For better or for worse these are increasingly changing times in which we live. The events of the last year have culminated to provide, for lack of a better term, a mish-mash of new rules competing with standard practices to create a new normal—again.
One sector that has certainly been in topsy-turvy world is real estate, and while it hasn’t particularly changed the standard approaches to residential real estate investment, it has changed how each type of investor should approach the market we have inherited.
Investors Defined
Those four standard residential investor types are: the Traditional Single-Family Home Owner, the Multiple Residential Property Owner, the Speculative House Flipper, and the REIT (Real Estate Investment Trust) Investor.
The rumblings we first started seeing in the realty market in mid-2020, have required investors to step up their normal research in order to take advantage of market influences, or gain leverage—which is really the “secret sauce” of being a real estate investor.
The pandemic influenced real estate in several specific ways:
It made many apartment or high-density dwellers think twice about continuing in that scenario for much longer. A lack of both interior and exterior square footage, and the inability to put more daylight between you and your neighbor, playing primary roles here. This created a unique and rather large tranche of new, first-time home buyers.
It also created a greater number of families looking for larger homes and second residences out of the fray of urban areas.
Close to home, we have seen this scenario play out in the form of people who live in more congested areas such as Bethesda and Arlington looking for more space and more value for money here in our greater Annapolis and Eastern Shore markets.
The result has been historical, according to Brad Kappel, of TTR | Sotheby’s International Realty.
“We had the lowest inventory ever recorded,” Kappel explains. (As of interview date: December 7, 2020) “We also have the highest demand, with the most contracts in the year 2020, and the lowest days on the market.”
Less homes for sale has created pros for some of our investor types and cons for others.
Which brings us to one of the biggest changes and decidedly a notch in the “pro” column—historically low interest rates. (At the time of this writing, the 30-year fixed rate was 2.71 percent.)
And experts expect this trend to continue well into 2021. So how should the perspective single family home buyer approach the market in 2021?
Strategies for the Aspirational Traditional Single-Family Homeowner
What never changes in any real estate scenario is value for money. All the things we traditionally think of when securing a sound home investment apply here, specifically location. “The home should be in a neighborhood of similarly valued homes that feed into a strong school system,” Kappel suggests.
And while buying a home that has been well maintained is always the gold standard, with interest rates being so low, it is especially important and highly advisable to choose a home that already has the upgrades you may want, as it makes no sense to get less and then have to spend additional monies that you may need to acquire at a higher rate to address upgrades or deferred maintenance issues later.
You especially would not benefit buying a home that needs upgrades if you’re using other investments like your 401K or mutual funds that are realizing decent returns to make those changes. Nor would you wish to jeopardize your normal cash flow to address deferred maintenance issues on an ongoing basis. These are losing leverage scenarios that you want to avoid.
“People buy houses and then they’re house-poor because the house keeps nickel and diming them to death,” Kappel says.
Once you have secured the right property, you will also reap the advantage of the annual mortgage interest deduction (if you choose to itemize your deductions) and you will have maximized leverage in the single-family home buyer scenario.
Of special note: if you’re looking for a home in our current low-inventory market, ensure that you have been pre-qualified with a lender prior to making any offers. The seller’s market has created a highly-competitive space in which to operate as a prospective buyer and your pre-qualification will provide you with more leverage.
More House for the Money
One of the most significant changes that has affected the real estate market is the threshold for the conforming mortgage amount on FHA, conventional loans, VA loans, and farm loans which took effect January 1, 2021. The FHFA (Federal Housing Finance Agency) increased the maximum home price for qualification in Anne Arundel County, for example, from $510,000 to $548,250 — which means more house for qualified borrowers. Log on to FHFA.gov for the conforming mortgage amount in your specific area.
Strategies for the Multiple Residential Property Owner
In this particular scenario the adage, “There are two sides to every coin,” certainly applies. On one side, if you came into the pandemic market as a multiple property owner with some inventory in the right location, you are probably sitting pretty right now. If your investments were in the more dense and urban areas, however, you may be in a scenario you never even imagined you would be in—and now you’re the one sitting on the inventory.
And herein lies the risk and reward nature of every multi-residential property owner.
