property owners find that they’re in the rental housing business almost by accident. Although solid reasons to invest in and own rental real estate exist, many owners begin their real estate careers by chance or through circumstances beyond their control, such as the following:
Some people inherit a house or condominium from a relative and don’t want it to sit empty.
Other people transfer to a job in another city and can’t sell their old home, so they’re forced to rent the property because they want some income to help cover their new mortgage and operating expenses.
Some folks who are looking to own their own place find a great duplex where they can live in one unit and rent out the one.
Other owners are upside down on their mortgage (owe more than the house is worth) and can’t sell their property for enough money, so they rent it (while finding more modest accommodations for themselves) until the market improves for sellers. Note that this scenario also applies to some couples who are going through a divorce.
Whatever the circumstances, the bottom line is the same: The property owner hopes to generate sufficient income from the property to cover the debt service and all operating expenses, and possibly even to provide some cash flow, along with tax benefits, appreciation, and equity buildup.
The buy, fix, and flip or refinance owner
If you have ever had insomnia, you have likely seen infomercials about people who have made great fortunes buying and flipping properties. Although this concept is fundamentally sound, it is much easier said than done. Just as gamblers tell you only about their great wins, the reality is that many pitfalls await the novice. But there is a place for this type of real estate investor — another category of real estate ownership in which a competent and savvy property manager can make a real difference.
In a solid real estate market, you often find properties appreciating at an annual rate of 3 to 5 percent — a solid, sustainable rate of appreciation that rewards investors with long-term investment horizons who take the buy-and-hold approach with their real estate assets. This buy-and-hold strategy works and should always be the foundation of your wealth-building.
But in some areas, the demand for housing is so great that the limited supply of new and existing properties on the market is insufficient to meet demand. It’s in markets with high demand and rapidly escalating prices that real estate speculators with a buy-and-flip strategy tend to appear.
The buy-and-flip strategy can also work with existing homes or condominiums that the investor can purchase from a motivated seller at a wholesale price that’s below market value. The investor may not even have to close escrow before finding a buyer who’s willing to pay retail price. Some minor cosmetic work or simple improvements may be needed before reselling, but typically, buy-and-flip investors really make their money when they buy at a discount, renovate and then locate a buyer at full market value.
With the buy, fix, and refinance strategy, you invest in rental housing properties to which value can be added through repairs, upgrades, and improvements. You take a distressed property and turn it into a solid, well-maintained property with a good, stable tenant. Over the years, with increased equity in the property and as long as interest rates are attractive, you could refinance the property if you so choose and use some of your equity to make other real estate investments.
The long-term investment rental property owner
Although we have seen real estate demand ebb and flow during up and down cycles over the past 12 years, and lately even through a pandemic, residential real estate remains one of the best, most reliable, and most consistent investments in terms of long-term return. For many current landlords, of course, the popularity of real estate started with the tremendous increase in the value of real estate from the mid-1990s to the mid-2000s. Many people found that real estate investing became a key element of their diversified investment portfolio. And why not? Real estate is a cornerstone of the American dream. Many people strive for years to own their first home and then realize the tremendous investment opportunity offered by income-producing residential rental real estate.
I often serve as an expert witness in real estate litigation matters and recently had a case that illustrated the challenges of the buy-and-flip strategy for a home featured on one of those cable programs on your favorite real estate home improvement channel. The stars of this show are a young couple; she is the designer, and he is the contractor. One day, while scouting a popular high-demand area of Henderson, Nevada, they located a vacant home with weeds 3 feet high, a leaking pool, dated appliances and countertops, drafty windows, a bootleg garage-to-bedroom conversion, and so on. They purchased the property for $199,000.
The show highlighted the demolition of pretty much everything in the interior of the home, down to the studs. Then a time-motion video showed the process of renovating the kitchen with new counters and appliances, decorative painting and tiling, and pool replastering, making the property the best home on the block. The beautifully completed home was sold to an older couple from out of state for $295,000. Thus, with renovation costs of $24,000, and closing costs of $11,800, the couple claimed that they made a net profit of $60,200 in four months.
That was great until the buyers sued them, alleging that the workmanship of the renovation was deficient and that the property had construction defects that would cost $150,000 to correct. The case ultimately settled, but no follow-up episode of the program acknowledged that the $60,200 “profit” was really a loss of more than $100,000! So, don’t think that those impressive home improvements, “Buy low/sell high” “reality shows” are always the true “reality”!
Although they can be very entertaining and give you some great upgrade ideas for your existing rental properties, these shows are not realistic; they always seem to understate the true costs of acquiring, holding, upgrading, and reselling property. The flippers seem to have significant available cash, which they tie up for four to nine months at zero cost, never placing a value on their sweat equity or time, and ignoring the real costs of commissions and operating costs such as property taxes, association dues, or utilities during the hold period. Finally, when was the last time one of these shows featured a flip that was actually a flop? That outcome is likely at least a third of the time for even the savviest flippers.
In today’s world, more and more demands are placed on your time, so many aspects of rental property ownership are appealing. People want to supplement their current retirement plans (which are predominantly invested in cyclical stocks, bonds, and mutual funds) with additional sources of cash flow, and real estate has a proven track record as one of the greatest wealth-builders of all time. Most folks find that generating a stable income without having to punch a time clock and not being limited to earning an income only for time spent working for someone else is an attractive option. Even most professionals, such as lawyers and accountants, find their income to be constrained by their billable hours. Usually, the more hours they work, the more money they make. But they are limited in the actual number of hours they can work, which limits their income potential, so having ways to generate income
