Tips for Investing During a Downturn

Don't wait for the market to turn to get you own piece of the real estate investment pie.

December 1, 2008

Join these savvy real estate professionals who have parlayed large for-sale inventories and more affordable home prices into a personal buying opportunity—and in the process helped ensure a prosperous future.

Why is it a great time to buy residential property for your personal investment portfolio? For all the reasons you’ve been telling buyers—lots of inventory, low mortgage rates, and motivated sellers. In addition, circumstances that make it harder for some buyers to own increases the pool of renters.

"There’s a better opportunity now in a lot of ways. During the top of the market, you couldn’t get the investment numbers to make sense and provide positive cash flow in many higher-priced markets," says Nelson Zide, CRB, CRS®, with ERA Key Realty Service in Framingham, Mass., who’s been a real estate investor since 1981.

And while purchase prices for homes have fallen in many areas, rents haven’t followed suit. This means enough cash flow in your pocket to cover debt, says Terry Reitz, with Keller Williams Legacy in San Antonio. Like several practitioner-investors we spoke to, Reitz, who now owns seven properties, focuses her investment goals primarily on rental income, not appreciation. "Appreciation is the icing on the cake; cash flow is the meal for me," she says.

"Flipping is just too precarious these days unless you have the financial reserves to hold the property for the year or more it could take to sell," agrees Zide.

In markets such as Dallas where home prices didn’t see big increases, it’s still possible to buy for appreciation, says Linda Waller, ABR®, CRS®, of Main Street Real Estate in Garland, Texas. Waller, who owns some 30 homes, looks for properties that can be freshened up with "cosmetic redos" where she can invest $20,000 or less to spruce up the asset for renting. "If you’ve ever dreamed of investing in real estate, now is the time," she says.

Where to Find the Properties

Because they’re in the market every day, real estate practitioners are in a unique position to find the best investment buys.

"After all, who knows the local market better than you do," says Zide. The MLS is the first and most productive source for most real estate practitioners who invest—and these days there are lots to choose from. "Three years ago, it was hard to buy, but now short sales are just coming in front of me every day," says Martha Laird of Delta Realty Group in Sugarland, Texas. Laird got her investing start four years ago by buying a short sale, which she fixed up and sold.

Foreclosures, FSBOs, and new construction that isn’t selling are all sources of viable investments, says Reitz. She favors three- or four-bedroom homes in the middle of her market’s price range. "Almost anyone can live in a home that size, so there will be a good market when I’m ready to sell," she explains. She avoids condos, since they compete with apartments for renters.

Stacy Worthington, with Keller Williams Preferred Realty in Westminster, Colo., prefers to invest in condos so she doesn’t have to worry about the maintenance. Although she’s been a real estate salesperson for less than a year, Worthington, a former lawyer, has been investing for more than eight years. She now owns four properties and plans to buy more.

"There’s lots of inventory sitting out there, and I’m confident that in a year or two, real estate’s cyclical market will rebound," she explains.

Burned out investors, as well as those without the resources to weather a problem at a property, can also be prime sources of good buys, says Waller, a real estate broker and certified public accountant who also buys foreclosures. "Inexperienced investors think it’s easy. They see themselves playing a numbers game in Excel. Instead they have someone calling them at 6 a.m. to complain about a plumbing leak. They just want out."

Purchasing a property from a seller when a deal falls through is another viable source of deals, providing you don’t step over the fiduciary line, says trainer and investor Walter Sanford of Sanford Systems and Strategies in Kankakee, Ill.

"Remember that as a real estate salesperson, you owe a fiduciary duty to your clients. If I do buy a property after a buyer I’m representing backs out, I don’t take a commission, even though it’s legal to do so," he says.

Buying a property you’ve listed may also be an option, but to avoid any conflicts of interest or violations of the REALTOR® Code of Ethics, refer the listing to another broker for a referral fee. It’s also a good idea to make it clear that you’re a licensed real estate professional whenever you’re buying a property, even if you have no agency role in the transaction, say NATIONAL ASSOCIATION OF REALTORS®’ attorneys.