“Buying and owning real estate is not for everyone. This type of investment requires commitment and involves many risks,” says Marina Painter, CPA of Ally Tax Group in Annapolis. “As long as the investor is properly educated, however, buying real estate is a good way to diversify your investment portfolio, create a major reserve of equity for retirement, potentially create tax-free cash flow, and have tax savings.”
This market, however, has recently taken the stark reality of the risk and reward proposition of being a landlord to the extreme. That is why it is essential to do the homework, especially the math homework, associated with each and every property you are considering.
Part of any homework process is the understanding of the mean or average rental income price for your given area or neighborhood, going in. With the recent shifts in our daily live/work situations, these amounts may noticeably vary from what they were just 18 months ago. This also ties into assessing that the demand for rentals in your chosen area can support the financial goal you have set for the investment over the term.
Once you have obtained that information you will want to make sure the rental amount you have set represents at a minimum, a breakeven point for cash flow for you. The shrewd investor makes sure that sum includes wiggle room for some other eventualities.
“It is critical to model two things in your calculations: vacancy and repairs,” says David Orso of the David Orso Team of Compass Point Real Estate. “Most investors forget that things happen and that market conditions won’t always be perfect.”
Another consideration—calculating in the money you would need to pay a property manager. Most multiple property homeowners, especially those who do not live nearby, require this extra pair of eyes, ears, and hands to address tenant issues as they come up in a timely manner.
An Investment Mortgage Primer
Most likely you will not be moving forward with any of these plans if you have not established your source of financing.
“Buying an investment property can be financially rewarding. When it comes to getting a mortgage to buy an investment property it is important to know the guidelines, and often, it requires a bit of creativity,” says Wes Tower, Managing Partner & Mortgage Advisor for Atlantic Prime Mortgage in Annapolis.
It’s also important to note that guidelines for investment mortgages are different than mortgages for primary residences and second homes, as are interest rates, which are higher than primary home purchases. You will also notice a difference when it comes to the amount of down money required. For the best terms on an investment property mortgage, Tower explains, a down payment of 20 percent or more, is typically required.
“One of the creative options we often do for our clients to offset the down payment needed, is to borrow against their current primary residence with either a HELOC (Home Equity Line of Credit) or second mortgage,” Tower says.
“This gives the investor-buyer the down payment to get the best terms on financing their investment property. Investors that buy and hold properties typically do very well over the long-term. Appreciation combined with the rental income collected on a rental home is a great way to build wealth. As investors add multiple properties to their portfolio, mortgage financing can become even more tricky as the buyer’s Federal Tax form Schedule E will come into play for evaluating their income qualifications,” Tower explains.
As you would imagine, your overall financial/tax picture will become complicated, but with proper record-keeping, planning, and advice, it is something that cannot only be managed, but leveraged.
“Bookkeeping plays a very important role in any business, including real estate,” Painter says. “If you are a landlord, how do you know how well your rental properties are doing if you are not keeping track of their income and expenses? After all, you are in business to make money and you cannot do tax planning and make an educated decision if you don’t have those numbers readily available.”
Painter explains that there are a lot of tax-saving strategies that can be applied not only while you own real estate, but also when you are selling it.
“Again, proactive tax planning is the key. If you are selling a piece of real estate and have an estimated capital gain of $250,000 that can cost you $60,000 to $80,000 in tax. That is your hard-earned money and something you’ve been working for, for years, paying mortgage interest, taxes, upkeep on the property, insurance, etc. So why wouldn’t you take advantage of the tax code and not pay a dime more in tax than you have to?”
Painter says it’s essential to seek the advice of a CPA before making any major real estate investment decision.
“Sometimes a smallest adjustment or modification can result in a major tax outcome. Failure to plan is planning to fail!”
Strategies for the Speculative House Flipper
If you’ve been sitting watching HGTV all pandemic and thinking, “That house flipping doesn’t look so tough. I bet I could do that. They always seem to be able to make money. Maybe there’s some decent investment potential out there for me.”
To this thinking, Orso counters definitively: “Keep your day job. It is so hard to find homes at the right price and the competition is so incredibly stiff right now because HGTV has made flipping seem fun and popular.”
Indeed, this is a particularly tough market in which to get started, with its low level of inventory, and these types of investments are often a lot more challenging than the television shows make them out to be.
