Recent declines in the stock market have many people looking for safer investments to protect their hard-earned dollars. While real estate investments have not recently yielded the kind of returns the stock market offers, it is rare that real estate declines in value, as has been the case for stocks during the 2000-01 time frame. It is also a known fact that approximately 70% of the millionaires in the United States became millionaires by buying real estate.
You should consider investing in residential real estate to spread the risk of having too much of your assets in the stock market and taking advantage of some additional tax deductions that are only available to active real estate investors. Active real estate investors may deduct up to $25,000 per year from their gross incomes for interest, taxes, depreciation, maintenance, repairs and other miscellaneous expenses, as long as their adjusted gross income does not exceed $150,000.
If you decide that investing in residential real estate has merit based on building assets, providing long term income and providing additional tax breaks, you need to develop an investor game plan. This is where my experience as an investor may be beneficial to you.
The way to make money from residential real estate requires locating one or two homes each year that can be rented out for amounts equal to or greater than the mortgage payment on that property each month. The properties generate “positive cash flow” or monthly income. Plus, properties usually increase in value over time and the properties can lower the federal and state taxes the investor pays each year by deducting as much as $25,000 off of taxable income.
This method does not require being handy or investing one’s sweat and substantial amounts of time. In fact, it does not require looking at run-down properties either. The investor can actually look for investment properties that are in excellent condition. The search can be conducted by utilizing the newspapers, Internet, and MLS information through real estate agents.
The decision that I made as an investor was to use an approach that provides long-term income from my investment properties. The approach of “flipping” properties does not provide long term income, only short-term income. The income that I derived from my employment has always been adequate to live on. Therefore, I decided to look at my real estate investments as long-term with the intent of paying off the mortgages as soon as possible. Once the mortgages are paid off, the monthly income skyrockets. So, I set a goal to take as much of the positive cash flow as possible and pay it towards the principal of the loan, to reduce the term. While the investor certainly does not have to return the positive cash flow to the principal to shorten the loan term, it has dramatically reduced the payoff terms for me. In addition, the return on investment is roughly the mortgage rate of 8% or higher compounded over 30 years. A nice guaranteed rate of return.
I also discovered that if you never sell your real estate investments, you never have to pay capital gains taxes on the increase in value. Nor do you have to pay back the depreciation that you get to deduct yearly on the investment property. I also found out through an attorney that the real estate investments could be placed into a trust that would pass to my heirs without having to pay capital gains or repay depreciation. All this in addition to the previously mentioned $25,000 annual tax shelters confirmed my decision to own the investment properties for life, as opposed to many investors that constantly buy and sell properties.
Hopefully, many of you will begin to see that residential real estate investments can provide supplemental income or a retirement income which you cannot outlive. My thought process went something like this. When I reach retirement age, social security will provide about $1,500 per month, which would only insure that I could live. Not live well. I figure that every rental house that I own free and clear will generate an additional $1,000 net income per month and that additionally I should be able to raise the rent to keep up with inflation.
For instance, if you need $8,500 per month to live comfortably in retirement, and you can look for $1,500 from social security, you had better plan to purchase and pay off 7 rental houses by your retirement date. In order to accomplish this objective or any other that you may have, you need a plan. Your plan should call for a realistic purchase of at least one rental house per year. You should be prepared to invest up to 15% of the purchase price of such a property in cash to obtain the property, although some properties can be purchased for a lot less.
You should limit your home search to single-family homes or duplexes that have their own yards, garages and provide more privacy than condos or apartments. My experience is that single-family homes are always in demand, as they are a definite move up from any apartment. This is not true of condos as many people view them as just another apartment. They can be very difficult to sell in a depressed real estate market.
The price range of the homes that you should search for should be at the lower price range, but not the lowest price range. You want homes that will rent for a positive cash flow and the lower price homes tend to be this while the mid to upper price homes, generally will not rent for the payment, creating a negative cash flow. On the other hand, the very lowest priced single-family homes tend to be in run down areas, which will only get worse with time.
The next goal that you should set is to locate properties that have good terms for real estate investors. That is, properties that can be purchased by real estate investors without incurring numerous hassles from lenders. Investors quickly discover the fact that they pay higher interest rates, higher points, and are required to put more money down than owner-occupant purchasers. In addition, many lenders limit investors to 4 investment properties.
To save you and your clients a lot of lender hassles, limit your search of investment properties to those that have VA mortgages on them and properties where the seller is willing to provide financing. The reason to limit your search is that it will save you a lot of hassle, as FHA loans are no longer assumable by investors and properties requiring conventional investor financing allow the conventional lender to gouge the investor. That is, instead of 7% and zero points, with only 5% down, conventional lenders making investor loans might charge 8-8.5% interest, 2-5 points and require 10-25% down.
On the other hand, a VA mortgage could be assumed by the investor at 7% interest, for .5% assumption fee and a $300 processing fee, plus whatever equity, if any, is in the property. There are no limits to how many VA mortgages may be assumed by the investor. And the investor does not have to be a veteran or occupy the property. VA rules state that the investor must qualify for the loan in order to release the veteran from liability. However, a little know rule change that came out in 1990 with VA circular 26-90-37 (see page 15-B COMP.GUIDE) allows for two major exceptions to qualifying:
- First VA will allow non-qualifying assumptions if the (A) veteran is unable to continue making payments (B) reasonable effort has to have been made to find a credit-worthy buyer for the property. This non-qualifying assumption is granted on a case to case basis.
