Conducting Formal Due Diligence

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I am currently reading "Real Estate Investing for Dummies" by Tyson and Griswold, a well-written and thorough book that covers the basics of what real estate investors should know. I've long considered "Investing in Real Estate" by McLean and Eldred as one of the best introductory texts for real estate investing. Yet after reading the "Dummies" book, I find it equally as good, and perhaps a little more accessable for the new investor.

Here is my list of Top New Real Estate Books that I posted on Amazon.

For today's blog, I'm incorporating key parts of the "Due Diligence" chapter from the "Dummies" book with my own real estate observations.

Once you have made an offer on a house and it had been accepted by the seller, the "due diligence" period begins and you have until the close of escrow (or completion of the sale) to check out the physical and financial condition of the property. If you discover that the property has problems, but you think the deal is still worth pursuing, the seller may be willing to correct any deficiences, or give you money to to complete the necessary work yourself.

It's during this time frame that you must get all of your questions answered and be sure you know what you are getting. If done properly, it will require quite a bit of effort on your part. But it must be done, if you wait until after the property is in your possession, its too late to ask the seller to replace that broken furnace.

You should work closely with the seller but take his word for anything. Only trust what you have in writing.

In my case, most of the house that I buy aren't bought from the owner. They have been reposessed by a bank, the Veteran Administration or HUD. But I still do due diligence by having my friend/handyman go through house with a fine tooth comb. He knows more about the house repair than anyone I know.

There are two key components of due diligence process:

1. review of books and records
2. the physical inspection

A thorough look at these two components should allow you to determine if the property is worthwhile, priced right, and your goals. The due diligence is your last opportunity to either complete the transaction, or cancel the escrow, have your money returned, and look for another property.

Next post: Reviewing Books and Records

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Guest Fixer-Upper Article on "Gather Little by Little" Blog

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I encourage you to check out my guest article entitled Making Money in Real Estate with Fixer-Uppers at gatherlittlebylittle.com.

I also direct your attention to another excellent article at BiggerPockts.com entitled Managing Tenants Part 1: 5 Favorite Lease Clauses by Connie from conniebrz.com. The article has clauses that you can plug right into your contract and great observations, like, "A strong lease depersonalizes the landlord/tenant relationship-you no longer need to rant and whine and threaten. Simply point to the lease-The Lease Says So, therefore it must be done."


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Roundup of of Favorite Real Estate and Investment Blogs

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Once again, here is my unsolicited, unbiased, and unwarranted weekend blog roundup of favorite real estate and investment blog articles of the week.

The Importance of Being Organized at conniebrz.com/
IRS Form 1099-Misc. Deadline is Just Around the Corner at twowiseacres.com
Keeping it real: Confessions of a Personal Finance Blogger at gatherlittlebylittle.com
What to do with the Fed Economic Stiumlus Package Tax Rebate at moolanomy.com
It's Not a Good Thing! at rentalsrus.blogspot.com
Inflation Causation at whinecountryrealestate.blogspot.com (Overcoming Real Estate Loses)
How to Sell Your Stuff on Ebay at christianpf.com
Look up the Facts About Your Neighborhood Rentals with Zilpy at mytwodollars.com.
Does Financial Industry Subtract Value from the Economy? at getrichslowly.org/blog/.
Rental Property Appraisal Surprises and Delays at wealthisgood.blogspot.com (the world of wealth)


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Why Buy a House Instead of Renting & How to Buy a House that will Make Money

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Why Buy a House?

Owning a home is one of the best investments anyone can make. Don't expect to get rich by being a renter. The U.S. Federal Reserve Survey of Consumer Finances reports that in 2004 the average renter had a net worth of $4,000 while the average homeowner's net worth was $184,000. In addition, homeowners have the comfort of knowing that they are building equity and living in a place that belongs to them. They can plant trees, paint rooms, build a wall, and no one can stop them, or raise their rent. If you rent for 30 years at $1,000 a month you could have spent over $350,000, and wind up with no house.