“The money is made on the buy side,” Orso says. “First-timers typically screw up by overpaying up front and then overestimating how much they can sell it for.”
If you are of hardy stock, have done your homework, and still think flipping is something you want to pursue, Kappel has some advice for the determined.
“You have to be able to find a property that has enough upside that you can: one, buy it, then renovate it, and then turn around and sell it (with enough) to pay the transaction costs, to be able to get out from under it.”
By transaction costs you must consider the amount you will most likely pay a realtor on the buyer’s side and that’s if you handle your end as a “For Sale By Owner” transaction.
You will also have to pay a transfer tax (in Anne Arundel Country that’s 1.1 percent) because you have not lived in the home. There could also be capital gains implications because you have not lived in the home. And unfortunately, we are not done yet.
“The other thing that you have to factor in and that people don’t put a value on is their time,” Kappel says. “If you consider the carry costs from the point where you secure the property and it transfers into your name, to the point where you sell it and it goes into the new buyer’s name. What is that amount of time worth to you?”
Again, if you are willing to make peace with all these factors, there are two things you can do to make your sailing in the flipping market a bit smoother. One, is wait until we have navigated back to calmer buyer’s market waters. The other, Kappel says, is to align yourself with a realtor who you trust implicitly to give you the straight skinny on what a realistic price of sale would be once you have done your renovations.
What is the Most Common Question Asked by Investment Property Owners?
“What can I deduct on my rental property? This is the most common question we get as CPAs,” Painter says. “Like anything in accounting the answer is ‘it depends.’ It depends on facts and circumstances of each individual case. For example, if you buy a laptop, it might be tax deductible if it’s being used primarily for your rental real estate business to manage your properties, doing property research, bookkeeping, etc. Anything can be tax deductible!”
Strategies for the REIT Investor
A REIT (Real Estate Investor Trust) is a construct in which you can have some skin in the real estate market game without having to do the actual buying, selling, or flipping of properties. There are different types of REITs to choose from, their funds are generally made up of commercial properties and/or mortgages on those types of properties, and they are considered viable portfolio versification tools.
Do your research, but more importantly have those important conversations with your financial adviser. Not all REITs are created equal—and the pandemic has caused significant volatility in some of these funds due to the commercial nature of their structuring.
The primary issues in the short-term lie in the blow the pandemic dealt to the commercial office and small business sectors. There is less need for office space when everyone is working from home and industry experts agree that many of those jobs will never return to traditional offices in commercial spaces. With small businesses having to curtail hours and services, many of their landlords have had trouble collecting rent. (Note: the impact of social distancing restraints and business closures varies widely across real estate and REIT sectors, but for some, the effects were severe.)
Until the economy can return to normal, most analysts are taking solace in that fact that prior to the pandemic, these investments were positioned particularly well in the market with strong balance sheets and ample amounts of liquidity, and they see this financial strength as supportive for their positive mid- to long-range outlooks on REITs.
The Future… Only Younger
As we look forward, realtors are preparing to see more of the same when it comes to inventory shortages as we continue into 2021. Despite that particular challenge, they remain enthusiastic.
“In my professional opinion, 2021 will be incredible,” Orso says. “There are so many buyers looking for homes and 2021 will see new inventory and more sellers ready to pull the trigger. Inventory is the issue for active buyers, but it is also the issue for home sellers because they are saying, ‘I can’t list now because there is nothing to buy.’ More listings is the answer!”
The future will also highlight the group predicted to be the most plentiful among those new investors—millennials.
“Everything I am reading from the NAR (National Association of Realtors) is talking about engaging with millennials because they are the most populous part of our population right now and they’re all going to become home buyers at some point in the next five years,” Kappel says.
Traditionally, he explains, this might not have a profound effect on an area like Annapolis because in generations past, the younger adults would be headed to more urban areas like D.C. or New York City initially.
“They want to be able to go out to dinner, go to yoga class, and have everything at their fingertips,” Kappel says.
Post-pandemic, he says, they see areas like Annapolis as a more practical alternative, with a better climate, better schools, and better pricing.
“They were headed to the cites, but now…they’re coming to town.”
Yes, the times, they are a’ changing!
