Investing In Real Estate

Investing In Real Estate
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Praise for Gary Eldred
“Donald Trump and I have created Trump University to offer the
highest quality, success-driven education available. Our one goal is to
help professionals build their careers, businesses, and wealth. That’s
why we selected Gary Eldred to help us develop our first courses in
real estate investing. His books stand out for their knowledge-packed
content and success-driven advice.”
—Michael W. Sexton, CEO
Trump University
“Gary has established himself as a wise and insightful real estate
author. His teachings educate and inspire.”
—Mark Victor Hansen, Coauthor,
Chicken Soup for the Soul
“I just finished reading your book, Investing in Real Estate, Fourth Edi-
tion. This is the best real estate investment book that I have read so far.
Thanks for sharing your knowledge about real estate investment.”
—Gwan Kang
“I really enjoyed your book, Investing in Real Estate. I believe it’s one
of the most well-written books on real estate investing currently on
the market.”
—Josh Lowry
Bellevue, WA
President of Lowry Properties
“I just purchased about $140 worth of books on real estate and yours
is the first one I finished reading because of the high reviews it got.
I certainly wasn’t let down. Your book has shed light on so many
things that I didn’t even consider. Your writing style is excellent.
Thanks again.”
—Rick Reumann
“I am currently enjoying and learning a lot from your book, Investing
in Real Estate. Indeed it’s a powerful book.”
—Douglas M. Mutavi
“Thanks so much for your valuable book. I read it cover to cover.
I’m a tough audience, but you’ve made a fan here. Your writing is
coherent, simple, and clean. You are generous to offer the benefits of
your years of experience to those starting out in this venture.”
—Lara Ewing
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Sixth Edition
John Wiley & Sons, Inc.
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2009 by Gary W. Eldred, PhD. All rights reserved.
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Library of Congress Cataloging-in-Publication Data:
Eldred, Gary W.
Investing in real estate / Gary W. Eldred.—6th ed.
p. cm.
Includes index.
Rev. ed. of: Investing in real estate / Andrew J. McLean and Gary W. Eldred.
5th ed. 2006.
ISBN 978-0-470-49926-9
1. Real estate investment—United States. I. McLean, Andrew James.
Investing in real estate. II. Title.
HD255.M374 2009
Printed in the United States of America.
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Prologue:Investin RealEstate Now! xix
Acknowledgments xxvii
22 Sources of Returns from Investment Property 3
Will the Property Experience Price Gains from Appreciation? 4
Will You Gain Price Increases from Inflation? 5
Earn Good Returns from Cash Flows 6
Magnify Your Price Gains with Leverage 6
Magnify Returns from Cash Flows with Leverage 7
Build Wealth through Amortization 7
Over Time, Returns from Rents Go Up 8
Refinance to Increase Cash Flows 9
Refinance to Pocket Cash 10
Buy at a Below-Market Price 10
Sell at an Above-Market-Value Price 10
Create Property Value Through Smarter Management 11
Create Value with a Savvy Market Strategy 11
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Create Value: Improve the Location 12
Convert from Unit Rentals to Unit Ownership 12
Convert from Lower-Value Use to Higher-Value Use 12
Subdivide Your Bundle of Property Rights 13
Subdivide the Physical Property (Space) 14
Create Plottage (or Assemblage) Value 14
Obtain Development/Redevelopment Rights 15
Tax Shelter Your Property Income and Capital Gains 15
Diversify Away from Financial Assets 16
Is Property Always Best? 16
The Birth of “Nothing Down” 18
Should You Invest with Little or No Cash or Credit? 19
What’s Wrong with “No Cash, No Credit, No Problem”? 20
Leverage: Pros and Cons 22
What Are Your Risk-Return Objectives? 27
Maximize Leverage with Owner-Occupancy Financing 28
Owner-Occupied Buying Strategies 28
Current Homeowners, Too, Can Use This Method 29
Why One Year? 29
Where Can You Find High-LTV Owner-Occupied
Mortgages? 30
What Are the Loan Limits? 30
High Leverage for Investor-Owner Financing 32
High Leverage versus Low (or No) Down Payment 32
Creative Finance Revisited 32
Are High-Leverage Creative-Finance Deals Really Possible? 38
What Underwriting Standards Do Lenders Apply? 39
Collateral 40
Loan-to-Value Ratios 40
Recourse to Other Assets/Income 41
Amount and Source of Down Payment and Reserves 41
Capacity (Monthly Income) 42
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Credit History (Credibility!) 43
Character and Competency 44
Compensating Factors 45
Automated Underwriting (AUS) 46
Make Money When You Buy, Not Just When You Sell 48
What Is Market Value? 48
Sales Price Doesn’t Necessarily Equal Market Value 49
Sound Underwriting Requires Lenders to Loan Only
Against Market Value 50
How to Estimate Market Value 51
Property Description 52
Identify the Subject Property 52
Neighborhood 52
Site (Lot) Characteristics 59
Improvements 60
The Cost Approach 61
Calculate Cost to Build New 61
Deduct Depreciation 61
Lot Value 62
Estimate Market Value (Cost Approach) 63
The Comparable Sales Approach 64
Select Comparable Properties 64
Approximate Value Range—Subject Property 65
Adjust for Differences 65
Explain the Adjustments 66
The Income Approach 67
Income Capitalization 69
Net Operating Income 69
Estimate Capitalization Rates (R) 72
Compare Cap Rates 72
The Paradox of Risk and Appreciation Potential 73
Compare Relative Prices and Values 74
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Valuation Methods: Summing Up 74
Appraisal Limiting Conditions 75
Valuation versus Investment Analysis 76
Will the Property Yield Good Cash Flows? 77
Arrange Alternative Terms of Financing 79
Decrease (or Increase) Your Down Payment 80
Buy at a Bargain Price 82
Should You Ever Pay More than Market Value for a
Property? 83
The Debt Coverage Ratio 84
Numbers Change, Principles Remain 85
Will the Property Yield Profitable Increases in Price? 85
Low-Involvement versus High-Involvement Investing 86
Compare Relative Prices of Neighborhoods (Cities) 87
Undervalued Neighborhoods and Cities 88
Beverly Hills versus Watts (South Central Los Angeles) 88
Demographics 89
Accessibility (Convenience) 90
Improved (Increased) Transportation Routes 90
Jobs 91
Taxes, Services, and Fiscal Solvency 91
New Construction, Renovation, and Remodeling 91
Land-Use Laws 92
Pride of Place 93
Sales and Rental Trends 93
Summing Up 95
Why Properties Sell for Less (or More) Than Market Value 96
Owners in Distress 97
The “Grass-Is-Greener” Sellers 97
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Stage-of-Life Sellers 98
Seller Ignorance 99
Prepare Screening Criteria 100
Bargain Sellers 101
Networking/Get the Word Out 102
Newspapers and Other Publications 102
Cold Call Owners 103
Agent Services 105
Internet Listings 107
Seller Disclosures 107
The Disclosure Revolution 108
Income Properties 108
Summary 109
The Foreclosure Process 110
Lender Tries to Resolve Problem 111
Filing Legal Notice 111
The Foreclosure Sale 112
REOs 112
Buy Preforeclosures from Distressed Owners 112
Approach Owners with Empathy 113
The Difficulties of Dealing Profitably with Owners in
Default 113
Prequalify Homeowners and Properties 115
Finding Homeowners in Default (Prefiling) 117
Networking 117
Mortgage Collections Personnel 117
Drive Neighborhoods 117
Find Homeowners (Postfiling) 118
Cultivate a Relationship with Property Owners 118
Two More Issues 119
Vacant Houses 120
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Satisfy Lenders and Lien Holders 121
All Parties Are Better Off 123
Win by Losing Less 123
Profit from the Foreclosure Auction 124
Why Foreclosures Sell for Less than Market Value 124
Make the Adverse Sales Efforts Work for You 125
How to Arrange Financing 126
The Foreclosure Sale: Summing Up 127
Bad News For Sellers/Builders, Good News For You 128
How to Find REOs 129
Follow Up with Lenders after Foreclosure Sales 129
Locate Specialty Realtors 130
HUD Homes and Other HUD Properties 131
Homeowners versus Investors 132
“As-Is” Condition 132
Potential Conflict of Interest 133
Buyer Incentives 133
The Bid Package 134
Department of Veterans Affairs (REOs) 134
Big Advantages for Investors 135
Fannie Mae and Freddie Mac REOs 136
Agent Listings 136
Investors Invited 137
Federal Government Auctions 137
Buy from Foreclosure Speculators 138
Probate and Estate Sales 138
Probate 138
Estate Sales 139
Private Auctions 139
How to Find Auctions 141
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Fix, Flip, Profit! 142
Look for “Fixers” 143
The Browns Create Value in a Down Market 144
Research, Research, Research 145
Improvement Possibilities 146
Thoroughly Clean the Property 146
Add Pizzazz with Color Schemes, Decorating Patterns,
and Fixtures 147
Create Usable Space 147
Create a View 148
Capitalize on Owner Nearsightedness 148
Eliminate a Negative View 149
Enhance the Unit’s Natural Light 149
Reduce Noise 150
Required Repairs and Improvements 150
Plumbing 151
Electrical System 151
Heating and Air-Conditioning 151
Windows 152
Appliances 152
Walls and Ceilings 152
Doors and Locks 152
Landscaping 152
Storage Areas 153
Clean Well 153
Safety and Health 153
Roofs 153
Improvements and Alterations 154
You Can Improve Everything about a Property—Including
Its Location 154
The South Beach Example: From Derelicts to Fashion
Models 154
Community Action and Community Spirit Make a
Difference 155
Neighborhoods Offer Potential 156
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What Types of Improvements Pay the Greatest Returns? 157
How Much Should You Budget for Improvements? 157
Beware of Overimprovement 158
Other Benefits 158
No-No Improvements 159
Budgeting for Resale Profits 159
Estimate the Sales Price First 159
Estimate Costs 160
Future Sales Price Less Costs and Profit Equals
Acquisition Price 160
Comply with Laws and Regulations 162
Should You Buy a “Fixer”? 162
Too Little Time? 163
Put Your Creativity to Work 163
Lease Options 165
Here’s How Lease Options Work 165
Benefits to Tenant-Buyers (An Eager Market) 166
Benefits to Investors 167
The Lease Option Sandwich 168
How to Find Lease Option Buyers and Sellers 169
A Creative Beginning with Lease Options
(for Investors) 170
Lease Purchase Agreements 170
“Seems” More Definite 171
Amount of the Earnest Money Deposit 171
Contingency Clauses 171
Conversions 172
Condominium Conversion 172
Tenants in Common 174
Convert Apartments to Office Space 175
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Master Leases 176
Assignments: Flipping Purchase Contracts 178
Summary 179
Win-Win Principles 181
The Purchase Contract 183
Names of the Parties 184
Site Description 184
Building Description 184
Personal Property 185
Price and Financing 185
Earnest Money Deposit 186
Quality of Title 187
Property Condition 187
Preclosing Property Damage (Casualty Clause) 188
Closing (Settlement) Costs 189
Closing and Possession Dates 189
Leases 190
Contingency Clauses 191
Assignment and Inspection 192
Public Records 193
Systems and Appliances 193
Environmental Hazards 193
No Representations 194
Default Clause 194
Summary 197
The 10:1 Rule (More or Less) 199
Think First 200
Know Yourself 201
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Know Your Finances 201
Know Your Capabilities 202
Smart Strategic Decisions 202
Local Markets Require Tailored Strategies 203
Craig Wilson’s Profit-Boosting Market Strategy 203
How Craig Wilson Used Market Information to Enhance
the Profitability of His Property 206
Results 210
Cut Operating Expenses 210
Energy Audits 210
Property Insurance 211
Maintenance and Repair Costs 214
Property Taxes and Income Taxes 214
Increasing Value: Final Words 215
The Mythical “Standard” Lease 216
Your Market Strategy 216
Search for Competitive Advantage 218
Craft Your Rental Agreement 219
Names and Signatures 219
Joint and Several Liability 219
Guests 220
Length of Tenancy 220
Holdover Tenants (Mutual Agreement) 220
Holdover Tenants (without Permission) 221
Property Description 221
Inventory and Describe Personal Property 221
Rental Amounts 222
Late Fees and Discounts 222
Multiple Late Payments 222
Bounced Check Fees and Termination 223
Tenant “Improvements” 223
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Owner Access 223
Quiet Enjoyment 224
Noxious Odors 224
Disturbing External Influences 224
Tenant Insurance 225
Sublet and Assignment 225
Pets 226
Security Deposits 226
Yard Care 228
Parking, Number, and Type of Vehicles 228
Repairs 228
Roaches, Fleas, Ants 229
Neat and Clean 229
Rules and Regulations 229
Wear and Tear 230
Lawful Use of Premises 230
Notice 230
Failure to Deliver 231
Utilities, Property Taxes, Association Fees 231
Liquid-Filled Furniture 231
Abandonment of Property 232
Non-waivers 232
Breach of Lease (or House Rules) 232
No Representations (Full Agreement) 233
Arbitration 233
Attorney Fees (Who Pays?) 234
Written Notice to Remedy 235
Tenants Rights Laws 235
Tenant Selection 235
Property Operations 237
Evictions 237
Landlording: Pros and Cons 238
Possibilities, Not Probabilities 238
Professional Property Managers 238
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Design a Winning Value Proposition 240
Yet Generic Prevails 240
USP versus WVP 241
Craft Your Selling Message 243
Use a Grabber Headline/Lead 244
Reinforce and Elaborate 244
Add Hot Buttons 244
Establish Credibility 245
Compare to Substitutes 245
Evoke Emotional Appeal 245
Reduce Perceived Risks 245
Make It Easy for Prospects to Respond 245
Follow Up with Your Prospects 247
Reach Potential Buyers 247
For Sale Signs 247
Flyers/Brochures 248
Networking (Word of Mouth) 249
Web Sites/Links 249
Sales Agents 249
Should You Employ a Realty Agent? 249
Services to Sellers 250
Services to Buyers 251
Co-Op Sales 252
Listing Contracts 252
The Risks of Change and Complexity 255
Homeowner Tax Savings 256
Capital Gains without Taxes 256
Rules for Vacation Homes 257
Mortgage Interest Deductions 258
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Credit Card Interest 258
Rules for Your Home Office 259
Depreciation Expense 259
Land Value Is Not Depreciable 259
Land Values Vary Widely 260
After-Tax Cash Flows 260
Passive Loss Rules 261
Taxpayers in the Real Property Business (No Passive
Loss Rules) 262
Alternative Minimum Tax 262
Capital Gains 263
A Simplified Example 263
The Installment Sale 264
What’s the Bottom Line for Sellers? 265
Implications for Buyers 265
Tax-Free Exchanges 265
Exchanges Don’t Necessarily Involve Two-Way Trades 266
The Three-Party Exchange 266
Exchanges Are Complex but Easy 266
Are Tax-Free Exchanges Really Tax Free? 268
Section 1031 Exchange Rules 268
Reporting Rental Income and Deductions 269
Tax Credits 271
Complexity, Tax Returns, and Audits 272
Use a Tax Pro 275
Property Taxes 276
Summary 278
Lower-Priced Areas 281
What about Property Management? 283
Tenant-Assisted Management 283
Property Management Companies 283
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Emerging Growth Areas 284
The Creative Class 284
Implications for Investing in Real Estate 284
Right Place, Right Time 285
Emerging Retirement/Second-Home Areas 285
Which Cities and Areas? 286
Income Investing 286
Commercial Properties 286
Property Management 287
The Upside and Downside 287
Opportunity for High Reward 287
Commercial Leases Create (or Destroy) Value 289
Triple Net (NNN) 290
Self-Storage 291
Mobile Home Parks 292
Profitable Possibilities with Zoning 294
Tax Liens/Tax Deeds 294
Localities Differ 294
Are Tax Liens/Tax Deeds an Easy Way to Make
Big Profits? 295
Discounted Paper 295
What Is Discounted Paper? 295
Here’s How It Works 296
Broker the Note 296
Do Such Deals Really Occur? 296
Due Diligence Issues 296
Should You Form an LLC? 297
Different Strokes for Different Folks 297
Insufficient Court Rulings 297
One Size Doesn’t Fit All 298
Less Risk 301
Personal Opportunity 301
Index 304
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early everywhere I speak these days, someone from the audience
asks, “Do you feel the real estate market will drop further? Have
we reached bottom yet? When do you think property prices will
fully recover?”
I answer, “I do not know. I really do not care. And neither should
Why do I give such seemingly flip answers? First, because they are
true. All investment pros encourage you to focus on your wealth-building
goals—not profit maximization per se. Waiting for the bottom merely gives
you an excuse to procrastinate. I’ve seen would-be investors make this
mistake a thousand times.
And second, because the questions are ill-formed. They miss iden-
tifying the multiple ways that you can profit with property. To invest
successfully in real estate, you need not, and should not, focus on pre-
dicting market valleys (or peaks). More productively, think in terms of
possibilities, probabilities, and strategy—not merely the lowest price.
If you asked financial journalists (or their quotable experts) whether you
should now invest in real estate, you would likely receive a variety of
answers. But nearly all of their answers would focus on one central point:
the expected direction of short-term price movements.
Journalists and their media molls love to play the game of short-
term forecasting. They do it with stocks, gold, commodities, interest rates,
and, for the past 10 years, properties. Are prices climbing? Buy. Are prices
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falling? Get out and go sit on the sidelines. As a result of their obsession
with short-term price movements, the media have distorted and confused
the idea of investing in real estate.
In contrast to media hype, the most experienced and successful real
estate investors do not weight their deal analysis with any significant
emphasis on short-term price forecasts. Instead, we typically look to an
investing horizon of three to 10 years (or longer). More important, we
realize that in addition to price increases, property provides us with many
possible sources of return. Here are some (but certainly not all) of these
profit possibilities.
Earn price gains from appreciation.
Earn price gains from inflation.
Create unleveraged cash flows.
Use leverage to magnify returns from price gains.
Use leverage (financing) to magnify returns from cash flows.
Grow equity gains through amortization.
Refinance to increase cashflows
Refinance to generate cash (lump sum).
Buy at a below-market-value price.
Sell at an above-market-value price.
Create value through smarter management.
Create value through savvy market strategy.
Create value by improving the location.
Subdivide your bundle of property rights.
Subdivide the physical property.
Create plottage (assemblage) value.
Convert the use (e.g., residential to offices, retail to offices).
Convert type of tenure (e.g., rental to ownership).
Shelter income from taxes.
Shelter capital gains from taxes.
Create and sell development/redevelopment rights.
Diversify away from stocks and bonds.
I explain each of these possible sources of return in Chapter 1 and
then illustrate and elaborate to varying degrees in the chapters that follow.
With this extensive range of possibilities in view, you can always find
profitable ways to invest in real estate.
Unlike investing (or speculating) in stocks, bonds, gold, or commodi-
ties, you can generate returns from properties through research, reasoning,
knowledge, and entrepreneurial talents. In contrast, when you buy stocks,
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you had better pray that the market price goes up, because that’s your only
possibility to receive a reasonable return.
