A Real Estate Investment Plan for Beginners

By
Real Estate Agent with Keller Williams Realty

The number of real estate investors that decide to purchase their first investment property without a plan of action in place is staggering.  It seems that every week or so you hear a story about an investment property that has been foreclosed upon or placed under short-sale status.  Real estate investing, however, is no different than any other type of investing.  It requires forethought, proper planning, and discipline to achieve the desired goals.  This article provides a simple yet proven effective plan for a beginning real estate investor wishing to invest for the long term to grow their initial investment into a sizable investment portfolio.

Wall StreetThe real estate market can be compared in many ways to the stock market.  Like in the stock market, your initial goal should be to buy low without exposing yourself to too much risk.  Unlike the stock market, real estate is more stable as the value of the land underlying the property does not fluctuate as much or as quickly as stocks or similar investments available through Wall Street.  As a beginning investor, it should be a goal to find one initial property that can be purchased for at least 20% below typical market value.  This is often where people make their first mistake.  Instead of researching the market to find a good deal they either buy the first property that they like, or they fail to buy any property because they set unreasonable goals such as a property with a 40% discount.

The first step in any real estate investment plan has absolutely nothing to do with real estate, but rather solid financial planning and risk avoidance.  To be sure that a property will cash-flow immediately and to avoid risk in your first investment purchase, I always suggest a minimum of 15% cash, with a preference of 20% to 25% cash down to purchase the first property.  Though many investment vehicles can be used to purchase property at 5% or 10% down, this drastically increases the risk of being unable to achieve income on the property because rents are fairly stable and do not account for highly leveraged properties.  Also, don't get sucked in by the latest 0% down investment craze.  Many of these so-called investor gurus are just selling you a fantasy.  Very few people have the credit to get a true 0% down investment property, and even fewer can find one that will cash flow with this much leverage.  This is a huge mistake that many first time investors make.  They purchase a property with high leverage (which can be a good thing as your portfolio grows), but are unable to get high enough rents to cover the mortgage and expenses of owning the property.  Thus I believe a safe bet is to set a goal of paying 20% down on your first property and then adjusting the price range of homes or multi-family units you investigate based upon your available cash, and also leaving an additional $2,000 to $5,000 or so set aside for cleaning and improvements necessary to get the property ready for lease.  If you wish to invest in real estate, but do not yet have the ability to put 20% down then you should simply look for a partner and have each put down 10%.  You will have to share the profits, but will not have to save as much money at the outset.  Once you have determined the amount of cash you can invest in your first property, the next step is to find an appropriate investment property.

The easiest way to quickly find a property at a discount is to find a competent Realtor® in your investment area that can scour the market for distressed properties, foreclosures, short sales, etc. and knows which areas in the investment area tend to have a good outlook for future growth and property appreciation.  In the Dallas area market I tend to focus on foreclosures and short sales in the northern suburbs of Dallas where the homes are only a few years old (see blog http://activerain.com/blogsview/39816/-Almost-New-Homes).  New homes undergo an interesting phenomenon after purchase where they actually go down in value temporarily because of the competition of the home builder, until gradually appreciating over a 3 to 5 year period as the subdivision is finished out.  Thus if I can find an almost new home sold in foreclosure I can find a double discount for both the builder competition and the fact that it is a foreclosure and may need cleaning up and some updating.  Multi-family units can also have good potential (duplex, triplex, fourplex or even apartments), but they tend to be more expensive and attract the more savvy investors who already have a larger portfolio and available cash.  For this reason, I would suggest starting with a simple single family home with at least 3 beds and 2 baths.

Now that you have found one or two distressed properties that can be purchased at at least a 20% discount over what they would typically be worth, it is time to run the numbers.  Have your mortgage or financial advisor give you an estimate of costs associated with the note on the property.  The figure should include the monthly principal and interest payment, the monthly escrow for taxes (always use an escrow for taxes with investments), and the monthly escrow for insurance on the property (there should not be any mortgage insurance because you are putting 20% down).  Then add in typical expenses in the area for non-tenant paid utilities and other recurring expenses.  I always suggest that the owner plan on paying for the lawn maintenance and increasing the rent accordingly as tenants are notoriously poor at keeping the landscaping of a home in good shape.  Perhaps the most important number is the potential rental rate of the property.  Have your Realtor® run the lease rates and give you a range of price per square foot in the area (for example $0.58 to $0.67 per square foot).  Then assume that you will lease it at the lower end of the price range in order to get a conservative estimate (in the above example about $0.60 per square foot is a conservative figure).

