Editor’s Note: Dennis Fassett is a former corporate finance executive turned real estate investing “Cash Flow Mercenary.” Dennis specializes in single-family and multi-family cash flow properties and thoroughly enjoys assisting his fellow investors with their own strategies, including how to buy your first apartment building.
As an ongoing contributor to Mogul’s “Market News Updates,” Mr. Fassett provides us with his own unique, lively, and thought-provoking commentary on the timely industry news and events of today that are impacting our industry. And be sure to check out his other super-helpful Market News Updates. For now, enjoy...
From Dennis Fassett, Cash Flow Mercenary...
Well, it seems that the mainstream financial media is jumping on the rental real estate bandwagon – with gusto.
And quite frankly, I don’t know if this is a good or bad thing.
The reason is historical. If you recall, back in 2005 and 2006, before the start of the “great recession,” they were positively hyperventilating about real estate in general, including rentals. They were right of course, but they were way, way late to join the party.
And that was a bad thing – because while it was still possible to get into rentals, it got exponentially more difficult almost overnight due to the explosion of foreclosures.
My colleagues and I who had a laser focus on good areas and top school districts had a few challenges, but we made out fine. But I know a boatload of people who bought at or near the top of the market in really bad areas like Detroit and some suburbs who basically walked away from everything they had bought... And were obliterated, financially, in the process. Some are just now getting out from under the bankruptcies they were forced into because of it.
So now with an overheated real estate market, we’re seeing signs similar to what we saw 7 or 8 years ago…
Case in point – I read a piece on TheStreet.com that was titled: “5 Real-Estate Investments for Higher Returns”
Their main suggestion was that we should “consider what the smart money -- private-equity funds -- has been investing in” over the past several years. And follow their lead. That’s great in theory, but it’s hardly relevant to us individual investors.
And while they did a pretty good job of pointing out the five areas, their analysis, as usual for them, was only an inch deep in that it didn’t talk about any of the risks inherent in investing in an overheated market that may well be at or near the top.
So with those caveats, here’s what they listed as their five real estate investments that generate higher returns.
Rental Properties
Residential mortgages can be used to buy single-family homes and condominiums for rental properties. You'll need a minimum down payment of 20% to avoid private mortgage insurance, just as with a primary residence. Because lenders consider renters to be a slightly greater risk, your interest rate will be higher by perhaps a fraction of a percent. Insuring a rental property is more expensive, too, but usually only by a few hundred dollars a year.
Growing families, in particular, might find it advantageous to buy a second home and rent out the old home. It's still quite doable.
The short-term goal of any investment property is positive cash flow. The monthly costs of the home rented out should be lower on balance than the rent collected. And over time, the asset, as a whole, should appreciate, thanks to the land, even if depreciation is taken on the structure at tax time. Remember, too, the purchase of the property is leveraged. That is to say, if the buyer put 20% down, or $40,000, on a $200,000 house, an appreciation of 1%, or $2,000, is a 5% gain of the down payment.
Long term, think of the process as having a tenant pay off the mortgage, and, afterward, the continuing rent payments are a guaranteed income stream. Capital-gains taxes will apply when the property is sold -- and without the $500,000 exemption on the sale of a primary residence receives.
But tax deductions also can be taken annually on the mortgage interest, insurance and other expenses. Make sure, though, a lease exists to prove to the bank and the Internal Revenue Service that this home is a rental property, unless you would qualify for two primary residence mortgages.
Two- to Four-Unit Buildings
Purchasing a two- to four- unit apartment building with a residential mortgage is cheaper than with a commercial loan. Oftentimes, buyers also make one of the units their home. The interest rate always depends on the buyer's credit history, debt-to-income ratio and the down payment. The rate, however, will be only slightly higher, perhaps five-eighths of a percent, above a comparable owner-occupied home mortgage. The interest rate and fees are lower, though, than on a commercial mortgage, too.
Down payments are generally 25%, but exceptions exist, such as the Federal Housing Administration's 3% down mortgages for residences of up to four units. In fact, as long as you can prove you are upgrading in space, and your family has grown, you can get multiple FHA loans with only 3% down.
Add Rental Space to Your Home
Here's a twist on the current interest in rentals: With rents growing faster than the cost of buying a home, some homeowners are borrowing on their home's equity (via a cash-out refinance, home-equity loan or home-equity line of credit) and using the money to add rental space to their homes.
I've seen clients build basement mother-in-law apartments or construct small freestanding rental cottages behind their homes. The added income can help pay the mortgage or put extra money in your pocket, as long as zoning permits it.
Second Homes
The relatively cheaper cost of buying versus renting also inspires some to, rather than endure a super-long commute, purchase second homes in cities where they work rather than renting there.
Mortgage rates on second homes are similar to a primary residence with down payments as small as 5%. But there are caveats when it comes to financing: Your second home must be at least 50 miles from your primary residence, and you must be prepared to prove that this is neither a second home nor a rental.
Vacation Homes
The hot housing market also has sparked a boom in vacation home purchases among affluent owners, particularly baby boomers who are aiming to retire to pleasant surroundings. Mortgage requirements, fees and rates are identical to those for second homes with one exception: lenders need your vacation home to be not only 50 miles distant from home but also in a vacation community, such as a beach town or a mountain resort town.
The bottom line, though, on vacation homes, as seductive as they are, is that they are expensive to maintain and generally aren't practical for middle-class buyers.
Overall, the good news in the market is that recently, the number of homes in default nationally was 1.3%, the lowest since December 2007. Banks are seeking to sell almost 600,000 houses they have taken over from homeowners who defaulted. So for now, the foreclosure crisis appears to be behind us.
But a rise in interest rates, a potentially earth shattering factor, still looms large in front of us. And the question isn’t IF they’re going to rise, but WHEN.
So whatever flavor of real estate investing you favor, keep your eyes open. While real estate will always be a good investment, not every property is a good investment.
Whatcha Think?
Is there a specific kind of investment prop mentioned that you’ll dive into? Tell us why in the comments section below.