For practitioners who both represent investor clients and act as investors themselves, the proposition is trickier still. "I never bid against a client for a property, even if it’s a good deal. Otherwise, I wouldn’t get any business," says Zide. Knight will buy a property he’s offered to investors, but only if 48 hours go by and no client has expressed an interest in buying.

Also remember that while it may be a great time to buy, "don’t get greedy and try to buy five properties at once," urges Laird. Otherwise, you’ll get in over your head and risk losing your investment if markets continue to soften.

Norman Wehner, broker-owner of Real Trust Associates in North East, Md., says that even though there are lots of tempting deals today, he’s sticking with his strategy of buying one or two properties a year. Being a landlord himself also adds to his credibility with the 20 percent of his clients who are investors, he says. Waller, on the other hand, has been on a relative buying spree. She bought nine properties in 2007 alone.

How to Pick the Deals

While most of the real estate professionals we talked to are actively buying property today, all agree that purchasing investment property is less about market timing than good analysis. "I don’t think there’s a good time or a bad time to buy, only good deals and bad deals," says Joe Still, ABR®, CCIM, of Still Training in Seattle. You may, however, find more properties that meet your yield requirements in a slower market where prices have declined.

While cash flow, appreciation, leverage, and taxes all figure into the investment analysis equation, the bottom line for most buyers is positive cash flow—or at least breaking even—after paying the mortgage and taxes. "A break-even investment can be a good investment if you’re planning to hold it for more than five years," says Zide.

Overall, he looks for annual cash-on-cash returns of 3 percent to 5 percent on single-family homes and condos and 7 percent to 8 percent on three- to four-family properties. He prefers properties with smaller square footage because he can realize a higher rent per square foot.

Many single-family home investors look for the same attributes as home buyers looking for a place. "I never buy a house I wouldn’t be prepared to live in," says Laird. While not everyone goes that far, investors agree that homes in good areas with good schools, near jobs and shopping, are the best options for a long-term hold.

"I look for an area where there’s a pride of ownership in the area," says Sanford, the author of Insider Investing for Real Estate Agents (John Wiley & Sons, 2006). In his analysis, Sanford uses a 35 percent expense factor and then subtracts that amount from projected income to see if the property will generate enough cash flow to cover loan payments. "I know some people would consider that high, but I find it realistic," he says.

In Charlotte, Mike Knight, founding partner of Charlotte Investment Properties, focuses on homes in the "path of progress" for jobs and economic growth on behalf of both his investor clients and his own portfolio. Since his company specializes in investment sales, "we hear about a lot of properties through our network of banks, attorneys, and other investors," he says.

For his clients, Knight favors newer single-family homes and smaller properties because there’s a greater opportunity for appreciation. For himself, he’ll take a chance with properties that need more renovation, but "since you can’t always estimate what you’ll find, it’s riskier."

And while he always tries to purchase below market value, he doesn’t consider buying in a distressed neighborhood a bargain, whatever the price. "Just because it’s a great deal on paper doesn’t mean you should buy it. I want to know that there will be a good economy in the area in five to seven years when I expect to sell," he says.

And while it may be tempting to purchase that luxury property you can proudly point to as yours, most real estate professionals favor moderately priced properties. Moderate prices mean moderate rents, which means not only a larger pool of tenants, but also tenants who are less likely to jump quickly to homeownership, explains Reitz. "We try to target areas for investment that aren’t too high-end. We want tenants who are reliable working people but who aren’t necessarily in a position to buy a home," agrees Worthington.

Wehner also favors single-family homes as his primary investment. "Multifamily properties can be harder to sell because, unlike single-family homes, the value of a multifamily building is strictly tied to its net operating income. If interest rates go up faster than rents, a multifamily property can actually go down in value."

Where to Get the Money

Perhaps the single biggest barrier for real estate practitioners who want to invest these days is finding the money. No money down, even in the form of a 20 percent soft second mortgage, is pretty much gone. "You must have a down payment; you’re not going to get a loan with 3 percent down," says Laird, who worked as a loan officer for three years in addition to her real estate career.

