Each month, San Diego State University lecturer and Zillow Blog contributor Leonard Baron will answer two questions from readers regarding buying, selling and investing. Have a question? Send it to Leonard@ProfessorBaron.com
Real estate lessons learned
Hi Professor — I enjoy reading the guidance you give in your Zillow blog and writings. I’m just getting started in learning about real estate investing, and I wanted to know more specifics about some of those “hard lessons” you’ve learned. Andrea R., Des Moines, IA
Hi Andrea — Oh there have been so many! Real estate is truly a business that we learn as we go. Where do I start? None of these will I ever do again:
- Fixer-uppers: It seems like it will be fun and profitable to buy a fixer-upper and fix it up! It’s not. There are too many buyers chasing these, so the prices get pushed above what they are worth. Plus it always costs a lot more to renovate and takes a lot longer than you anticipate. Plus you have to pay for all the cost overruns right out of your own pocket. Some people can make these work, but I suggest leaving the fixers to the contractors who are skilled and in the business of renovating properties.
- Prize, negative cash flow properties: I own a really nice beach property that I bought 10 years ago. I didn’t know that rents in prize areas are way too low for the prices the properties command. I’m just breaking even — almost — on the rent, less expenses, after a decade. Moderately priced properties can be cash-flow positive from year one. Buy those!
- Vacation rentals: These are the worst. You’ll hear people say the monthly income pays the entire year’s mortgage, which may be true. The problem is there are all kinds of other expenses, and those expenses as a portion of rental income can approach 80 percent, just like a hotel. A normal rental property is typically 35-40 percent.
- Land investment: Land is 100 percent speculative. Buy assets that pay rental income, dividends or interest, and skip assets where you don’t get some cash return back along the way.
Ask me again in a few months, and I’ll throw more mistakes onto the above list!
Selling one property to buy another
Hi Leonard — I am thinking about selling an investment property I have to buy another. The current one is a good property, pays me nice cash flow, has plenty of equity and has done well for me. But I want to sell and buy something bigger. Can I do a 1031 exchange. Bob M., Los Angeles.
Yes Bob, you can. But I’m wondering why you would. If you have a great property, that you know well, and it’s doing well, keep it! If you sell, even if you do a 1031 tax-deferred exchange, you’ll spend about 10 percent of the property value in transaction costs, so that equity is wiped out. Keep it! If you want to buy more real estate, find out about a cash-out refinancing on the existing one so you can add another property to your portfolio while keeping the great one you have.
Also, 1031 exchanges are complicated, and you have to be on tight timing. I’ve seen many people sell one property and rush to buy another one — even though it’s a really bad property — because that is the only one they can purchase in the IRS-allowed time frame, and their only goal is to avoid paying taxes. So they sell a good property to buy a real dog.
To summarize, if you have a good property, keep it!