In the correction part of the real estate cycle, fear looms. Cash balances in
banks build up. Investors and savers join in a flight to quality. They will-
ingly accept certificates of deposit (CDs) that pay low-single-digit interest
rates. Investors think, “Who cares about return on capital? I just want to
feel confident that I receive a return of capital.
In his highly regarded book The Intelligent Investor, Benjamin Graham
created the parable of Mr. Market. Mr. Market represents that crowd men-
tality whose moods swing like a pendulum from irrational exuberance
to bewildered fear and confusion. Which market mood provides the best
investment opportunities/possibilities? Which market mood throws in-
vestors the highest amount of actual risk? Which market mood corre-
sponds to the least amount of actual risk?
Booms Increase Actual Risk
You know the answers. During the irrationally exuberant boom times, in-
vestors perceive little risk, but actual risks loom larger and larger as prices
climb higher and higher, income yields fall, and unsustainable amounts of
mortgage debt pile up.
In Las Vegas, so-called investors (actually speculators) believed that
flipping properties paved their way to wealth. Few perceived that their
property risks actually laid down poorer odds than the slots at Harrah’s.
And who but a fool (or Panglossian optimist) would borrow money to
play the slots? Yet Las Vegas property buyers loaded up with excessively
high loan-to-value (LTV) ratios of 90, 95, and 100 percent (or more). They
merely assumed that the future would continue to pay off as they had
experienced in the recent past.
On many of their properties, loan payments (principal, interest, taxes,
and insurance [PITI]) approached $2,000 a month. Potential rents for the
same properties would reach no more than $1,200 a month. When an
alligator is chewing your leg off, you are in a world of danger (and a
world of hurt). As I have written in nearly every one of my books, high
debt, low income yields, and exaggerated hopes for outsized continuing
With property, I have earned per annum returns of 25 percent or more—without
a single dollar of price gain.
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increases in price (for either stocks or properties) always trigger a reversal
of fortune. (See especially my Value Investing in Real Estate, John Wiley &
Sons, 2002.)
The speculative buying of Las Vegas houses serves as an outside-
the-norm example. Few other areas experienced such heightened frenzy
among both builders and buyers. Nevertheless, irrational exuberance
infested the moods and minds of property buyers throughout many
of the world’s principal cities (though during the boom of late, not
Dallas, Berlin, or Tokyo—each had suffered its own irrationally exuber-
ant property market 15 to 20 years back, and sat out this most recent
party). In nearly every instance, borrowed money fueled property prices
upward without commensurate growth in rent collections or personal
Market Corrections Vanquish Market Risk
Within a few short years, many property markets have shifted from sell-
ers’ markets driven by loose lending and buoyant dreams of fast, easy
money to buyers’ markets sustained by stricter credit standards, record
numbers of foreclosures, a 25-year high in unemployment, and multiple
major banks taking hits for unprecedented amounts of losses. No wonder
fear and confusion have chased many potential property investors out of
the game.
So here is the $64,000 question: How should you interpret these and
other dismal facts from the dismal science? Do lousy economic conditions
diminish your chance to build a prosperous and secure future by investing
in property? Or do they vanquish market risk?
To make this question of risk easier, first address the following 10
issues. When is the best time to acquire investment property:
1. (a) When builders are bringing to market near-record numbers
of new houses, condominiums, and condominium conversions,
or (b) when new housing starts have fallen to the lowest level
since before 1959?
2. (a) When buyers flock to open houses and beg sellers to accept
their above-asking-price bids, or (b) when investors and home
buyers remain relatively scarce?
3. (a) After economic recovery pushes interest rates higher, or
(b) when interest rates sit near the low end of the past 40 years?
4. (a) When inflation seems subdued (as occurred during the
past eight years), or (b) (as today) when massive amounts of
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government borrowing and huge increases in the money supply
seem sure to push inflation (and interest rates) to higher levels
within the coming decade?
5. (a) When properties sell for prices at a 20 to 50 percent premium
above their replacement costs, or (b) when you can buy properties
at a 20 to 50 percent discount below their replacement costs?
6. (a) When millions of home buyers overleverage to purchase
houses that they cannot afford, or (b) when stricter credit and
high unemployment lead many people to double up (or even
triple up) on their housing?
7. (a) When most sellers can hold out for top dollar, or (b) when
financial distress and more than one million foreclosures/REOs
create millions of desperately motivated sellers?
8. (a) When property prices sit in the clouds well above the level
that rents will support, or (b) when market values fall to the
point where income yields make sense and investors can reason-
ably expect to achieve positive cash flows—either immediately
or within a few years?
9. (a) When hundreds of thousands of new investors overleverage
themselves to buy rental properties that they do not know how
to manage, or (b) when those same starry-eyed investors rudely
awaken to the fact that successful investing requires reserves of
cash and credit, knowledge, thought, and an operating system
and strategy?
10. (a) When economic recovery and increasingly positive news pro-
pel millions of backbenchers into the game, or (b) now?
If you’ve answered (b) to each of these 10 issues, you display the
courage and foresight to become a great investor. You know that market
corrections vanquish risk and multiply your possibilities for profit.
Never Wait for Market Peaks or Bottoms
To invest successfully, never try to time a market bottom—or a market top.
Neither you, I, nor anyone else can develop that skill. Why? Because more
often than not, random events trigger short-term turns in markets. We
can tell when markets are becoming too pricey. We can tell when market
conditions greatly favor investors. But only by extraordinary luck can we
pick the one best time to sell or buy. (Just as importantly, the way you
negotiate a deal can create as much or more opportunity for you than the
market conditions themselves.)
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My Texas Example I owned properties in Texas in the early 1980s. By
mid-1984, I had sold all of them (at substantial gains). The market contin-
ued to go up. Property agents told me that I shouldn’t have sold. Later,
after the crash in 1985, they told me that I had sold too soon. What do you
When do you replace the tires on your car? At the last possible
moment before they blow out? Or when you see the tread wearing down
and the risk of a blowout increasing? If you want to save your life, do not
try to run your tires until the last possible moment.
Likewise with property, when irrational exuberance fuels prices ever
higher and these prices are unsupported by rent levels or personal in-
come growth, risk builds excessively. Prudence sells to save profits. Only
fools hold on to capture the last dollar—or the last 1,000 miles from that
risky, worn tire. And only bigger fools believe that tires or booms will last
Look for Solid Value—Not Necessarily a Market Bottom or Market Boom
Today’s markets offer multiple low-risk, high-profit possibilities. Over
a time horizon of three to five years—if you follow the principles laid
out in this book—you will enjoy strong profits. I encourage you to get
in the game now. No one can predict the course of prices during the
next year or two. But today, you can certainly find solid values in most
In my experience, two major mistakes prevent people from profiting
with property: (1) They wait too long to exit an irrationally exuberant
market, and (2) they wait too long to take advantage of the possibilities
that are theirs for the taking.
As you read through the following pages, you will discover how property
provides at least 22 sources of financial returns. Plus, you will discover
multiple ways to harvest those returns.
Buying, improving, and holding income properties—especially
when you purchase them at bargain prices and finance with smart
leverage—offers the surest, safest, and, yes, even the quickest way to build
wealth. But even long-term investors such as myself will venture along
other avenues when clear opportunities arise.
In addition to the buy, improve, and hold approach, other tech-
niques include discounted paper, real estate investment trusts (REITs),
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condominium conversions, fix and flip, adaptive reuse, tax liens, mobile
home parks, self-storage centers, lease options, triple net leases, and other
possibilities to profit through property.
If you want a secure future—a future free of financial worries, a life
that you can live as you would like to live—property, especially property in
today’s markets, provides a near-certain route to wealth. All that remains
is for you to choose, develop, and execute your own strategy now.
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any people have contributed directly and indirectly to this sixth
edition of Investing in Real Estate. Because of their efforts, this
best-selling classic text on property investing has been made even
Accordingly, I thank Donald Trump and Michael Sexton for inviting
me to work with Trump University to help create some of the best real
estate educational products and services available (e. g., Trump Univer-
sity books—all published by John Wiley & Sons—CDs, seminars, online
courses, webinars, and coaching programs). Working with the Trump team
and Trump University students has broadened and deepened my perspec-
tives on property investing as well as how to simply and effectively convey
that knowledge to property investors at all levels of experience.
I also express my appreciation to Dr. Malcolm Richards, dean of
the School of Business and Management at the American University
of Sharjah (AUS). In recognizing the critical need for real estate educa-
tion in the Middle East—and especially the hyper-growth Sharjah/Dubai
metroplex—Dean Richards carved out a rewarding position for me from
which I have added substantively to my knowledge and analytical abili-
ties as they apply to international property markets. Under Dean Richards,
the School of Business and Management of AUS has established itself as
the premier school for business education in the Middle East—and I am
pleased to have been able to participate in its development. My assistants
at AUS, Mohsen Mofid and Sadaf Ahmad Fasihnia, too, deserve recogni-
tion for their cheerful and competent assistance in all of my writing and
teaching activities. (Alas, both have now graduated and I will miss them
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My best-selling real estate titles—including Investing in Real Estate
have been translated into numerous foreign languages such as Russian,
Indonesian, Vietnamese, and Chinese. Thanks go to the skillful translators
of these volumes and to my Asian property adviser, Sit Ming (Laura) Lee.
Last but far from least, I thank my supervising editor, Shannon Vargo;
senior production editor Linda Indig; and the entire staff at John Wiley &
Sons, with whom I always enjoy working. This edition of Investing in
Real Estate marks the 23rd manuscript that I have completed for this 200-
year-old company that represents the finest publishing traditions. I look
forward to completing many more.
Gary W. Eldred
Vancouver, Canada
August 2009
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lder workers rush back into the jobs market as downturn
wrecks their retirement portfolios,” so headlined a recent
front-page article in the Financial Times (May 9, 2009). Other
major newspapers such as the Wall Street Journal,theNew York Times,and
Investor’s Business Daily have run similarly disconcerting articles.
The Financial Times article (and others similarly written) depart from
the mainstream media view that dominates. For the past 15 years, most
major media—and especially personal finance magazines such as Money,
Smart Money, and Kiplinger’s—have primarily served up inept mantras for
the masses disguised as financial wisdom. Such widely read magazines
and newspapers have published hundreds (quite likely thousands) of ar-
ticles that promise investors that they can achieve wealth without work,
effort, or thought.
Just keep pouring monthly payments into your IRAs, 403(b)s, and
401(k)s and you will enjoy financial security. “Over the long run stocks
outperform all other investments. Over the long run stocks will protect
you against inflation.”
Indeed, just as I was about to write this chapter, voil
a, my local
paper obliged with a perfect example. A reader, Nasir Iqbal, posted
this comment: “I don’t trust stocks. I think I will receive higher re-
turns with property. With property, I will feel financially secure when
I retire.”
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The journalist, Cleofe Maceda, responded as follows:
Is buying property the right way to secure your retirement?
Experts [sic] say people like Iqbal are better off looking into
other avenues for capital growth—which can reduce the long-
term risk of running out of income in retirement.
Maceda (the journalist writing the article) then quotes one of his
so-called experts,
The challenge with property is that you can only sell it for what
people are willing to pay. [Duh?] It can take two years or longer
to sell a property. There is no liquidity with property.
Continuing a bit further in this article, the journalist again quotes his
Stock markets offer the best possibility to beat inflation over
periods of five years or more. This is because shares produce
dividend income in addition to the ability to grow in price.
As to volatility—that other big issue that confronts investors—the
mantra persists. No need to worry about 30 to 50 percent drops in the
stock markets...
...that volatility can work for an investor’s advantage because
it allows them to maximize their buying power [i.e., when stock
prices fall, your $1,000a month deposits(or whatever) buy more
In one short article, Maceda scores six out of six widely popularized,
yet false claims:
1. Stocks outperform all other assets.
2. Liquidity favors stocks.
3. Stocks pay you good income.
4. Stocks protect you against inflation.
5. Stocks reduce the risk of running out of money in retirement.
6. You don’t really lose when your stock portfolio crashes, you gain.
Evidently, Maceda—like a majority of journalists (and investors)—
prefers not to think for himself. He prefers not to look at the actual
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historical recordof stocks.He preferstoremain ignorant of property.Stand-
ing against conventional wisdom, the Financial Times (at least in the article
quoted) has captured the sad reality of stocks. Maceda only perpetuates
the mantra manufactured by Wall Street.
This chapter sets the record straight. It provides you (and Nasir Iqbal)
a more enlightened perspective on property, stocks, and several other asset
classes (bonds, annuities) that investors might turn to as they strive to build
wealth and achieve financial security.
When so-called experts compare property with stocks, they rarely get
their comparisons right. More often than not, they assume that property
yields only one source of return that counts: potential gains in price. For
example, in his acclaimed book, Winning the Loser’s Game, Charles Ellis
concludes that:
Owning residential real estate is not a great investment. Over
the past 20 years, home prices have risen less than the consumer
price index and have returned less than Treasury bills.
Leaving aside for a moment how and where Ellis came up with
his long-term house price figures—no statistics I have ever seen re-
port that housing, relative to incomes or consumer prices, has become
cheaper—Ellis (and other finance/economics types) err most egregiously
in how investors should measure the total potential returns that property
offers. Ellis omits at least 20 other sources of financial returns that investors
can earn from their portfolio of properties.
To evaluate property, certainly weigh the possibilities for price gains,
but go further. You can earn double-digit rates of return (and sometimes
much more) from your property investments—even without any gain
in price.
It’s up to you to decide which sources of returns best fit your in-
vestment goals—and correspondingly, for each property you evaluate,
which sources of return seem doable. Few properties present a full range
of possibilities. But to fully see potential, apply each test of possibility
His two-decade time horizon also fails as a representative period because it in-
cludes the late 1970s and the 1980s—treasuries paid record-high interest rates
during those years.
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to all properties you consider. Every property presents multiple sources
of returns.
Will the Property Experience Price Gains from Appreciation?
In everyday speech, most people do not differentiate price gains that result
from appreciation and those that result from inflation. Appreciation occurs
when demand grows faster than supply for a specific type of property
and/or location. Inflation tends to push prices up—even if demand and
supply remain in balance.
Homes in Central London, San Francisco’s Pacific Heights, and
Brooklyn’s Williamsburg neighborhood have experienced extraordinar-
ily high rates of appreciation during the past 15 to 20 years. And just since
1990, houses within a mile or so of the University of Florida campus have
tripled in market price—primarily because UF students and faculty alike
now strongly prefer “walk or bike to campus” locations.
Areas Differ in their Rate of Appreciation. Although properties lo-
cated in Pacific Heights and Williamsburg have jumped in value at rates
much greater than the rise in the Consumer Price Index (CPI), some
neighborhoods in Detroit have suffered major declines in value. Appre-
ciation does not occur randomly. You can forecast appreciation potential
using the right place, right time, right price methodology discussed in
Chapter 15.
Likewise, you need not get caught in the severe and long-term down-
drafts that plague cities and neighborhoods that lose their economic base
of jobs. Just as various socioeconomic factors point to right time, right
place, right price, similar indicators can signal wrong place, wrong time,
wrong price.
You Do Not Need Appreciation. Should you always invest in prop-
erties that are located in areas poised for above-average appreciation?
Not necessarily. Throughout the rest of this chapter, I show you many
ways to profit with property. Some investors own rental properties
in deteriorating areas—yet still have built up multimillion-dollar net
worths. My first properties did not gain much from price increases
(appreciation or inflation)—but they consistently cash flowed like a slot
machine payoff.
If you choose a fast money, flip and fix strategy, appreciation doesn’t
count for much either. Also, when you buy at a price 10 to 30 percent below
market value, you earn instant appreciation that is not related to market
temperature. Throw away the urge to believe that you can’t make good
money with property unless its market price appreciates.
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Will You Gain Price Increases from Inflation?
In his book, Irrational Exuberance, the oft-quoted Yale economist, Robert
Shiller, concludes that houses perform poorly as investments. According
to his reckoning, since 1948, the real (inflation-adjusted) price growth in
housing has averaged around 1—at best 2—percent a year.
“Even if this $16,000 house sold in 2004,” says the eminent profes-
sor, “at a price of $360,000, it still does not imply great returns on this
investment ... a real (i.e., inflation-adjusted) annual rate of increase of a
little under 2 percent a year.”
Shiller Thinks Like an Economist, Not an Investor. Every investor
wants to protect his wealth from the corrosive power of unexpected infla-
tion. Even if we accept Shiller’s numbers—and I believe them reasonable,
though certainly not beyond critique—the data do show that property
has kept investors ahead of inflation in every decade throughout the past
75 years.
Not true for stocks (or bonds). Consider the most inflationary period
in U.S. history: 1966–1982. In 1966, the median price of a house equaled
$25,000; the Dow Jones Index hit 1,000. During the next 18 years the CPI
jumped from 100 to 300. In 1982, the median price of a house had risen
to $72,000; the DJIA closed the year at 780—below its nominal level of
18 years earlier.
Inflation Risk: Property Protects Better than Stocks. No one knows
what the future holds. Will the CPI once again start climbing at a steeper
pace? At the runaway rate the U.S. government prints money and floats
new debt, the odds point in that direction. During periods of accelerating
inflation, most people would rejoice at just staying even.
Imagine that in the early to mid-1960s you were a true blue “stocks
for retirement” kind of investor—and you were then age 45. In 1982, as
you approach age 65, your inflation-adjusted net worth sits at maybe
30 percent of the amount you had hoped and planned for. What do you
do? Stay on the job another 10 years? Sell the homestead and downsize?
Borrow money from a wealthy friend who invested in real estate?
Property Investors Do Not Buy Indexes and Averages. Economists
calculate in the netherland of aggregates and averages. Investors buy
specific properties according to their personal investment objectives. An
economist’s average does not capture the actual price gains (inflation plus
appreciation) that real investors earn.
No investor who intelligently chooses properties for their wealth-
building potential selects such properties randomly. Investors apply
some variant of right time, right place, right price methodologies (see
page 285). If you want to outperform the average price increases of real
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estate—even though the averages themselves look quite good—you cer-
tainly can.
Earn Good Returns from Cash Flows
Unlike the overwhelming majoritystocks, incomeproperty typically yields
(unleveraged) cash flows of 5 to 12 percent.
If you own a $1,000,000
property free and clear of financing, you can pocket $50,000 to $120,000 a
year. If you owned a $1,000,000 portfolio of stocks, you might pocket cash
flows (dividend payments) of $15,000 to $30,000 a year.
Historically, the largest source of return for unleveraged properties
has come from cash flow. If you want to grow a passive, inflation-protected
stream of income, own income properties.
Economists and financial planners greatly embarrass themselves
when they sleight or ignore this critical source of return. Before Charles
Ellis, Robert Shiller, and others of their ilk again take up their pens to write
on real estate, they might set aside their misguided claims of expertise on
realty returns and first learn something about the actual practice of invest-
ing in real estate. If they did, they would also learn that nearly all property
investors magnify their returns with leverage.
