My clients Jim and Pam were excited about their first real estate purchase. They were friends as well as clients, so our conversation over dinner turned into a mixture of personal and business. They had a successful business and up until now had put all of their time, energy and money into the business.
It was paying off now and they had more time. Jim was a great handyman kind of guy so the plan was to buy a fixer upper and turn it into a rental. The houses where we lived were just too expensive to make sense as rentals. The rents would never cover the investment you’d have to make in the home.
So they looked in another state that they knew well. Jim went off by himself to buy, but he kept sending Pam pictures. The dinner we were having together was a celebration an unveiling of what they’d bought.
“Well, the deals were so good, I didn’t want to buy just one,” Jim began. “I bought 3.”
Pam jumped in, “And I made sure they were good properties. The kind I would want to live in,” she said and hesitated, looking at Jim. “That is, after Jim fixes them up.”
That was the first red flag. This might not be a good investment after all. When a client says they want investments just like they would live in, chances are they are buying higher end houses. The best deals are usually working-class homes.
Jim and Pam’s neighborhood was anything but working class, with the custom pools, expansive landscaping, custom cherry wood cabinetry, home entertainment systems and ensuite bathrooms for each of the 6 bedrooms.
If the houses they bought were up to that standard, or rather would be after Jim “fixed” them, I wasn’t sure how good the investment would be.
I asked about the budget and expected return once the properties were rehabbed and rented. From the dazed look, I knew that was the first time they had considered that.
Red Flag #2: Buying an investment property with emotion instead of analysis.
Richard and I have had a lot of fixer upper properties that we rent out. Buy the right property and set a preliminary budget. Make sure you have financing figured out. If you can’t do it for cash, how will you fund the fixing part? If it’s credit card debt, plan for a quick out from that high interest rate solution. That could mean a cash-out refi, but make sure you and the property would qualify and that you won’t have to carry big balances on your credit cards for any length of time.
I didn’t want to be a wet blanket, especially at a social dinner so we agreed to meet to talk about the purchases later that week.
When we did, Jim had already seen where the conversation was going to go. He had put together a spreadsheet analysis with the purchase price of the properties, the estimated cost of the rehab and estimated rental income. And, of course, he’d factored in the insurance and property tax cost. Even if they could get a cash out refi (and it didn’t look promising), the mortgage payment would be higher than the rent they would receive.
They could continue to carry the property expenses with credit card debt, but that just made the numbers worse.
They had already closed on the houses so there was no way to back out. And even though there was appreciation in the area, it wasn’t enough in just a couple of weeks to cover all their closing costs.
We penciled out a couple of solutions. Buy and hold. Rent to own to get a better return. Keep one of the properties and sell the others.
In the end, they sold all the properties for pretty much what they’d paid. The closing costs were out of pocket though, a lesson learned.
The moral of this true story is that you have to do your analysis first before you buy real estate investments. Buy like a real estate investor, not a home buyer, if you want to make money as an investor.
On Saturday, 9/18/2021, real estate investor and advisor Matt Bowles and I are putting on a free webinar at 9 am Pacific. If you can’t make it, or you’re reading this blog afterwards, you can go to USTaxAid.com to download your copy. (It’s available when you sign up for tax updates).
To join the real estate webinar, go to LINK.