Initial price of property key in real estate investing

Published 9:31 pm Friday, July 10, 2009

Question: I am planning to start investing in real estate.

I have read your past columns about how to manage rental property. I agree with the two points you made, the first being that this will be a part time job for me and the second is the importance of finding a good tenant.

Now that I’m ready to get started, can you give me some information regarding the initial purchase?

Answer: First of all, there’s an old saying in real estate that you make your profit when you buy, not when you sell. In other words, you have to buy the property at a low enough price so that you are certain to make a profit when you sell. If you count on appreciation to raise the value of your property and generate a profit, then you really are gambling.

Many first-time real estate “investors” learned that lesson the hard way during our housing bust. I put the term investors in quotes because they weren’t really investing in real estate with a sound business plan, they were simply buying houses with the hope that somebody else would pay more for them 6 to 12 months later. That can work if you are very lucky and get in and get out at just the right time, but it never works as a long-term strategy.

It’s a highly risky plan for anyone other than an experienced real estate investor.

Your question deals with buy-and-hold property, so I will focus on that strategy in this column. If you buy a rental property with little or no down payment, it will be virtually impossible to generate enough rental income to cover the high monthly mortgage payments — not to mention the typical maintenance and repair costs. You would have a negative cash flow, which means that you would be paying money out of your pocket every month just to hang onto the property. Real estate investors call this an alligator because it can eat you alive.

Your only hope of turning a profit is if property values go up faster than you are losing money in monthly carrying costs. In my opinion, that’s a risky bet.

The best way to minimize your risk is to try to buy a property below market value so that will not lose money if you are forced to sell sooner than expected. That can be difficult to do because average home values are still falling and who knows when they will bottom out. The best strategy is to concentrate in lower-priced housing areas where there are homes that are affordable to first-time home buyers.

Even in a slow housing market, there are always people looking to buy their first home. We are already starting to see sales of starter homes pick up now that prices have fallen dramatically from the market’s peak in 2007.

Also, don’t limit your search to your local neighborhood. You may have to go a long way from home to find property that makes sense as an investment. For example, way back in the housing boom of 1989-90 I couldn’t find any houses in the Seattle-Bellevue area that I could buy at a low enough price to make sense as a rental property. I had to go all the way to Tacoma where I paid full-market value for a nice little house near the University of Puget Sound campus. It had a break-even cash flow from day one and I still own that house. It is now worth about three times what I paid for it, even after the recent drop in home values, and it rents at a very nice positive cash flow.

The key is to try to find a property that you buy at a low enough price, and with low enough mortgage payments, to at least break even with your monthly rent income. That probably means making a big down payment of at least 20 percent to 30 percent and shopping very hard to find a decent deal. If possible, try to stay within a 30- to 45-minute drive from your home in order to make it easier to rent and manage the property. However, you may have to go farther out if you live in a fairly expensive housing area. Don’t rush, take your time and make sure you buy right.

I know this advice is a lot different than what the get-rich-quick guys tell you, but this is a realistic way to buy and hold real estate without gambling on appreciation to bail you out of a dumb mistake.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206, or e-mail him at economy@heraldnet.com.