Magnify Your Price Gains with Leverage
Know-nothing economists, financial analysts, and various media-anointed
experts claim that price gains from property provide real (inflation-
adjusted) returns of one to two percent a year. In doing so, they omit the
return-boosting power of OPM (other people’s money—typically, mort-
gage financing).
Low Rates of Price Gain Create Big Returns. Assume you acquire
a $100,000 property. You borrow $80,000 and place $20,000 down. During
the following five years, the CPI advances by 50 percent. Your property,
though, lagged the CPI. Its price only increased by 25 percent. Your real
wealth fell, right? No, it increased.
You now own a property worth $125,000, but your equity wealth—
your original $20,000 cash equity in the property—has grown to $45,000
(not counting mortgage amortization of principal). You have more than
doubled your money. To have stayed even with the CPI, your equity only
needed to grow to $30,000.
Yields in the U.K., Asia, and most of Europe often fall somewhat below those
available throughout the United States.
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Acorns into Oak Trees. Real estate investing builds wealth because it
grows acorns (small down payments) into free and clear properties worth
many multiples of the original amount of invested cash. Let’s go back to
that Shiller example.
The homebuyer paid a price of $16,000 in 1948. Did that homebuyer
pay cash? Not likely. Ten to 20 percent down set the norm—say, 20 percent
or $3,600 (.2 × $16,000). At Shiller’s hypothetical 2004 value of $360,000,
the homebuyer multiplied his original investment 100 times over. Even
if we say the 2004 property value comes in at $180,000—the homeowner
enjoyed a 50-fold increase of his $3,600 down payment.
What about stock gains during that period of 1948 to 2004? In 1948 the
DJIA hovered around 200 (by the way, still about 40 percent below its 1929
peak of 360). In 2004, the DJIA stood at about 8,000—a 40-fold gain. Not
bad, but still less than the gains from property (and much, much less when
we bring cash flows into the comparison of returns). [Note: As I write
in mid-2009, the DJIA still sits around 8,000—whereas property prices
(in all but the most distressed areas) are still up from 2004 and way up
from 1998, which is the year that the DJIA first hit 8,000.]
Magnify Returns from Cash Flows with Leverage
Traditionally, investors not only magnify their equity gains from leverage,
they also magnify their rates of return from cash flows. You pay $1,000,000
cash for an apartment building that yields a net income (after all operating
expenses) of 7.5 percent (no financing). Not bad. But if you finance $800,000
of that $1,000,000 purchase price at, say, 30 years, 5.75 percent interest,
you invest just $200,000 in cash. Your net income equals $75,000 (.075 ×
1,000,000) and your annual mortgage payments (debt service) will total
around $56,000. You pocket $19,000 ($75,000 less $56,000). You’ve boosted
your cash flow return (called cash on cash) from 7.5 percent to 9.5 percent
(19,000 ÷ 200,000).
Build Wealth through Amortization
Assume for a moment that your $1,000,000 apartment building throws off
zero cash flows. You apply every dollar of net operating income to paying
down your mortgage balance of $800,000. After 20 years, you own the
property free and clear. This property experienced no gain in price. It’s
still worth $1,000,000.
No price gains from inflation, no price gains from appreciation, and
no money pocketed from cash flows. Quite unrealistic and pessimistic,
right? Yet, over a 20-year period, you grew your equity from $200,000 to
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$1,000,000—a five-fold gain, and annual compound growth rate of more
than 8 percent.
Your tenants just bought you a $1,000,000 property. That’s why I tell
my students, “Rent or buy?” asks the wrongquestion. All tenants buy—the
real question is one of ownership. If you rent, you still pay your landlord’s
mortgage. Your landlord reaps the rewards of ownership—while tenants
bear the cost. Seems to me a great deal for property investors.
Over Time, Returns from Rents Go Up
Most property owners raise their rents. Maybe not this year. Maybe not
next year. But over a period of five years or more, increasing rents yields
increasing cash flows. If you’ve selected a right time, right place, right price
location, demand will push rents up as more people want to live in the
neighborhood where your property is located. Or perhaps, as government
floods the economy with paper money, inflationary pressures force rents
up. Either way, you gain. In fact, you can gain even if your rent increases
fail to match the inflationary jumps in your expenses.
Let’s return to our apartmentbuilding example.Grossrentcollections
equal $125,000; net operating income equals $75,000; mortgage payments
equal $56,000; your cash flow equals $19,000.
Gross rents $125,000
Vacancy and expenses 50,000
Net operating income 75,000
Annual mortgage payments 56,000
Cash flow 19,000
First, assume your rents and expenses each increase by 8 percent.
Here are the revised amounts:
Gross rents $135,000
Vacancy and expenses 54,000
Net operating income 81,000
Annual mortgage payments 56,000
Cash flow 25,000
An 8 percent increase in rents and expenses boosts your cash flow by
31 percent:
25,000 ÷19,000 = 1.31
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If expenses had increased by 12 percent and rents stepped up mildly
by just 6 percent per annum (p.a.), you would still increase your cash flow:
Gross rents $132,500
Vacancy and expenses 56,000
Net operating income 76,500
Annual mortgage payments 56,000
Cash flow 20,500
20,500 ÷19,000 = 1.08
[Note: You can run multiple scenarios with these numbers and other
numbers presented throughout this chapter. No results are guaranteed.
Through your own market and entrepreneurial analysis, you will both
estimate and create the potential returns for the properties you buy.]
But I do encourage you to realistically envision the return pos-
sibilities that property investing offers. Then as you evaluate markets,
properties, and the economic outlook for your geographic areas of inter-
est, figure the probabilities. Which sources of return look most promis-
ing? Which sources of return seem remote? What risks could upset the
Refinance to Increase Cash Flows
You increase your cash flows when you increase your rents (or decrease
your expenses). You also increase your cash flows when you refinance to
lower your annual mortgage payments. Today, a future refinancing at rates
lower than those currently available seems somewhat remote.
But who knows? From 1930 until the early 1950s, interest rates on
long-term mortgages ranged between 4.0 and 5.0 percent. A refi from a
6.5 percent, 30-year loan into a 4.5 percent, 30-year loan would not only
slice your mortgage payments by 20 percent, it would lift your cash flows
by an even greater percentage.
In some future time, we might again confront mortgage interest rates
of 8 to 10 percent. Under those market conditions, a later refinance at lower
interest rates becomes ever more likely.
(Note: Chapter 2 introduces a technique called a wraparound mort-
gage whereby investors can obtain the benefit of a lower-than-market inter-
est rate throughseller financing. Wraparounds give buyers a reduced inter-
est rate and at the same time, from a seller’s perspective, the wraparound
creates another source of return, cf. p. 34.)
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Refinance to Pocket Cash
Unless history makes a U-turn, buy a property today and within 10 to
15 years, you can sell it for 50 to 100 percent more than the price you paid.
You gain a big pile of cash. But what if you do not want to sell? Can you
still get your hands on some of that equity that you have built up? Sure.
Just arrange a cash-out refi.
Here’s how this possible source of return works. Say after 10 years
your $1 million property is now worth $1.5 million. You’ve paid down your
loan balance to $650,000. Your equity has grown from $200,000 to $850,000
($1.5 million less $650,000). You obtain a new 80 percent loan-to-value ratio
(LTV) mortgage of $1.2 million. You pocket $550,000 tax free!
But don’t spend that cash. Reinvest it. Buy another income property.
Yes, you now owe higher monthly mortgage payments on your first prop-
erty, and your cash flows from that property will decrease. But with the
additional cash flows from your second property, your total cash flows
will go up. How’s that for having your cake and eating it too?
Buy at a Below-Market Price
When the economists (mis)calculate the returns that property investors re-
ceive, they omit the fact that savvy buyers often acquire greatproperties for
less than their market value. Opportunity (grass-is-greener) sellers, don’t-
wanter sellers, ill-informed sellers, incompetent sellers, unknowledgeable
sellers—and most importantly in today’s markets—financially distressed
sellers all will sell at below-market prices.
And unlike in normal times, the financially stressed and distressed
today not only include individual property owners but also the mortgage
lenders themselves. Financial institutions now own more than a million
foreclosures (called REOs) that they must sell as quickly as they can line
up buyers to take these properties off their books.
How do you find and buy these properties for less than they are
worth? See Chapters 5, 6, and 7.
Sell at an Above-Market-Value Price
How do you sell a property for more than market value? Find a buyer
who is unknowledgeable, incompetent, or pressed by time. Offer seller
financing, a wraparound, or perhaps a lease option. Develop your skills of
promotionand negotiation (see Chapter 13). Match the unique features and
benefits of the property. Sell the property with a below-market-interest-rate
assumable (or subject-to) loan.
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Sometimes buyers pay more than market value because they don’t
know (or do not care) what they’re doing. Sometimes they pay more to
obtain a much-desired feature or terms of purchase/financing. Whatever
their reason, if you wish to exploit this possibility, you’ve created another
source of return.
Create Property Value Through Smarter Management
When you manage your properties and your tenants more intelligently,
you increase your rent collections (without necessarily raising your rents);
you reduce tenant turnover; you increase prospect conversions; you spend
less, yet spend more effectively for maintenance, promotion, and capital
replacements. You enjoy peaceful, pleasant, and productive relations with
Fortunately for you, most owners of investor-size (as opposed to
institutional-size) rental properties manage their investments poorly. Why
fortunately? Because their mal-management provides opportunities for
you. Upon acquiring a property, you can execute a more effective and
competitive management strategy to increase the property’s cash flows
and, simultaneously, lift its market value.
How can you achieve such performance? Rely on Chapter 11 to
develop your profit-maximizing management and market strategy.
Create Value with a Savvy Market Strategy
Although investors tend to manage their properties poorly, they show
even less skill as savvy marketers. Go to the property web site, Click through to a sample of listings. Look at the listing
promotional information provided. Look at the property photographs.
Does the agent tell a persuasive story about the property? Does the sales
message position that property against the tens of thousands of competing
properties that also hunger for attention? Do the photographs of proper-
ties reveal a well-cared-for property—a property that invites tenants to call
it home?
I will give you the answers. No! No! No! The implication? More
opportunities for you to gain competitive advantage. When you com-
bine the management know-how and marketing strategy lessons of
Chapters 11 and 13, you earn higher cash flows; you provide a better
home for your tenants; and when the time to sell arises, your property will
command a higher price.
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Create Value: Improve the Location
A famous clich
e in real estate says, “You can change anything about a
property except its location.” True or false? Absolutely false. As Chapter 8
shows, not only can you improve a location, but doing so also offers one
of your most powerful sources of return.
Think for a moment. What does the concept of location include? What
makes the location where you live desirable or undesirable? Accessibility,
aesthetics, quiet, good public transportation, cleanliness, the people who
live in the neighborhood, schools, parks, shopping, nightlife . . . the list
could go on and on. What’s the best way to improve any or all of these
attributes? Community action. Examples abound throughout the United
States and throughout the world.
Convert from Unit Rentals to Unit Ownership
Buy wholesale, sell retail. A grocer buys a 48-can box of tomato soup and
then sells each can individually along with a retail mark-up. Property
investors can execute a similar wholesale-to-retail strategy.
Buy a 48-unit apartment building; then, after completing legal ap-
provals and documentation, sell each apartment individually. In princi-
ple, you can apply a similar condo-conversion strategy to office buildings,
neighborhood strip centers, self-storage warehouse units, mobile home
parks, hotels, marinas, boat storage facilities, private aircraft hangars, and
other types of rental real estate where potential users might prefer to own
versus rent. In each case, you typically pay less per unit (or per square
foot) for an entire building than retail buyers are willing to pay for the
smaller quantities of space that they require to meet their needs.
Opportunities for conversion profits never remain constant. As prop-
erty markets change, potential profit margins swing between “make an
easy million” to “call the bankruptcy lawyer.”
To capitalize on this source of return, monitor the relative per-unit
prices of properties sold as rentals (income property investments) and
comparable space sold in smaller sizes to end users (see pp. 172–175).
Convert from Lower-Value Use to Higher-Value Use
Assume that in your city, single-family residential (SFR) space rents for,
say, $2 per square foot (psf) (due to a severe shortage)—offices rent for
In such distressed market conditions, you might profit from reverse conversions.
Buy a fractured condo and operate it as a rental property.
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$1 psf (due to excess supply). Five years from now, single-family space
rents for $1.50 psf (due to excessive overbuilding), and because of strong
economic and job growth, office space rents for $3.00 psf. What might you
do (if zoning permits)? Convert your SFR to offices.
Conversions of use typically require you to renovate (at least to some
degree) the old, lower-value space use to fit the market needs of the higher-
value use. But when relative prices and/or rent levels grow progressively
wider, conversion of use can generate a lucrative source of returns (see
p. 175).
Subdivide Your Bundle of Property Rights
When you own a freehold estate in property, you actually own an extensive
bundle of divisible property rights. Such rights may include (but are not
limited to):
Oil and gas
When Donald Trump built his United Nations World Tower, several
nearby property owners pocketed several million dollars. Why? Because
Trump paid these owners to transfer a portion of their air rights to him.
After purchasing their air rights, the City of New York permitted Trump
to build 80 stories instead of 40 stories, as the zoning law then specified.
When you are in Hong Kong, notice that high-rise apartments tower
directly above some of the MTR stations. Developers paid the Hong Kong
government for the right to use that airspace—even though the govern-
ment retained ownership and use rights of the land beneath the apartment
Nearly everyone understands thatproperty owners can sellleasehold
rights to earn revenues. (Not all governments, though, permit leaseholds
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for all properties—and when they do, they may severely limit the terms
and price of the leasehold agreement.) However, in addition to leasehold,
you might sell, lease, or license other rights that derive from a freehold
estate. Transferring one or more of these other rights can generate another
source of return.
Subdivide the Physical Property (Space)
In one sense, condominium conversions represent one form of subdivid-
ing. But usually subdividing refers to selling or leasing land or buildings
in smaller parcels, most commonly, a developer who buys 500 acres and
cuts it up and sells off half-acre lots to homebuilders. For another example,
consider a shut down Kmart store. A still-thriving big box retailer might
pay $10 per square foot to let the entire now-vacant building.
Instead, a property entrepreneur could master lease the property
and subdivide the interior space into a variety of uses such as childcare,
offices, and/or smaller retail merchants. Each small tenant pays a higher
ppsf (price per square foot) rental rate than would the Best Buy or Lowe’s
who might otherwiselease the total building. If the new space users require
lower parking ratios than the old Kmart, the entrepreneur might subdivide
some of the parking lot area for additional retail/restaurant uses.
Thoughtful entrepreneurs steeped in market knowledge and pos-
sibility thinking persistently search for properties to subdivide. In such
cases, the sum of the parts exceeds the value when viewed as a whole.
Create Plottage (or Assemblage) Value
You createplottage or assemblage value when you combine smaller parcels
into a larger parcel of land or space. Say you discover a perfect site to
build a new neighborhood shopping center. Zoning and planners require
a minimum of four acres for such a development. The site equals four acres
but it is owned by eight different persons in one-half acre lots. Individually,
the lots are worth $10,000 apiece—or $80,000 in total.
However, as a four-acre shopping site, the land would sell for
$250,000. You now see how to earn a good profit. Persuade each of the
current owners to sell you his lot at its current market value (or even at
a price that sits somewhat above market value). Perhaps the champion
assembler to create plottage value was the Walt Disney Company. Over a
period of 10 years, Disney secretly accumulated 25 square miles of Central
Florida land at agricultural-valued prices. Oncethey completedthis assem-
blage, the value of the aggregate site probably exceeded cost by a factor of
20 (or more).
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Obtain Development/Redevelopment Rights
Return to the four-acre neighborhood shopping center example. You suc-
ceed. You acquire all eight lots at a total price of $130,000 (several of those
owners did not want to sell—so you sweetened your offer). Can you start
building the center? No. You must first secure a long list of government
permits and approvals. So, your $250,000 current site value stands inde-
pendent of a government go-ahead.
With permits in place, the land could command a price of $500,000.
You could sell now and take your profit. Or you could stay in the game.
Spend $50,000 (or so) for lawyers, soil tests, public hearings, environmental
clearance, traffic studies, and whatever else the city powers throw at you.
This permit process requires (with luck—and no unanticipated delays)
6 to 12 months. If all goes as planned, you earn another $200,000.
In real estate, government approvals add to the value of any property
that is ripe for development, redevelopment, renovation, conversion—or
Obtain those necessary permits and you earn a good-sized
Tax Shelter Your Property Income and Capital Gains
To build wealth, protect your income and capital gains from the greedy
grasp of government. Fortunately (under current tax law), investing in
real estate provides you more opportunity to avoid paying taxes than any
other asset class.
Depreciation (noncash) deductions shelter all (or nearly all) of your
positive cash flow. A Section 1231 exchange shelters your capital gain as
you pyramid your investment properties. The $250,000/$500,000 capital
gain exclusion provides you tax-free gains from the sale of your personal
residence(s). A cash-out refinance (that your tenants will repay for you)
deposits tax-free cash into your bank account. And if you buy a “first-time”
home, the newly enacted $8,000 tax credit provides part (or maybe all) of
the cash for your down payment.
Some na
ıve souls might object. “I can build my stock market wealth
tax free through my 401(k), 403(b), and IRA plans. That tax break beats
Well, even if that tax break did beat property—which it doesn’t—you
forget that when you begin to draw on that cash during retirement, the
Yes, government even requires permits to tear down buildings. In Sarasota,
Florida, the Ritz Carlton fought a four-year battle to obtain permission to tear
down a historic house located on part of the site where the Ritz planned to build.
In compromise, the Ritz eventually paid to move the house to another site.
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government will tax every penny as ordinary income. In addition, if you
want to tap into that cash kitty prior to reaching age 59-1/2 (as nearly
50 percent of Americans do), the IRS will grab 35 to 50 percent of those
amounts (taxes plus penalties). If you die before you withdraw, the IRS
still reaches in and pulls out its share.
To minimize loss of income and wealth to the IRS, buy investment
real estate. (For a discussion of property taxes and income tax laws, see
Chapter 14.)
Diversify Away from Financial Assets
Although some investors prefer stocks, those investors would prove them-
selves wise to diversify part of their portfolio into property.
As investment experience shows, during periods of expected and
unexpected inflation, property prices have kept pace with or exceeded the
rate of growth in the CPI. Even better, leverage transforms small price
gains into double-digit rates of increase in your equity wealth.
Property prices show much less volatility than stock and bond prices.
The recent depression, surfeit of foreclosures, and price downturns for
many properties seem mild compared to the precipitous periodic drops
in stock prices. Even in the hard-times property markets, prices have only
fallen back to their 2004-2005 levels. As I write, all major stock indices sit
below their levels of 1998.
Today, most financial planners encourage asset diversification. His-
torical as well as recent experience support that view. The mantra “stocks,
stocks, and more stocks for retirement” does not meet the test of experi-
ence. Add property to your investments—if not for its superior returns,
then to reduce your portfolio risks.
