Small Business Taxes & Management^TM--Copyright 2014, A/N Group, Inc.

Introduction

Despite the recovery in real estate values, it's not too late to be investing in rental properties in many markets. One of the reasons is the generally strong demand for residential rental properties and good demand for office space. But, location is critical when it comes to pricing. It's tough to do well in an overheated market, especially when coupled with less than vigorous rental demand.

No matter what the market, you should always keep in mind that making money in real estate is not as easy as it's often portrayed. Just because your co-worker may be soon to retire at 50 on his rental empire doesn't mean that the outcome will be the same for you. Making consistent money in real estate isn't as easy as it sounds. The article below contains a brief discussion of suggestions, pitfalls, and options.

Rental Properties

Do your homework. Study the market and your options carefully. Buying the right property is key and just jumping in is a good way to get stung. We know one investor who studied the market and looked at properties for over two years. When a distressed property in a good area with significant rental potential came to market she jumped and got a fantastic deal.

Long haul. While money has been made flipping properties, that's best left to investors who can deal with foreclosure transactions (the selling bank will usually not wait for you to get a loan) and the rehabbing it will take to get the property in shape. You may not have time to do a complete inspection of the property and an unseen problem such as mold, asbestos, or a bad septic system can wipe out potential profits. In addition, success in flipping properties is dependent on timing. Buying at the right time and selling at the right time. If the market sours during your holding period, you may not recoup your investment, much less earn a profit. You're chances are better if you're in a hot market and you've got experience in construction. First timers should consider partnering with someone with experience in flipping.

Developing raw land can produce significant profits, but it often requires a substantial investment of time, money, and work. The danger is that during the holding period the market can turn on you. That's what happened to many investors in the recent crash. Your expenses can continue and you may have little or no income. Should the property be foreclosed on, there's a good chance you'll lose your entire investment.

Buying a rental property, getting a good cash flow to pay the expenses, providing a return on your equity, and selling for a capital gain some years in the future generally produces the best return. While the market could still turn on you and selling the property could be difficult, if the property is generating positive cash flow, holding won't be nearly as painful. Real estate can be very illiquid. Not the smart move if you'll need money for your daughter's college in two years. (In some markets houses have been known to take several years to move.)

Single family residential, office building, retail space? Money can be made on virtually any property. Two partners invested in a two-family houses in a dying mill town in New England. Rents were low, but the houses could be bought for a steal. One of the partners was a plumber, the other was handy at construction.

The different types of properties all have advantages and disadvantages. A single family residence has a lower acquisition costs, less management demands, maintenance and zoning is usually similar to a personal residence, and there's a better chance for a quicker sale if need be. The market for a single-family residence is much bigger than that for a commercial, retail, or apartment building. Multi-tenant commercial property requires more management and dealing with only even five tenants can be taxing at times. Office buildings are generally less management intensive than retail space. And retail space with food service such as a restaurant can ramp up management problems. Depending on the location and size, commercial properties can be far more expensive to purchase than a single family property.

Fixer-Upper. "We'll get it cheap, spend a few bucks, and rent it out". Unless you have construction background or are at least handy and have the time, this could be a bad move. Painting the outside of the house could easily exceed $4,000. A new roof $6,000. Of course this depends where you live, how big the house, etc. Even a number of relatively minor upgrades can hit $50,000 quickly. Before committing, get estimates for the work, then increase the number by 30%. You may still be low, but closer. And, if you sold the property soon afterward you're unlikely to recover your investment. Unless you've already got a couple of properties, you can buy the place very cheaply, or you've got a lot of spare cash, it's probably best to avoid a fixer-upper, at least until you have experience.

Another point. The longer it takes to bring the property to rental status, the more costly the project, even if you don't pay more to the contractors. Every month the property is vacant you're losing rental income, yet paying the mortgage, insurance, taxes, and sundry other costs.

Developing a property. The dream of many entrepreneurs. Buy raw land and construct a building on the property. Or gutting and redoing an existing building. Much the same story as in "Fixer-Upper" above, but with many additional problems.

If you've got a construction loan, the lender may provide additional funds only after reviewing the work that's been done. You'll also get much more scrutiny from the local government which could even have specific requirements as to the parking lot, outdoor lighting, wetlands, etc. You'll need an architect and probably and attorney to working on zoning and permits. Municipal inspections of the work can slow progress and may even require rework. Acquiring permits may also delay progress.

If you're developing a property with multiple tenants you'll need to get it leased. This is often more difficult than leasing residential rentals. It can easily take a year or more to get even a quality building or shopping center fully leased. During that time the mortgage, taxes, etc. must be paid, even if the rental income won't cover the expenses. Leases for office buildings and retail properties don't turn over as frequently as they are usually written for three, five, or even ten years. That limits your universe of prospective tenants. Other factors include the vacancy rate in your area, recent new construction, market growth, etc. Finding tenants for a property can entail a significant marketing effort.

Single tenant commercial property. A retail or office space with only one or two tenants is easier to manage, but when a tenant leaves it can be difficult to find a replacement for the large space. In many cases it can take a year or more to replace a tenant, even in a good location. That can be very costly. You should consider only the best tenants and get a long lease term.

In some cases a single tenant may be your only option. Fred's Auto Service is likely to be the only occupant of a property. The plus is that Fred's is unlikely to move; the negative is that the business could fail. If you're looking to buy such a building, checking the tenant is just as important as an appraisal and engineering check on the property. You should be particularly careful with certain tenants such as auto repair, manufacturers, etc. where hazardous chemicals could be present.

Vacation properties. Sounds like a no brainer. Buy a condo in Florida, rent it during the year to vacationers and spend just a month in it during the winter. The renters pay for your vacation home and you stuff some extra cash in your pocket. You're not the first one to have that idea. And generally it doesn't work out nearly that well. Commissions to renting agents, maintenance, repairs, condo fees, taxes, and other expenses will likely decimate your gross income. You'll most likely have to pump in significant amounts of cash every year.

On the other hand, if you're renting to your friends or office buddies, found a good property in an attractive area, etc. you could do well. And some seasonal rentals can produce a very good return on investment. Areas such as the Cape Cod area, the Hamptons on Long Island, etc. Vacation home on an attractive lake? Again, chances are high for a good return. A home in town two miles from the lake? Probably not. Spend at least one vacation season in the area you're looking to buy a property. Your accountant may be able to help. Chances are he's got clients who have rental properties in the areas you may be interested in.

We'll discuss lease issues and buying a property in Investing in Rental Real Estate--Part II.

--Last Update 10/27/14