Once you have all the numbers you need it is time to investigate the income potential on the property.  Let's assume that you have found a 2,000 square foot home worth $130,000 that can be purchased for $100,000.  The discount (30/130 = 23%) is more than 20% and the home is only two years old and in good repair.  You have $30,000 in cash that you have set aside to invest.  Costs to clean the home and repair minor items will be about $500.  You learn that the principal and interest and escrow payment will be right at $800 a month (an easy number for this example but may not be a real figure).  In addition to the mortgage you expect to pay $50 per month for lawn maintenance, and have set aside an additional $50 per month for other maintenance.  Thus total costs are budgeted at $900 per month.  The rents are assumed to be $1,200 per month at $0.60 per square foot.  Thus you have estimated income of about $300 per month, which is good.  Keep in mind that you also need to run the figures yearly because of the fact that tenants will move every year or two and you will miss out on at least one month's rent.  I typically suggest that clients assume two months rent every year will not be achieved because of a previous tenant moving out not renting for one month, added the costs to repair and clean for the next tenant.  Thus you have rents of 1,200 x 10 which is $12,000 per year less expenses of 900 x 12 = 10,800.  You then have a very conservative yearly estimate of $1,200 in income over expenses.  This is actually a good figure because you will likely not lose two months rent every year and overall you are receiving a return of at least $1,200 per year on a $20,500 investment (not too mention property appreciation fees which are discussed next).

The main reason that investing in real estate can be so effective is that you can receive regular income from a property while that same property gradually appreciates.  In the Dallas area we typically see a steady 3 to 4% appreciation rate over a four or five year period.  Because you have purchased a newer home in a growing area at a discount, however, you can potentially achieve an even higher rate of return.  This brings us to the next step of our investment plan, the sale (or exchange) of the initial property.  Assuming that your initial investment of $30,000 is all you ever intend to dedicate to real estate investing you can still grow it into a large portfolio over time.

You generally should assume that any investment property should be held at least four or five years before sale or exchange in order to achieve the desired property appreciation.  In my suggestion, let's assume that the builder finishes the subdivision after three years and that at that time the property could be sold for about $135,000.  You counsel with your Realtor® and decide to hold it for two more years to take advantage of the property appreciation experienced in this nice recently completed subdivision.  At the end of two more years the property is worth $160,000 (not outside the realm of possibility considering that it was really worth $130,000 five years before if not for the fact that it was distressed.  Thus you can sell the home for $60,000 more than you paid for it, and have equity of $75,000 because you have paid on the note for five years or more.  So we should sell it, take the $75,000 and invest in another property, right?  Wrong!!!.  Instead you want to transfer this property with $75,000 in untapped equity and turn it into a property or properties worth $320,000 in a qualified 1031 Exchange (see my blog on 1031 Exchanges at http://activerain.com/blogsview/31532/How-to-Turn-Apples).

MoneyFederal tax law allows an investor to take our property worth $160,000 and exchange it for one or more properties worth up to 200% of the market value (or $320,000) without having to pay any capital gains tax.  Thus we can use the $75,000 in equity to purchase two properties worth a total of $320,000 without having to pay any taxes.  Basically you put the original property on the market, sell it for $160,000 and give the proceeds of sale less related fees and expenses to a qualified 1031 Trustee.  You then have a set time period to identify and purchase your next investment properties without have to pay any capital gains tax.  In this next step, my suggestion is that you purchase two properties with the equity you have available.  After fees and expenses associated with sale lets assume you have $65,000 left to invest into our two homes.  Again we will put down 20% on each home (or $32,500 for each).  Thus our $32,500 per home can purchase two homes for $162,500 each or $325,000 total.  You now know the price ranges you are looking in and can follow the above steps to purchase two homes up to $320,000 without having to pay any taxes.