Some people think that I serve as head cheerleader for investing in real
estate. In one sense, they are right. The record shows that more average
people have built sizeable amounts of wealth through property than any
other type of savings or investment.
However, I do not say, “Property investments will beat stocks or
bonds any time, any place, at any price.” As early as 2005, I told my
investor audiences that I would not buy property in the then-current hot
spots such as Las Vegas, Miami, Singapore, Dublin, or Dubai. Speculative
frenzydrove those markets—not reasonedfundamental evaluation of risks
and rewards.
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So, when people ask me, as they often do, “Which investment pro-
vides the best returns —stocks or real estate?” I answer, “It all depends.”
Certainly, in 1989, I would rather have invested in the S&P 500 index
fund than Tokyo real estate. In 1993, I would have preferred the DJIA to
property in Berlin. In 1997, I would rather have bought Apple Computer
stock than a Hong Kong condominium located on the Peak.
You must rely on investment and market analysis. Investors do not
always make more money with property than they do with stocks. I have
never said otherwise. But that begs the question, “Which investment offers
the best possibilities and probabilities today?”
Given today’s bargain property prices relative to where property
values will likely stand 6 to 10 years from now; given the fact you can
build large increases in property wealth (equity) without big gains in price;
given the relative income yields of property versus stocks (or bonds); given
the tax advantages of property relative to all other investments; given the
multiple sources of returns that property offers; and last—but far from
least—given the entrepreneurial talents that you can apply to property to
increase its price and cash flows; then, yes, in today’s market, I am willing
to lead the cheers for investing in real estate.
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o build wealth fast, use borrowed money. Used smart, financial
leverage magnifies your gains. Used dumb, leverage not only in-
creases your chance of loss, it magnifies the loss you incur. Smart
borrowing leads you to financial security. Dumb borrowing leads to sleep-
less nights, drained bank accounts, and forced property sales.
As recent experience shows, excessive debt has drowned the hopes
and dreams of many investors and homebuyers. To help understand why,
look back to the faulty advice that (until recently) enticed millions of na
and ill-prepared Americans to borrow dumb.
In the early days of the get-rich-quick real estate gurus, property
prices were escalating 10 to 20 percent a year. Just as occurred dur-
ing 2001–2006, back then nearly every would-be investor wanted to get
a piece of the property action. Yet a majority of these hopeful buyers
lacked cash, credit, or both. They possessed the will, but they lacked the
Enter Robert Allen, Carlton Sheets, Tyler Hicks, Al Lowry, Mark
Haroldson, and other promoters of “nothing down.” To sell their books,
tapes, CDs, DVDs, and seminars, these pundits promised the ill prepared
a solution to their dilemma. “No cash, no credit, no problem.” Just learn
the tricks and techniques of creative finance and you too can become a real
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estate millionaire.
Not surprisingly, the property boom of late reinvigo-
rated those guru promises of easy wealth. Scores of books, CDs, seminars
and boot camps have promoted all types of get-rich schemes that tell
wannabe investors that they can win big in real estate through lease op-
tions, short sales, foreclosures, flipping, and a sundry collection of other
so-called no cash, no credit techniques.
In his book Multiple Streams of Income: How to Generate a Lifetime of
Unlimited Wealth (John Wiley & Sons, 2004), Robert Allen recounts his
famous boast to the skeptical Los Angeles Times: “Send me to any city,”
Allen told the newspaper. “Take away my wallet. Give me $100 for living
expenses. And in 72 hours, I’ll buy an excellent piece of property using
none of my own money.” (p. 140)
In response, the L.A. Times hooked Allen up with a reporter, and off
they went. “With this reporter by my side,” Allen writes, “I bought seven
properties worth $722,715. And I still had $20 left over.” The Times ate crow
and headlined a follow-up article “Buying Homes without Cash: Boastful
Investor Accepts Challenge—and Wins.” “Yes, these techniques do work,”
Allen writes.
No question, Robert Allen and others who have preached a similar
gospel are right. You can buy with nothing down, but that begs the real
question. The real question is whether you should buy with little or no cash
or credit.
If investing in real estate with little or no cash or credit were a sure route
to wealth, this country would be awash in real estate millionaires. Indeed,
more than 10 million people have bought various nothing-down books,
tapes, videos, courses, and seminars. With all this knowledge of creative
finance floating about, you might think that the secrets of building real
estate wealth were available to almost everyone.
So where’s the catch? Why, among so many who have signed up, can
so few boast of success, and why have so many perished?
The term creative finance eludes precise definition. In general, it refers to the use
of multiple sources of credit (e.g., sellers, real estate agents, contractors, part-
ners) and out-of-the-norm financing techniques such as mortgage assumptions,
subject-to purchases, land contracts, lease options, second or third mortgages,
credit card cash advances, master leases, and so forth. In some circumstances, in-
vestors can use creative financing to buy real estate even though they lack cash or
good credit. Each of these topics is discussed in this chapter.
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What’s Wrong with “No Cash, No Credit”?
To begin with, let me emphasize that many smart, experienced, and suc-
cessful investors and homebuyers do use various forms of creative finance.
I endorse creative finance. I use it myself.
However, we have all seen so many deals crash and burn that I
advise caution. Many promoters of creative finance have oversold its ad-
vantages and underplayed its potential perils. Before you imbibe such an
intoxicating elixir, think through the following issues:
Do You Live below Your Means? In their bestseller The Millionaire
Next Door (Longstreet, 1997), Thomas Stanley and William Danko reveal
that self-made millionaires typically live below their means. More often
than not, they avoid prestige spending. They do not drive new Jaguars
or BMWs, dress for success in Armani suits, spend lavishly with their
platinum American Express cards, or wear $200 (let alone $2,000) wrist-
watches. Serious wealth builders display no foolish affectations of con-
spicuous consumption.
In contrast to the typical wealth builder, many of the dreamers who
were attracted to the schemes of the real estate gurus never learned to
spend (or invest) wisely. They primarily see real estate as a means to
circumvent their money and credit problems—a quick and painless way
to live the envied lifestyles of television’s rich and famous.
In fact, promoters of “no cash, no credit” shamelessly encourage this
lavish image. They typically display themselves in fabulous settings. Mark
Haroldson’s photo on the cover of his book (How to Wake Up the Financial
Genius Inside of You) shows him lounging on the hood of a Rolls Royce.
Irene and Mike Milin (How to Buy and Manage Rental Properties) instead
chose a Mercedes 600 for their photo backdrop. And, of course, nearly
everyone has seen the TV infomercial where Carlton Sheets sat by the pool
enjoying a beautiful Florida bay-front estate.
Take a hard look at yourself. Is your goal to sensibly pursue the inner
security and confidence of a millionaire next door? Do you presently live
well below your means? Do you save a large percentage of your earnings?
Or do you frequently fail to discipline your fiscal frivolities? Do you try
to show the world you’ve “made it”? Do you believe creative finance
techniques can override your need to shape up your financial fitness?
If a borrow-and-spend personal profile describes you, align your
motives and priorities. The “no cash, no credit” gurus have lured too
many people into believing that, as one such promoter puts it, “nothing
down can make you rich.” Wrong! Nothing down can help get you started
in real estate, but only fiscal discipline can pave your path to long-term
wealth and financial security. Before you look to creative finance, critically
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review and adjust (revolutionize, if necessary) your habits of spending,
borrowing, and saving.
Price versus Terms. Some creative-finance gurus urge their students
to talk sellers into creative-finance schemes with this gambit: “You set the
price, let me set the terms.” In this way the seller will (ostensibly) receive a
price that exceeds his property’s market value (along with great bragging
rights). In exchange, the creative-finance buyer asks for terms that may
include seller financing, little or nothing down, a below-market interest
rate, lease option, or other seller concessions.
In their eagerness to jump into a “your price/my terms” deal, novice
investors frequently fail to adequately inspect the property for problems.
In addition, they end up owing more than their properties are worth.
When problems develop that a buyer can’t afford to pay for—or otherwise
remedy—he or she also faces the problem of owning a property that can’t
be sold for a price high enough to pay off the mortgage balance. Experience
shows that the financially weak and ill-prepared flock to property during
boom times with no idea that (in the short run) quick advances in price
often signal a coming downturn.
The lesson: Anytime you agree to pay more than a property is worth,
you invite financial trouble. The terms of creative finance can seldom
overcome the tenuous position that an overfinanced, overpriced property
presents. (You’ll see a specific financial example of “you name the price,
I’ll set the terms” later in this chapter.)
Credibility versus Creativity. Many would-be investors use creative
financing techniques not just to buy with little or nothing down but also
to work around credit problems (no credit record, slow pay, write-offs,
bankruptcy, foreclosure, self-employment, etc.). Nevertheless, regardless
of your credithistory,beforeyou can arrange any type of sensiblefinancing,
establish your credibility.
Yet credibility and creativity often clash. In contrast to the boom
years, today’s dealmakers have wised up. If you suggest a deal that seems
strange, risky, or simply off-the-wall, other would-be participants in the
transaction (broker, seller, mortgage lender) may doubt that you really
know what you’re doing. Or they may come to believe that you lack
financial resources, experience, or both.
Before you try to negotiate a creative-finance scheme, sound out the
views and possible responses of the other players in the deal. If you go too
far from the reasonable, others may simply walk away and dismiss you
as a fake (big hat, no cattle). For your failure to establish credibility, you’ll
lose good properties.
Perseverance versus Productivity. Nearly all “no cash, no credit”
gurus admit (at least in their fine print) that the majority of sellers, brokers,
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and mortgage lenders will reject most of their financing techniques. “How
often does a transaction like this happen?” Robert Allen (Multiple Streams
of Income, p. 142) asks rhetorically after explaining one of his zero-down
techniques. “Very rarely. One in a hundred. It takes luck, chutzpa, and
quick feet.”
Now, ask yourself: Will the search for creative finance lead to success?
For many in thepast, that answer has beenno. When these previouslyeager
investors have met repeated rejection and disappointment, they gave up.
They came to see real estate “investing” as a waste of time.
In doingso, they missedthe success they could have enjoyed had they
prepared themselves financially and pursued conventional financing and
acquisitions. In other words, if you chase after deals that stand little chance
of profitable completion, steel yourself against slammed doors and fatigue.
To achieve creative possibilities, persevere. Realize, too,that most investors
who build long-term wealth and financial security not only design and
forecast their potential rewards from a deal, they anticipate risks. They
build contingency plans to follow when events turn against them.
Leverage: Pros and Cons
Never assume that good refinance possibilities will exist at the time you
most need them. Never let anyone tempt you into believing any deal rep-
resents a sure thing. Rents can fall. Vacancies can increase. In the short run,
you may not be able to sell your property at a price high enough to pay off
your loan(s). Interest rates can go up, and loan-underwriting standards can
tighten. Today’s foreclosures are multiplying (in part) because of the false
beliefs and assumptions that lay behind “no cash, no credit, no problem.”
Leverage Magnifies Returns. With risks in view, now the good points.
The term leverage means that you employ a proportionately small amount
of cash to acquire or control a property. To illustrate: you buy a $100,000
rental property that produces a net operating income (NOI) of $10,000
If you finance this unit with $10,000 down and borrow $90,000
(a loan-to-value ratio of 90 percent), you highly leverage your purchase.
You own and control a property. Yet you put up only 10 percent of
the purchase price, whereas if you paid $100,000 cash for the property, you
would not have leveraged your purchase (no OPM).
But leverage can magnify your cash-on-cash returns. The following
four examples calculate rates of gain in equity from price increases based
on alternative down payments of $100,000 (an all-cash purchase), $50,000,
$25,000, and $10,000.
Obviously, in high-priced areas of the country, $100,000 won’t buy a studio apart-
ment. But to illustrate, it’s an easy figure to work with.
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Example 1: $100,000 all-cash purchase
ROI (return on investment) = Income (NOI)/Cash investment
= $10,000/$100,000
= 10%
In this example, you pocket the full $10,000 of net operating income
(rental income less expenses such as insurance, repairs, maintenance, and
property taxes). Now, if you instead finance part of your purchase price,
you will make mortgage payments on the amount you borrow. If we
assume you find financing at 8 percent for 30 years, you will have to pay
your lender $7.34 a month for each $1,000 you borrow. Now, using various
percentages of leverage, the subsequent examples show how to magnify
your rates of return.
Example 2: $50,000 down payment; $50,000 financed. Yearly mort-
gage payments equal $4,404 (50 × $7.34 ×12). Net income after mortgage
payments (which is called cash throw-off) equals $5,596 ($10,000 NOI less
ROI = $5,596/$50,000 = 11.1%
Example 3: $25,000 down payment; $75,000 financed. Yearly mort-
gage payments equal $6,607 (75 × $7.34 ×12). Net income after mortgage
payments (cash throw-off) equals $3,394 ($10,000 NOI less $6,606).
ROI = $3,394/$25,000 = 13.6%
Example 4: $10,000 down payment; $90,000 financed. Yearly mort-
gage payments equal $7,927 (90 × $7.34 ×12). Net income after mortgage
payments (cash throw-off) equals $2,073 ($10,000 NOI less $7,927).
ROI = $2,073/$10,000 = 20.7%
With the figures in these examples, the highly leveraged (90 percent
loan-to-value ratio) purchase yields a cash-on-cash return that’s double
the rate of a cash purchase. In principle, the more you borrow, the less cash
you invest in a property, and the more you magnify your cash returns. Of
course, the realized rate of return you’ll earn on your properties depends
on the actual rents, expenses, interest rates, and purchase prices that apply
to your properties. Work through those numbers at the time you buy to
see how much you can gain (or lose) from leverage.
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Now, for better news. Here’s a greater way that leverage can magnify
your returns and help you build wealth faster.
Over the years (if well-selected), your rental properties will increase
in price. If the price of that $100,000 property we’ve just discussed increases
at an average annual rate of 3 percent, you earn another $3,000 a year. If
its price increases at an annual rate of 5 percent, you’ll gain $5,000 more
a year. And at a 7 percent annual rate of appreciation, your gains will hit
$7,000 a year.
Add together annual rental income and annual price gains, and you’ll
gain these combined returns:
Total ROI = Income +Appreciation/Cash investment
Example 1: $100,000 all-cash purchase and (a) 3 percent, (b) 5 percent,
and (c) 7 percent rates of appreciation:
(a) Total ROI = $10,000 +$3,000/$100,000 = 13%
(b) Total ROI = $10,000 +$5,000/$100,000 = 15%
(c) Total ROI = $10,000 +$7,000/$100,000 = 17%
Example 2: $50,000 down payment and (a) 3 percent, (b) 5 percent,
and (c) 7 percent rates of appreciation:
(a) Total ROI = $5,596 +$3,000/$50,000 = 17.2%
(b) Total ROI = $5,596 +$5,000/$50,000 = 21.2%
(c) Total ROI = $5,596 +$7,000/$50,000 = 25.2%
Example 3: $25,000 down payment and (a) 3 percent, (b) 5 percent,
and (c) 7 percent rates of appreciation:
(a) Total ROI = $3,394 +$3,000/$25,000 = 25.6%
(b) Total ROI = $3,394 +$5,000/$25,000 = 33.6%
(c) Total ROI = $3,394 +$7,000/$25,000 = 41.6%
Example 4: $10,000 down payment and (a) 3 percent, (b) 5 percent,
and (c) 7 percent rates of appreciation.
(a) Total ROI = $2,073 +$3,000/$10,000 = 50.7%
(b) Total ROI = $2,073 +$5,000/$10,000 = 70.7%
(c) Total ROI = $2,073 +$7,000/$10,000 = 90.7%
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When you combine returns from annual net rental income and price
increases, highly leveraged properties may produce quite strong annual
rates of return—even without unrealistically high average annual rates of price
increases. That’s why even small investors in rental properties have (over
time) built net worths that run into the millions of dollars. When you own
rental properties, steady rent and price increases grow acorns (relatively
low down payments) into oak trees (property equity worth hundreds of
thousands [or millions] of dollars). As the years pass and you pay down
your mortgage balances, a property portfolio of just 6 or 8 houses or
perhaps 12 to 16 apartment units (sometimes less) can build enough wealth
to guarantee a secure and prosperous future. (Note, too, how these income
property rates of return outshine the widely believed [yet overstated]
10 percent average annual gains that the stock market has supposedly
produced since 1926.)
Manage Your Risks. The advocates of get-rich-quick real estate
schemes often fail to warn their followers that highly leveraged real es-
tate magnifies risks as well as returns. As a result, many na
ıve real estate
investors have lost their shirts. These buyers optimistically expected the
market values of their properties to show price gains of 10 to 20 per-
cent a year. They lost touch with reality. In fact, many “investors” barely
cared what purchase prices they paid, what rent levels they collected,
or how they financed their properties. They just knew that they would
be able to sell their properties in a few years for twice the amount they
had paid.
One such investor, for example, bought a $300,000 fourplex with a
down payment of $30,000. After paying property expenses and his mort-
gage payments, the investor faced an alligator (negative cash flow) that
chewed up $1,000 a month. But the investor figured that $1,000 a month
was peanuts because he believed the sales price of the property would
go up 15 percent a year. Based on that rate of gain, here’s how this in-
vestor calculated the annual returns that he (unrealistically) expected to
ROI = Income +Appreciation/Cash investment
=−$12,000 (12 ×−$1,000) +$45,000 (.15 ×$300,000)/$30,000
= $33,000/$30,000
= 110%
As it turned out, this investor, like so many others, could not con-
tinue to feed his alligator $1,000 a month. He fell behind with his mortgage
payments, and as the market slowed, he was unable to sell the property.
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The lender foreclosed, and the investor lost the property, his down pay-
ment of $30,000, the $24,000 of monthly cash outlays he had made before
his default, and his once-high credit score.
Here are four lessons you can take away from this investor’s bad
1. Never expect the value of real estate, stocks, gold, antique auto-
mobiles, old masters, or any other type of investment to increase by 10, 15,
or 20 percent year after year. When you need high rates of price gain to
make your investment look attractive, you set yourself up for a big loss.
(Avoid dot-com mania.)
2. Bewareof negative cash flows. If the income you earn froman asset
does not support the price you pay, you magnify your risk and chance of
loss. You are speculating more than investing. That’s okay if that’s what
you want to do. Just recognize that speculators (whether they realize it or
not) play in a high-risk game.
3. Beware of financial overreach. High leverage (a high loan-to-value
ratio) usually requires large mortgage payments relative to the amount of
net income that a property brings in. Even if at first you don’t suffer
negative cash flows, vacancies, higher-than-expected expenses, or large
rentconcessions intended to attract good tenants can pushyou temporarily
into the swamps where alligators feed.
Over a period of, say, 10 to 20 years, owning real estate will make
you rich. But to get to that long-term future, you will likely pass through
several cyclical downturns. Without cash (or credit) reserves to defend
against alligator attacks, you may get eaten alive before you find the safety
and comfort of high ground.
I first offered this advice in the 1995 (2nd) edition of this book. Un-
fortunately, many recent investors did not heed it. The more times change,
the more they stay the same.