Most real estate investors in smaller properties should expect to put 20 percent down on conforming loans, due to changes in mortgage insurance restrictions, says Brad Blackwell, Wells Fargo’s retail national sales manager for the western United States, providing they have good incomes and good credit scores.

Even with 10 percent down, loans can "very hard to come by," says Zide. But if you have 20 percent to put down, verifiable assets, and verifiable income tax returns for two years, "there’s still money out there," he says. Local lenders—especially those who know you—are the best funding source, he adds.

The tough financing climate of today is becoming even more challenging for investors, thanks in part to a new Freddie Mac regulation that prohibits the GSE from purchasing mortgages made to an investor who owns more than four one- to four-unit financed properties. Fannie Mae continues to set its investment property ownership loan limit at 10 and expects that number to remain constant, according to a source at the company.

But despite the challenges, most real estate investor-practitioners still favor the 30-year fixed loan to finance their purchases. "When you obtain a variable interest rate mortgage at the bottom of the market, it will probably only get worse," notes Sanford in Insider Investing. And since most investors these days are buying for the longer hold instead of the quick turnover, a 30-year loan offers the best choice to maximize cash flow, notes Blackwell.

Shorter term loans can make sense if you’re planning on holding the property for only three to five years, notes Reitz. The deciding factor is whether or not the market will be strong when the rate changes, notes Worthington. Although for her first investment she took out a 5/1 ARM that recently reset only $16 higher, she’s opted for the security of fixed loans on all her other properties.

Wehner uses a line of credit he’s established with a lender to make initial purchases. This flexibility allows him to make buys quickly and increases the likelihood he can buy preforeclosure properties before a bank takes possession. In the past, he’s quickly converted the debt to 30-year fixed loans. Now, he says, new antiflipping rules make it necessary for him to hold properties for six months before either selling or refinancing for a higher value, increasing his costs.

If you had the foresight to fund your retirement account during the recent go-go years, those funds are another great resource for purchasing investment property, says tax expert Diane Kennedy, president of Phoenix-based Individuals with a Solo 401(k) or Solo Roth 401(k) can use monies from these accounts for real estate investment, so long as income from any properties is returned to the accounts, she notes.

What if You Can’t Afford to Buy?

Convinced, but still short of cash to buy today? Don’t despair. The deals you get in a year or two may not be as sweet as those you could get today, but there are always promising transactions out there if you have patience and do your financial analysis, agree our investors.

"Markets have momentum, but the basic elements of property analysis don’t change," says Still, who presented an education session on "The Four Measurements of Real Estate Investing" at the recent REALTORS® Conference & Expo in Orlando, Fla. But whether you buy now or later matters less than joining the 41 percent of REALTORS® who already own investment real estate. "The real long-term wealth in real estate is not from listing and selling; it’s from investing," Zide says.

Tips for Better Investing

  • Think cash on cash.
  • Determine your return based on the equity you have in the deal, not the total price of the property, says Zide.
  • Make your money on the buy.
  • Don’t make the mistake of believing that the asking price represents the final price or value or expect short-term appreciation to bail you out. Do your analysis and negotiate, notes Still.
  • Get preapproved for a loan.
  • Follow the same advice you give clients and get a mortgage preapproval before you begin looking at properties. Otherwise, you miss a buying opportunity in this dynamic market, says Blackwell.
  • Protect your assets from lawsuits.
  • Always hold each investment property in a limited liability company or other legal entity to protect the rest of your assets in case you’re sued, suggests Kennedy.
  • Don’t buy more than you can manage.
  • With more than 10 or so properties, you’ll probably need a professional manager or you’ll take too much time away from your selling career, says Wehner.
  • Don’t overlook deductions.
  • Even if a property is generating income, tax deductions for depreciation and expenses such as mileage related to managing your investment can reduce your taxable obligation, says Kennedy.
Mariwyn Evans

Mariwyn Evans is a former REALTOR® Magazine writer and editor, covering both residential brokerage and commercial real estate topics.