Thursday, December 13, 2007

My Life In and Out of Real Estate Markets, conclusion

Part III: Lessons Learned

In Part I of this series, I explained why I decided to become a real estate investor, and how I came to own a rental property. In Part II of this series, I described my frustrations with owning a rental property, and how I got out of the real estate market just in time.

In this final post in this series, I will share with you what I learned from my time as a landlord. It is my sincere hope that you learn from my mistakes, and consider carefully whether real estate investing is the right investment for you before taking the plunge.

So, what did I learn from my three and a half years as a landlord?

  • Real estate can pay off big.
  • Owning a rental property can be painful.
  • Real estate has some drawbacks compared to stocks.

Real Estate Can Pay Off Big

By investing in real estate, you can use credit to leverage a down payment into a pricy asset, which generally appreciates over time. This means that you can make big gains, even with only a modest appreciation in the value of a house.

For example, if you make a down payment of 20% on a property that appreciates 3% in the first year, your down payment has netted you a return of 12% in one year - not bad at all, especially if your mortgage payment is close to what you were previously paying for rent. Buying a home with a large down payment and the intention of living in it for a long period of time makes great sense, especially if you don’t overpay for your house, and if you don’t buy more house than you need.

Owning a Rental Property Can be Painful

When you invest in a rental property, on the other hand, you’re not paying a mortgage instead of rent – you’re paying a mortgage in the hope of recovering some or all of your costs by renting to others. Over time, rental inflation will bring your rental income above your costs, assuming that your mortgage payments remain the same.

If your costs exceed what you are able to rent the property for by a wide margin, or if you are using an adjustable-rate mortgage, then you are not really investing; you are speculating: Speculating that interest rates will stay low and so will your payment; Speculating that house prices will go up fast enough to bail you out.

Whether you are a risk-adverse investor like me, or a reckless speculator, you will be on the hook for making mortgage payments when the property is vacant, and unless you pay several thousand dollars a year, you will be responsible for managing the property as well. This may sound fine, but unless you enjoy working on weekends and holidays, you will not be happy about it; take my word for it.

Stocks perform better over long periods of time than most asset classes, including real-estate. Stocks also include built-in management (of admittedly varying quality), so if you can find the right individual stock or fund, you can do as well as you would owning rental properties, especially if you account for the value of the time that you don't have to spend managing the companies that you are invested in.

I could have purchased any number of stocks, including real-estate stocks such as Boston Properties (BXP) or Caterpillar (CAT), and made the same money that I did with my rental in the same period of time, without the same frustrations.

Real Estate Has Some Drawbacks Compared to Stocks

Since we’re on the subject of comparing real estate to stocks, here is my complete list of shortcomings of real estate as an asset class:

  1. Personal Responsibility. You have duties as a landlord, from making timely repairs to spending Saturdays showing the house to prospective tenants. It is a second job, and paying someone to manage your property is not cheap.
  2. Financial Responsibility. You are on the hook for those mortgage payments, whether you have a tenant or not.
  3. Illiquidity or Slippage. You have to find the right buyer. You need to have the house vacant. Houses are not identical (or fungible), and yours could have or develop an attribute that makes it undesirable, such as a neighborhood that becomes blighted by foreclosures.
  4. High transaction costs. 6% in, 6% out, unless you want to try to sell the house yourself, which means even more responsibility and another part-time job.

So, Do You Really Want to Be a Landlord?

So, when a co-worker mentions to me they are thinking of taking advantage of the current downturn in house prices to buy a rental house, I ask them: Are you sure that you want a second job? Are you sure that you can afford to have a vacant rental for several months? Do you enjoy calling people to ask for money that they owe you? Are you good with a hammer and power-tools?

If you are like most people, the answer to one or more of these questions is an emphatic “no”.

So, do you really want to be a landlord?

I don’t.

Friday, December 7, 2007

My Life In and Out of Real Estate Markets, continued

Part II: Getting Out

In the first post in this series, I told the story of how my wife and I came to own a rental property at the start of 2004. In this post, I will tell you about the problems that I had with tenants, how I was tempted by mortgage brokers who prey on landlords with vacant properties, and why I concluded that owning a rental property was more trouble than I needed.

