Many a new real estate investor starts his or her career by seeking the guidance of a local real estate agent. The problem is most residential real estate agents know little about real estate investing. What’s worse is most agents think they’re investment experts and many a newbie investor’s career has come to an abrupt end after being led into a bad and stressful investment purchase.
I am a licensed real estate agent in Virginia. But I was first a real estate investor. I never intended to get my real estate license until I realized the difficulty of finding a good real estate agent, especially if you’re looking for assistance in purchasing investment properties.
Buying a property for investment purposes is not the same as buying your own home. Most agents know how to do the paperwork to facilitate a purchase, but few residential agents know the financial fundamentals of a good investment property.
I don’t recall receiving much training at all in my Realtor licensing courses concerning real estate investing, and there is almost none at all in my continuing education. This doesn’t stop agents from portraying themselves as investment experts.
I’m concerned about the fundamentals of the Washington real estate market, and I’m beginning to buy properties outside of our area. I’m familiar with several markets where I invest or have invested in the past. And I’ve identified several other markets where the average home is much more affordable and the local economy appears strong or poised to do well over the next few years.
I am moving some funds back into long-term buy and hold investments, and some of my investors are joining me. I’m a seasoned landlord and familiar with my markets, but doing business out of the area requires greater dependence on other people.
To that end, I have been contacting local investors, contractors and yes, real estate agents in these target markets. Once again, I’m running into agents who at first are excited to work with an investor. They think I’m going to run out and buy 10 homes off the open market. Then they hear my investment strategy and think I’m crazy. Their typical modus operandi is to convince you that you’re crazy. The new investor will often be unsure of themselves and they end up following the agents’ advice and paying too much for a property or buying a property that is otherwise a poor investment like the situation I wrote about in my last post.
Many investors pay thousands of dollars on education before they attempt to buy their first property. Yet they still let that agent talk them out of sound investment strategies and into a purchase that leads to stress and financial loss.
Buying rental properties is about the safest real estate investment strategy as long as you acquire properties that are sustainable for the long run. I mean you need to buy properties at a low enough price or with a big enough down payment that the rental income will cover the expenses even if the overall value of the property decreases in the short term. Then you have to consider the return on your investment. You also need to make a return on your down payment that is greater than what you could expect from other more liquid and less stressful investment options.
Most real estate agents just want you to buy a home at market price. If you get a deal that they believe is 10 percent under market value then they are really proud of themselves. It doesn’t matter if the property loses money and raises your blood pressure every month. In their mind they did a great job.
In my forays into other real estate markets, I recently had an agent from out of town contact me and tell me he had deals in his local market. This agent had been spending time on a real estate investor networking site that I know well. During our first couple of exchanges he used some keywords that made me think maybe he knew the business. His market was not one I was immediately considering but I told him I would look at his deals.
I told him how to screen deals for me. I have two basic criteria. I need deals that have at least an 8 percent capitalization rate. This means that the property will produce an 8 percent return on the purchase price each year after all expenses, not including the mortgage. I also need my purchase price, closing costs and renovation expense not to exceed 80 percent of the homes after repair value.
“No problem,” he said. “I’m going to find you properties with at least a 10 cap.” And he went to work.
Within hours he was sending me deals. “Hey look, Justin, this property is listed at $1.5 million and the gross rents are $160,000 per year. That’s over a 10 percent return.”
Looking at the numbers, I saw the taxes on the property. I also noticed that the property had a past vacancy rate of nearly 15 percent average. It has a high legal expense, which probably means they’re doing lots of evictions. I estimated the taxes, insurance, maintenance, vacancy, repairs and management to be around $72,000. Running the numbers, $160,000 gross income minus $72,000 in operating expenses equals $88,000 in net operating income. This gives us a 5.9 percent capitalization rate — not 10 percent.
This agent didn’t even know how to compute capitalization rates. He asked me: “You want your returns to be at least 8 percent after you subtract all the expenses?”
Yes, that’s what a return is. It doesn’t matter that you’re making a million dollars if the investment is costing you $1.1 million. He then tells me that those numbers are unrealistic.
I saw other problems with the property, such as the fact that there was a huge lawn but no lawn maintenance costs. I also noted that the past average vacancy rate was around 15 percent, but within the last few months it had dropped to under 5 percent. That worried me, making me think that they reduced their screening criteria to fill units to bolster the numbers. I worried that I’d have a lot of nonperforming tenants and a lot of legal expenses in the first year of ownership.
Time after time, I’ve had agents tell me I can’t buy properties for the price I need to make them cash flow. They believe the only way to value a property is based on comparable sales analysis, which is the primary method for valuing residential properties. Investment properties are primarily evaluated by the cash-flow method or the capitalization rate. If you can’t buy a property at a price that is low enough that the income will cover the expenses and provides a minimal profit then I highly recommend that you don’t buy at all. And don’t let an agent tell you that a property is a good deal because the purchase price is 10 percent below market value.
It’s great that you have 10 percent equity, but if you’re losing hundreds of dollars per month in the operation then that equity does you no good. Market value is at best a moving target and even if the agent is right it will probably cost you 8 percent of the property value in closing costs and commissions to sell the home. You may be stuck.
Agents, like many other professionals, feel like they control the information. They see themselves as experts. When they are dealing with investors they often begin to talk down to you and try to convince you that you’re naive or unrealistic.
Usually, in this case, it’s the agent who is uninformed. It’s perfectly reasonable to look for real estate bargains even in a hot market. A good real estate investor is not going to buy just any house listed on the market. A good real estate investment deal is much more elusive.
The real estate investor has to know his or her numbers and his or her market. They cannot rely completely on the advice of an agent and they need to know enough to realize when they are getting bad advice.
Real estate agents should also educate themselves about real estate investing and what makes a good investor. Having a couple investors in your back pocket can be a great resource when you find the right deal, but you really have to know how to use them. Dedicating your time to an investor may just end up with you writing a bunch of lowball offers with no payday.
The real estate investor cannot begin his career with a major information deficiency. You don’t need to be an expert on day one but you need to know and be comfortable in the fundamentals before you start.
Do your homework before you start and know that not buying a property at all is better than buying a bad property. Don’t get bullied or talked off your game but make sure you’re realistic in your expectations.
If you’re a new investor, ask your agent if he or she has worked with investors before. Get references. Call them and see if they’ll share the numbers with you from their deals. If they’re happy with the experience, ask what their buying criteria was and compare it to your own. See if they’re still acquiring properties and if they’re using that agent to do so.
Being a real estate agent does not automatically make a person a real estate investment expert. If you cannot independently verify that your agent is an expert in real estate investing then don’t rely on their real estate investing advice.
If you’re an agent, make sure you know what you’re getting into when you start working with real estate investors. It’s not easy and it’s not the same as working with retail buyers. It can be a lucrative relationship but if you don’t know what you’re doing, you’re likely to end up wasting a lot of time and effort or ending up with an unhappy client stuck in a bad deal.
Justin Pierce is a real estate investor and real estate agent who regularly writes about his experiences buying, renovating and selling houses in the Washington area.