Ways to Buy a House That Will Make You Money

1. Buy a house where you can add value, such as fixer-uppers. Some sellers don't bother to clean up properties before putting them on the market. This often requires them to accept a lower price, and allows you great ammunition to negotiate a better deal. Painting, replacing old carpeting, replacing old appliances or doing some landscaping, are things that most people can easily do to make a fixer-upper look like Cinderella.

You can also buy a property with enough land, and with zoning, to allow you to build a rental property in the back. Or, you might have a larger house where you can convert one room, one section, or a basement, into a rental.

2. Buy when others are selling. When the economy is slow, and unemployment rates go up, people purchase fewer houses and prices go down. You will have less competition from other buyers and more houses to chose from.

3. Buy from motivated sellers. If you view enough houses, eventually you will cross paths with someone who is highly motivated to sell. They may need to move, or need cash for a new house that they bought before they sold their old one, or for a variety of personal financial problems. How do you know if someone is motivated? Ask a lot of questions!

4. Buy during the holiday season when sales are slow. Hardly anyone looks to buy a house around Christmas time. It's another opportunity to buy with less competition from other buys, and from motivated sellers.

5. Learn to negotiate. One good way to be a good negotiator is to be in a position where you don't have to buy. Be patient and be willing to walk away from a deal that doesn't suit your fancy.

6. Buy in a nice area. If you buy in the right area, you greatly increase your chances for a lifetime of increasing equity in your house.

Here is a version of this article that includes book recommendations I posted at Amazon.com entitled Home Buying for Advanced Dummies.

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Time to Refinance?

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With interest rates dropping to 5.5%, have you thought about refinancing your principal residence? You're not the only one. Since November last year, refinance applications have risen 92%, and up 16% over the last few weeks, according to the Inman News article "Refi applications climb 16.9%."

According to Jay Brinkmann, the Mortgage Bankers Associations vice president of research and economics. "With tighter credit conditions we do not know how many of these applications will become loans, but it is clear that borrowers are responding to the 40- to 80-basis-point drop in rates we have seen since Nov. 2 across products."

I refinanced several of my properties when the interest rates were hitting historical lows a couple of years ago. Now the rates are even lower than when I refinanced before. Is it worth it to refinance? It depends on what your present interest rate is, and on what you use the money for. If you re-finance to buy another property, you're on the right track. Of course, you have to balance that against borrowing too much and over leveraging your real estate investments.

Time to refinance? Maybe not, but it might be worth thinking about.


For more insightful perspective on mortgages see:

The Mortgage Crises Has a Silver Lining (and other truths you won't hear on cable news this week) at Bigger Pockets.


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Roundup of Favorite Blog Posts from the Past Week

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Below are the blog posts from the last week that I found most edifying and enjoyable.

Terry Sprouse’s book: Fix ‘em Up, Rent ‘em Out at Conniebrz.com (What can I say? I liked it.)
An easy way to reduce vacancies and rental property turnovers at twowiseacres
Landlord Profitability: Distance + Knowledge = Time and Money at Landlord Business Insider
Buy Now or Pay Later? by FSBO Jane
Down She Goes at Rentals R Us
Rehab Pros: DIY or Hire it Out? at BiggerPockets
Live and Learn at My REI
10 Ways to Completely Ruin Your Credit at Moolanomy
Don't save it all up for retirement by ChristianPF
Money talk at the barber shop by getrichslowly




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Serial Home Sellers, Part 6: Examples

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A “serial home seller” is one who buys a house, moves in , repairs it to increase its value, sells at a tax-free profit up to $250,000 ($500,000 for married couples), and then does it over again. Thanks to the 1997 Taxpayer Relief Act (or, Internal Revenue Code 121) investors can create a profitable home fix-up business with a tax-free “payday” every 24 months. Below are two examples of people who became serial home sellers.