- The veteran borrower may also sell the VA property on an installment contract, lease purchase, contract for deed or similar arrangement in which the title is not transferred from the VA seller to a buyer. VA does not consider this a “disposition” of the residential property securing a VA loan, and therefore does not require approval by VA or the loan holder prior to the execution of such agreement. The veteran would remain liable for repayment of the loan.
The significance of this rule change is that any Veteran could sell his house to investors in 3 acceptable ways. 1. Sell to an investor with the investor being qualified and approved by VA. In this case, the veteran is no longer liable for repayment of the loan, the investor would be. The veteran’s eligibility would still be tied up in the loan to protect the lender. But said veteran could purchase another house elsewhere using the Nehemiah gift program or FHA or conventional financing programs. 2. If the veteran is headed towards a foreclosure due to financial difficulty, the veteran may be able to accept an investor non-qualifying offer to purchase. The veteran would avoid foreclosure and having his credit ruined, the VA would avoid having to pay a foreclosure claim The investor can purchase without going through the loan-qualifying situation. 3. The veteran could sell to an investor under the installment provision, allowing the vet to sell quickly without requiring the investor to go through formal loan qualification. The investor would pay the veteran’s mortgage payment from the rent and pocket any positive cash flow. The veteran is still the owner of record and could take the property back in the event the investor does not meet the terms of the installment purchase.
Properties where the seller will carry the financing are also desirable, because the seller of the property is motivated to sell and has no axe to grind with investors. This seller will often provide market rate financing and are not nearly as stringent on loan qualifications, as conventional lenders are.
Once you have set some parameters such as price range and loan types to look for, you should begin reading your local newspaper under homes for sale and having a real estate agent search their multiple listing system looking for properties that have VA mortgages. I personally have set the following requirements: price range $75,000 – 120,000, size 3 bedrooms, 2 baths, 2 car garage, minimum 1,400 Sq. Ft. Property must have assumable VA loan or seller financing, with no more that 15% of purchase price to assume or put down. (I am fully aware that in high cost areas of the country such as the East and West coast these parameters are not possible, but in the Midwest, South and Southwest they may be.)
Now that we have some general residential real estate investment goals set, let us outline what they are. You may wish to change the goals to suit your needs and you may have to adjust the property requirements to meet the housing available in your area.
1. Let’s assume the goal is to purchase a minimum of one residential single-family home or duplex each year, with the total number eventually owned free and clear at 8-10. These properties should generate $8,000-10,000 per month retirement.
- The home should be at the lower end of the price spectrum, but not the very lowest. The home should be no less that 1,400 sq. Ft. with 3 bedrooms, 2 baths and 2 car garages.
- The home should be in good for-sale condition, to limit work and expense.
- The property must have an assumable VA mortgage or the seller must be willing to provide a first mortgage of 90% of the purchase price for 30 years at not more than 7.5% interest.
- The total cash ought to be 15% of the purchase price or less. This include cash to assume VA loans or down payment and closing costs, if seller financed.
- The house must rent for at least the total house payment. The greater the positive cash flow, the better.
- The home must be in a reasonably well cared for neighborhood.
- The age of the house should not exceed 20 years.
- Look at this investment as long term, not as an immediate investment.
2. The purpose of purchasing residential real estate investments.
- To build long term wealth and assets.
- To build a supplemental retirement income.
- To reduce taxable income by as much as $25,000 per year.
- To produce a positive cash flow, which a large portion can be used to make advance payment to principal, in order to pay the mortgages off before the scheduled payoff dates.
3. Tax and estate planning goals to remember.
- The investment properties purchased should be purchased with the thought of never selling them, as no capital gains are owed if the property is never sold. The properties should be placed into trusts for one’s heirs, so they will not have to pay capital gains on the properties.
- If the investment properties are never sold, there will be no recapture of the depreciation taken each year. Once again, the depreciation will not be recaptured if the property is placed into a trust for any heirs.
- One can leave one’s heirs a lifetime trust income, instead of giving a large percentage of it to federal and state governments in the form of estate taxes.
Here is the perfect scenario for those of you looking for residential investment property, which will take time and effort to locate: Listing price $112,000. 3 bedrooms, 2 baths, 2 car garage, 1500 Sq. Ft., Existing VA loan dated 3/98 $102,000. Requires $10,000 to assume 7.5% loan. PITI $805/mo. (property will rent for $850 – 1,150 depending on location).
Properties like this exist in many areas of the U.S. and are actually listed for sale with real estate agents who no longer bother to identify the loan type as VA or the loan balance of $102,000 in the listing sheet that is sent to the Multiple Listing System. Consequently real estate investors can not locate and purchase them, even though a full price offer might be appropriate. Why not, you ask? The listing agents simply do not understand how attractive these properties are to real estate investors or they mistakenly believe investors can not assume the VA loans. Listing agents who do not discuss the possibility of selling the VA loan on assumption with the veteran seller are somewhat derelict in their listing duties.