If you are like me, you may be reflecting on how poorly your investment portfolio performed in 2011. All stock indices, except the Dow Jones, were down. Your savings account, if any, may have earned an anemic 0.25 percent. Assuming you are convinced that 2012 is the year to take the real estate investment plunge, you may want to consider the following.
Real estate limited partnerships, or pools that invest directly in property, may provide an attractive vehicle. Those partnerships are generally formed by real estate professionals with prior experience in buying, financing, operating, managing, leasing and selling real estate to maximize their investors’ overall return. They will often seek to reduce their risk by buying a diversified portfolio such as office or apartment buildings, commercial or industrial property, mortgage notes or even bank-owned real estate (REO).
For those looking to actively manage their real estate investment, and especially for the first-time investor, I would recommend purchasing a residential condominium — ideally, a two-bedroom unit in a prime location with low condo fees. These are typically the easiest to rent out and command the highest rental rates.
In a condominium, you need to make sure that investors are welcome. Many condominiums restrict condo unit rentals and impose stiff move-in or move-out fees that you may not be able to pass through to your tenants. You should also check with the management company to make sure that the condominium does not have so many investors that it is no longer eligible for Fannie Mae conforming financing. Lenders typically will not make loans in condominiums that have too many investor-owners.
The condominium declaration, bylaws and house rules must be reviewed to verify that you can legally rent out your unit. I strongly recommend you thoroughly investigate the condominium association’s solvency to make sure it is collecting its condo fees in a timely manner. This financial due diligence should analyze the condominium’s cash reserves to make sure they are sufficient to cover all scheduled maintenance items such as roof replacement, HVAC systems and elevator replacement. The condominium’s treasury should be analyzed to see if it can pay for emergency repairs for unforeseen events such as floods, fires or storm damage not covered by insurance.
Because condominiums historically have not appreciated in value as much as other properties, many folks, seeking to maximize their profit, turn to single-family homes. But single-family homes also pose the greatest risk and require extensive hands-on time, effort and expertise. Especially for the first-time investor, the first step in buying a single- family home as an investment is to conduct a thorough and professional home inspection. You should accompany the inspector so he can show you the home’s “bones” and point out any defects or necessary repairs. He should also provide you with a written cost estimate to make those repairs or replacements. Depending on the home inspection’s results, additional detailed chimney, HVAC, radon or mold inspections may be wise. Most lenders will require a pest inspection.
The next major step is to create the budget and timeline for any repairs, replacements or improvements you intend to complete. Unless you intend to do this work yourself and thus invest your “sweat equity,” you will need to hire a general contractor. Depending on the scope of the work, you may want to be your own general contractor and hire the necessary licensed and insured subcontractors. Once you have your initial timeline and budget, go back and recalculate, this time assuming it will cost twice as much and take three times as long as your original estimate. Only then will you have a reasonable plan.
In making any investment decision for rental real estate, you need to factor in your annual rate of return from your rental income as well as any anticipated capital appreciation. I do not recommend basing an investment decision on future appreciation projections. Rather, the safest course is to invest only if you think that your total annual rental income will equal or exceed your total annual carrying costs. In other words, don’t invest unless you are cash flow positive, or at least cash flow neutral. Total annual rental income can be estimated by working with a competent, local real estate agent who handles rentals. Online services such as Craigslist are also essential resources in estimating rental income.
Total estimated carrying costs include: mortgage principal, interest, taxes, insurance (if not covered by your condo fee), condo fee, special assessments, tenant move-in fees, utilities, repairs, maintenance, cleaning, rental commissions, rental licenses, legal and accounting fees and a vacancy allowance. When making the investment decision, I recommend a conservative approach and ignore any beneficial tax considerations such as deductions for mortgage interest, real property tax or depreciation.
Yes, it’s cliche, but it’s absolutely true: The most important factor in making any real estate investment, whether in condominiums, townhouses or single-family residences, is location. You can always renovate, redecorate or redesign your property’s interior to correct certain design imperfections, but you cannot do anything about an inferior location. Do not assume that the neighborhood will improve. Do not assume you can make up for an inferior location by getting a bargain purchase price. It is a bargain purchase price because it is an inferior location. You will be selling at a bargain sales price when you go to sell regardless of how nicely you have fixed up the interior.
Harvey S. Jacobs is a real estate lawyer in the Rockville office of Joseph, Greenwald & Laake. He is an active real estate investor, developer, landlord and lender. This column is not legal advice and should not be acted upon without obtaining legal counsel.