6 Things to Consider When Buying an Investment Property
Making wise real estate investments goes far beyond a gut feeling and a little luck. In fact, successful investors put plenty of time and education into each decision, ensuring that every single property is the perfect fit. Making a well-reasoned purchase goes beyond the basics, too; while a solid understanding of concepts like average returns and feasibility of purchase price is important, an understanding view of the bigger picture means even more.
If you’re on the hunt for a great piece of investment property, a knowledge of the potential obstacles standing in your path is key. Here are six things to consider before taking the plunge.
Inexperienced investors see the list price and assume that’s all that matters, but seasoned investors know the cost of purchasing a property goes far beyond the surface. From inspections to closing costs, there’s always more than meets the eye when it comes to buying real estate.
Acquisition costs can run into the thousands of dollars, so going by the face value of a property can be a big mistake. For pricey properties, the costs of closing a transaction can run into the multiple thousands, so if the list price is already at the top of your budget, you may not have the available cash to close on the property.
Closing costs make up a significant chunk of acquisition expenses in real estate transactions. These often include:
- Attorney’s fees: The costs associated with hiring and working with an attorney to ensure all paperwork is in order
- Loan origination fee: For purchases requiring a conventional mortgage, loan origination fees often range between 0.5% and 1%; For purchases using hard or private money, fees are typically 3-4%.
- Appraisal costs: Costs associated with the determination of the true market value of a piece of property
- Title insurance: An extra protective measure that covers against losses resulting from title defects discovered after a completed purchase
Investors should estimate all costs relating to acquiring a property when evaluating whether they expect a property to be a profitable investment.
Potential Upgrade Costs
Few properties are perfect upon initial purchase, especially in a fix and flip situation. For investors who aim to turn a profit by buying a house in need of repairs at a discount, it’s important to evaluate both the list price of a home and the improvements that will need to be made.
While beginners to this process tend to underestimate the costs associated with renovations and remodeling, those with experience often understand the true expenses that upgrades entail. Additionally, experienced flippers can differentiate between jobs that they can manage themselves versus projects that require a professional.
To avoid sky-high costs, all properties should be inspected with high expense projects in mind. For example, foundation damage, water damage, roof damage, and siding damage can bankrupt your entire operation, while repainting, bathroom remodeling, and kitchen upgrades can often be handled for a relatively affordable rate.
Rather than expecting to cut corners during the remodeling process, it’s generally recommended that investors be conservative with their estimates. Unexpected costs can arise if an inspector identifies an issue with the renovations, which can result in extra costs to correct the issue or a reduction in the purchase price, either of which will impact your return on investment.
Instead of letting idealism take over, be as realistic as possible by using industry averages and personal experience to estimate possible upgrade costs. There’s a big difference between spending $25,000 to improve areas that add the most value and $100,000 to simply bring a property up to code.
As the adage goes, location, location, location. Known as the three rules of real estate, this simple phrase truly sums up a large part of what you need to know when investing: location matters. Period.
While perhaps a cliché today, the reality is as true now as it ever has been. Where you plan to purchase, hold, or fix and flip a property can have an enormous effect on your overall success. A home purchased in Newport Beach, CA will have a drastically different value than a home purchased in Cheyenne, Wyoming, even if the costs to upgrade are similar.
Whether you’re willing to travel or you want to invest in your hometown, the difference between a good neighborhood on the rise and a bad one in decline can have a huge effect on your success. Before purchasing a property, consider details like:
- School districts: A key point for families, it’s much easier to sell a home in an area with strong public schools.
- Crime rates: An influx of crime can scare off buyers and lower property values, making it less likely you’ll see a return on your investment.
- Cost of living: A high cost area is more likely to yield higher home prices, making a property with rock bottom prices in need of substantial repairs more likely to be a worthwhile investment.
- Job market: When unemployment is high, residents are less likely to buy. When plenty of jobs are available, your pool of potential buyers will grow significantly.
It may be tempting to jump on an offer that sounds like a steal, but remember: something that seems too good to be true probably is. Rather than taking a chance on a property that may end up costing you, take plenty of time to research the local area. As with most things in life, it’s better to be safe than sorry.
No matter where you live or where you purchase property, there’s no escaping taxes. While most homeowners don’t put much thought into taxes, real estate investors need to consider the tax implications of adding real estate to a portfolio. Taxes apply no matter what you choose to do with your real estate, how much you purchase it for, how much you sell it for (unless you take a loss), or what you intend to do with it.
If you choose to hold property and serve as a landlord, you must pay taxes on all income received from renting. While not necessarily considered income in the same class as earnings reported on a W2, you must report the rent you accept as rental income. Rental income includes all rent paid less security deposits and is generally accrued on a cash basis. This income must be reported on Form 1040, Schedule E, Part I. Deductions related to the cost of managing, conserving, and maintaining property are available, providing a way to recoup day to day expenses.
If you’re a fan of fixing and flipping, don’t assume you’re off the hook. The proceeds from your sale are likely taxable and could end up costing you as high as 35 percent. This rate depends on how long you hold a property.
In general, tax is due on the difference between the sales price and adjusted basis, or the cost of property plus the value of any improvement you make. If, for example, you buy property for $200,000, invest $20,000 in upgrades, and sell for $250,000 after closing costs, you will owe tax on $30,000.
The IRS has historically kept an eye on chronic home flippers, so be careful. Acting too quickly or too hastily could gain you extra scrutiny and a tax reclassification as a trade or business – a highly undesirable switch for most investors. Consult with your tax attorney to see how your taxes may affect you.
No seasoned investor sets their sights on one single property. No matter the value of a piece of real estate, investing is always part of a large-scale strategy that, when planned properly, should include a wide range of assets and opportunities. Before making an investment in any residential or commercial property, it’s critical to ensure that the property fits with the other holdings in your portfolio.
How much you can feasibly spend on a property often depends on what else you have in your portfolio. When evaluating the pieces of your portfolio, it’s important to consider elements like:
- Appreciation potential
While it’s not possible to know how all investments will work out, diversity, earning potential, and access to cash are all important.
Before buying a property, you should have a strong idea of how you plan to move forward.
If you plan to fix and flip a property for fast returns, the immediate costs will mean more. For example, acquisition costs will be significantly more influential – most short-term investors are hesitant to pay high closing costs – and the renovations you make will need to be as affordable as possible. In this rapid-fire situation, market conditions are much more applicable, as there’s no time to wait for things to turn around.
If you plan to hold a property in an up and coming area as an income generating property, another home, or a vacation spot, some of the initial costs will mean less. You will have more time to recoup your losses, upgrade as needed, and slowly make improvements as appropriate. It’s also more likely that you’ll see a nice profit, especially as housing prices rise with inflation. With no urgent need to sell, you can wait for circumstances to improve, too.
Some investors also plan to hold property indefinitely, waiting for a situation in which cash is a necessity or the right opportunity presents itself. When profit isn’t on the radar soon, you’ll have even more flexibility to follow your instincts rather than focusing on little else besides the bottom line.
The Bottom Line
To make the most out of your purchase, it’s important to focus on the big picture, from the implications of location to your chosen exit strategy, to the decision that’s right for you. While every investment is a gamble, a thorough understanding of the greater climate can ensure you have the best possible chance at seeing the gains you deserve.
Scott Clift is a licensed real estate broker with Westpark Loans. He has been in the real estate industry since 1994. His team of seasoned professionals specialize in providing real estate loans for investors and other self-employed individuals. When you are ready to invest in real estate, call Westpark Loans to secure your financing at (844) 574 LOAN or by visiting westparkloans.com.