4. Even when the financing looks “good,” avoid overpaying for a property.
Overly optimistic investors buy overpriced properties with little or no
down payment deals. In the earlier fourplex example, the investor agreed
to pay $300,000 for his fourplex not because the property’s net income
justified a price of$300,000. Rather, he paid$300,000 becausehe was excited
about his easy-credit, low, 10 percent down-payment financing. Compared
with the $600,000 sales price that he expected to reap after just four or five
years of ownership, his $300,000 purchase price looked cheap.
Again, I emphasize: I do not want to discourage you from making
low down payments. But when you do, anticipate possible setbacks. To
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successfully manage the risks of high-leverage finance, follow these six
1. Buy bargain-priced properties. You build a financialcushion intoyour
deals when you pay less than market value or pay less than a property is
worth—not quite the same thing. Discover how in Chapters 4 through 7.
2. Buy properties that you can profitably improve. To build wealth fast
and reduce the risk of leverage, add value to your properties through
creativity, sweat equity, remodeling, and renovation (see Chapter 8).
3. Buy properties withbelow-market rentsthat youcan raise to market levels
within a relatively short period (six to twelve months). As you increase your
rental income, your mortgage payments will eat up a lower percentage of
your net operating income (NOI).
4. Buy properties with low–interest-rate financing such as mortgage as-
sumptions, adjustable-rate mortgages, interest-rate buydowns, or seller financing.
Low interest rates help you manage high debt. Of course, high rates make
debt less affordable—so beware of low interest rates that may disappear
within just a few years or less.
5. Buy right time, right price, right place properties. “All real estate is
local” is an oft-cited clich
e that contains some kernel of truth. Various
neighborhoods and cities offer unique differences with respect to price,
location, and market timing. To reduce risk and increase rewards, proac-
tively study and select from such opportunities (see Chapter 8).
6. When high leverage presents an anxious level of risk, increase your down
payment to lower your loan-to-value ratio and lower your monthly mortgage
payments. If you don’t have the cash, bring in a money partner. Don’t act
penny-wise and pound-foolish. Share gains with someone else rather than
risk drowning in the swamps where the alligators prey.
What Are Your Risk-Return Objectives?
Little- or nothing-down finance creates opportunities for you to magnify
your returns. Smart borrowing and smart investing pyramids your real
estate wealth. But the more you borrow (other things equal), the more you
research and prepare for an adverse turn in the market or your property
operations. When you highly leverage your properties, a slight fall in rents
may push you into negative cash flows. A decline in your property’s value
can pull you underwater. Steer clear of sunshine-every-day optimism.
Work through the numbers for the deals that come your way with various
potential market changes. Decide what profits are worth pursuing and
what risks you prefer to avoid.
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If you can’t find properties in your favored area(s) that yield the
numbers you would like to see, look elsewhere. Sift your discovery
from low-promise cities (neighborhoods to areas that offer better income/
appreciation potential.
You now know the pros and cons of high leverage (little or nothing down).
Use it; do not abuse it. In this respect, you can pursue low-down good
possibilities with owner-occupied property financing.
The easiest qualifying and often the lowest-cost way to borrow
most (or even all) of the money you need to buy a property remains
owner-occupied mortgage financing. Even at the height of the credit cri-
sis, high-LTV (loan-to-value) owner-occupied loan programs were readily
available on single-family homes, condominiums, townhouses, and two-
to four-unit apartment buildings. LTVs of 90, 95, 97, or even 100 per-
cent financing populate this financial arena. If you do not arrange for
owner-occupied financing (i.e., you choose not to live in the property),
most lenders (banks, mortgage bankers, savings institutions) limit their
mortgage loans on investment properties to a 70 percent to 80 percent
loan-to-value ratio.
So, owner-occupied loans provide great advantage
(as to LTV) relative to loans to finance rental properties. (However, some
higher 85 to 90 percent investor loans are available, such as VA REOs—see
Chapter 7.)
As another benefit, owner-occupants pay lower interest rates than in-
vestors. If lenders charge 6.0 to 6.5 percent for good credit, owner-occupied
loans, the interest rate for investor properties will probably range between
6.5 and 7.5 percent. As a beginning real estate investor, weigh the possibil-
ities of owner-occupied mortgage loans.
Owner-Occupied Buying Strategies
If you do not currently own a home, here’s how to begin your wealth
building in rental properties with little or nothing down—if you favor
From the late 1990s to 2006, some lenders offered investor loans with total LTVs as
high as 100 percent. When the property boom receded, such liberal lenders either
went broke due to excessive borrower defaults, or tightened their qualifying to
match or exceed more conservative (safer) underwriting standards.
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this approach. Select a high-LTV loan program that appeals to you.
a one- to four-unit property. Live in it for one year, then rent it out, and
repeat the process. Once you obtain owner-occupied financing, that loan
can remain on the property even after you move out. Because the second,
third, and even fourth homes you buy and occupy will still qualify for
high-LTV financing (low or nothing down), within a period of 5 or 6 years,
you can accumulate as many as 8 to 16 rental units in addition to your own
residence—all without large down payments.
You can work this homeowner gambit three or four times, possibly
more. But you may not be able to pursue it indefinitely. At some point,
lenders may shut you off from owner-occupied financing because they will
object to your game plan. Nevertheless, serial owner-occupancy acquisi-
tions make a great way to accumulate (at least) your first several income
Current Homeowners, Too, Can Use This Method
Even if you own your own home, weigh the advantages of owner-occupied
financing to acquire your next several investment properties. Here’s how:
Locate a property (condo, house, two- to four-unit apartment building)
that you can buy and move into. Find a good tenant for your current
house/condo. Complete the financing on your new property and move
into it. If you like your current home, at the end of one year, rent out
your most recently acquired property and move back into your for-
mer residence. Alternatively, find another “home” to buy and again fi-
nance this property with a new owner-occupied, high-leverage, low-rate
Why One Year?
To qualify for owner-occupied financing, you must assure the lender that
you intend to live in the house for at least one year. Intend, however, does
not mean guarantee. You can (for good reason, or no reason) change your
mind. The lender may find it difficult to prove that you falsely stated
your intent at the time you applied for the loan. Beware: Do not lie about
your intent to occupy a property. Lying violates state and federal laws, and
governments will prosecute.
Many of these programs are described with more detail in my book, The 106
Mortgage Secrets That Borrowers Must Learn—But Lenders Don’t Tell, Second Edition
(John Wiley & Sons, 2008).
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During thepast propertyboom, borrowerslied andloan repswinked.
Many borrowers and loan reps failed to comply with the “intent-to-
occupy” rule. In fact, a loan rep at Wachovia (a bank that subsequently
went bust) suggested that I finance a new rental house that I was buying
as if it were a second home. I declined.
To succeed in real estate over the short and long term, establish,
maintain, and nurture your credibility with lenders—and everyone else
with whom you want to make deals or build a relationship of trust. To
slip through loopholes, make false promises, sidestep agreements, or en-
gage in other sleights will destroy your reputation for integrity. Unless
you encounter an unexpected turn of events, honor a lender’s one-year
occupancy requirement.
Where Can You Find High-LTV Owner-Occupied Mortgages?
Everywhere! Even in today’s tighter credit market: Look through the yel-
low pages under “mortgages.” Then start calling banks, savings institu-
tions, mortgage bankers, mortgage brokers, and credit unions. Mortgage
lenders advertise in local daily newspapers and on the Internet. Check
with your state, county, or city departments of housing finance. Many
homebuilders and Realtors know of various types of low- or nothing-
down home finance programs. Explore the web sites,,, (Freddie Mac), and
The specific maximum amount you can borrow under these high-LTV
programs varies by type of loan and area of the country. However, the
loan limits are high enough to finance properties in good neighborhoods.
For example, Freddie Mac and Fannie Mae programs nationwide will lend
up to the following amounts (usually adjusted upward each year):
No. of
Contiguous States, District
of Columbia, & Puerto Rico Higher-Priced Areas
1 $417,000 $729,750
2 $533,850 $934,200
3 $645,300 $1,129,250
4 $801,950 $1,403,400
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FHA varies its loan limits by county. Here are several examples:
Low-Cost Areas (FHA/HUD)
Type of Residence Loan Limits
One-unit $271,050
Two-unit 347,000
Three-unit 419,425
Four-unit 521,250
High-Cost Areas (FHA/HUD)
Type of Residence Loan Limits
One-unit $729,750
Two-unit 934,200
Three-unit 1,129,350
Four-unit 1,403,400
For VA loans, eligible veterans may originate—and veterans and
nonveterans alike may assume—up to the following amounts:
Lowest-Price Areas Highest-Price Areas
$737,500 $417,000
Unlike Fannie/Freddy and FHA, the VA applies a single loan limit
for all 1–4 unit properties. However, VA has significantly boosted its loan
limit and like FHA, varies each specific limit according to the prevail-
ing local price levels. One- to four-unit properties that are priced higher
than these stated limits seldom bring in rents high enough to cover ex-
penses and mortgage payments. So, when you select rentals that pay for
themselves—even with a small down payment—the limits set by the re-
spective insurers and guarantors should not unduly restrict your choice of
When a veteran makes a down payment, these loan amounts may be higher. Also,
higher limits may apply in selected high-cost areas. Periodically, VA increases its
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Assume you’ve reached as far as you want to go with high-LTV (low
down payment) owner-occupancyfinancing possibilities.Or maybe you’re
happy in your present home. No way will you (or your spouse) move
(even temporarily) to another property. Without owned occupied, what
other ways help you avoid placing 20 to 30 percent of the purchase price
in cash from your own savings? In other words, what high-leverage (low
down payment) OPM (other people’s money) techniques can you use to
buy and finance your investment properties?
High Leverage versus Low (or No) Down Payment
Before we go through various low- and no-down-payment techniques,
note this distinction: High leverage does not necessarily require a low
down payment. High leverage means that you’ve acquired a property
using little cash (say, 10 to 20 percent of the purchase price, or sometimes
less) from your own funds.
You find a property priced at $400,000, and your lender agrees to
provide a first mortgage in the amount of $280,000. Because you can’t
(or don’t want to) draw $120,000 from your savings to make this large
down payment, you need another way to raise all (or part) of these funds.
If successful, you will have achieved a highly leveraged transaction. You
will control a $400,000 property with relatively little cash coming out of
your own pocket.
You gain the benefits (and risks) of high leverage in either of two
ways: (1) Originate or assume a high-LTV first mortgage, or (2) originate
or assume a lower-LTV mortgage, then to reduce (or eliminate) your out-
of-pocket cash input, use other sources (loans, equity partners) to cover
some (or all) of the difference between the amount of the first mortgage
and the purchase price of the property.
Creative Finance Revisited
Creative finance encourages you to think through multiple financing al-
ternatives. The term gained popularity when property prices shot up and
millions of hopeful buyers felt shut out of the fast money because they
lacked sufficient cash, credit, or both to enter the game. The central theme
of my course,” wrote Ed Beckley in No Down Payment Formula, “is to teach
you how to acquire as much property as you can without using any of your
own money.... Starting from scratch requires that you become extremely
resourceful. You need to substitute ideas for cash” (p. 69).
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How might investors use creative thinking and resourcefulness to
substitute for cash?
Look for a Liberal Lender. Under today’s tighter underwriting, most
banks and savings institutions loan only 70 to 80 percent of an (non-owner-
occupied) income property’s value. However, some specialty lenders will
make 90 percent (or higher) LTV loans. As credit markets ease, lender
competition will most likely (once again) edge up LTVs.
In addition, some wealthy private investors provide high-LTV mort-
gages. Find these private investors through newspaper classified ads: Ad-
vertise in the “Capital Wanted” section, or telephone those who list them-
selves in the “Capital Available” section. Also call mortgage brokers who
may have contacts with as many as 20 to 100 sources of property financ-
ing. Through their extensive roster of lenders, mortgage brokers may find
you the high LTV you want. Beware: Read the fine print. Many of these
nontraditional (subprime, hard money) mortgages include costly upfront
fees, high interest, and steep prepayment penalties. Foolish optimism plus
subprime loan equals foreclosure.
Second Mortgages. In the past,some income property lenders per-
mitted what are called 70–20–10 loans, or some other variation such as
75–15–10, or maybe even 80–15–5. The first figure refers to the LTV of a
first mortgage; the second figure refers to the percentage of the purchase
price represented by a second mortgage; and the third figure refers to out-
of-pocket cash contributed by the buyer. A 70–20–10 deal for the purchase
of a $100,000 property would require the following amounts:
First mortgage $70,000
Second mortgage $20,000
Buyer’s cash $10,000
More often than not, the property seller makes the best source for
second mortgage loans. Typically referred to as “seller seconds” or seller
“carrybacks,” these loans require less red tape, paperwork, and closing
costs. You can sometimes persuade a seller to accept an interest rate that’s
lower than what a commercial lender would charge. At a time when first
mortgage rates were at 11 percent, and commercial second mortgage rates
were at 16 percent, my seller carried back a $75,000 interest-only second at
a rate of 8 percent.
(Sellers are more likely to offer below-market interest
rates when market rates climb upwards—unlike today’s low market rates.)
In this case, the seller second primarily served to reduce my overall cost of bor-
rowing thanks to its low interest rate.
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My deal looked like this:
Purchase price $319,500
First mortgage at 11% $180,000
Seller second at 8% $75,000
Cash from buyer $64,500
If the sellers won’t cooperate, look to private investors, mortgage
brokers, banks, and savings institutions. Before you do turn to “loan-
sharking” commercial second mortgage lenders, think of friends or family
members who might like to earn a relatively safe return of 7 to 10 per-
cent (more or less) on their money. Compared to certificates of deposit
and passbook savings that in most times pay interest between 2.0 and
5.0 percent, a 7 to 10 percent rate of interest could look pretty good.
Borrow against Other Assets. If you’re a homeowner with good
credit, you can raise seed money for investment real estate by taking out
a home equity loan (i.e., second mortgage) on your home. Through an
equity line of credit you might raise a fair amount of cash—but remember,
stay prepared for adverse changes in the market or your own nances.
Alternatively, consider a high-LTV refinance of your first mortgage.
What other assets can you borrow against? Retirement accounts,
cars, jewelry, artwork, coin collection, life insurance, or vacation home?
List everything you own. You may surprise yourself at what you discover.
Convert Assets to Cash (Downsizing). Rather than borrow against
your assets, downsize. Friends of mine sold their 6,000-square-foot
Chicago North Shore residence for $1,050,000. With those proceeds they
bought a vacation home, a smaller primary residence, and an in-town
condominium. In the U.K., they call this popular practice “mouse-holing.”
Could you live comfortably in a smaller or less expensive home?
Are you wasting money on unproductive luxury cars, jewelry, watches, or
clothing? Are you one of the many Americans who live the high life—for
now—but fail to build enough wealth to support the twin goals of financial
security and financial independence?
In their study of the affluent, Thomas Stanley and William Danko
(The Millionaire Next Door) interviewed a sample of high-income profes-
sionals whom the authors named UAWs (underaccumulators of wealth).
They chose a sample of PAWs (prodigious accumulators of wealth)—who
worked in less prestigious jobs and earned less income. Because of wise
budgeting and investing, the PAWs’ net worths far surpassed those of the
high-income prodigious spenders. Downsizing now pays big dividends
WraparoundMortgage. A wraparound mortgagehelps buyers obtain
a high LTV while it provides a seller with a good yield. Investors use
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wraparounds to gain some benefit from a below-current-market-rate loan
that exists against a property—and, yet also obtain a relatively high LTV.
To accomplish these twin goals, the investor “wraps” the existing
below-market loan with a new wraparound loan at a higher interest rate.
The seller continues to pay the existing low interest rate loan while the
buyer pays the seller on the new wraparound loan. The seller profits on
the spread in interest rates. The wraparound works best during periods
when interest rates shoot up. Figure 2.1 provides an example.
In Figure 2.1, the seller creates and carries a new loan of $210,000
at 9.0 percent. Payments on the seller’s existing first mortgage total
$1,077 per month. Payments on the new wraparound loan are $1,691 per
month. Therefore the seller earns a $614 per month profit. As a return
on the $60,000 the seller has left in the deal, he or she earns a return of
12.28 percent (12 × 614 ÷ 60,000 = 12.28). The investor gains because the
interest rate charged by the seller falls below the then-prevailing market
interest rate on newly originated loans. (If you wrap a “nonassumable”
mortgage, the seller’s underlying mortgage lender may choose to exercise
its “due-on-sale” clause. If that happens, you and the sellers would have
to pay off the seller’s mortgage and work out some other type of financing.
However, during the past 25 years—and especially during periods of high
foreclosures, lenders rarely throw their performing loans into default by
demanding full payment.)
Use Credit Cards. Although this is one of the more risky techniques
of creative finance, some investors take advantage of every credit card offer
they receive in the mail. Then when they require quick cash to close a deal,
they raise $10,000, $25,000, or even $50,000 from cash advances. Investors
sometimes even pay cash for a property with the entire sum raised from
credit cards.
Naturally, it makes no sense to use cash advances for long-term
financing. On occasion, though, you might find plastic a quick and
Seller Pays
Seller Receives
Sales price $225,000
Cash down 15,000
Wrap balance 210,000
Mo. pymt. @ 9%/30-year 1,691
Seller pymt. 1,077
Seller nets per mo. 614
Seller ROI on $60,000 12.28%
Mtg. bal. $150,000
Mo. mtg. pymt. @ 7.0%
(24 years left) $1,077
Figure 2.1 Wraparound Loan Example
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convenient source to cover short-term needs. For example, you might
find a steal of a deal that you can buy (and renovate?), then immediately
flip (resell) the property at a profit. For my taste, credit card cash costs
too much and generates too much risk. But it’s still a possibility– if you
clearly calculate that the rewards decisively trump the risks—and you can
see multiple unlocked exit doors.
Personal Loans. In the days before credit card cash advances (which
arenow themost popular type of personal loan), personal loanswere called
signature loans. As you build your wealth through growing real estate
equity, you’ll find that many lenders will grant you signature loans—at
much lower fees and interest rates than credit card cash advances—in
amounts of $10,000, $25,000, $50,000, or even $250,000, if your credit record
and net worth can support repayment. Use the money from these signature
loans for down payments or renovation funds.
Although mortgage lenders do not favor borrowers who use per-
sonal loans for down payments, investors routinely find ways to use this
technique. OWC (owner will carry) sellers who finance property sales
probably won’t inquire (and maybe won’t care) about the source of your
down payment. If you’re short on cash, compare the risks and benefits
of using a cash advance or signature loan to raise money for your down
But again, weigh the risk factors. Ill-conceived borrowing can push
you into those ugly toss-and-turn, sleepless nights, if not financial ruin.
Make sure repayment does not depend on some speculative (uncertain or
unpredictable) contingency.