Suzanne Brangham (from her book Housewise)
Also, see my Amazon book list Safest Ways to Invest in Real Estate.

Suzanne was looking for work in San Francisco when she discovered that there were 25 other people competing for each available job, some willing to work for peanuts just to have a view of the Golden Gate Bridge. She didn’t want to work for peanuts. At the same time, she was looking for a place to live. She found a dilapidated old apartment house in a well-to-do neighborhood where you pay 4 times the price for 4 times the view. They were advertising apartments for sale or rent.

Suzanne made an offer to the sales manager that in lieu of paying the $800 per month rent, she would renovate the 2 bed/2bath apartment, spending the equivalent of one year’s rent, $9,600, in labor and materials. She also requested a year’s lease option, an agreement to rent with an exclusive option to buy at anytime during or at the end of the year. The asking price was $45,000. The sales manager agreed.

The job was done in four months, and at a party she was hosting, someone offered her $85,000 for the apartment. She exercised her option to buy the apartment, then sold it for the $85,000. Then, she contracted to buy a second apartment from the same manager. She put 10% down no a 4 bed/3 bath $90,000 apartment, and used the rest of her earnings for renovation. When the renovation was done, she had an offer for $140,000.

From that auspicious beginning she went on to buy 71 more houses and apartments.

Ruth Donohue

Times Online, in "Confessions of a Serial Home Buyer," interviews Ruth Donohue, who has gone through the cycle several times and says that she does it more for the joy of the process and a love of the challenge. She is able to instantly spot a house with potential and visualize how the renovated home will look.

Ruth’s son Nick is also catching the bug. When they drive by a house, Nick will point out that the roof line just doesn’t look right. “Give me a boy until he’s five and I’ll show you an adult serial home renovator,” she says.

Husband Kevin sums things up by saying, “The family know they’ll always have a roof over their heads, they’re just never sure which roof it will be.”

Getting Started

Suzanne Brangham encourages anyone to join her in her chosen field, saying, “Home wrecking (house renovation) is for anyone who wants to begin marching down a delightful path toward security strewn with appreciating assets. Whether you want to sow the seeds of an empire or simply start a little venture of your own, what could be more natural than buying, renovating, and selling houses?”

What could be more natural indeed.


Thanks to Connie at conniebrz.com for her re-review of my book!


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Serial Home Buyer/Seller Tax Exemption, Part 5 - sources of fix-up houses

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Sources of Fix-up Houses

For serial home buyers/sellers who utilize the federal tax exemption to pay no capital gains tax, a key to making the process work is to find lower-priced houses in need of repair.

There are good deals to be had even though we just operate on a part-time basis. The pros – the full-time investors - will get eye-popping deals, but there are still enough good left-over deals for us small time operators to get a share of the pie also. It’s like a yard sale. The people who get the huge bargains will be up before dawn, knocking on doors before the yard sales are scheduled to start. Nevertheless, there are still some bargains left when the rest of us show up a little later in the morning. For my wife and I, finding good fix-up deals primarily involves reading the newspaper, checking the internet, and driving through neighborhoods.

A good source of fix-up houses are those repossessed by banks. These are houses where the owner cannot make the payments on his bank loan and is forced to leave the house when the bank takes it from them. Often the former owner will express his bad feelings toward the bank by destroying fixtures, doors, walls and other parts of the house. While this may give the house an unlivable appearance, most of the damage is fairly easy to repair. This is just the type of house the aspiring handyman investor is looking for, as it has built-in equity because the damage is only superficial.

A second source of good fix-up properties is from the Veteran’s Administration (VA) and Housing and Urban Development (HUD). These properties have had owners who cannot make payments on their loans from these respective organizations, and the VA and HUD have repossessed the houses and put them back on the market. VA and HUD houses are usually offered at a fairly good price, below market if they need serious fix up work done. As in bank repos, the owners have either let their houses run down and are generally in need of, at minimum a paint job, and sometimes a more major fix-up.