This reminiscence is especially timely given what is happening in the real estate and mortgage markets currently. As I look around at the wave of foreclosures and at all of the borrowers who are facing increased mortgage payments as their exotic mortgage products reset to higher interest rates, I am reminded of how fortunate I am to have been born with a cautious streak. So many real estate investors lost thousands of dollars because they were tempted by mortgages offering lower monthly payments.

But I am getting ahead of myself, again. My last post ended with telling the story of how I became a landlord. This post gets into the reasons that I decided to quit my second job as a landlord.

Did I mention that being a landlord is a second job?

The Honeymoon Ends

As the person who had come up with the idea of buying a rental property, my wife rightly pointed out, it was my job to find and manage the tenants. She was glad to co-sign the mortgage and help with cleanup and repairs (bless her heart for her patience), but the day-to-day finding and management of tenants would be my job.

An important factor that I failed to consider, as it turned out, was that a lot of people who had good credit and were in the habit of paying rent on time were becoming homeowners at the same time that we were becoming landlords. So, the initial plan of only renting to people with good credit quickly went by the wayside. Landlords who had such tenants were eager to keep them, and there were fewer such tenants by the day as people with good credit and a few thousand dollars to their names purchased their own homes.

As competition between landlords intensified, long-standing practices such as collecting the first and last month’s rent during the move-in inspection also went by the wayside. I quickly discovered that the descriptions of “ideal tenants” in my real estate books, like so much of the other information in those books, no longer corresponded with reality.

So, I settled for tenants who simply met some basic employment and income guidelines, such as having a job for more than a year and having gross income in excess of three times rent. And I only collected the first month’s rent and a small deposit. I figured: they had the money to pay rent and would make it a top priority, just like I make paying the mortgage on time a top priority.

I was wrong. They often had other priorities. It seemed like every time that tenants left town before the end of their lease, or left without paying the last month’s rent, they left behind a child’s fantasyland of high-priced toys or a well-stocked home bar.

Part of the problem was that the tenants were not good with money, but part of the problem was that I was not firm enough. When I was told a sufficiently harrowing sob-story, I would volunteer to waive late fees and accept rent a few days (or even a few weeks) late. As soon as they sensed that they were dealing with someone who would cut them some slack, they started taking advantage.

Eventually I felt so taken advantage of that I began enforcing the late fees no matter what the story. Then they would often cut and run, leaving my wife and I to shampoo the rug, spackle the walls and seek out another tenant, usually in the depth of winter when few people move. The low point of my life as a landlord was when my wife and I spent New Year’s Eve, 2005, cleaning the house late into the night so that we could rent it out again.

Happy New Year, indeed.

It is when your spirits are low, when you are eating that mortgage payment by burning up your savings, when the metaphorical blood is in the water, that the sharks begin to circle.

Fending off the Exotic Mortgage Sharks

“We have a great mortgage product for you” said the chipper-sounding young woman on the other end of the phone. She had apparently pulled my business number from the advertisement that I had placed in the Seattle Times. “It is designed for landlords just like you.”

Like me? The hair on the back of my neck started to stand up and I furrowed by brow. I don’t like being pitched to, and something seemed really wrong already, just five seconds into this call.

“You get to decide what payment you want to make” she continued. ”You can make a full payment with principal and interest, a payment on just the interest for the month, or nothing at all. Skipping a payment really takes the heat off when you have a vacancy.”

This piqued my interest. I certainly loathed taking the mortgage for the rental out of savings when the property was vacant. She was reading my mind.

“So,” I replied, “If I skip a payment, what happens to the interest? Is it a fixed-rate mortgage?”

“If you skip a payment, the interest is added to your principal. But at current rates, that doesn’t add up to much. And it is tied to the London Interbank Overnight Rate, or LIBOR, so you don’t have to worry about the Federal Reserve hiking rates – they don’t set this rate!”

“That sounds a bit risky,” I said, realizing that that my first instincts had been correct. I had no interest in playing interest-rate roulette.

“Well, I would love to meet you at Starbucks to walk you through our program,” she said, “Let me give you my number.”

“No, thanks.” - I hung up.