Land Contracts. A land contract—sometimes referred to as a contract
for deed, contract of sale, or agreement of sale—permits buyers to pay sell-
ers for their property in installments. Under a land contract, a buyer agrees
to buy a property and pay principal and interest to the seller. Unlike mort-
gage financing, title to the property remains in the seller’s name until
conditions of the contract are fulfilled. The buyer takes possession of the
property. If a buyer defaults on the agreement, the seller can typically re-
possess (not foreclose on) the property. Sellers favor repossessions because
they’re quicker, easier, and less costly than foreclosure.
Land contracts may be useful in “wrapping” existing low interest rate
financing (see the previous discussion of wraparounds). Caution: These
contracts include pitfalls for buyers and sellers. State law governs land
contract sales, so consult a competent, local real estate attorney before
accepting this form of financing.
Often, properties sold on land contracts are “nonconforming” prop-
erties such as storefronts with living quarters in the rear or above, farm-
houses with acreage, older properties in need of repair, or larger house that
have been split up into multiple apartment units. My first investment was
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a five-unit property—a large, old house split into four one-bedroom apart-
ments and a one-bedroom, one-bath carriage house that sat on the rear of
the lot. I paid $10,000 down, and the seller (an elderly widow) financed
the balance at 5 percent interest. She said that was the same rate she could
get on a savings account in a bank so she didn’t think it would be right to
charge more than that. (I would like to find sellers like her today.)
In the present market, land contracts serve the same purposes they
always have (nonconforming properties or subpar cash/credit buyers).
Yet, as many traditional mortgage lenders reach out to attract more diverse
homebuyers and neighborhoods, people and properties that might not
have gained lender approval in decades past might now qualify at credit
unions, banks, and other types of mortgage companies. In addition, two
types of seller-assisted financing have become widespread: lease-purchase
and lease-option agreements (see Chapter 9). To some degree, these “rent-
to-own” alternatives have substituted for the use of land contracts.
Nevertheless, land contracts can play a role in your property acqui-
sition strategy. Properly written, land contracts are low cost and relatively
easy to complete; they offer maximum flexibility in price and interest rate;
and they can give sellers quick remedies for borrower default while they
protect buyers against unfair forfeiture and future title problems. If you
find (or create) a good deal using a land contract, don’t pass it up without
thoughtful review (and informed legal advice).
Sweat Equity (Create Value through Renovations). You might buy
some properties with 100 percent financing if you can enhance their value
through improvements and renovations. Say you find a property that
should sell (in tip-top condition) for around $240,000. Yet because of its
sorry state of repair, as well as an eager seller, you can buy the property
at a price of $190,000 with short-term, no-money-down owner financing.
You then contribute labor and $15,000 in materials that you pay for with
credit cards.
After you complete your work and bring the property up to its
$240,000 market value, you arrange a 70 percent LTV mortgage with a
lender. With your loan proceeds of $190,000, you pay off the seller and
your credit card account. Voil
a—you have not only achieved 100 percent
financing for your acquisition price and rehab but also created $35,000 of
instant equity (wealth).
Use Your Imagination. In addition to the high leverage techniques
discussed, here are several others:
Bring in partners. If you can’t (or don’t want to) draw on your
own cash or borrowing power, find a good deal and then show
potential money partners (friends, family, contractors, wealthy
investors) how they will benefit if they join you in the transaction.
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Agree to swap services or products. Would the seller accept some ser-
vice or expertise that you can provide? Take stock of your skills
(law, medicine, dentistry, writing, advertising, carpentry, account-
ing, landscaping, architecture, etc.). How about products? Say you
own a radio station or newspaper. Trade off advertising time or
space for a down payment. Anything you can produce, deliver, or
sell wholesale (at cost) might work.
Borrow (or reduce) the real estate commission. Most brokers and sales
agents generally hate this technique. Still, sometimes buyers and
sellers do ask the agents involved in a transaction to defer payment
until some later date. A few agents actually prefer to have their
commissions in the deal. In doing so, they avoid paying income
taxes on these fees, and at the same time they build wealth through
interest payments or their receipt of a “piece of the action” (future
profits from a sale).
Simultaneously sell (or lease) part of the property. Does the property
include an extra lot, a mobile home, or timber, oil, gas, air, or
mineral rights? If so, find a buyer who will pay you cash for such
rights. In turn, this money will help you close the deal.
Prepaid rents and tenant security deposits. When you buy an income
property, you are entitled to the existing tenants’ security deposits
and prepaid rents. Sayyou close on June 2.The seller (of a fourplex)
is holding $4,000 in tenant security deposits and $3,800 in rent
money that applies to the remaining days in June. Together, the
deposits and prepaid rents amount to $7,800. In most transactions,
you can use these monies to reduce your cash-to-close.
Create paper. You’ve asked the seller to accept owner financing with
10 percent down. She balks. She believes the deal puts her at risk.
Alleviate her fears and bolster her security. Offer her a lien against
your car or a second (or third) mortgage on another property
you own. Stipulate that when principal payments and property
appreciation (added together) lift your equity to 20 percent (LTV
of 80 percent), she will remove the security lien she holds against
your other pledged asset(s).
Lease options. To discuss creative finance, one must include lease
options. And because of their widespread usage, Chapter 9 ad-
dresses the pros and cons of this technique.
Are High-Leverage Creative-Finance Deals Really Possible?
Yes, definitely. I have used some type of creative finance (as either buyer
or seller) in more than one-half of the property transactions in which I’ve
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been involved. To make creative finance work, however, you must know
what you are doing. Clearly envision all possible ways the deal might turn
against you. Stay calm. Do not become so excited to make the deal that you
concede too much. Beware: Low down, creative-finance deals frequently
tempt new investors into buying troubled properties or paying excessive
prices. Honor commitments—and, just as important, critically affirm that
the commitments you make are worth honoring.
Fewer Sellers. Because creative finance violates so-called standard
operating procedures, your property choices become fewer. While nearly
every seller will accept all cash, smaller numbers are willing to provide
financing with little or nothing down.
Nevertheless, look for profit-packed high-leverage creative-finance
deals, which are out there. Sellers who first claim they’re not interested
will soften their attitude once you persuasively explain what’s in it for
them and then hand them your signed offer.
Lower-Quality, Overpriced Lemons. Keep a sharp eye out for prop-
erty owners who want to entice you into buying overpriced lemons.
These sellers have read the nothing-down books. They know that adver-
tising come-ons like “owner financing,” “nothing down,” “no qualifying,”
“make offer,” and “EZ terms” will bring dozens of calls from the latest
“graduates” of the Ima Guru School of Creative Finance.
Just standing by to fleece the sheep, these sellers surreptitiously lead
eager buyers into ill-advised purchase contracts. Maintenance and repair
problems, disappearing tenants, phantom leases, illegal units, neighbor-
hood crime, short-term balloon mortgages, troublesome neighbors, and
undisclosed liens represent just a few of the setbacks na
ıve buyers have
run into. (For many other types of potential problems, see my book The 106
Common Mistakes Homebuyers Make (and How to Avoid Them) (John Wiley
& Sons 2008, 4th ed.) In other words, don’t let the siren call of creative
finance crash your boat into the shoals soon after leaving port.
To decide whether to grant your request for a mortgage, lenders apply
a variety of mortgage underwriting guidelines.
The more you can learn
For a more extensive discussion of financing properties, see my book The 106
Mortgage Secrets That All Homebuyers Must Learn—but Lenders Don’t Tell, Second
Edition (John Wiley & Sons, 2008).
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about these guidelines, the greater the chance that you’ll locate a lender
(or seller) who will approve the property financing you want.
In times of cheapand easymoney, lenders shovel outmoney toalmost
anyone who rolls a wheelbarrow into the bank. In periods of tight money
(which always follow periods of loose underwriting), lenders tighten their
1. Collateral (LTV, property characteristics, recourse personal
2. Amount and source of down payment and reserves
3. Capacity (monthly income)
4. Credit history (credibility!)
5. Character and competency
6. Compensating factors
Lenders set underwriting standards for properties (not just borrowers).
Although such standards vary, all lenders specify the types of properties as
collateral for their mortgage loans. Some lenders won’t finance properties
larger than four units. Some won’t finance properties in poor condition
or those located in run-down neighborhoods. Many lenders verify that
a property is serviced by all utilities (e.g., some lenders avoid properties
with septic tanks instead of sewer lines). Lenders set standards that apply
to paved streets, conformance with zoning and building regulations, and
proximity to schools, public transportation, shopping, and job centers.
Before you look at properties and write up an offer to buy, verify
whether that property meets the criteria of the lender and loan program
that you intend to use. Otherwise you may waste time and money (loan
application costs, appraisal, and other miscellaneous fees). Often, lenders
will not refund these prepaid expenses.
Loan-to-Value Ratios
As discussed, lenders loan up to a specified percentage of a property’s
market value (or contract price—whichever is less). After your property
meets the lender’s feature profile, the lender will order an appraisal.
To calculate loan-to-value requires an independent estimate of value,
which, as you learned in Chapter 3,may or may not prove accurate or
In good times, appraisers tend to “overappraise.” In tough markets,
they “underappraise.” Thus, as an investor, you face two potential pitfalls:
(1) In loose money, the lender may approve a loan that actually exceeds the
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safe amount you should borrow (without accepting undue risk); and (2) in
tough times, the appraisal may come up short. It will either kill your deal
or force you to increase the amount of your down payment. To avoid any
or all of these underwriting issues, carefully review the lender’s appraisal.
(See Chapter 3.)
Recourse to Other Assets/Income
In addition to the mortgaged property, lenders might also require you
to pledge other assets (property, bank accounts, stocks, etc.) to enhance
their security. Indeed, at times you might even offer cross collateralization
(or pledged collateral) to a bank in exchange for an LTV that’s higher than
you might otherwise receive. In close (and sometimes not so close) calls, a
boost in the collateral you provide will tip loan approval in your direction.
In addition to collateral, banks (and sellers) will ask property in-
vestors to sign a personal note to further guarantee repayment of the
monies owed. If you default, such a recourse loan gives the lender (note-
holder) the right to go after not just the mortgaged property or other
pledged assets, but also, more generally, other assets in which you own
an interest or income you are entitled to receive. Odd as it might sound,
though, once you advance from smaller properties to larger apartment
buildings, offices, and retail centers, lenders typically grant nonrecourse
mortgages. The pledged collateral stands as sole security for repayment.
In case of payment shortfalls, the lender cannot make a claim against your
income or other assets. Other things equal, you should definitely prefer
nonrecourse mortgages. When possible, negotiate for a nonrecourse clause
in your loan agreements.
Assume that your lender sets a 70 percent LTV for its first mortgage.
Plus your seller will carry back a second mortgage for the balance of the
purchase price. Will the lender approve your loan application? Maybe;
maybe not.
Regardless of LTV, lenders like to see their borrowers put at least
some of their own cash into their properties at the time they buy them.
Moreover, the lender will probably ask you where you’re getting the cash.
The best source is ready money from a savings account (or other liquid
assets). In contrast, most lenders would not want to hear that you’re taking
a $10,000 cash advance against your credit card.
Likewise, most lenders want you to retain cash (or liquid assets) after
you close your loan. Often, they like to see enough reserves to cover two
or three months of mortgage payments. However, the more cash you have
available, the better you look.
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Capacity (Monthly Income)
As another underwriting guideline, mortgage lenders evaluate your
monthly income from employment and other sources, as well as the ex-
pected NOI of the property you want to finance. For owner-occupied
properties, a lender will (directly or indirectly) emphasize “qualifying ra-
tios.” A qualifying ratio is the percentage of your income that you can
safely allocate to mortgage payments (principal, interest, property taxes,
and insurance, or PITI). If a lender sets a 28 percent housing-cost qualifying
ratio and you gross $4,000 a month, the lender may limit your mortgage
payments (PITI) to $1,120 a month.
If you are buying your first or second rental house, the lender may
count 75 percent of the rents towards your qualifying ratios—but on this
point lenders differ. Some will count more and some will count less. Also,
for your first few investment property loans, lenders look more to your
personal credit and income to support the loan. As you gain investment
experience, they become more willing to look at your individual property
mortgages on a stand-alone basis. However, the lender will likely still re-
quire a personal guarantee from you, thus placing your net worth/earned
income as additional backup to the collateral property itself.
For apartment buildings and commercial rental properties, lenders
apply a debt coverage ratio (DCR). A debt coverage ratio shows the lender
whether the property brings in enough rental income to cover operating
expenses and debt service (principal and interest). Here’s an example of
DCR for a fourplex whose units each rent for $750 a month:
Gross annual income (4 × $750 × 12) $36,000
Vacancy @ 6% p.a. $2,160
Operating expenses and upkeep $7,200
Property taxes and insurance $2,360
Net operating income (NOI) $24,280
If a lender sets a 25 percent margin of net income over debt service,
you calculate your maximum allowable mortgage payment by dividing
the property’s annual NOI by a debt coverage ratio (DCR) of 1.25:
NOI/DCR = Annual mortgage payment
$24,280/1.25 = $19,424
To check, we reverse the calculations:
NOI/Debt Service = Debt coverage ratio
$24,280/$19,424 = 1.25
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Table 2.1 Monthly Payment Required per $1,000 of Original Mortgage Balance
Interest (%) Monthly Payment Interest (%) Monthly Payment
2.5 $3.95 7.5 $6.99
3.0 4.21 8.0 7.34
3.5 4.49 8.5 7.69
4.0 4.77 9.0 8.05
4.5 5.07 9.5 8.41
5.0 5.37 10.0 8.77
5.5 5.67 10.5 9.15
6.0 5.99 11.0 9.52
6.5 6.32 11.5 9.90
7.0 6.65 12.0 10.29
Note: Te r m s = 30 years
From these figures, you can see that with a required 1.25 DCR, the
property will yield enough income to support a monthly mortgage pay-
ment of $1,619 ($19,424 annual mortgage payment ÷ 12). To figure how
much loan a mortgage payment of $1,619 a month will pay off (amortize)
over a 30-year term, refer to Table 2.1.
At mortgage interest rates of, say, 6.0, 7.5, or 9.0 percent, the lender
could loan you up to $270,284, $231,617, or $201,118, respectively.
6.0% Mortgage Interest Rate
$1,619/$5.99 = $270,284 loan amount
7.5% Mortgage Interest Rate
$1,619/$6.99 = $231,617 loan amount
9% Mortgage Interest Rate
$1,619/$8.05 = $201,118 loan amount
Lower interest rates dramatically boost your borrowing power. The
interest rate and debt coverage ratio will partially determine how much
financing a lender will provide (subject to how well you look vis-
a-vis the
lender’s other underwriting criteria).
Credit History (Credibility!)
Must you produce high credit scores to buy and finance rental houses,
condos, and apartment buildings? No, but good credit expands your pos-
sibilities. Without a strong credit score, you’ll be limited to seller financing,
“subject to”loan/purchase agreements, or “B,” “C,” or “D” loans that carry
higher discount points, origination fees, and interest rates (if they are even
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available). If you show an excellent credit score and credit record, lenders
will welcome your business with competitive rates and terms. You become
a sought-after customer.
Strengthen your credit score. Satisfy your monthly credit obligations
on or before their due dates. Recently, we have heard so much about
“lenders making loans tough to get.” But for investors who show strong
credit scores—say 720 or higher—even troubled lenders have rolled out
the red carpet.
Nevertheless, in our highly competitive mortgage market, some
mortgage lenders will accept borrowers who have experienced foreclo-
sure, repossession, and bankruptcy. To qualify with these lenders, you
typically need (1) to have paid on time, every time for the past 18 to
24 months; (2) to attribute previous adverse credit to divorce, unem-
ployment, accident, illness, or other outside-your-control misfortune; and
(3) to persuade the lender that your present and future financial well-being
is planted on a firm foundation.
If you’ve faced serious credit problems in the past, you need
not wait 5, 7, or 10 years before a lender will qualify you for a new
mortgage—especially if you live in the property you buy. (Remember,
lenders provide their easiest qualifying, lowest costs, and best terms for
owner occupants.)
Character and Competency
Although U.S. lenders cannot legally underwrite by age, race, religion, sex,
marital status, or disability as they evaluate your loan application, they
can and do look at other personal characteristics such as the following:
Education level
Career advancement potential
Job stability
Stability in the community
Saving, spending, and borrowing habits
Dress and mannerisms
Experience in property ownership
A mortgage lender might not arbitrarily reject your loan application
because you dropped out of high school, dyed your hair purple, wear
a silver nose ring, change jobs every six months, or have not registered
a telephone in your own name. Nevertheless, subtle (and not so subtle)
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influences still count—especially for investors, and especially when tight
underwriting prevails.
Property ownership requires commitment. Smart lenders trust you
to fulfill your responsibilities. Convince the lender that you are a solid and
dependable worker, investor, and borrower. When appropriate, assure the
lender via a business plan (or other means) that you’ll manage the property
to enhance its value.
The legendary banker J. P. Morgan once told a U.S. congressional
committee, “Money cannot buy credit. A man I do not trust could not get
credit from me on all the bonds of Christendom.” J. P. Morgan knows lend-
ing: character does count. As “liar’s loans” proliferated during 2001–2006,
many lenders ignored (to their later regret) J. P.’s sound advice. Although
during some future boom period lenders will again lose their common
sense, in all loan markets you are wise to play it straight.
Compensating Factors
As you study a lender’s underwriting guidelines, remember, these are
guidelines. Most lenders do not evaluate their mortgage loan applications
by inflexible rules. Lenders weigh and consider. You can help persuade a
lender to approve your loan. Emphasize your positives and play down or
explain away negatives.
If your debt coverage ratio falls below a lender’s desired minimum,
show the lender how you plan to improve the property and increase rents.
If you have accumulated credit problems, compensate with a higher down
payment or pledged collateral. If you’ve frequently changed jobs, point
out the raises and promotions you’ve received. If you lack experience in
property ownership or property management, tell the lenders how you’ve
educated yourself by reading real estate books and how you’ve developed
a winning market strategy (see Chapter 11).
Use employer letters, references, prepared budgets, a business plan,
or any other written evidence that you can come up with to justify your loan
request. Anything in writing to persuade the lender that you are willing
and able to pay back the money you borrow may help. Compensating
factors can make the decision swing in your favor.
Remember, lenders differ—especially when they underwrite in-
vestors. What one rejects, another accepts. To get the loan you want, search
the mortgage market. With thousands of lenders and loan brokers compet-
ing for loans, chances are you can find a lender (or seller) who’s right for
you. If not, those lenders have just sent you a powerful signal: You must
improve your financial fitness and borrower profile.
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Automated Underwriting (AUS)
For the past 10 to 15 years, mortgage lenders have relied on automated un-
derwriting. Using such a system, a loan rep gathers pertinent underwriting
facts and enters them into a software program.
Ifyour borrower(andproperty)profilematches thestandardswritten
into this loan approval program, great. It means a faster, less costly path
to closing, and a shorter stack of paperwork. But if your profile needs
outside-the-box attention, work with a savvy loan rep who can apply the
skill and knowledge necessary to get your loan approved—or at least tell
you the reasons why your application falls short and how you can work
to overcome deficiencies.
To see how you might fare with automated underwriting, go to From this site, you can learn your credit scores and obtain
pointers on how to improve them.