I purchased a VA home, in 2003, in a nice neighborhood that scared off many other investors because there had been water damage to the ceiling in both bathrooms. Upon close examination, I traced the damage to some cracks in the water cooler on the roof. Was it worth it to pay $105,000 for a house in a neighborhood where similar houses sold for $150,000 (and now sell for $200,000)? You bet it was. I could replace the cooler and repair the ceiling for $2,000 to $3,000. The remaining $45,000of equity went to the only person who took the time to climb up on the roof and thoroughly examine the cooler with a flashlight. That was me. HUD, VA and repossessed houses from other federal agencies can be found at the HUD/VA website.

To find bank repos and other fix-up houses, my wife and I carefully scan the newspaper classified ads every day and we spend weekends driving around areas where we might like to buy. We bought our first bank repo by responding to an ad in the newspaper. Based on the ad, it appeared to match all of our requirements, a fix-up house priced at below-market in a nice neighborhood. I visited the property with my handyman friend, made an offer and purchased the property.

To purchase VA and HUD repos, you can also pick up printed listing from real estate agents, some of whom specialize in such sales. Recently repossessed homes are generally listed every two weeks.

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Part 4 of Serial Home Buyers/Sellers, What properties do serial home buyer/seller buy?

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Serial home sellers buy houses, live in them for at least 2 years, and then sell them and pay no federal capital gains tax. The key to making a serial home seller business work is to find houses that you can add value to. How do they do this?

They buy houses below market value that need repair

We now know, if we didn’t know it before, that prices don’t continue to rise every year at 5%. In fact, it appears that house prices may continue to drop for several years into the future.

So, that means that we have to add value to the house. We must find houses in need of repair and bring them back to their former glory, to force the value of the house to go up.

I know, you’re saying, “But Terry, your answer to everything it to buy a fix-up house. You have been promoting that forever. That’s they name of your blog, and your book, and probably your dog.”

My response is, how did you find out the name of my dog?

Actually, my response is that this is not merely an improbable coincidence, but it actually is the way to make the system work. You must find the right house in need of repair to buy before you can expect to make any money when you sell.

Key Advantages of Fix-up Houses

The three great advantages of buying fix-up houses are:

1.) You buy them for much less than you would pay for
a normal house, so you spend less of your investment money to get in;

2.) Because the price is less, monthly mortgage payments are also lower than if you had bought a traditional house;

3.) After the repairs are completed, the house automatically increases in value, and is valued the same as other houses in the neighborhood. This is a faster and more certain way to add value, rather than having to wait for housing prices to appreciate.

Learn to Make Repairs

Another key to making the serial home buyer/seller approach work is to make your own house repairs, as far a possible, instead of paying someone else to do it.

Never miss an opportunity to do your own repair work. Think of it as part of your educational process. You lose two ways when you hire someone to do your work. First, you lose the chance of a free education, and second you lose the money that you would have saved by doing it yourself. It may take you four hours to change an electrical receptacle or fix a toilet that won’t flush, something a professional could do in minutes. Don’t be concerned, in the long run you have learned a skill to be used for the rest of your life.

To learn more about making repairs, read “So You Want to Learn the Zen of Making House Repairs” that I posted at Amazon.com.


Where you find these properties in need of repair? Tune in to the next blog installment.


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Serial Home Seller Tax Exemption, Part 3

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Advantages of the selling a home every two years and claiming the exemption

1. No more tenants

One of the biggest gripes of real estate investors is dealing with problem tenants. In fact, based on what I have heard from former investors that I have talked to, that is probably the biggest reason that investors decide to get out of the business. The next best thing to biting the bullet and learning how to deal with tenants through the school of hard knocks (or reading a copy of Property Management for Dummies), is to have no tenants.

