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.

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