Strategic Thinking About Things That Really Matter
Filed under: Home Buying, Real Estate Investing
Your real estate investment will be shaped, to a great extent, by the kind of financing you obtain. Therefore, your earliest strategic thinking should be about your appearance of creditworthiness. Once you buy a property with an ARM, the clock has started ticking and you need to have plans to sell it in a timely way. Although this sounds stressful, I don’t think it is to people who know what they want to do. The intricacies of the real estate market usually prove less challenging than the investor’s own fears and indecisions. Try to be less concerned about interest rates and the like, and be more concerned about your emotional and mental processes!
What is Your Goal?
“The happiness of your life depends on the quality of your thoughts.”
—Marcus Aurelius Antoninus
To succeed as a real estate investor, you must have a goal. Having strategies or plans implies that you have goals. As goals, most of us want wealth, health and happiness. Such goals are vague, as are most people’s strategies for achieving them. However those goals need not be vague, not if you define them in terms of real estate. In other words, what property holdings would it take for you to enjoy wealth, health and happiness? Owning a home and beach house would be more than enough for some. Others might need a mansion in town, a bunch of rental properties, and a retreat in the mountains. But what these people share is a goal expressed in terms of property. That focuses them on becoming successful real estate investors according to their own ambitions. You will find more about this and similar matters in my CD, Strategic Thinking, in the series, Partnering for Profits.
How many, and what kind, of properties do you want to own? Until we own at least one property, most of us have no idea. If you had told me ten years ago what I would own today, I would have laughed in disbelief. But it’s not so much about the quantity and quality of the properties you gather, as it is about the fact that you have something real and achievable as a goal. Once you see exactly what you want before your eyes, it becomes easier to plan on how to get it.
Your age, family status and present financial resources will help define your goal. They should not be seen as obstacles, but as realities of life that suggest appropriate courses of action.
Set a goal for yourself. Select some kind of property in a price range you will qualify for, in a suitable area. That goal may change. It may grow bigger or smaller. But now, at least you have a goal.
What Kind of Property Should You Initially Buy?
I’ve already mentioned that many assume a home should be their first purchase. If you are paying rent at the usual level, it probably should be. If you have a good living arrangement, buy a rental property instead of a home. The kind of property is not so important as the fact that you own property. You are in the game. You are no longer on the outside looking in.
How Long Should You Wait Before Selling?
If you have used an ARM to buy a property, it is usually a good idea to sell before the adjustable rate kicks in. It is also usually a good idea not to wait until the last minute before doing so. Being a year early is better than being a month late. If the house is a fixer-upper, you sell as soon as you can. As for flipping condos, like most real estate investors I’m willing to flip any property if the price is right. However, I never depend on making a quick sale. The only time you can lose money in real estate is by selling. If you can’t get the price you want, hold onto the property until you do.
For planning over extended periods, it is realistic to assume that properties will appreciate in value by five percent each year. This is by complex interest, which is much more rewarding than simple interest. Never refuse a good offer because you have attached a long-term label to a property. Sell it and buy two others.
What Type of Investor Do You Want to Be?
“He who plants a garden, plants happiness.”
—Chinese Proverb
There are four basic types of real estate investor: (1) safe/secure; (2) moderate; (3) risk taker; and (4) full-time real estate investment freak.
- Safe/secure investors own their homes. They are willing to invest in other properties, but want to carefully review all the benefits and risks or they won’t get into the game.
- Moderate investors often own one or two additional properties as well their homes. They like to take small, educated steps. For them, the grass is always greener in other people’s deals.
- Risk takers thrive on possibilities and are quick to discern good deals. For them, money is the means to something rather than the goal itself.
- Full-time real estate investment freaks eat, sleep and drink real estate. When they are not structuring deals for themselves, they are doing so for friends. Some people never see opportunities even if they see so many that they have to avoid tripping over them. Investment freaks tend to have a good solid foundation in real estate and are successful people who take action quickly. Their outlook is that they have nothing to lose and everything to gain.
It is easy to see these four niches as being occupied by different personality types and account for them in that way. In real life, however, you are not stuck as one of these four types just because of your personality. Instead of four different types, you can view these as four levels of real estate investment through which people can pass, from one to four, as they develop as real estate investors. I’m not saying that everyone passes through these four levels, but if you develop as a real estate investor, these are the levels through which you are likely to pass. You will find much more about types of investors in my CD, What Type of Investor Are You? Which is in the series, Partnering for Profits.
At which of these four levels do you see yourself as an investor? The answer to that may depend on your risk tolerance. If you are risk averse, the first or second levels are most likely. If you have amore devil-may-care personality, you may start out on the third level. As with any kind of investing, however, caution pays off in real estate, especially for beginners who have yet to learn the rules of the game. However, some experienced investors are held back by their extreme caution, and always will be. These are the real type one investors. Lifelong type two investors often lack the drive that motivates others to become type three risk takers as they gain confidence.
How do you end up as a type four, full-time investor? Well, one success leads to another. You learn to make quick decisions. You know that you must change your life to change your income. Over time, you see the things you need to do to change your life, and you do them. You control your fears. With experience, you become educated in real estate. You begin to trust yourself.
“As soon as you trust yourself you will know how to live.”
—Johann Wolfgang von Goethe
Are you a hands-on manager or do you operate better from a distance? You will come to better understand the relationship between cost and time. You will also gain increased understanding of the ways in which every real estate transaction has the potential for either gain or loss. You win and you lose. You have arrived!