Who wouldn’t want a world without tenants? It’s a dream come true! No more weekend calls about clogged garbage disposals and toilets not flushing. No more staying up late balancing the books. No more late payments and far-fetched excuses. No more rush to put the place back together and quickly rent it out again, when someone moves out. No more surprise midnight moves by tenants who get out under the cover of darkness.

2. Lower interest rate

Owner occupants can pay 1% less for their mortgages than people who don’t live in their investment properties. For a $200,000 house that can be an additional $132 a month, or $1,584 per year, that you don’t pay for your mortgage.

3. You control the whole process

If you become a serial home buyer/seller and move from one house to another every two years, you alone are in total control of your investment future. You’re captain of the ship.

Since you live in the house, maybe while you fix it up, you’re just making mortgage payments that you would be making anyway, if this wasn’t a business for you. So, you’re not out any extra money, except for the closing costs when you buy or sell.

If you decide you want to live in the house a few years longer, no problem. You can live there as long as you want to, 20 years if you like, and still take the tax exemption.

But you can also decide to buy and sell every few years, and each cycle buy a nicer home, like Suzanne Brangham did, as described in her book Housewise: the Smart Woman‘s Guide to Buying and Renovating Real Estate for Profit. She started in San Francisco in 1972 when she couldn’t find a job that she liked. She decided to create her own career. She started by investing $9,600 in a condo and wound up renovating and selling 71 houses and apartments.

Regarding self-reliance, Ms. Brangham says:

“The biggest lesson I learned in the property business in that there are no absolutes except yourself. Prices fluctuate; products change. Markets move up and down. Tax laws are rewritten every year. Interest rates are as predictable as unwired champagne corks. But there is one stable element in all of this: the person who renovates for profit.”

Disadvantages of utilizing the exemption every two years

1. No long-term profits

In addition to losing the headaches associated with tenants, you also lose many benefits by selling rather than renting. You lose:

a. An monthly rent payment. Its easy to get used to those once they start coming in.

b. Tenants are gradually paying off your mortgage for you.

c. Tax deduction for depreciation and for interest on your loan.

d. You lose the long-term appreciation of 5% per year. Its nice to have the option of cashing in on that appreciation by selling off a house or two when you are ready to retire.

2. It's difficult to time the market

This is not a disadvantage of the exemption as much as a disadvantage of operating a business of buying and selling every two years. Under this investment strategy, you may not be able to time your house buying and selling to accommodate the fluctuations of the market. For example, many would say that now is not the best time to sell. Some real estate analysts say that cycles usually last between 2 and 10 years, and naturally the ideal time is to sell is when demand is high and the prices are up.

A similar problem exists for buying your properties, you may be caught in a cycle when prices are artificially high.

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What is the secret to overcoming these seemingly insurmountable obstacles? Where do you turn? What’s that up in the sky? A bird? A plane? Who was that masked man?

The next installment of this series will address some of those questions.


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Tax Exemption for Serial Home Buyers/Sellers, Part 2

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How it works

Utilization of this tax exemption is one of the safest investment strategy for the conservative investor who wants to take few risks. Under this strategy, the investors can quality for the least expensive loan, the owner-occupied loan. There is no need to worry about tenants destroying your rental property or not paying the rent. You completely control the investment by living in the property yourself. When you sell, you have the opportunity to bring in up to $500,000 tax-free money every two years.

Here is an example to show how the exclusion works, illustrated in Table 1. You and your wife file jointly and you continuously buy and sell homes over the years, each time purchasing a more expensive home as a replacement. Let’s say that you bought a house for $300,00. For the last 5 years you have owned the home and it is now worth $600,000, with $300,000 worth of accumulated gain. If you were to sell your home now for $600,000, without the tax exemption you would be subject to a capital gains tax on $300,000. The amount of taxes saved with the tax exemption would be $84,000. Table 1 also illustrates other amounts of gains.