Automated underwriting (AUS) looks at more than your credit score.
These programs incorporate calculations that evaluate your qualifying ra-
tios, earning power, cash reserves, debts, and assets. When your trimerged
credit scores exceed, say, 720 (or so), the AUS will loosen up on other stan-
dards. Conversely, a score of, say, 640 (or so) will cause the AUS to subject
your financial profile to stricter standards and more documentation of
income, savings, and other pertinent financial data.
Exactly how AUS programs balance and trade off individual un-
derwriting criteria remains a guarded secret. But savvy loan reps have
developed some rule-of-thumb insights. So ask them. Benefit from their
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pply the know-how of Chapter 2, and you will find ways to finance
your investment properties. But financing provides only a means
to a goal. Your goal is to buy and finance properties that offer
strong potential for profit. And to invest profitably requires you to estimate
(present and future) market value.
Experience shows that many real estate investors (and homebuy-
ers) have glossed over this critical point. Most popular how-to books on
real estate investing give short shrift to valuing properties. Why? Because
many authors and investors have mistakenly assumed that “inflation cures
all mistakes.” Na
ıvely, many investors (speculators) have thought that to
make money in real estate, all you have to do is buy it. Even if you pay too
much, price increases will eventually bail you out. As example, here’s what
multimillionaire investor and author, David Schumacher, once advised:
The amount I paid for this property is inconsequential because
of the degree to which it has appreciated [sic: he means in-
creased in price due to inflation and appreciation] in value....
In my opinion, it is ridiculous to quibble over $5,000 or even
$50,000 in price if you are buying for the long term.... In 1963,
I bought a four-unit apartment building for $35,000. Suppose I
had paid $100,000 for it. It wouldn’t have made any difference
because the property’s worth $1.2 million today. (The Buy and
Hold Real Estate Strategy, John Wiley & Sons, 1992)
Assuming 20 percent down at 5 percent interest, 30 years, for Schumacher’s
example property, the monthly payment on $80,000 (assuming a $100,000 purchase
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Other top-selling real estate authors advise would-be investors to
tell sellers, “You name the price, I’ll name the terms.” If the property
owner agrees to sell on easy terms (usually little or nothing down), the
buyer will agree to the seller’s price. “Who cares about the price you pay
today? What’s important is all that money you’re going to make when you
sell.” During the go-go boom years 2001–2006, I witnessed this mistake
hundreds of time in places as diverse as Dubai, Dublin, and San Diego.
Long-term price increases (inflation, appreciation) will typically boost a
property’s eventual selling price. But before you can profit from the long
run, you must survive the short run. If you overpay, you may have to wait
five years (or more) for the market to catch up.
Even worse, during that wait, negative cash flows (the alligators)
may eat you alive. You lose the property. Someone else picks up the same
property at a much lower price. Even when investors do struggle through
a swampland of alligators, they still miss the rewards they could have
obtained if they had chosen a surer and safer route.
Want to profit? Buy right! Long-term successful investors make
money when they buy, not just when they sell. You reduce risk and increase
your chance for great returns when you buy properties at or (preferably)
below their market values. But this tactic requires that you know what
the term “market value” really means. (Note: When you buy at a bargain
price, you often pay less than market value for a property. However, I also
encourage you to buy “undervalued” properties. In this sense, underval-
ued refers to all properties and/or locations that are loaded with strong
potential for gains that may result from a variety of sources. You’ll learn
how to find and evaluate “undervalued” properties in later chapters.)
To the uninformed, “appraised value,” “sales price,” and “market value”
all refer to the same concept. In fact, “Appraised value” could refer to an
insurance policy appraisal, a property tax appraisal, an estate tax appraisal,
or a market value appraisal. Sales price itself merely identifies the nominal
price) would equal $430, whereas a $28,000 loan ($35,000 purchase price) would
have required a payment of just $150 a month.
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price at which a property has sold. That sales price could equal, exceed,
or fall below market value. Market value reliably reflects sales price only
when a property is sold according to these five stipulations:
1. Buyers and sellers are typically motivated. Neither acts under
2. Buyers and sellers are well informed about the market and nego-
tiate in their own best interest.
The marketing period and sales promotion efforts are sufficient to
bring the property to the attention of willing and able buyers.
3. No atypically favorable or unfavorable terms of financing apply.
(During the most recent property boom, lenders offered dangerously easy
financing, thus pushing sales prices far above their natural market value.)
4. Neither the sellers nor the buyers offer any extraordinary sales
concessions or incentives. (For example, the builders in many countries
offered off-plan buyers three years of rent guarantees—clearly a red flag
that the builders’ prices exceed market value.)
To further illustrate the stipulated conditions underlying the concept
of market value, say that two properties recently sold in a neighborhood
where you’re interested in buying:
Thirty-seven Oak sold at a price of $258,000, and 164 Maple sold at
a price of $255,000. Each of these three-bedroom, two-bath houses was in
good condition, with around 2,100 square feet. You locate a nearby house
of similar size and features at 158 Pine. It’s priced at $234,750. Is that a
bargain (below market value) price? Maybe; maybe not. Before you draw
a conclusion, investigate the terms and conditions of the other two sales.
What if the sellers of 164 Maple had carried back a nothing-down,
5 percent, 30-year mortgage for their buyers (i.e., favorable financing)?
What if the buyers of 37 Oak had just flown into Peoria from San
Francisco and bought the first house they saw because “It was such a
steal. You couldn’t find anything like it in San Francisco for less than
$1.2 million” (i.e., uninformed buyers)?
What if the sellers of 37 Oak had agreed to pay all of their buyer’s
closing costs and leave their authentic Chippendale buffet because it was
too big to move into their new condo in Florida (i.e., extraordinary sales
Sales Price Doesn’t Necessarily Equal Market Value
When you buy real estate, go well beyond merely learning the prices at
which other similar properties have sold. Investigate whether the buyers
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or sellers acted with full market knowledge, gave any unusually favorable
(or onerous) terms of financing, bought (or sold) in a hurry, or made
concessions that pushed up the nominal selling price—or perhaps pulled
it down. If you find that the sales of comparable properties do not meet
the conditions of a “market value” sale, weigh that information before you
write your contract offer on a property.
In other words, before you rely on comp sales prices to value a
property: (1) verify the accuracy of your information; (2) verify the date of
sale; and (3) verify the terms and conditions of the sale. Faulty information
about a comp property’s features or terms of sale can make bad deals look
good (or vice versa). Also, market value assumes no hidden defects or title
issues. A comp (or subject) house with a termite infestation should sell at
a price below market value (see later discussion).
Sound Underwriting Requires Lenders to Loan
Only Against Market Value
Financial institutions loan against market value, not purchase price, un-
less your purchase price falls below market value. When you apply for a
mortgage, you may tell the lender that you’ve agreed to a price of $200,000
and would like to borrow $160,000 (an 80 percent LTV). Yet the lender will
not necessarily agree that this price matches the property’s market value.
First, the lender will ask about special financing terms (e.g., a $20,000
seller second) and sales concessions (e.g., the seller’s plan to buy down
your interest rate for three years and pay all closing costs). If your transac-
tion differs from market norms, the lender won’t loan 80 percent of your
$200,000 purchase price—even if it routinely does make 80 percent LTV
loans. The lender may find that easy terms of financing or sales concessions
are worth $10,000. So, the lender may calculate your 80 percent LTV ratio
against $190,000, not the $200,000 purchase price.
Second, to verify that your purchase price of $200,000 equals or ex-
ceeds market value, the lender will order a market value appraisal. If that
appraisal report comes back with a figure that’s less than $200,000, the
lender will use the lesser amount to calculate an 80 percent LTV loan. Take
notice: You don’t have to passively suffer the results of a low appraisal.
Critique the original. Ask the appraiser to correct errors. Or you can ask
the lender to order a new appraisal with another firm. The lender needs a
file document (appraisal) to justify its lending decision. If you provide an
acceptable (revised or remade) appraisal of a satisfactory amount, you’ll
often get the loan you want.
Danger: Just because a lender’s appraiser comes up with a market
value estimate that matches your purchase price, never assume that the
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appraisal accurately sets market value. Accept personal responsibility for
your offering price. Loan reps routinely tell their appraisers the value
estimate they need to make a deal work. In return, appraisers know that if
they fail to “hit the desired numbers,” loan reps will select another, more
accommodating appraiser to prepare their reports.
If you’re a good customer of a bank (or if the bank would like you
to become a good customer), the loan rep may encourage the appraiser to
issue an MAI (made as instructed) appraisal. I know of many instances
where appraisers have acquiesced to not-so-subtle hints from a loan rep
and submitted appraisals that overstated a property’s value. (Indeed, as
early in the property boom as 2003, government investigators found that
loan reps were pressuring appraisers to lift their value estimates.)
You will work with appraisers, and you will solicit their opinions,
but never accept those opinions as the final word. To protect yourself
against inaccurate appraisals (your own, as well as others), understand
how to calculate, apply, and interpret the three technical methods used to
estimate market value.
Investors, lenders, and appraisers rely on three techniques to value
1. Cost approach. (1) Calculate how much it would cost to build a
subject property at today’s prices, (2) subtract accrued depreciation, and
(3) add the depreciated cost figure to the current value of the lot.
2. Comparable sales approach. (1) Compare a subject property with
other similar (comp) properties that have recently sold, (2) adjust the prices
for each positive or negative feature of the comps relative to the subject
property, (3) via this detailed and systematic comparison, adjust for pos-
itive and negative property differences, and (4) estimate market value of
the subject property from the adjusted sales prices of the comps.
3. Income approach. (1) Estimate the rents you expect a property to
produce, and (2) convert net rents after expenses (net operating income)
into a capital (market) value amount.
You evaluate a property from three perspectives to check the value
estimates of each against the others. Multiple estimates and techniques
enhance the probability that your estimate reflects reality. If your three
value estimates don’t reasonably match up, either your calculations err,
the figures you’re working with are inaccurate, or the market is acting
“crazy” and property prices are about to head up (or down).
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Figure 3.1 shows a sample appraisal form for a single-family house.
Refer to this form as you read the following pages and you’ll see how to
apply these three techniques to appraise properties. Photocopy this form
(or print a copy from the Internet). Use the forms to fill in property and
market information as you value potential property investments.
To accurately estimate the value of a property, first describe the features
of the property and its neighborhood in detail. List all facts that might
influence value favorably or unfavorably. Investors err in their appraisals
because they casually inspect rather than carefully detail and compare.
Focus on each of the neighborhood and property features listed on an
appraisal form. You will value properties more profitably.
Identify the Subject Property
To identify the subject property seems straightforward. Nevertheless, you
might experience some pitfalls. For example, the street address for one
of my previous homes was 73 Roble Road, Berkeley, California 94705.
However, that property does not sit in Berkeley. It is actually located in
Oakland. The house sat back from Roble Road (which is in Berkeley) about
100 feet—just far enough to put it within the city limits of Oakland. As a
result, the city laws governing the property (zoning, building regulations,
permits, rent controls, school district, etc.) were those of Oakland, not
Similarly, Park Cities (University Park and Highland Park) are high-
income, independent municipalities located within the geographic bound-
aries of Dallas, Texas. Among other amenities, Park Cities are noted for
their high-quality schools. Yet (in the past) if you lived in Park Cities on
the west side of the North Dallas Tollway, your children would attend the
lesser-regarded schools of the Dallas Independent School District.
The lesson: Street and city addresses don’t always tell you what you
need to know about a property. Strange as it may seem, a property may
not be located where you think it is. (See also forthcoming discussion of
site identification.)
As theappraisal form shows, aneighborhood investigationshould note the
types and condition of neighborhood properties, the percentage of houses
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Uniform Residential Appraisal Report
File #
Freddie Mac Form 70 March 2005 Page 1 of 6 Fannie Mae Form 1004 March 2005
The purpose of this summary appraisal report is to provide the lender/client with an accurate, and adequately supported, opinion of the market value of the subject property.
Property Address City State Zip Code
Borrower Owner of Public Record County
Legal Description
Assessor’s Parcel # Tax Year R.E. Taxes $
Neighborhood Name Map Reference Census Tract
Occupant Owner Tenant Vacant Special Assessments $ PUD HOA $ per year per month
Property Rights Appraised Fee Simple Leasehold Other (describe)
Assignment Type Purchase Transaction Refinance Transaction Other (describe)
Lender/Client Address
Is the subject property currently offered for sale or has it been offered for sale in the twelve months prior to the effective date of this appraisal? Yes No
Report data source(s) used, offering price(s), and date(s).
I did did not analyze the contract for sale for the subject purchase transaction. Explain the results of the analysis of the contract for sale or why the analysis was not
Contract Price $ Date of Contract Is the property seller the owner of public record? Yes No Data Source(s)
Is there any financial assistance (loan charges, sale concessions, gift or downpayment assistance, etc.) to be paid by any part y on behalf of the borrower? Yes No
If Yes, report the total dollar amount and describe the items to be paid.
Note: Race and the racial composition of the neighborhood are not appraisal factors.
Neighborhood Characteristics One-Unit Housing Trends One-Unit Housing Present Land Use %
Location Urban Suburban Rural Property Values Increasing Stable Declining PRICE AGE One-Unit %
Built-Up Over 75% 25–75% Under 25% Demand/Supply Shortage In Balance Over Supply $ (000) (yrs) 2-4 Unit %
Growth Rapid Stable Slow Marketing Time Under 3 mths 3–6 mths Over 6 mths Low Multi-Family %
Neighborhood Boundaries High Commercial %
Pred. Other %
Neighborhood Description
Market Conditions (including support for the above conclusions)
Dimensions Area Shape View
Specific Zoning Classification Zoning Description
Zoning Compliance Legal Legal Nonconforming (Grandfathered Use) No Zoning Illegal (describe)
Is the highest and best use of the subject property as improved (or as proposed per plans and specifications) the present use? Yes No If No, describe
Utilities Public Other (describe) Public Other (describe) Off-site Improvements—Type Public Private
Electricity Water Street
Gas Sanitary Sewer Alley
FEMA Special Flood Hazard Area Yes No FEMA Flood Zone FEMA Map # FEMA Map Date
Are the utilities and off-site improvements typical for the market area? Yes No If No, describe
Are there any adverse site conditions or external factors (easements, encroachments, environmental conditions, land uses, etc.) ? Yes No If Yes, describe
General Description Foundation Exterior Description materials/condition Interior materials/condition
Units One One with Accessory Unit Concrete Slab Crawl Space Foundation Walls Floors
# of Stories Full Basement Partial Basement Exterior Walls Walls
Type Det. Att. S-Det./End Unit Basement Area sq. ft. Roof Surface Trim/Finish
Existing Proposed Under Const. Basement Finish % Gutters & Downspouts Bath Floor
Design (Style) Outside Entry/Exit Sump Pump Window Type Bath Wainscot
Year Built Evidence of Infestation Storm Sash/Insulated Car Storage None
Effective Age (Yrs) Dampness Settlement Screens Driveway # of Cars
Attic None Heating FWA HWBB Radiant Amenities Woodstove(s) # Driveway Surface
Drop Stair Stairs Other Fuel Fireplace(s) # Fence Garage # of Cars
Floor Scuttle Cooling Central Air Conditioning Patio/Deck Porch Carport # of Cars
Finished Heated Individual Other Pool Other Att. Det. Built-in
Appliances Refrigerator Range/Oven Dishwasher Disposal Microwave Washer/Dryer Other (describe)
Finished area above grade contains: Rooms Bedrooms Bath(s) Square Feet of Gross Living Area Above Grade
Additional features (special energy efficient items, etc.)
Describe the condition of the property (including needed repairs, deterioration, renovations, remodeling, etc.).
Are there any physical deficiencies or adverse conditions that affect the livability, soundness, or structural integrity of the property? Yes No If Yes, describe
Does the property generally conform to the neighborhood (functional utility, style, condition, use, construction, etc.)? Yes No If No, describe
Figure 3.1 Appraisal Report
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Uniform Residential Appraisal Report
File #
Freddie Mac Form 70 March 2005 Page 2 of 6 Fannie Mae Form 1004 March 2005
There are comparable properties currently offered for sale in the subject neighborhood ranging in price from $ to $ .
There are comparable sales in the subject neighborhood within the past twelve months ranging in sale price from $ to $ .
Proximity to Subject
Sale Price $ $ $ $
Sale Price/Gross Liv. Area $ sq. ft. $ sq. ft. $ sq. ft. $ sq. ft.
Data Source(s)
Verification Source(s)
Sale or Financing
Date of Sale/Time
Leasehold/Fee Simple
Design (Style)
Quality of Construction
Actual Age
Above Grade
Total Bdrms. Baths Total Bdrms. Baths Total Bdrms. Baths Total Bdrms. Baths
Room Count
Gross Living Area sq. ft. sq. ft. sq. ft. sq. ft.
Basement & Finished
Rooms Below Grade
Functional Utility
Energy Efficient Items
Net Adjustment (Total) + - $ + - $ + - $
Adjusted Sale Price
of Comparables
Net Adj. %
Gross Adj. % $
Net Adj. %
Gross Adj. % $
Net Adj. %
Gross Adj. % $
I did did not research the sale or transfer history of the subject property and comparable sales. If not, explain
My research did did not reveal any prior sales or transfers of the subject property for the three years prior to the effective date of this appraisal.
Data source(s)
My research did did not reveal any prior sales or transfers of the comparable sales for the year prior to the date of sale of the comparable sale.
Data source(s)
Report the results of the research and analysis of the prior sale or transfer history of the subject property and comparable sales (report additional prior sales on page 3).
Date of Prior Sale/Transfer
Price of Prior Sale/Transfer
Data Source(s)
Effective Date of Data Source(s)
Analysis of prior sale or transfer history of the subject property and comparable sales
Summary of Sales Comparison Approach
Indicated Value by Sales Comparison Approach $
Indicated Value by: Sales Comparison Approach $ Cost Approach (if developed) $ Income Approach (if developed) $
This appraisal is made “as is”, subject to completion per plans and specifications on the basis of a hypothetical condition that the improvements have been
subject to the following repairs or alterations on the basis of a hypothetical condition that the repairs or alterations have been completed, or subject to the
following required inspection based on the extraordinary assumption that the condition or deficiency does not require alteration or repair:
Based on a complete visual inspection of the interior and exterior areas of the subject property, defined scope of work, statement of assumptions and limiting
conditions, and appraiser’s certification, my (our) opinion of the market value, as defined, of the real property that is the subject of this report is
$ , as of , which is the date of inspection and the effective date of this appraisal.
Figure 3.1 (Continued)
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Uniform Residential Appraisal Report
File #
Freddie Mac Form 70 March 2005 Page 3 of 6 Fannie Mae Form 1004 March 2005
COST APPROACH TO VALUE (not required by Fannie Mae)
Provide adequate information for the lender/client to replicate the below cost figures and calculations.