To spread your risk or become involved in larger projects, you invest with other people. However you make sure that these are people who understand the risks of investing and you never guarantee profits. You are friends and fellow investors who recognize the potential ups and downs of each transaction. You include them in the educational process of putting the deal together.
“Somebody should tell us, right at the start of our lives, that we are dying. Then we might live life to the limit, every minute of every day. Do it! I say. Whatever you want to do, do it now! There are only so many tomorrows.”
—Michael Landon
Risk has its lighter side. Life is no fun without risk. You create the life you want. You create what you deserve. Move forward. Move fast. Educate yourself. Do it now!
Are All Your Eggs in One Basket?
The first thing I have to say is that real estate investments are not eggs. You probably won’t have dozens of properties to scatter around for safety’s sake. It is much easier to diversify with stocks and bonds than with properties. All the same, if you invest only in beachfront condos, in a single big resort, you may be exposing yourself to risks of oil spills, red tides, hurricanes, or shark attacks — things not directly connected to the real estate market itself. Any one of those risks could affect all your beachfront condos. Are you willing to accept the downside of those risks for the upside of owning highly marketable, waterfront properties? Most of us would take that chance. But why are they all in one resort? Having condos in more than one resort would be a way to diversify. You may know the area and have important connections there. The risks may be higher if you buy in another resort that you don’t know as well.
The temptation is strong to repeat a success. I find it hard to resist. If you have done very well by buying a one-family rental property in a certain neighborhood and you get a chance to purchase another, I say you should grab it. Turning it down in order to buy something different elsewhere, solely for the sake of diversification, may increase rather than lower your risk. I am always interested in different kinds of properties in other areas, but never for the sake of moving eggs from one basket to another.
Don’t Get Stranded by Success
Some small companies are killed by success. The owners, like everyone else, would like to make a lot of money by only investing a little. Though it is doing better than expected, a small company’s need for cash to cover its costs can be much higher than projected. Cash flow problems can close a small company’s doors, while unfulfilled orders continue to pile up. A real estate investor with a portfolio of valuable properties can run into a similar problem if he or she hasn’t realistically planned cash flow. Estimating costs alone is not sufficient. You have to provide the funds. Under these circumstances, a cash shortfall can be difficult to explain convincingly. Have you been killed by success? Reasonably enough, lenders may assume that they are not being told everything.
Your rental properties have to generate a monthly income that more than covers their costs. Look carefully at any rental property that generates a negative income, meaning that its mortgage payments, property taxes and maintenance amount to more than its rental income. This is frequently the case with condos, where owners expect the profit to come from increased value on selling. That risk is fine for people who actually understand the risk involved, but many don’t. Unless you need the negative income for tax purposes, my advice is to look for a positive cash flow and as much of it as you can find.
If you own property, sit down and work out your cash flow over the next year. Your properties may be in good shape, but faulty financial planning can strand you high and dry.
Tax Planning
When you talk about investment strategies and financial planning, it is always necessary to include tax planning. When income arrives, the tax collector is never far behind. Tax planning can help you lessen, postpone, or avoid taxes in legal ways. Residential real estate, as an economic activity, gets preferential treatment by the federal tax code. Mortgage interest deduction, property tax deduction, certain closing costs deductions, capital gains exclusions and 1031 transfers, are dear to every real estate investor’s heart—or should be. Some tax rules are very complicated and I recommend seeking professional advice.
Condo Tax Benefits
Three kinds of condo expenses are deductible from your federal taxes: mortgage interest, operating expense and depreciation. Since ninety percent of your early mortgage payments are likely to be interest payments, the tax deduction can be large. Operating expenses include property taxes, condo fees, hazard insurance, and repairs and maintenance. Since no land is involved, the full cost of a condo can be depreciated. These deductions can amount to a considerable annual sum, which is often larger than the annual rental income, thus producing a negative income. If your adjusted gross income does not exceed $100,000 and you actively participate in the management of the property, you can deduct up to $25,000 of this negative income from your other income. This should include such items as salary, dividends and interest. For adjusted gross incomes of more than $100,000, deductions are more complex. You can carry forward losses from year to year. You can even carry all the losses forward until you sell the condo and deduct them from the sales income. Once more, I recommend a real estate accountant’s advice on the complexities of tax regulations. An expert accountant may contribute additional recommendations, such as deductions for advertising.
Capital Gains Tax Exclusion
I have mentioned this capital gains tax exclusion before and have a few things to add here. Saying it one more time, when you have owned and used a home as your principal residence for at least two of the five previous years, you can exclude a gain of up to $500,000 if you are married and filing jointly, and $250,000 if single. If a couple bought a home for $100,000 and sold it for $600,000, they would owe not a penny in federal income tax. If they sold the $100,000 house for $1 million, they would owe taxes on $400,000. For details, see IRS Publication 523. The exclusion does not apply to condos. It applies to vacation homes only when they qualify as principal residences for the necessary time.
This is not, as many people think, a once-in-a-lifetime offer. You can make use of it every two years. If you sell in less than two years, because of a change in your place of employment, health or unforeseen circumstances, you may be able to get a reduced exclusion. Tax officials have given examples of what they consider unforeseen circumstances, and they include divorce, legal separation, job loss, and the birth of twins or triplets. If unforeseen circumstances cause you to sell after one year instead of two, you typically receive half the exclusion.