Table 1
Home Selling under the Taxpayer Relief Act Exemption
(assuming a 28% tax bracket)

Home/ purchase price/sales price/ capital gain/ tax saved

#1/ $150,000/ $200,000/ $50,000/ $14,000
#2/ $200,000/ $300,000/ $100,000/ $28,000
#3/ $300,000/ $600,000/ $300,000/ $84,000


Ownership and Use Tests

To qualify for the tax exclusion, you must pass both the ownership and use tests. This simply means that during a 5-year period, ending of the date of sale, you have:

1.) Been owner of the house for 2 years (ownership test)
2.) Lived in the home for w years and it was your main residence (use test)

Maximum Amount of Exclusion

A total amount of $250,000 can be excluded if all of the following are true:

1. You meet the ownership test
2. You meet the use test
3. You did not exclude the gain from another home sale during the 2-year period

A total amount of $500,000 can be excluded if all of the following are true:

1. You are married and filed a joint return for the year
2. Either you or your spouse meets the ownership test
3. Both you and your spouse meet the use test
4. Neither you nor your spouse excluded gain from the sale of another home during the 2-year period ending of the date of the sale.

Can You Get a Partial Exemption?

Unforeseen circumstances may allow you to claim a reduced exclusion if either one of the following is true:

1. You did not meet ownership and use tests due to :
- a change in location of employment
- health problems
- unforeseen circumstances (see below).

2. Your exclusion would have been disallowed because you sold more than one home during a 2-year period, except that you sold the home due to :
-a change in location of employment
-health problems
-unforeseen circumstances

Unforeseen circumstances can include:

1. Death
2. Divorce or separation
3. Not eligible for unemployment compensation
4. Multiple births from the same pregnancy
5. Damage to the home from natural disaster, war, or terrorism.
6. Condemnation, seizure, etc.

In these cases, the amount of capital gains tax the could be excluded would be based on the number of months that the home owner lived in the home during a 24-month period. If a home owner couple lived in their home for 12 months, they could exempt 50% of the $500,000 exclusion, or $250,000.

What are the advantages and disadvantages of becoming a serial home buyer/seller using the tax exemption?

The next installment we will examine that question.

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Take Advantage of Tax Exemption When Selling, Part 1

One of the most useful advantages for real estate investors is also one of the most under-utilized. My wife and I bought a house we are presently repairing that we plan to sell utilizing the federal tax exemption. This generous gift from the all-wise lawmakers in Washington DC is part of the 1997 Taxpayer Relief Act.

The 1997 Taxpayer Relief Act was a great boost for average people who wanted to sell their home and buy a new one. It was also a great boost for investors. Couples are allowed to exclude up to $500,000 of the capital gain on the sale of their primary residence. Single individuals can exclude up to $250,000. In other words, the sale of the house is never reported on your federal IRS forms if the capital gain is less than the $500,000 and $250,000 limits. This exclusion is based on compliance with two requirements:

1. The home must have been the primary residence for both spouses during two of the last five years. The two years do not have to be consecutive but if you rent out the primary residence for more than three years you would be required to occupy it again for two years.

2. The exclusion is available only once every two years.

Capital gains above $250,000 for singles and $500,000 for couples are taxed at the applicable rate. What if you sell your house before meeting the two year requirement? If you qualify under one of the unforeseen events listed in the IRS publication, such as a job change, illness or an unusual hardship, you can still qualify for a prorated exclusion. Check Publication 523 for a complete list of unforeseen circumstances, at:

http://www.irs.gov/pub/irs-pdf/p523.pdf

There are many advantages to buying, repairing houses and selling after two years, while utilizing the tax exemption. My wife and I maintain rental properties that provides regular monthly income, but we are also buying and selling with the tax exemption, to generate cash for future investments, and just to have more cash on hand. I will cover more details of the tax exemption in up-coming posts, such as how it works, advantages to investors of using the exemption, what properties to buy, and other topics.

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