Real estate … the 6 ways it pays

What a deal!  Real estate pays you in 6 different ways!  Yep, that’s a lot of streams of income.  So even if your property is “cash flow neutral”, which I would definitely try to avoid, you’re still making money in at least some of the other 5.  And here they are in no particular order.

Cash Flow

Cash flow is simply the money that goes into your pocket each month.  It’s income minus expenses.  When you’re buying a property, this is the metric you should use to evaluate whether or not it’s a good deal.  Remember, cash flow negative properties CAN make you money, but if you buy one, you’ll have to subsidize if for a while from other income.  I only buy properties that are at least somewhat cash flow positive.

Appreciation (Market Appreciation)

Aside from the bubbles that have occurred lately in real estate, houses and apartments typically appreciate at slightly above the rate of inflation nationwide and in some markets, much more.  I never count on a proprety appreciating in value because I consider this more in the realm of “speculation” and I’m not a good speculator.  When my properties do appreciate in value (which they always seem to do), it’s a bonus.

Appreciation (Forced Appreciation)

If a $500 upgrade (say, new paint and carpet) allows you to raise the rent by $100 / month ($1200 / year), you have just increased the value of your asset many times the amount spent.  As a property owner (unlike the owner of other investments), it is in your power to make these improvements.  Your $500 investment pays itself back through increased cash flows ($1200 a year in this case), and through increase property value which can be accessed by selling the property or taking a loan out against it or using it as collateral for buying other houses.

Equity Capture

When you buy a property, you will (hopefully) not buy it at full market value.  If you buy an $100,000 property for $80,000, you have just added $20,000 to your net worth.  Like Forced Appreciation, this $20,000 isn’t immediately available to you in cash.  However, some investors will immediately refinance properties like these at the full market value ($100,000 in this case) to pull out their cash for another deal.

Principle Paydown

If your property is financed with a land contract or bank loan, part of the rent each month will go toward principle paydown.  Your liability (debt as a mortgage or land contract) will eventually paid off as you make your loan payments.  Paying off a liability increases your net worth by increasing your debt.  A few notes on principle paydown … the first is that you have to pay taxes on principle paydown.  The second is that is does not show up on Quickbooks’ Profit and Loss report, only on the balance sheet.  When you make a mortgage payment, part of that payment goes to interest (which can be counted as an expense) and part goes to principle (asset account to asset transfer rather than expense).

Tax Advantages

If you considered investing in real estate through a REIT, don’t do it!  You may take advantage of market appreciation (through an increase in share price) and possibly cash flow (through dividends) but that’s the end of it.  You don’t get any of the awesome tax advantages that real estate provides.  For starters, any and all expenses (including mortgage interest and meals with prospective buyers or sellers) can be written off of your income or “expensed”.  Furthermore, and this will merit it’s own entire post, is depreciation.  The IRS allows you to take 1 / 27.5 of the value of the property (building only, not land) and consider it an expense.  That’s right, you can expense something that didn’t come out of your pocket and write it off of your income at tax time.

In closing

Not every property will always pay you in all 6 ways although if you buy a house using a loan and rent it out, it will as long as the market is going up and you make some improvements.  Flippers or folks that buy properties using cash (as opposed to loans) may not get the benefits of one or two of the six but still benefit way more than what is possible with bonds or equities or other “paper investments”.  Just know that when you start buying property (even if it’s just one rental house), you will start a snowball of income that will increase exponentially and very quickly relative to your other investment choices.

Buying a house on Craigslist

Treadmills …. sure.  Lawn mowers …. maybe.  But a house?

Definitely!  Craigslist is an awesome tool for buying anything from juicers to concert tickets and even houses!  When I am on the search for houses to buy as rentals, Craigslist is my first and often only destination.  Sure, you can search the local real estate company or ForSaleByOwner.com but what you’ll find there are folks trying to sell their houses the “traditional way” … or maybe in the case of ForSaleByOwner.com, close enough to the traditional way that we are not interested.  What I mean by that is that the vast majority of people that sell their houses, whether by owner or through an agent, want to be PAID IN FULL at closing.  These are not the types of houses that college students (or someone with let’s say “less-than-stellar” credit) look for unless you got lucky and found a cosigner for a mortgage or found a local bank willing to give you a non-conforming loan.  As a college student, you are looking for the proverbial needle in the haystack … you’re looking for the owner that is willing act as your banker and sell on a Land Contract.

In fairness, most sellers have no other choice than to be paid in full at closing.  Most houses have loans on them that need to get paid off when the title changes hands.  Some sellers need to sell their house in order to clear their credit and buy another house.  Some need the proceeds from the sale for another down payment.  Land Contracts for all intents and purposes are not possible, or at least very risky, if there is an existing bank loan on a property so let’s not go there right now.    We are not interested in houses with bank loans on them.  In fact, we would rather not deal with banks at all.

