Guidelines for Buying Real Estate for Profit
QUESTION: As a longtime homeowner and recent realty investor, I look forward to your sage advice. What are your guidelines for buying investment properties? Currently I own two rental houses but am considering buying apartments and maybe commercial buildings. What do you think of land investments?
ANSWER: My basic guidelines for buying investment property include buy “fixer property,” which will go up in value $2 for each $1 you spend on improvements; make as small a cash down payment as possible to get the best terms and obtain seller financing; buy properties in locations that you expect will appreciate in market value, and aim for at least break-even cash flow from rentals.
This last guideline is hard to meet on rental houses but I don’t mind a little negative cash flow if the residence is appreciating nicely in market value.
The profit on rental houses usually comes from the resale , whereas profits from apartments and commercial buildings come from net operating income and, hopefully, resale profit, too.
I do not recommend investing in vacant land because it is very difficult to finance and usually requires a large down payment, usually produces little or no income and may never appreciate in market value. I prefer improved property, especially well-located but run-down property that can be upgraded for immediate increase in market value.
Use ‘Lemonade’ to Get Rid of Sour Deal
Q: Please help me. I recently inherited a one-sixth partnership share in an apartment building. The estate executor tells me it is worth about $200,000. But the other five partners do not want to sell the building, which produces a nice cash flow. I have tried to sell my share to the other partners but the best I can get requires a 20% discount. I want to use the money to buy a nice home. Any suggestions?
A: As you have discovered, there is virtually no market for a one-sixth share of an apartment building partnership. But that $160,000 offer for a $200,000 partnership share is very good. You might reconsider accepting it.
Another alternative is to offer to trade the partnership share as all or part of your down payment on the home you want to buy. Many home sellers would love such a big down payment, especially since it produces a good cash flow. But you may have to sweeten your offer with a little cash, especially to pay the realty agent’s sales commission. This technique is called “lemonading.”
Does It Matter to Be Realty Dealer?
Q: As an investor, I frequently buy and sell properties. I recall years ago it used to be important to avoid being called a “real estate dealer.” Since the capital gains and ordinary income tax rates are now the same, does it matter anymore?
A: Yes. Although I haven’t heard of the IRS arguing much about dealer status lately for very active realty investors who frequently buy and sell properties, if you are declared to be a dealer then you would become ineligible for depreciation of your properties and for tax-deferred exchanges. Those are the two major disadvantages of being a realty dealer. Consult your CPA for further details.
Be on Guard Against Property Milker
Q: About a year ago, we sold our apartment building and carried back a $225,000 second mortgage. All went well for about six months. Then our mortgage payments stopped coming in. When I contacted the buyer, she said the building was suffering high vacancies and she couldn’t afford to pay us.
But I drove by the building and didn’t see any vacancy sign. I phoned some of my old tenants who still live there. They said the new owner has cut back on maintenance and the building is going downhill rapidly. As far as they knew, the apartments are all full. What can I do to get my money?
A: The new owner is obviously milking your former building by keeping the rental income and failing to pay the expenses. Check with the first-mortgage lender to see if payments are being made. If not, to prevent the first lender from foreclosing and wiping out your second mortgage, your best protection is to immediately begin foreclosure.
You may also be able to get a receiver appointed by the court to collect the rents, operate the building and pay the expenses. You may already have waited too long to consult a real estate attorney to start foreclosure.
Negligent Agent Is Liable for Thefts
Q: I live out of town and a local realty agent manages four rental houses for me. When one was vacant, the agent gave the key to a prospective renter who came to his office. The key was never returned. The next day the agent went to the house and found it stripped of the appliances, new carpets, water heater and even some of the light fixtures. The cost of restoring the house will be about $4,000. Do you think the realty agent should pay?
A: Yes. The realty agent who manages your houses appears to have been grossly negligent for giving out the key to a prospective renter without accompanying him or at least taking identification, such as a copy of the prospect’s driver’s license and holding some credit cards as security. Since the agent breached his fiduciary duty to you, the agent should pay for your loss.
Be Prepared for IRS Tax-Deferral Challenge
Q: About a year ago, we tried to sell our home but were unable to do so because of local economic conditions. So we rented the house. Now we want to sell as the market has improved considerably. Will we be able to defer the tax on our sale profit which we expect will be about $30,000?
A: Probably. As you surely know, Internal Revenue Code 1034 allows you to defer your home sale tax when selling your principal residence if you buy a replacement principal residence of equal or greater cost within 24 months before or after the sale.
However, this law does not say if a temporary rental due to local economic conditions will disqualify the tax deferral. But a Tax Court decision (Clapham 63 T.C. 505, 1975) allowed tax deferral in similar circumstances where the seller took three years to sell his former residence which he rented in the interim.
If you claim tax deferral be prepared for an IRS challenge which you may successfully meet. Please consult your tax adviser for full details.
What Is Break-Even Point for Commercial?
Q: I am considering buying a mixed-use commercial and residential property. The apartments are 95% full. But the commercial space is about 35% vacant, due to absentee management. The seller is offering the property at eight times gross income. Do you think this is a good buy?
A: Never, never, never buy income property based on its gross rent multiplier. The reason is the gross multiplier does not consider the operating expenses and debt service. The gross multiplier method of pricing income properties is used by sellers who hope an inexperienced buyer will overpay for the investment.
Since the property has a very high vacancy factor, one approach to evaluating it is to consider its break-even point. Based on realistic rents, not the seller’s projections which are probably far too high, calculate what rental income is needed to break-even with operating expenses. Then evaluate the probability of attaining at least the break-even point within six months.
Presuming the property is well-located and in basically sound condition, another approach to evaluating income property is to capitalize its net income. Be sure to include a realistic vacancy estimate. Use a capitalization rate for the net operating income (excluding depreciation and mortgage payments) based on recent sales prices of comparable nearby income properties.
Resale Market Slim for Partnerships
Q: Just before the 1986 Tax Reform Act, I invested $40,000 in a small real estate limited partnership syndication of 12 investors. The property is doing quite well and provides nice cash flow of about 12% annually.
However, the other investors have no intent of selling the building any time soon. But I want to sell my share. I offered it to all the other investors and they will pay me only a small fraction of my investment. I contacted Liquidity Fund in Emeryville, Calif., which you recommended some time ago but they are not interested. Any ideas?
A: One way to get rid of your limited partnership share is to offer it as all or part of your down payment on real estate you may want to buy. But you may have to sweeten your purchase offer with a little cash. However, be sure to first consult your tax adviser about the tax consequences of such an offer.
Letters and comments to Robert J. Bruss, a San Francisco-area lawyer, author and real estate broker, may be sent to the Real Estate Section, Los Angeles Times, Times Mirror Square, Los Angeles 90053.
