Taking Real Estate Investing To The Next Level-Active Investing
Many people understand real estate investment on a basic level—you buy a house, collect rent from tenants, wait for appreciation to work its magic, and sell the house at a profit.
This is how many real estate investors get their start, using a series of beginner-friendly strategies like buy-and-hold or house-hacking to close their first deals. We cover these strategies in our beginner’s guide, alongside some basics on financing, valuation, cash flow management, risk analysis, and building your investing team.
Eventually, however, most real estate investors want to move on to the next level. Buy-and-hold rental strategies are just the tip of the iceberg when it comes to turning property into profit.
Some methods of real estate investing are more “passive” than others. These include:
● Buying and holding rental properties
● Buying and holding mortgage notes
● Private lending
● Investment in syndicated deals (we’ll get to that)
At the other end of the spectrum are active methods of real estate investment. Some methods of active investment are more beginner-friendly than others, but they have one thing in common —they more closely resemble entrepreneurship, starting a business as opposed to investing money.
If you are new to real estate investment, this might just serve as an intriguing glimpse into future possibilities. If you have cut your teeth in real estate, however, and want to try active investing, here are some strategies to consider ...
House-flipping is high-velocity real estate investing, made popular and sexy by popular real estate shows like Flip or Flop and Masters of Flip. Sometimes referred to as the “fix-and-flip” strategy, the idea is to buy a house (or other property) at a bargain price, add value to the house through repairs, renovations, or rehabilitation, and then sell it as soon as possible.
Sound simple enough? Maybe so, but beginners often underestimate the scope of the task they are getting themselves into. Here are some considerations to take to heart about the fix-and-flip strategy:
Finding the Deal
Obviously a brand-new or newly-renovated home, targeted at families for their primary residence, is not a good candidate for a house flip. If you buy a house at market value, it is very hard to sell it quickly for a profit unless you catch a one-in-a-lifetime seller’s market.
Usually, you are looking for a house you can get at a discount. Ways to find candidate houses include:
● Fixer-Upper listings in the MLS or other real estate advertising sites.
● For-sale-by-owner listings.
● Foreclosure auctions.
● Wholesalers (more on these guys later).
● Marketing for motivated sellers (again, more on this to come).
● Real Estate Owned (REO) departments at banks, consisting of homes they took back in
How can you tell if you are getting a good deal on the property? Compare it to sales of similar properties. If it is substantially below the closing price of recently-sold similar properties, you might have a deal on your hands.
Investors use comparable recent sales to determine an ARV (after-repair value) for the house. This is what they expect to sell the house for at the end of the project.
Many flippers have a threshold of how much they are willing to pay for a flip property, building in a big margin for things to go wrong and still turn a profit. They might express that tolerance like this:
Maximum Purchase Price = (ARV x 70%) - carrying costs - rehab cost
If a house has an ARV of $300,000 and will have $50,000 in repairs and carrying costs throughout the flip, the investor using this formula will only pay $160,000 for that house ($300,000 x 70% - $50,000). It’s a deep discount indeed, so the seller would have to be very motivated.
Budgeting the Rehab
This brings us to the question—how much will the rehab cost? Some companies promulgate “rehab calculators” which allow you to enter the needed repairs to estimate a cost, but the costs of materials and labor vary so much from location to location.
If you are not a contractor yourself, it is best for beginning house flippers to find an experienced rehab contractor they trust and obtain their opinion of the repair cost. You don’t want to be caught off-guard by a plumbing, electrical, or dry-rot problem you didn’t have the expertise to spot.
Of course, a contractor can’t be held to that opinion. If the repair costs balloon out of control (as they so often do), much of the flip profit could be eaten up. That’s why many house flippers try to build in a big margin.
Just because no one is living in the house during the rehab doesn’t mean there will be no expenses. House flippers need to budget for carrying costs, including:
● Property taxes for the months they own the house.
● “Vacant home” insurance (pricier than regular home insurance) for the months they
own the house.
● Utilities like electricity and water.
Financing a House Flip
So how do house-flippers come up with the money to buy these houses? Do they go through the whole rigamarole of getting a mortgage for a house they will only own for a few months? Pay cash?
The short answer is that most house flippers won’t put that much cash at risk—they usually leverage their investment with a mortgage loan. But it usually isn’t the kind of mortgage loan that most homeowners are used to.
Home flips are usually financed by hard money lenders or private lenders. Hard money loans usually come from companies, private loans from private individuals, but they often function in much the same way.
Like a traditional mortgage, they consist of a deed of trust and a promissory note. The difference is in the approval process and the loan terms.
Private or hard-money loans usually close quickly—important if the house flipper is buying from a motivated seller who may be facing a deadline for foreclosure.
Private and hard money lenders also tend to take into account the “business plan” of the house flip in a way that traditional mortgage lenders do not. They may also take into account the investor’s experience and track record, not just the investor’s credit score.
Whereas a bank may only lend 80% of the purchase price, a private or hard money lender may lend the entire purchase price and possibly also the rehab price.
The terms of a hard money loan usually include a short term (1-2 years at most); interest-only payments with a balloon payment to retire the debt (perfect for managing cash flow on a short- term deal); and a higher interest rate, in the range of 8-13%.
13% may seem like a big bite, but when you consider a target ROI of 20-30%, it could be more than justified.
Selling the Finished House
Once the rehab is completed, the money isn’t made yet—the house still has to be sold. Considerations for an investor planning to sell a flip property include:
● Getting the Listing Price Right. If the house sits on the market unsold, carrying costs will erase the profit and the hard money loan may even get called.
