer. In most transactions, the two agents will split the commission received for the sale. You can see where the conflict of interest exists. It is in the best interest for your real estate agent to have you pay a higher price for a property despite the fact that they are representing you. However, the real estate brokerage industry is going through some great changes. The internet is causing many ‘brick-and-mortar’ brokerages to lower their commission schedules. Discount brokerages are also becoming popular. The average seller will pay six percent of the sale price to the real estate agents. This is an extremely high price to pay for not much work on the part of the brokerage firm. Imagine, if you were selling a building/home for $500,000 then your agent be paying $30,000 to your real estate agent.

Doesn’t this seem a little high for how much work your real estate agent actually does?

Discount brokerages have begun charging two percent or less for their services. As competition increases, I am certain that the rates of real estate brokerages will continue to decline.

 

Mortgage brokerages work in a similar manner. Their interests are in direct conflict with your interests in securing a reasonably priced loan. These brokers are paid on a commission basis, and therefore finding you the best rate on a loan is not always their top priority. In certain instances, certain brokers may receive compensation from the lending institution that grants the loan. An ethical mortgage broker should provide you with a summary detailing their compensation for the loan. Mortgage banks and commercial banks profit from your loan in two ways. When you close a loan at a lending institution the bank or finance company will often charge points on your loan directly to you. Additionally, the loan will be sold to another investor such as Fannie Mae at a markup that can range anywhere from one to three percent of the total value of the loan. Banks and finance companies rarely hold loans very long anymore. The primary source of income for financial institutions is fees and not interest income. These institutions are not required to disclose the amount of money they receive from selling your loan to another investor. However, this industry is also going through changes. Many of the direct lending institutions are beginning to charge flat fees instead of a percentage of the loan amount. This is especially true with lenders that loan money in the form of home equity loans and second-lien mortgages. The competition to close loans has intensified with the decline of interest rates over the last five years. This is a direct result of financial institutions selling their loan assets into secondary markets. These institutions are now dependent on an increasing number of deals instead of receiving revenues from interest payments from borrowers.

 

Credit scoring is an important part of your success as a real estate investor. Although your real estate purchases may be made through a corporate entity, your debts will almost always have to be personally guaranteed. Only after you have proved years of success will a bank or finance company offer you the ability to borrow without having to personally guarantee the loan. Your credit score will be an important factor when approaching a lender for a loan. One of the interesting things about the proliferated use of credit scoring is that it has made lending much more of a quantitative science. Years ago when a person wanted a loan from a bank or finance company was at the mercy of their banker. Additionally, the credit scoring system has equalized the lending markets. The credit scoring system is primarily based on a set of algorithms developed by Fair, Isaacs, and Company. Credit scores are also referred to as FICO scores. The exact methodology for computing credit scores is not known, but in order to have a good credit score you must pay your bills on time, and not have over extended your existing credit lines. Small discrepancies or negative remarks on your credit report can dramatically reduce your

FICO score. Before approaching a lender when seeking a loan, you should obtain your credit report. If you fix all of the negative items before applying for a loan, you will have a much smoother process.

 

Banks and finance companies do not lend solely on credit scores. If you plan to purchase a piece of real estate for investment purposes then it is important to have projected cash flows and a brief market analysis. This analysis should be built in the same manner as you would for a business plan. In addition to being a worthy credit risk, banks and finance businesses want to ensure that you are knowledgeable about your future venture. Finally, real estate investing can be one of the best investment vehicles that you use, but it can and will come with a number of headaches. Disputes relating to real estate purchases can be tied up in courts for years, and so anything done in this world should always be carefully planned. Always retain the services of a good lawyer and accountant before starting any real estate venture, and remember that some of the people that you will employ for your real estate investing have interests that conflict with your own.