Personal Finance (Sec. 6.4)

Fundamentals of Finance by Adam J. McKee

SECTION 6.4: Real Estate

One need only flip the channel over to HGTV to realize that people can make astonishing profits investing in real estate.  House “flipping” has been a craze for a while, and low-interest rates have drawn many hopeful entrepreneurs wanting to get rich quick.  Flipping isn’t the only way to make money in real estate, and it certainly isn’t the easiest.  As you will recall from earlier chapters, buying a home for your family is not merely a purchase; it is a sizable investment that you should enter into with extreme caution and with an eye toward capital appreciation.  Because we considered the family home as an investment vehicle earlier, we will not cover those concepts again here.  In this section, we will consider investments other than the family home as potential investments.  There are many types of real estate investments to choose from, and you will need to balance the risks and rewards as well as your time and skill constraints.

Real estate is a compelling investment space because the profits can be exceptional.  What the television shows don’t always make apparent is that the extreme profit real estate strategies like flipping million dollar homes is that novices usually can’t afford to make bets that big, and even when they can afford it, they are doing so without understanding the probability of success.  The secret to making money is real estate is no secret at all:  You merely need to buy low and sell high.  The hard part is gaining the knowledge and experience that lets you accurately appraise homes and other real properties in order to determine what fair value is for the property.

When it comes to real estate, buying low means buying the property at a cost that is below fair value, or else improving the fair value at a cost that is less than the final value.  Selling high means getting a premium price for the property, or else charging (and getting) rents that are commensurate with a premium price.  Premium rents require a keen knowledge of the market and the use of successful marketing strategies.  Premium sale prices require excellent skills in sales, cooperative markets, good neighborhoods, good schools, and myriad other factors that require a vast amount of knowledge and experience.

The Learning Curve

The biggest reason that you should be cautious when considering real estate as an investment vehicle is that there is a steep learning curve that you’ll have to overcome if you want to make a profit.  If you inherited a property, then, by all means, consider how you can use the property to make money.  Since you have an initial investment of zero, the bar is set pretty low for making a tidy profit.  If you are starting a real estate empire with cash or bank loans, the profit margins will be much, much lower and your risk versus reward computations need to be precise.  The margins for being merely a “deal maker” that hires a professional for every task are very, very low and you are likely to lose money.  If you have a skill set that you can use to trade “sweat equity” for cash, then you may be in a better position to make an actual profit.

If you grew up in a family where construction was the family business, then you are in a good position to leverage your contracting skills and labor to make a hefty profit.  Labor costs are among the most expensive aspects of real estate investing, and saving on labor–especially highly skilled labor–can provide a massive boost to your profit margins.  If you know enough about contracting to find, hire, and supervise your own manual labor pool and hire competent subcontractors at a reasonable price, then you can make money.  If you must hire a general contractor to handle these tasks, your profits will be eaten away quickly.  You can educate yourself in the ways of home construction and interior design, but that will take many years of careful study that ultimately will not be worth the investment.  This, of course, doesn’t apply if you love home improvement and want to take your DIY skills to the next level.  If overcoming the learning curve is a hobby rather than work, then you may not be concerned with the time as an investment per se.

If you have experience as a realtor or appraiser, you can make a tidy profit, even if you must hire contractors to do any necessary work.  This is because of two major factors:  As a realtor or appraiser, you have a keen eye for the fair value of homes (at least in the geographic area where you worked in that capacity).  You also have a keen eye for quickly and intuitively identifying aspects of the property that can be improved at a low cost while adding a high amount of value.  You will also need to be aware of the various codes and zoning ordinances in your area.  These types of things tend to be done on a local basis and vary from completely regulated to needing a lawyer and an engineer just to get a permit to build a dog house.  Electrical work and plumbing are among the most expensive trades, and DIY projects that you can complete competently can save you big money—if you can do it legally of course.

The bottom line is that buying and selling real estate is not as easy as it may sound.  This is especially true when substantial improvements must be made to the property to increase its value.  Without an edge that the average Joe doesn’t possess, you will most likely spend a huge amount of time and make very little money.  Time is a key consideration that most novice property flippers do not account for in their analysis.  Mortgage Interest is a function of time, construction loan interest is a function of time, property taxes are a function of time, and management of contractors and subcontractors are a function of time.  Even the volatility in home prices is a function of time.  Much like with stocks and options, home values tend to go up over the long term.  However, prices can fluctuate–sometimes dramatically–in the short term.  The bottom line is that house flipping is a risky investment that can cost you dearly in both time and money.  If you have a day job and want to flip houses on the side, don’t do it unless you have expertise that gives you a distinct advantage.

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