So how do we find these elusive sellers who own their house free and clear and who don’t need a lump sum of cash immediately?  We search for Land Contracts.  Personally, I would start by scrolling through the listings before doing a more targeted search.  In your cities Craigslist, under “Housing”, click on the “Real Estate for Sale” link.  The problem with this directory as a whole is that the majority of the listings end up being brokers who have wised up to the power of Craigslist and are posting their client’s houses there.  Lame.  You can tell these apart because they have the “real estate – by broker” link after the listing.  You see, some real estate agents (or Realtors ®, as those that are part of the National Association of Realtors like to be called) have wised up to the “power of the interweb” and think that putting their listings on Craigslist is a good idea.  But don’t get me started on Realtors … or real estate agents for that matter.

To find the individual owners that are selling without brokers, scroll down until you find a listing with a “real estate – by owner” link after it.  Click on that link to get only the “For Sale by Owner” listings.  To make it quicker, you can just go to the following link …. http://annarbor.craigslist.org/reo (obviously substitute your city for the “annarbor” in the example).  These are the listings that we as savvy buyers are interested in and only include listings where the actual owner is trying to sell their own house.  The other stuff is just riff-raff and can easily be found and more effectively searched on Trulia or Zillow or any one of hundreds of websites that pull data from the MLS.

As you look at each listing in the “Real Estate by Owner” directory, you will start to get a feel for how common (or how uncommon) land contracts are.  Even in the For Sale by Owner listings, very few owners can or want to offer Land Contract terms.  As with the more traditional listings, most of these folks need to get paid in full at closing.  As far as Land Contract listings are concerned, some motivated sellers may advertise that they’re willing to offer a Land Contract right in the title of the listing like these gems, pulled straight from the http://annarbor.craigslist.org.reo on May 5th, 2013.

Large Campus/Downtown Ypsi Condo – Land Contract! $34900 / 2br – 1000ft²

3 Bedroom Brick Ranch. Land Contract Available

More often, the seller is willing to offer a land contract but would rather be fully paid at closing and therefore will not advertise it as a selling point.  In cases like these, this is usually indicated in the body of the Craigslist posting:

“NICE BRICK HOME, NEW ROOF WITH FULL BASEMENT FERNDALE SCHOOLS!!!!!!!!!!!!  XTRA LARGE KITCHEN AND DINING AREA NICE LIVING ROOM.  GOOD SIZE BEDROOMS.  HARD WOOD FLOORS.  THIS HOUSE IS A FIXER UPPER NEEDS KITCHEN COUNTERS , PLUMBING, WATER HEATER ONLY $3500 LAND CONTRACT WITH LOW MONTHLY PAYMENTS.  BRING ALL OFFERS OWNER WILL ACCEPT A LAND CONTRACT.  THIS IS A NICE SOLID HOUSE IN A CENTRAL LOCATION.  CALL XXX-XXX-XXXX FOR DETAILS.”

Why do so many sellers write their ads in all caps?  That’s a very good question.

Let’s talk a little bit about the psyche of people that are selling their house on Craigslist.  As a buyer or investor, ideally we are looking for motivated sellers.  We are looking for people that REALLY want to sell their house.  If someone is offering a land contract as a selling point, then they are more than likely a very motivated seller.  So that’s a good thing right?   Well sort of … but be careful.  They could be motivated for all the wrong reasons.  If their house is trashed and unrentable without considerable improvements and repairs, then we may want to stay far away from that house.  A lot of the folks that offer land contracts fall unfortunately fall into that category.

So how do you figure out why someone is a motivated seller?  Well, give them a call!  There are tons of reasons why someone might be a motivated seller.  Maybe they’re moving out of town.  Maybe the are in the business of flipping houses, not managing them.  Maybe they’re sick of being a landlord.  Maybe they inherited the house … and the list goes on.  Also, just because a house need some TLC doesn’t necessarily mean it’s a bad house or a bad investment.

Buying houses on Craigslist is all about Social Credit and relationships.  Each and every time you contact a seller you are starting a relationship with them.  If you end up negotiating a Land Contract with them, this relationship could last for years.  I am still very good friends with the first guy I bought a house from on a Land Contract.  We have done several subsequent deals together, he has mentored me in many ways, and we have actually become close friends.

Once you’ve found the house you want to buy and begun a relationship with the seller, the negotiations begin.  With a deal like this, chances are you will not be using banks or real estate agents (or Realtors®, as they would prefer).  You will be using a sales contract, possibly a home inspector, and definitely a title company to close the deal.  The techniques for closing the deal can be found at the end of my “College Student Home Buying Guide“.  (Of course, the same techniques apply if you’re not a college student).

As always, it is my goal to help you buy a house, whether it’s your first house to live in or your first rental property.  If you have any questions, please feel free to contact me and I will respond as soon as possible with whatever advice I can give.  Thanks for reading to the end of this post and have a great rest of the day.