Over time you can see the brilliance of this type of investment strategy.  We have taken an initial investment of about $25,000 to $30,000 and turned it into two properties worth about $300,000 without paying capital gains tax in only five years (and with about $60,000 or more in equity).  Assume that four years later you decide to sell both properties after a period of high property appreciation.  At that point you can sell both for $450,000 because you purchased them at a good discount and you have a whopping $200,000 or more in equity accumulated in only 9 years.  You can then take this equity and use it to purchase a portfolio of properties worth 200% of $450,000 or $900,000 (and still put 15% to 20% down on each to allow for good cash flow).  Thus over a longer period of time you can take your initial $30,000 investment into a portfolio of investment properties that include single and multi-family units without ever having to pay capital gains tax.  In a little over ten years if you are conservative in your budgeting and smart about which properties to purchase and sell you can turn your $30,000 initial investment into properties worth over $1,000,000 and equity of $200,000 or more, and over a longer period of time you can set aside a sizeable retirement package of high cash yield properties.

Comments (13)

Anonymous
Stephen Katz, KatzMortgageTeam.net

Very informative. I do a lot of Investor loans and most RE investors have no idea of what they are doing or how much responsibility they are undertaking.

 

Stephen

Jun 27, 2007 03:34 AM
#1
Anonymous
Tavia
Thank you, Thank you, Thank you, Steve.. finally something practical for someone aspiring to invest to use as a guide line.  I absolutely love this blog!  
Aug 27, 2007 06:46 PM
#2
Ethan Dozeman
Realty Executives Platinum Group - Grand Rapids, MI
Real Estate in Grand Rapids
Very informative, how many investors have 20% down?
Aug 27, 2007 11:37 PM
Anonymous
Michael Collins

Very informative information. What is your take on the flipping business?

michael.collins33@hotmail.com

 

Thank you,

Oct 16, 2007 04:18 AM
#4
Bill Exeter
Exeter 1031 Exchange Services, LLC - San Diego, CA
1031 Tax-Deferred Exchange Expert

Hi Steven,

Great post with great information.  Well thought out and presented!  Good job!

It has always amazed me that most of our clients never seem to have a plan.  They just go through life 1031 exchanging properties.  The market seems to save most of them, though.

Jan 06, 2008 04:01 PM
Michael "Mike" Miller
EXIT REALTY SERVICES - Moon Township, PA
My service will move you! Help me, help you!

Steve,  Terrific post with very valuable information.  I agree with you about the 20% down.  It is extremely difficult to find single family properties that will cash flow with less than 20% down.  Possible, yes, bu few and far between.  Mike 

Jul 08, 2008 03:06 AM
Jeff Stinson
Kasteel Property Management - Property Manager - Springville, UT

Yes, people need a plan.  People that just jump in aren't going to be able to stick it through the tough times.  I like your blog.  It has a lot of good info.  Real Estate is a great way to go to build long tirm wealth.

Jeff Stinson

Property Manager

www.stonebridgerealestate.net

 

Jul 22, 2008 04:57 PM
Anonymous
Dan Perkins

Really nice article... lots of meat.  I work for a place called SmartZip.com - we turn out a score for Growth and Income. Your point about an investment tracking forward in terms of both growth AND income at the same time is well taken- I don't think people think in those terms enough these days, and with some growth staring us in the face in the coming years, income rental properties start looking really good, particularly if they can get close to 1% ROI.

Dan

Aug 06, 2009 07:48 AM
#8
A M
Plano, TX

As with all the other posters on here, I agree, excellent post with excellent information. It's pretty tough to beat a Lawyer/Realtor lol! Great plan though.

 

 

Andrew Molz, Realtor

Davenport Realty

http://www.OneClickSold.com

Aug 23, 2010 10:39 AM
Erik Barrow

Beginning investors need to take time to determine their goals and learn some basic concepts of investing before jumping right into making an investment. Your blog is interesting and very informative. Keep on writing such nice stuffs!

 

NRAS | $100,000 Government Grant

May 08, 2012 07:24 PM
Anonymous
Custodian Wealth Building

These tips are great and very useful for me in starting to invest. Thanks for sharing such informative article.

Custodian Wealth Builders

Oct 15, 2012 10:05 PM
#11
Anonymous
Custodian Wealth Builders

Real estate investment is all about the deal, the terms, and the return on investment. These ideas are great for a successful real estate investment workshop. Thanks! Custodian Wealth Builders

Dec 18, 2012 04:50 PM
#12
Charles Stallions Real Estate Services
Charles Stallions Real Estate Services Inc - Gulf Breeze, FL
Buyers Agent 800-309-3414 Pace and Gulf Breeze,Fl.

Wow a lot of information, investing takes time and effort so one has to really study and know the market. Find a GOOD realtor.

Feb 05, 2013 11:04 AM