How To Know When You're Ready to Invest In Commercial Real Estate
The adage of "invest in real estate because they're not making it anymore" has enticed more than a few people to buy property. There is money to be made in this alternative asset – and for the unwary, money to be lost.
That's because real estate isn't just an investment; it's a commitment, too. "If you're going to take on the responsibility of an investment property, you have to be prepared," says Nancy Doyle, author of "Manage Your Financial Life."
Even after you've shelled out a healthy sum to purchase an investment property, it continues to hit you with costs, whether for taxes, upkeep or refurbishment. If those costs are more than you're prepared to take on, selling the property won't be as easy or quick as trading a mutual fund, and as with any investment, price appreciation isn't guaranteed.
So forget about the late-night TV ads that say anyone can get rich quick in real estate. Not everyone can, especially investors who haven't thought things through, but you'll know you're ready to become an investment property owner if you can check off these five requirements.
Your personal finances are in order.
To know if you're ready to handle the costs, look at your personal spending. Doyle advocates using the 50/30/20 rule, which is 50 percent of your salary goes to needs, 30 percent to wants and 20 percent to savings.
You'll need savings because down payments to buy that first investment property can range between 20 and 25 percent of the purchase price, depending on the type of property, says Dean Hedeker, principal of Hedeker Wealth, a wealth management and financial planning firm in Lincolnshire, Illinois.
Take the time to boost your credit score, too. The higher your credit score is, the better the terms you can get for loans, Hedeker says. A good credit score helps because interest rates for investment property loans are usually higher, says Steve Azoury, owner of Azoury Financial in Troy, Michigan.
You're ready for a big learning curve.
Being a landlord isn't as simple as renting out your condo to someone, says Michael Anselmo, an associate attorney specializing in real estate at Anselmo Lindberg & Associates in suburban Chicago. Each city has its own laws regarding tenants' rights, and in condo buildings, the association may tack on another set of rules.
In Chicago, for example, landlords need to take special care with the security deposit. It must be segregated from the property owner's funds and in its own interest-bearing account. The lease must name the institution where the funds are held, and the interest must be paid to the tenant, among other requirements. Landlords who fail to comply with these rules can face fines two times the amount of the security deposit, Anselmo said.
You've researched the market.
Jeff Cronrod, founder of the American Apartment Owners Association, who says he has personally bought and sold 4,000 units, advises you to find out as much as you can about the area where you want to buy.
That includes understanding your competition – the type of units for rent, their going rates and vacancy rates – and your market, especially who lives in the area and what draws them to live there. Get everything in writing from the seller. "We've seen all kinds of fraud on the part of the sellers," Cronrod says.
Rent fraud in the form of an exaggerated claim for the going rate is common, he says. Don't rely on what sellers say is the current rent; get offset statements from renters instead. These signed certifications verify the amount of rent tenants pay, when it was last raised, the amount of the security deposit and the name of the person living in the rented unit. Then compare that information with the rent and other details stated on the lease.
You can handle vacancies and repairs.
When a property sits empty, the owner loses money and can be highly motivated to get anyone in the unit.
That can be a costly mistake if a landlord skips the renter's background check to get the unit rented sooner. "One reason why the eviction rates in the country are very high right now is because we have unsophisticated landlords making a lot of mistakes," Cronrod says. "People use fake IDs; people may not tell you the whole truth about everything, from their job to their past."
Background checks for credit, evictions and criminal records, including sex offender convictions, cost money. But the money spent upfront will save landlords thousands. "Evictions are just terribly expensive both in terms of attorney's fees and downtime lost rent," he says.
Even with good tenants, property owners still have maintenance costs, whether it's fixing broken pipes or replacing old windows. How much money you need to have saved for that upkeep will vary by location and property, but Cronrod says generally owners should expect fixed expenses to range between 35 and 45 percent of gross income on a multifamily building. Owners should set aside at least 10 percent of their scheduled gross income for big repairs like roofs.
You know your capabilities.
Are you good at negotiating purchasing prices and rehabbing properties for a quick turnaround of the investment? Or are you a patient investor who is willing to tie up money for many years to see if the property value appreciates? Your capabilities will determine the type of real estate investor you can be, as there are different ways to do it, Cronrod says.
Still, a few ground rules should steer you clear of trouble. "You always want to make sure you cover your downside," he says. "Invest for the long term. If you think you can get away with [an investment] in the short term, great. But if you fail to sell it, it shouldn't cost you anything to hold on."
Article originally appeared in U.S. News & World Reports.