What is your “social credit score”

Social Credit Score

Your creditworthiness amongst those that you have a relationship with.  The willingness of your friends, family, and acquaintances to lend you money.  An alternate way to think about your credit score that does not reduce you to a three digit number.

Today’s banking industry would have us believe that you are defined by a three digit number … the infamous credit score.  The powers that be have assigned each and every one of us a number that has the power to control much of our destiny.  But do we have to live in a word where we are defined in this way?  Does the system that bestows our credit scores upon us hold the only set of keys to borrowing money?  Increasingly the answer to this question is … NO!  More and more, individuals nationwide are opting out of the system that in the past 5 years (and arguably much longer) has not given them a fair shot at the nation’s wealth.  They are circumventing the system through crowd-sourced lending, local investing, land contracts or lease-options to purchase real estate, bartering, and cash transactions.  The “relationship model”, which has been largely replaced by FICO scores in most banking transactions, is making a comeback.  Although the FICO score (or other similarly calculated credit score) still holds a great deal of weight, for an ever-increasing number of people, it is their “social credit score” that really matters.

Picture with me for a minute an office of 10 people.  Every day for lunch, those 10 people go out either on their own or in groups to get lunch at a restaurant and every day, these 10 people lend and borrow money from eachother.  One day someone forgets cash, the next someone needs to stay back and asks his colleagues to pick something up.  If you’re in that situation, it doesn’t take long to figure out who will pay you back and who will not.  This is social credit.  Eventually those with low social credit scores, in other words those that don’t pay back what they owe or who never offer to buy for others, will have a smaller pool of people willing to buy lunch for them.

Now picture this happening on a larger scale, where in order to borrow money you don’t have to hope and pray that that credit card payment you missed 4 years ago will bring you down to 660 causing you to once again get denied by Bank of America for a mortgage.  Instead, you have to develop some sort of relationship with another individual and convince them that you are worthy to borrow their money.

Crowd Sourcing or Peer-to-Peer Lending

Crowd-sourced lending is a prime example of a marketplace where one’s social credit score matters.  Sure, to get approved at The Lending Club or Prosper.com you will have your regular credit score checked, but that is only part of what qualifies you for a loan.  The other part is the potential borrower’s story or their reason for wanting to borrow money.  The story, although often only a few lines of text, begins a relationship between the borrower and lender.  Here are a few examples of people’s stories from Proper.com …

1.  Purpose of loan:  Pay off four loans/credit cards  |  My financial situation:  I can easily make the payment and will probably pay it off early.

2.  Purpose of loan: To pay off existing high-interest debt and began saving for my son’s              college education.  |  My financial situation: I am a good candidate for this loan because I am an honest, hard-working professional educator who is tenured and never makes late payments to creditors.

3.  Purpose of loan: Rental property purchase.  This loan will be used to complete a purchase of a rental property.  |  My financial situation: Good.  I am a good candidate for this loan because I have my regular income and I also have rental income coming in I have almost completely paid my credit cards and I have had a loan with prosper before and paid it off early.

Unlike going to a bank that is only concerned with whether they will be able to sell your loan to Fannie or Freddie, peer-to-peer lending takes the power of lending money away from the government and puts it back in the hands of individual lenders and at least partially restores the relationship model of lending.

 Land Contracts or Lease Options to Purchase Real Estate

Take a look at your local Craigslist real estate listings (http://yourcity/craigslist.org/reo) and chances are you will find a home seller offering to sell their house via a land contract.  Alternatively, if you list your house to sell in that directory, you will certainly get emails or calls from potential buyers asking if you would consider a land contract or lease-option.  Land contracts and lease options are two ways that real estate ownership changes hands without financing from a bank.  In a land contract, the seller acts as the bank and the buyer makes regular payments straight to the seller for an agreed upon number of years.  In a lease-option, the buyer is considered a “tenant owner” and makes rental payments to the seller that not only cover rent but also pay down the balance on the agreed upon sale price.

Even more so than with with peer-to-peer lending, there is a necessary relationship of trust that is built between the buyer and seller.  As a buyer (or tenant owner) it is your job to convince the seller that you will make your payments and fulfill your part of the contract.  The seller for their part may request W2s, pay stubs, bank statements, or a down payment … just like a bank.  The difference is that the decision whether to lend money is brought down to the individual level.  The Social Credit Score of the buyer is paramount in this transaction whereas the FICO score is secondary or not a factor as all.

Conclusion

The concept of a Social Credit Score is not meant to reduce lending standards but rather to bring the lending decision from a national level to a personal or company level decision.  If your credit truly is bad, then it’s very likely that your Social Credit is as well.  For those of you with a few dings on the FICO score but good financial situations otherwise, consider alternate means of funding your projects that rely on Social Credit.  It’s time to break free from your three digits.