There are several ways to earn a profit in investment real estate. Wise investors select the strategy most fitting their personality, capacity and goals. These pages describe four of the most common approaches for investors who have progressed beyond single family rentals.
The ideas here are demonstrative, but not all inclusive. For clarity, each strategy will be illustrated by an investor who is typical of that approach. These strategies show much of what has been learned after discussing wealth building and preservation with thousands of real estate investors.
What are some of the main investment strategies?
This article considers four major approaches: 1) rehabilitation, 2) repositioning, 3) maintaining classics and 4),maintaining capital with low risk and no management. The strategies are presented in order of highest risk and highest potential return to lowest risk and lowest rate of return. They are also in the order of least capital to greatest capital needed to execute the strategies. A separate chart shows typical financial consequences after two years of each strategy.
Rehabilitation: “Make me rich fast!”
Joe earns about $70,000 and has $100,000 for his next investment. He describes himself as a young man in a hurry. Joe will acquire severely distressed property in areas that most investors are not comfortable with, in areas where the trends are not obvious. He will rehab the property. He is willing to solve larger than average problems and hopes to earn a more substantial return.
Joe will put $85,000 down and use $15,000 for closing costs and repairs. In the first ninety days of closing, he will spend $6,000 to fix the worst unit and paint the exterior trim, spruce up the landscaping and repair the roof. In the next nine months, he will put another $6,000 into fixing the units on turnover. He will pay $420,000 for a twelve unit building, perhaps in City Heights, Encanto, San Ysidro, or Spring Valley.
Rehabilitation involves higher risk in search of higher returns. Rehabilitation has the highest leverage, greatest percentage debt of the four ideas discussed here. Most investors seem to use all their cash to acquire the largest property they can finance. Typically they have few funds left for substantial improvements. Not all investors even have the $1,000 – $2,000 per unit for renovation. Aggressive investors will ask the seller to carry a second trust deed or will borrow the fix up costs from another source, maybe a home equity loan.
Rehabilitation typically involves a coat of paint, modest landscaping, some new carpet and appliances. It corrects deferred maintenance. It will typically cost less than $2,000 per unit. It can make sense even in the most economically challenged zip code.
Joe’s objective will be to raise the rents 10% – 15% within the first eighteen months. If things work correctly he will have $435,000 into the building and within two years it will be worth about $500,000. His hope is that his $100,000 initial investment will have grown to $170,000 equity or about 70% gain.
A few aggressive rehabilitater might even take on a building with a cracked slab. However that is more risk than most rehabilitaters will assume.
Reposition: Upgrade the Residents and Grow the Equity
The most energetic strategy is repositioning. It is a substantial improvement and shifting the marketplace’s perception of a property. The central idea is to upgrade residents and raise rents 15% – 30% within two years. Repositioning will do more than rehabilitation. This modernizing may cost from $5,000 – $10,000 per apartment.
In San Diego County we are creating apartment families about three to four times as fast as new apartments are being constructed. Most rental families cannot afford the luxury rents of $1.00 to $1.30 per square foot per month. In other words new apartments will charge more than $1,000, in some cases $1,500 or more for a two bedroom two bath unit.
A renovated two bedroom apartment may rent for $800 – $1,100. Repositioning aims for the discerning residents who can and will pay for an upgraded and improved apartment home.
Richard and Maria are investing with their long time business partners, Pat and Donna. All four are past 50. One family earns about $60,000; the other earns more than $120,000. One of the spouses took early retirement last year. These careful risk takers prefer to deal with residents of above average income who can and will pay for extra amenities.
These investors have $250,000 for their acquisition. They will use $175,000 for down payment and the other $75,000 for repositioning and upgrading the building.
On the exterior expect to change the property name, while freshening the landscape, painting the exterior or revising the color of the stucco.
On the insides spend money where the lady will appreciate it. Kitchen cabinets with a new finish and new knobs is a minimum. It is not uncommon to install new doors or even completely replace the cabinetry. The kitchen and bath floors will probably at least have new vinyl, or new tile installed. In some cases the counter tops will be replaced. Ceiling fans in the dining area and/ or master bedroom are routine. Closet organizers and mirrored closet doors frequently make sense. . Bathroom vanities may be replaced.
Repositioners have more discretionary cash than the average buyer. The renovator will obtain a conventional loan, maybe 75% loan to value. In addition he will have other cash reserves of $5,000 to $10,000 per unit for the cash needs involved in upgrading the property. In other words, someone may have 30% – 35% of the finished cost invested in hard cash. Perhaps after the work has been done, the resident profile has been changed and higher rents are in place, then the property will be refinanced. At that time the investor may be able to recoup most, maybe all, the extra funds used in the upgrade.
In order to serve our county’s population we will need even more repositioning investors for the next several years. We will come back to this strategy after finishing the survey of other alternatives.
Author: Terry Moore, CCIM