This was the first of many, many attempts by mortgage brokers to lure me away from the straight and narrow path of the 30-year mortgage with exotic mortgage products; but after fending off a cheerful voice on the phone promising to dispel my worries over vacancies, I had no problem throwing the mailed solicitations from the other mortgage brokers straight into the recycle bin. Even the ones offering cash-out refinancing, formatted as fake checks. So, I managed to avoid the mortgage sharks that preyed upon many other homeowners. I stuck with conventional 30-year fixed rate financing. Here, again, The Expert (the realtor who I mentioned in my last post) played a key role, telling me “30-year mortgages are simple and predictable. I have always left the exotic mortgages alone.”

A Little Help from USA Today

USA Today publishes a feature called Close to Home each Tuesday that takes an up-close look at house prices in cities scattered around the country. For each city, they provide three arrows to show the gains (or losses) in the last 12 months for the city, the state and the nation. At first, all of the arrows were pointed up. Boston was featured several times, and in 2003 and 2004, it had some of the strongest gains in the nation. But early 2005, it started to slow down, and by the end of 2005 Boston housing markets were down from the previous year.

I read this feature each week because I had learned about how housing markets in one part of the country can sometimes help to predict the course of housing markets in other parts of the country. And after my first tenant, I was thinking about shorter and shorter timeframes for holding this rental property. Over the course of 2006 more and more cities profiled in USA Today began turning down: Miami. Denver. By the end of 2006, only a few markets such as Seattle and Austin were still up over the last 12 months.

I had had enough with problem tenants by this point (I was starting to lose my longstanding faith in the goodness of humanity), and it looked like the appreciation was about to end for a while. I was ready to get out, and my wife agreed. We were convinced. If the rental had been a stock, I would have fired up my Web browser and sold in January, and been out at the end of that same day.

But a house is not a stock. It must be vacant and ready to sell. Then you must find a buyer, and that buyer will need to find a willing lender.

Slippage, part II: Waiting out the Lease

Thus began my second lesson in “slippage”, that great gulf between the transaction that we want and the transaction that we get. We had to wait until July for the end of the lease.

At the top of the market in April, we could have sold the property for $290,000. It took a few weeks to fix up the property after it became vacant in July – which would have been months if The Expert had not found the right people to do the repairs. We listed the property at $280,000 and waited for the buyers to arrive.

No dice. The pool of buyers was starting to dry up in response to tighter lending standards, spurred by the beginning of the subprime mortgage crisis. Also, caution was starting to reign in the real estate mania that was still alive and well in the greater Seattle area.

So, we lowered the price to $272,000. We found a buyer and haggled our way to $265,000. Between the date that the offer was accepted and the date that it closed in September, a larger house across the street went on the market for $275,000. If we were still holding that house today, we would be lucky to get $250,000.

We were very fortunate to have The Expert on our side, and to have the good sense to trust him and make use of his knowledge. I told him when discussing the sale of the house, “Please do exactly what you would do if it were your house and you were trying to sell it in this market – in terms of repairs, and in terms of the listing price”.

Considering the commissions that you pay when buying and selling real estate, it is foolish not to make full use of the specialized knowledge that your realtor has to offer.

Salvation from the Storm

My life as a landlord ended on Sept. 18, 2007, when the sale closed and I picked up the check from the escrow company. I was rewarded for doing my homework, resisting mortgage offers, being patient, and suffering through weekends and holidays cleaning up the house and making repairs - but I was also lucky. If my wife and I had lived in a part of the country that was hit by sudden job losses, as was much of Michigan, we would not have escaped with our principal, or our credit, intact.

In the next and final post in this series, I will discuss the lessons that I learned from my life as a landlord, and provide you with a list of issues that you should carefully consider before taking the plunge and becoming a landlord, yourself.

Thursday, December 6, 2007

My Life In and Out of Real Estate Markets

Part I: Getting In

It all seemed so simple in 2002.

Like many Americans, my wife and I had seen our stocks lose much of their value since 2001, while the value of our house first held steady, then began to swiftly rise.

I started thinking to myself “if my home appreciates this fast, I should really buy a second one. I can rent it out while it appreciates.” I didn't really understand why house prices were rising; nor did I understand how much more work it is to be a landlord than to be a homeowner.

