You’ve probably heard the old saying “too good to be true.” Unfortunately, in a lot of situations, that statement has quite a bit of truth to it, and the one place it’s most appropriate is in real estate investment.
Let’s run through a few types of real estate where you should be especially cautious. A quick note that you may feel that it sounds in this post like I’m rallying against all real estate. But that couldn’t be further from the truth. In fact, I consider myself the biggest advocate in the world about buying investment properties to own — for the long term.
The types of real estate investments below do not make much sense in my book and often are too good to be true. While it seems like there’s a lot listed, in total they probably make up less than 15 percent of the real estate available for sale.
And of course, some of these could work, but as always, buyer beware!
Be honest with and ask yourself if you have significant experience as a contractor renovating property. If not, you are doomed! First, rarely do fixers sell at a large enough discount to compensate for all the work that needs to be done. Second, while you certainly will add value to a property by renovating it, you probably won’t add more value than the cost to add that value. Hence, spend $30,000 on a kitchen, property value might increase $20,000. Most people, who are not contractors, who have tried a fixer-upper, will never try one again! In the long run, the idea of fixing a few things and reselling for a higher profit is something too good to be true.
Short term ownership of property is a virtually guaranteed way to lose money. First, properties always need more work, which equals more costs, than you estimate when you are hot in the buying process. Second, there are transactions costs of 3 percent to 5 percent on the purchase and up to 10 percent on the sale. That means you’d better be able to sell it for at least 20 percent more than you bought it for, and that’s just breaking even! With carrying costs, paint, new carpets, interest on your home loan, etc. I suggest don’t try this at, or with, a home.
Buying lots or land
Land investments may sound like a great idea but it can be some of the riskiest investments one can make. First, you usually have to pay cash. So any earnings you were making on that cash, like interest or dividends, are now gone. Plus you have to pay property taxes, insurance, and possible grounds keeping fees, etc. And if you plan to entitle the land for sale, or develop it, you need to pay consulting fees, architectural, surveyor, civil engineer, etc. before you can even consider actually building something that you could sell to earn back your money! And really, if it is still vacant and outside of town, who knows which decade into the future it will actually be primed for development. Buy something that pays cash flows, like rental property.
Fancy prize properties
Can we say negative cash flows together! If you put pencil to paper you will be able to determine if a property is cash flow positive or negative. Guess what, the beach house, the fancy downtown condo, the expensive neighborhood home, they all sound great, but are probably are going to be negative cash flow. With “prize properties” not only do you have to put down money to buy the property, each month you take more money out of your bank account to cover the expenses that are not covered by the rental income. The truth is that prize properties are too good to be true but moderately priced, boring and unremarkable properties pay cash flow and they are the real prizes!
Like a fancy prize property, vacation rentals can mean extremely high negative cash flows! Expenses as a percentage of rental revenue are 70 percent or more, just like a hotel, while normal rental houses or apartments probably run 35 percent to 50 percent of revenue for expenses. This is before accounting for your giant mortgage payment because if you want to get the property rented, you need a stellar location. Stellar locations cost a lot of money, which is why you have gigantic mortgage payments. Vacation rentals can also mean very short tenancy, so when a recession hits, people cancel vacation. Lastly, how do you really know how many weeks you get rented and at what rate? The real estate agent selling can give you huge numbers that sound great, without seeing the prior owner’s tax returns, you really have no idea. Unfortunately in these cases it’s often a lot worse than you think.
These properties often mean negative cash flows but with no money in rental revenue to offset the expenses! This means you are have to hope the property will go up in value to earn a decent return on your money, but it’s more than that. The home value has to go up enough to cover all your expenses over the years. So do yourself a favor and rent someone else’s second home when you want to go on vacation. Save your money in a “second home investment fund” that you can earn interest upon and use to buy a retirement home to live in down the road, if you so please.
Foreclosures at the courthouse
Picking up a foreclosure at the courthouse may sound like a great way to find deals on homes. But note a few things: first, there are way too many bidders these days and second, you usually can’t get inside a home to see its condition. Third, the owners might not appreciate you booting them out of their home, and they may boot a few holes in the walls themselves. Fourth, you must pay all cash, and there won’t be title insurance or homeowners insurance with the purchase. Last, there are many issues that come up with foreclosure so as potential buyer you need to be cautious.
I always note that some people can and do make money on the properties listed above, but the odds are against the average person increasing their wealth with one of these strategies. The more likely scenario is that you will lose significant wealth, or fail to earn that wealth on a better investment, by trying one of these.
Basically if you’re shopping for an investment property and it sounds too good to be true, then avoid it! The safest route to wealth, for an average individual investor, is to buy moderately priced rental properties, in decent shape, in decent areas, treat your tenants with respect, and manage them to a healthy cash-flow filled retirement.
Leonard Baron, MBA, CPA, is a San Diego State University Lecturer, a Zillow Blogger, the author of several books including “Real Estate Ownership, Investment and Due Diligence 101 – A Smarter Way to Buy Real Estate.” Read useful tips for real estate buyers in his blog, Making Smart and Safe Real Estate Decisions. See more at ProfessorBaron.com.
Note: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinion or position of Zillow.