Real Estate Investing 101

Real Estate Agent with Keller Williams Realty

I have noticed over the years, especially now that investing in real estate is such a hot topic, that many beginners to real estate investing can quickly get in over their head fast.  And though I am not a real estate investment guru by any means I have picked up a few tips along the way, first as an investor myself, second as the son of a homebuilder and builder of numerous duplexes and multi-family dwellings, and now as a REALTOR and agent for other investors.  If you want to get into investing or are a newer agent wanting to work with investors here are a few key concepts when getting started.

HIDDEN EQUITY:  The first and most important thing that all investors are looking for when investing in any real estate is Hidden Equity, though different terms of art are often used to describe it.  There are several ways to find hidden equity, however, and it does not really matter which is used:

  1. Distressed owners that have to sell below market value because of outside reasons
  2. Older property that is devalued because of condition and age but that is in a good area
  3. Foreclosures and REO properties (real estate owned) where the lenders are the owners (though all too often there is not as much hidden equity as people believe in foreclosed property)
  4. Short-sales (where the owner is near foreclosure status but has gotten the bank to agree to sell for less than the mortgage balance and wait to foreclose)
  5. Developmental property - property that rises in value sharply because of expansion and development in the area
  6. Poorly managed or maintained commercial property where rents are below market
  7. Poorly managed or maintained multi-family property where rents are below market

Though not an exhaustive list, it provides key areas in real estate where an investor can locate hidden equity in property and with a little time and effort turn the hidden equity into profit.  For the rest, I will focus on "Flipping," a popular and potentially risky but rewarding form of real estate investing.

Do you see the hidden equity?THE 30% RULE:  Of late, a popular rule of thumb that many investors use when evaluating property to "flip" or rehabilitate and sell within a short time frame is the 30% Rule.  Basically the rule requires that an investor purchase a property at a minimum of 30% below the actual potential worth of the property.  There are several reasons for this.  First the time value of money becomes key when flipping property.  Lenders charge higher rates to investors that are speculating in property and often require larger down payments.  Unless an investor has a large amount of cash on hand, they need to turn properties quickly and also account for the expense of borrowing when determining potential profits.  The second reason investors need this 30% equity is because of the cost and fixing up, rehabilitating, etc.  Finally, this equity provides some leeway in case a property does not sell as quickly as planned or does not sell for the price planned.

This is one area where new and even experienced investors make a mistake.  They assume that the 30% Rule requires that they purchase a property at 70% of the listing price.  Though it does make for a simple calculation, this ignores the true concept of hidden equity.  Some properties are listed above market and even if they sold at 70% of the listing price, it would not provide the amount of cushion desired.  Another reason to avoid over-simplifying is the fact that some properties are listed below market value or are listed for less than the potential value if remodeled.  Too often investors will pass on good investments because they cannot get the owner to sell the property for 30% under market value but forget that remodeling a property with a lot of hidden equity can often create value.

The goal!HOW TO EVALUATE THE AMOUNT OF HIDDEN EQUITY:  Once an investor has identified a property that they believe has hidden equity that can be tapped into, the first thing they need to do is have a trusted and competent REALTOR run a comprehensive CMA (comparative market analysis) on the property.  There needs to be two CMAs: a basic CMA on the current market value of the property, and a prospective CMA on the value of the property after the investor has remodeled, fixed up the property, etc.  Once a range for these two figures are established, the goal is to purchase the property at about 25 to 35% of the prospective CMA low end-value.  The reason for the fluctuation is that even the best REALTOR cannot be exact when doing a prospective CMA for an investor.  Notice that we do not care at all what the list price is, nor do we really focus on the current market value of the property.  In fact the reason to run the current market value CMA is not to help us in the offer, but rather to give us insight into the state of the owner.  If the owner has their property listed over the current market value, he may be difficult to come to terms with regardless of the amount of hidden equity.  If, however, the owner has it listed under current market value this can indicate a distressed seller who may be easier to purchase from because of their eagerness to sell.

BUDGET YOUR EXPENSES:  One final thing that must be addressed before making an actual offer on a property that meets the above requirements, a comprehensive budget of potential expenses.  If you are flipping a property you need to write down what you intend to do to remodel the property.  For example, list all the required repairs and expenses, and include financing costs (painting, carpet, new appliances, contractor fees, proposed time on the market after listing for sale, interest costs, etc.)  Take this comprehensive budget (and this is the area that often separates top investors from the rest) and determine the difference between potential gain on sale using the prospective CMA.  If your total expenses exceed or are too close to the potential gain on sale, then there is not enough hidden equity in the property or you need to reduce the potential expenses.  Determine what profit you desire and make sure that your budgeted expenses provide this figure and a little extra for cushion as there are always a few cost overruns.

Hopefully, this provides a little insight into the potentially profitable venture of real estate investing.  One other key thing to remember is timing the market properly, just like you would the stock market.  As an investor you want to buy low and sell high.  Thus, most investors should generally look to purchase their investment property in the fall or early winter, then plan to sell the property in the spring or early summer.  This will particularly help new investors because it makes it a little easier to identify distressed owners whose listings have been on the market through the summer.  It also provides time in the winter to do the work and makes sure the remodeled property hits the market at the beginning of the peak of the residential selling season.  Good luck and remember that even the savviest investors make some mistakes.  Expect to make a few mistakes yourself, provide a little extra cushion to guard against these mistakes in your budgeting and market analysis, and don't get discouraged if one or two deals don't work out.  And, perhaps most importantly, establish a good relationship with a local REALTOR, whose advice and expertise will be essential.

Comments (2)

Christopher Walker
Mission Grove Realty Inc. - Hemet, CA
Local Broker and Realtor - Hemet & San Jacinto, CA
Very informative and thorough post. Thanks Steven.
Jan 06, 2007 09:31 AM
It's my first time beginning real estate and your information was very helpful.  Thank you
Jan 19, 2007 05:30 AM