If I had, would I have done it? Hard to say, and hindsight is of course 20-20. I can, however, tell you a few things you should consider before you take on ownership and management of a rental property:

  • A landlord must be fair (which I was) but firm (which I wasn’t).
  • A landlord must be familiar with the ins and outs of the state and local Landlord-Tennant Acts (as I was).
  • Lastly, a landlord must also have deep pockets to cover repairs and to pay the mortgage during vacancies (my status on this front varied from year to year), and should ideally be adept at implementing some of the simpler home repairs with their own hands (I am a miserable handyman, alas).

If these points don't describe you, then you need to seriously consider whether buying a rental property is a good idea. When buying a stock, you simply have to ask yourself what the price is likely to be a few years from now; with a rental property, you must consider more than the future price. You have to ask yourself if you can afford or handle the responsibilities of being a landlord.

Real estate investing suits many people quite well, especially people who are good at saving, good with people and good with their hands. My realtor, a person who I like to call “The Expert” because of his deep understanding of the Puget Sound real estate business, has done well by buying and managing small rental properties over the last 20 years. He is compassionate but firm, and he is good at doing minor repairs himself and at finding people who can do sound repairs at a reasonable price.

Having his guidance on the purchase and sale of my rental property is one of the main reasons that this post describes bumpy ride to success, rather than the financial equivalent of a car accident.

It also helped to be able to avoid temptation. I stuck with a straightforward, fixed rate loan even when aggressive salespeople touted the very sort of interest-only, adjustable mortgages that have gotten so many people in trouble.

But I am getting ahead of myself. Let's get back to the run-up to my investment in real estate

A Little Knowledge

In 2003, I began buying books on real estate investing and liquidating some of my stocks to add to my savings so that I could come up with a down payment. Although many of the books that I read extolled the virtues of building real estate assets using “no money down” financing, I was determined to come up with a substantial down payment so that I could get a 30-year fixed-rate mortgage. I knew that I was speculating, but a cautious streak kept me from really playing with fire. I did my homework to reduce the risk as much as possible – at least on paper. I learned about the importance of looking at homes that were near major highways and job centers, and the importance of understanding local rental markets. And I began to follow mortgage rates.

The Mirror Test

However, I did not understand the human factors that would make real-estate investing particularly challenging for me. In other words, I failed to conduct what Peter Lynch calls “the mirror test:” that moment when you take a breath, think about what you are about to commit to, and then look yourself in the mirror to see if you are cut out for this kind of investment. Lynch was talking about stocks, and stomaching volatility and uncertainty; but a landlord’s mirror test should include facing the reality you might end up paying the mortgage for several months with the property vacant and no rent coming in.

Slippage, part I: Investor in Mark-up Land

I was fortunate to know a realtor who was an expert in helping people buy rental properties, and when my wife and I had finally saved enough for a modest down payment, we started hunting for houses within an hour’s drive of our home. In short, we had made the decision to buy a house – now it was merely a matter of finding the right house and the right seller.

The real estate market was moving up all around us in 2003. We knew that we wanted a house, but did not really know what we were looking for beyond that. My realtor was immensely patient with his very indecisive clients. We looked at a house that needed a bit more work than we had in mind, but which had a view of a nearby lake and was listed at $179,000 – a bargain for a view home in the greater Seattle area. We mulled it over, but by the time that we decided that it warranted another look, it was gone.

That left us ready to act when the next house that looked right came along, but we had to wait a while for that to happen. We needed the right house at the right price. This is an example of what stock traders call slippage: the difference between the price of an asset when you decide to buy and the price of that asset when your transaction actually takes place. The fact that each house is unique makes the process difficult, especially if you are hunting for a bargain.

Making the Buy

We eventually found our bargain. A new spec house, 1000 square feet, and priced at $175,000. We made an offer. The homebuilder accepted. We signed the paperwork at the beginning of 2004, placed an ad, and suddenly we were landlords. Landlords in search of a few good tenants.

In my next post, I will describe why being a landlord was a lot more trouble than I needed, and how I finally got out of speculative ownership of real estate.