● Cost to Sell. Of particular note, many house flippers choose to list the house themselves or use a “flat-fee” real estate agent in order to cut costs.
● Market Inventory. Investors should look at market inventory stats, paying special attention to how many houses sell in the neighborhood each month and how many houses are on the market right now.
For example, if three houses sell per month on this street and there are six houses on the market right now, an investor might do well to budget two months’ worth of carrying costs for the sale process.
Creative Real Estate
Outside of the basic strategies of “buy-and-hold” or “fix-and-flip” are a whole universe of “creative” real estate strategies.
Many first-time investors try to start with creative real estate entrepreneurship. This is partially because some of the strategies require no money or credit; partially because some of the strategies are just so cool.
However, creative real estate is often labor-intensive. It involves marketing for that rare breed— a highly motivated seller. Highly-motivated sellers usually come in the forms of:
● Borrowers behind on their mortgage and in danger of foreclosure.
● People facing a messy divorce.
● Estates of the deceased in probate, with heirs that can’t carry the costs.
● Abandoned houses.
Highly-motivated sellers usually want or need to sell as-is, preferably yesterday, and will accept terms that most sellers would balk at.
Here are some strategies creative real estate investors employ when they identify a motivated seller:
Real estate wholesalers are basically middlemen. They get houses under contract with minimal option fees and earnest money, then look for an end-buyer—a flipper, landlord, or aspiring homeowner—to sell the contract to at a markup.
A separate contract, called an “assignment agreement,” stipulates the wholesaler’s fee, usually in the thousands of dollars. Wholesaling is attractive to many beginners because it requires little money and no credit checks—just a lot of legwork finding the motivated sellers and pairing them with end-buyer investors.
Sellers don’t like wholesalers, because the wholesaler’s markup means that their house is worth more to the end buyer than they agreed to accept. However, if they need to sell quickly, a wholesaler may be the best bet.
Investors like wholesalers (or at least, reputable wholesalers) because they go to all the trouble of finding the motivated seller that the investor might not have had time for. Wholesalers market for motivated sellers through a variety of means, including:
● “We Buy Houses” ads, billboards, or bandit signs.
● Door hangers.
● Car wraps.
● Any other means they can think of to get the word out.
Mortgage wraps depend on a method called buying “subject to.” This is short for “subject to the original financing.” This means changing ownership of the property, but leaving the original mortgage in the name of the seller.
Most lenders do reserve the right to call in a mortgage loan if the title changes hands ... but they aren’t necessarily required to do so. They often choose not to if the mortgage was in default, and the buyer cures the default by paying all the arrears.
This saves the lender the expense of foreclosure and disposing of the collateral property. Keeping the performing loan in place is often the better option for the lender.
Also called “rent-to-own,” this is a strategy that has faced criticism in some jurisdictions due to the sometimes predatory nature of the practice. It involves buying a house, then “selling” it to an aspiring homeowner who doesn’t have the credit to get a mortgage.
What the investor then does is charge the “buyer” an option fee, usually the size of a down payment, creates a one-year lease agreement, then accepts rent payments on the lease with
the understanding that (s)he will sell the house to the buyer at an agreed-upon price at the end of that year, when (presumably) the buyer’s credit will be good enough to get a loan.
However many buyers don’t see their credit improve in this amount of time. The option expires, the investor potentially evicts the tenants, and finds another aspiring homeowner to pay a “down payment.” Lease options have come under fire recently for preying on unsophisticated buyers’ dreams of homeownership and lack of understanding of credit reporting.
If a motivated seller owes more on a property than it is worth, an investor might offer to negotiate a short sale. Lenders usually have a magic percentage of the loan which they will settle for to retire the debt in a short sale. The investor can contract the seller for less than this magic number, then perform the service of negotiating the short sale with the lender.
With enough experience, investors can come to know each lender’s “magic number,” helping them understand what to offer the seller and quickly negotiate with the lender.
Once the lender approves the short sale, the investor and the seller can execute the contract, and the house is the investor’s to do with as (s)he pleases—buy-and-hold, fix-and-flip, whichever.
One of the most complicated forms of active real estate investment is “deal sponsorship.” Deal sponsors create a syndication—basically a fund, small by real estate standards, where passive investors pool their money to buy a large property—an apartment complex, a commercial shopping center or office building, raw land for a development property, etc.
The deal sponsor manages the deal for the passive investors, whether it is a buy-and-hold, fix- and-flip, or development opportunity. (S)he has a fiduciary responsibility to the passive investors, but also complete autonomy over the managerial decisions of the property.
Obviously, this is a big responsibility. Good deal sponsors often get compensated handsomely, in one, two, or all three of the following:
● A percentage of the collected rents.
● An equity ownership interest in the property, without having to commit cash to the project. This can be worth hundreds of thousands of dollars for larger properties.
● A percentage of the purchase price and/or final sale price, cash at closing. This can also reach six figures in cash payouts for larger properties.
Depending on who you ask, you will encounter many people who argue that these active real estate investment strategies are not for beginners. But with adequate education and risk management, none of them are off-limits to beginners.
This guide only scratches the surface—there is so much more to learn about each of these strategies. One thing is for sure—for many real estate investors, active investment is when the real estate game really gets interesting.
Of course, plenty of others are perfectly happy with their passive returns; they don’t want to go this deep down the real estate rabbit hole.
But if active real estate investing appeals to you, the rabbit hole is deep indeed!