Support for the opinion of site value (summary of comparable land sales or other methods for estimating site value)
ESTIMATED REPRODUCTION OR REPLACEMENT COST NEW OPINION OF SITE VALUE.................................................................= $
Source of cost data Dwelling Sq. Ft. @ $ .....................=$
Quality rating from cost service Effective date of cost data Sq. Ft. @ $ .....................=$
Comments on Cost Approach (gross living area calculations, depreciation, etc.)
Garage/Carport Sq. Ft. @ $ .....................=$
Total Estimate of Cost-New ....................= $
Less Physical Functional External
Depreciation =$( )
Depreciated Cost of Improvements......................................................=$
“As-is” Value of Site Improvements......................................................=$
Estimated Remaining Economic Life (HUD and VA only) Years Indicated Value By Cost Approach.................................... ..................=$
INCOME APPROACH TO VALUE (not required by Fannie Mae)
Estimated Monthly Market Rent $ X Gross Rent Multiplier = $ Indicated Value by Income Approach
Summary of Income Approach (including support for market rent and GRM)
Is the developer/builder in control of the Homeowners’ Association (HOA)? Yes No Unit type(s) Detached Attached
Provide the following information for PUDs ONLY if the developer/builder is in control of the HOA and the subject property is an attached dwelling unit.
Legal name of project
Total number of phases Total number of units Total number of units sold
Total number of units rented Total number of units for sale Data source(s)
Was the project created by the conversion of an existing building(s) into a PUD? Yes No If Yes, date of conversion
Does the project contain any multi-dwelling units? Yes No Data source(s)
Are the units, common elements, and recreation facilities complete? Yes No If No, describe the status of completion.
Are the common elements leased to or by the Homeowners’ Association? Yes No If Yes, describe the rental terms and options.
Describe common elements and recreational facilities
Figure 3.1 (Continued)
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Uniform Residential Appraisal Report File #
Freddie Mac Form 70 March 2005 Page 4 of 6 Fannie Mae Form 1004 March 2005
This report form is designed to report an appraisal of a one-unit property or a one-unit property with an accessory unit;
including a unit in a planned unit development (PUD). This report form is not designed to report an appraisal of a
manufactured home or a unit in a condominium or cooperative project.
This appraisal report is subject to the following scope of work, intended use, intended user, definition of market value,
statement of assumptions and limiting conditions, and certifications. Modifications, additions, or deletions to the intended
use, intended user, definition of market value, or assumptions and limiting conditions are not permitted. The appraiser may
expand the scope of work to include any additional research or analysis necessary based on the complexity of this appraisal
assignment. Modifications or deletions to the certifications are also not permitted. However, additional certifications that do
not constitute material alterations to this appraisal report, such as those required by law or those related to the appraiser’s
continuing education or membership in an appraisal organization, are permitted.
SCOPE OF WORK: The scope of work for this appraisal is defined by the complexity of this appraisal assignment and the
reporting requirements of this appraisal report form, including the following definition of market value, statement of
assumptions and limiting conditions, and certifications. The appraiser must, at a minimum: (1) perform a complete visual
inspection of the interior and exterior areas of the subject property, (2) inspect the neighborhood, (3) inspect each of the
comparable sales from at least the street, (4) research, verify, and analyze data from reliable public and/or private sources,
and (5) report his or her analysis, opinions, and conclusions in this appraisal report.
INTENDED USE: The intended use of this appraisal report is for the lender/client to evaluate the property that is the
subject of this appraisal for a mortgage finance transaction.
INTENDED USER: The intended user of this appraisal report is the lender/client.
DEFINITION OF MARKET VALUE: The most probable price which a property should bring in a competitive and open
market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming
the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and
the passing of title from seller to buyer under conditions whereby: (1) buyer and seller are typically motivated; (2) both
parties are well informed or well advised, and each acting in what he or she considers his or her own best interest; (3) a
reasonable time is allowed for exposure in the open market; (4) payment is made in terms of cash in U. S. dollars or in terms
of financial arrangements comparable thereto; and (5) the price represents the normal consideration for the property sold
unaffected by special or creative financing or sales concessions* granted by anyone associated with the sale.
*Adjustments to the comparables must be made for special or creative financing or sales concessions. No adjustments are
necessary for those costs which are normally paid by sellers as a result of tradition or law in a market area; these costs are
readily identifiable since the seller pays these costs in virtually all sales transactions. Special or creative financing
adjustments can be made to the comparable property by comparisons to financing terms offered by a third party institutional
lender that is not already involved in the property or transaction. Any adjustment should not be calculated on a mechanical
dollar for dollar cost of the financing or concession but the dollar amount of any adjustment should approximate the market’s
reaction to the financing or concessions based on the appraiser’s judgment.
STATEMENT OF ASSUMPTIONS AND LIMITING CONDITIONS: The appraiser’s certification in this report is
subject to the following assumptions and limiting conditions:
1. The appraiser will not be responsible for matters of a legal nature that affect either the property being appraised or the title
to it, except for information that he or she became aware of during the research involved in performing this appraisal. The
appraiser assumes that the title is good and marketable and will not render any opinions about the title.
2. The appraiser has provided a sketch in this appraisal report to show the approximate dimensions of the improvements.
The sketch is included only to assist the reader in visualizing the property and understanding the appraiser’s determination
of its size.
3. The appraiser has examined the available flood maps that are provided by the Federal Emergency Management Agency
(or other data sources) and has noted in this appraisal report whether any portion of the subject site is located in an
identified Special Flood Hazard Area. Because the appraiser is not a surveyor, he or she makes no guarantees, express or
implied, regarding this determination.
4. The appraiser will not give testimony or appear in court because he or she made an appraisal of the property in question,
unless specific arrangements to do so have been made beforehand, or as otherwise required by law.
5. The appraiser has noted in this appraisal report any adverse conditions (such as needed repairs, deterioration, the
presence of hazardous wastes, toxic substances, etc.) observed during the inspection of the subject property or that he or
she became aware of during the research involved in performing this appraisal. Unless otherwise stated in this appraisal
report, the appraiser has no knowledge of any hidden or unapparent physical deficiencies or adverse conditions of the
property (such as, but not limited to, needed repairs, deterioration, the presence of hazardous wastes, toxic substances,
adverse environmental conditions, etc.) that would make the property less valuable, and has assumed that there are no such
conditions and makes no guarantees or warranties, express or implied. The appraiser will not be responsible for any such
conditions that do exist or for any engineering or testing that might be required to discover whether such conditions exist.
Because the appraiser is not an expert in the field of environmental hazards, this appraisal report must not be considered as
an environmental assessment of the property.
6. The appraiser has based his or her appraisal report and valuation conclusion for an appraisal that is subject to satisfactory
completion, repairs, or alterations on the assumption that the completion, repairs, or alterations of the subject property will
be performed in a professional manner.
Figure 3.1 (Continued)
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Uniform Residential Appraisal Report
File #
Freddie Mac Form 70 March 2005 Page 5 of 6 Fannie Mae Form 1004 March 2005
APPRAISER’S CERTIFICATION: The Appraiser certifies and agrees that:
1. I have, at a minimum, developed and reported this appraisal in accordance with the scope of work requirements stated in
this appraisal report.
2. I performed a complete visual inspection of the interior and exterior areas of the subject property. I reported the condition
of the improvements in factual, specific terms. I identified and reported the physical deficiencies that could affect the
livability, soundness, or structural integrity of the property.
3. I performed this appraisal in accordance with the requirements of the Uniform Standards of Professional Appraisal
Practice that were adopted and promulgated by the Appraisal Standards Board of The Appraisal Foundation and that were in
place at the time this appraisal report was prepared.
4. I developed my opinion of the market value of the real property that is the subject of this report based on the sales
comparison approach to value. I have adequate comparable market data to develop a reliable sales comparison approach
for this appraisal assignment. I further certify that I considered the cost and income approaches to value but did not develop
them, unless otherwise indicated in this report.
5. I researched, verified, analyzed, and reported on any current agreement for sale for the subject property, any offering for
sale of the subject property in the twelve months prior to the effective date of this appraisal, and the prior sales of the subject
property for a minimum of three years prior to the effective date of this appraisal, unless otherwise indicated in this report.
6. I researched, verified, analyzed, and reported on the prior sales of the comparable sales for a minimum of one year prior
to the date of sale of the comparable sale, unless otherwise indicated in this report.
7. I selected and used comparable sales that are locationally, physically, and functionally the most similar to the subject property.
8. I have not used comparable sales that were the result of combining a land sale with the contract purchase price of a home that
has been built or will be built on the land.
9. I have reported adjustments to the comparable sales that reflect the market's reaction to the differences between the subject
property and the comparable sales.
10. I verified, from a disinterested source, all information in this report that was provided by parties who have a financial interest
in the sale or financing of the subject property.
11. I have knowledge and experience in appraising this type of property in this market area.
12. I am aware of, and have access to, the necessary and appropriate public and private data sources, such as multiple listing
services, tax assessment records, public land records and other such data sources for the area in which the property is located .
13. I obtained the information, estimates, and opinions furnished by other parties and expressed in this appraisal report from
reliable sources that I believe to be true and correct.
14. I have taken into consideration the factors that have an impact on value with respect to the subject neighborhood, subject
property, and the proximity of the subject property to adverse influences in the development of my opinion of market value. I
have noted in this appraisal report any adverse conditions (such as, but not limited to, needed repairs, deterioration, the
presence of hazardous wastes, toxic substances, adverse environmental conditions, etc.) observed during the inspection of the
subject property or that I became aware of during the research involved in performing this appraisal. I have considered these
adverse conditions in my analysis of the property value, and have reported on the effect of the conditions on the value and
marketability of the subject property.
15. I have not knowingly withheld any significant information from this appraisal report and, to the best of my knowledge, all
statements and information in this appraisal report are true and correct.
16. I stated in this appraisal report my own personal, unbiased, and professional analysis, opinions, and conclusions, which
are subject only to the assumptions and limiting conditions in this appraisal report.
17. I have no present or prospective interest in the property that is the subject of this report, and I have no present or
prospective personal interest or bias with respect to the participants in the transaction. I did not base, either partially or
completely, my analysis and/or opinion of market value in this appraisal report on the race, color, religion, sex, age, marital
status, handicap, familial status, or national origin of either the prospective owners or occupants of the subject property or of the
present owners or occupants of the properties in the vicinity of the subject property or on any other basis prohibited by law.
18. My employment and/or compensation for performing this appraisal or any future or anticipated appraisals was not
conditioned on any agreement or understanding, written or otherwise, that I would report (or present analysis supporting) a
predetermined specific value, a predetermined minimum value, a range or direction in value, a value that favors the cause of
any party, or the attainment of a specific result or occurrence of a specific subsequent event (such as approval of a pending
mortgage loan application).
19. I personally prepared all conclusions and opinions about the real estate that were set forth in this appraisal report. If I
relied on significant real property appraisal assistance from any individual or individuals in the performance of this appraisal
or the preparation of this appraisal report, I have named such individual(s) and disclosed the specific tasks performed in this
appraisal report. I certify that any individual so named is qualified to perform the tasks. I have not authorized anyone to make
a change to any item in this appraisal report; therefore, any change made to this appraisal is unauthorized and I will take no
responsibility for it.
20. I identified the lender/client in this appraisal report who is the individual, organization, or agent for the organization that
ordered and will receive this appraisal report.
Figure 3.1 (Continued)
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Uniform Residential Appraisal Report
File #
Freddie Mac Form 70 March 2005 Page 6 of 6 Fannie Mae Form 1004 March 2005
21. The lender/client may disclose or distribute this appraisal report to: the borrower; another lender at the request of the
borrower; the mortgagee or its successors and assigns; mortgage insurers; government sponsored enterprises; other
secondary market participants; data collection or reporting services; professional appraisal organizations; any department,
agency, or instrumentality of the United States; and any state, the District of Columbia, or other jurisdictions; without having to
obtain the appraiser’s or supervisory appraiser’s (if applicable) consent. Such consent must be obtained before this appraisal
report may be disclosed or distributed to any other party (including, but not limited to, the public through advertising, public
relations, news, sales, or other media).
22. I am aware that any disclosure or distribution of this appraisal report by me or the lender/client may be subject to certain
laws and regulations. Further, I am also subject to the provisions of the Uniform Standards of Professional Appraisal Practice
that pertain to disclosure or distribution by me.
23. The borrower, another lender at the request of the borrower, the mortgagee or its successors and assigns, mortgage
insurers, government sponsored enterprises, and other secondary market participants may rely on this appraisal report as
part of any mortgage finance transaction that involves any one or more of these parties.
24. If this appraisal report was transmitted as an “electronic record” containing my “electronic signature,” as those terms are
defined in applicable federal and/or state laws (excluding audio and video recordings), or a facsimile transmission of this
appraisal report containing a copy or representation of my signature, the appraisal report shall be as effective, enforceable
and valid as if a paper version of this appraisal report were delivered containing my original hand written signature.
25. Any intentional or negligent misrepresentation(s) contained in this appraisal report may result in civil liability and/or
criminal penalties including, but not limited to, fine or imprisonment or both under the provisions of Title 18, United States
Code, Section 1001, et seq., or similar state laws.
SUPERVISORY APPRAISER’S CERTIFICATION: The Supervisory Appraiser certifies and agrees that:
1. I directly supervised the appraiser for this appraisal assignment, have read the appraisal report, and agree with the
appraiser’s analysis, opinions, statements, conclusions, and the appraiser’s certification.
2. I accept full responsibility for the contents of this appraisal report including, but not limited to, the appraiser’s analysis,
opinions, statements, conclusions, and the appraiser’s certification.
3. The appraiser identified in this appraisal report is either a sub-contractor or an employee of the supervisory appraiser (or the
appraisal firm), is qualified to perform this appraisal, and is acceptable to perform this appraisal under the applicable state law.
4. This appraisal report complies with the Uniform Standards of Professional Appraisal Practice that were adopted and
promulgated by the Appraisal Standards Board of The Appraisal Foundation and that were in place at the time this appraisal
report was prepared.
5. If this appraisal report was transmitted as an “electronic record” containing my “electronic signature,” as those terms are
defined in applicable federal and/or state laws (excluding audio and video recordings), or a facsimile transmission of this
appraisal report containing a copy or representation of my signature, the appraisal report shall be as effective, enforceable
and valid as if a paper version of this appraisal report were delivered containing my original hand written signature.
Company Name________________________________________
Company Address_______________________________________
Telephone Number______________________________________
Email Address__________________________________________
Date of Signature and Report______________________________
Effective Date of Appraisal________________________________
State Certification #______________________________________
or State License #_______________________________________
or Other (describe)__________________State #_____________
Expiration Date of Certification or License____________________
Company Name________________________________________
Company Address_______________________________________
Email Address__________________________________________
Company Name_____________________________________
Company Address____________________________________
Telephone Number___________________________________
Email Address_______________________________________
Date of Signature____________________________________
State Certification #___________________________________
or State License #____________________________________
Expiration Date of Certification or License_________________
Did not inspect subject property
Did inspect exterior of subject property from street
Date of Inspection_________________________________
Did inspect interior and exterior of subject property
Date of Inspection_________________________________
Did not inspect exterior of comparable sales from street
Did inspect exterior of comparable sales from street
Date of Inspection_________________________________
Figure 3.1 (Continued)
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and condominiums that are owner occupied, vacancy rates, property price
(and rental) ranges, the types and quality of government services, and the
relative convenience of the property to shopping, schools, employment
centers, parks and recreational areas—the appeal of the neighborhood to
potential buyers.
Next, imagine the future. Envision the changes that are likely to occur
in the neighborhood during the coming three to five years. Is the neighbor-
hood stable? Is it moving toward higher rates of owner occupancy? Are
property owners fixing up their properties? Do neighborhood residents
and local merchants take pride in their properties and the surrounding
area? Is a neighborhood (or homeowners’) association working to im-
prove the area? If not, could such an association make the neighborhood a
better place to live, shop, work, and play?
When you invest in property, you buy the future even more than
the present. View the neighborhood with both a crystal ball as well as
a magnifying glass. Visualize how the neighborhood will (or could be
made to) look, feel, and live five years into the future.
Site (Lot) Characteristics
Depending on the neighborhood, the size and features of a lot can account
for 20 to 80percent of a property’scurrentand futurevalue. Smartinvestors
pay as much attention to the lot (and its potential) as they do to the
In addition to site size and features (see appraisal form), review
the rules and restrictions that govern a site. Determine whether the build-
ings conform to zoning, occupancy, environmental, and safety regulations.
Many two- to four-unit (and larger) properties have been modified (re-
habbed, cut up, added to, repaired, renovated, rewired, reroofed, etc.) in
ways that violate current law. Of course, laws change. Even if the property
did conform, it may now violate today’s legal standards.
Land use law classifies properties as (1) legal and conforming, (2)
legal and nonconforming, and (3) illegal. When a property meets all of
today’s legal standards, it’s called legal and conforming. If it met past
standards that don’t meet current law, but have been “grandfathered,” the
property qualifies as legal but nonconforming.
If the property includes features or uses that violate standards not
grandfathered as permissible, those features or uses remain illegal. Even
work that conforms to the law might place the owner in jeopardy if such
work was performed without a valid permit.
If you buy a property that fails to meet current law, buy with your
eyes open. Lower your offering price to reflect risk. At some future time,
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inspectors may require you to bring the property up to code. Just as im-
portant, health, safety, and environmental violations may:
Subject your tenants to injury
Motivate a rent strike
Expose you to a lawsuit
Expose you to civil or criminal penalties (fines, and in serious
cases, prison)
Before you decide upon the price to pay for a property, verify code
compliance. To bring a nonconforming property up to code (or to tear
out and reinstall unpermitted work) can cost thousands (or even tens of
thousands) of dollars.
After you investigate the legal restrictions relative to site size, features, and
improvements (e.g., parking, driveways, fencing, landscaping, utilities,
sewage disposal), detail the size, condition, quality, and appeal of the
house or apartment units located on the site. Building size itself ranks as
one of the most important determinants of value. To determine size (room
count, square footage) requires more than mere counting or pulling out a
tape measure.
As you inspect properties, you’ll see converted basements, garages,
and attics; you’ll see heated/cooled and unheated/uncooled living areas;
you’ll see “bedrooms” without closets and “dining areas” without space
for a family-size table and chairs, let alone a buffet or china cabinet; you’ll
see rooms with 6-foot ceilings or lower, and rooms with 12-foot ceilings
or higher; you’ll see some storage areas that users can access easily and
others that you can reach only by crawling on your hands and knees or
standing on a ladder. You’ll see decks, patios, and porches that display
uniquely strange designs.
In sum, you’ll see that all space is not created equal. Go beyond
comparisons of size, purported space use, or room count. Judge the quality,
livability, traffic patterns, and storage areas within the property.
Even more challenging, not everyone measures square footage in
the same way: A builder recently asked five appraisers to measure one
of his new homes. In sales promotion literature, the builder listed the
home as 3,103 square feet. One appraiser came up with a square-footage
count of 3,047 square feet. The other appraisers came up with measures
that ranged between 2,704 square feet and 3,312 square feet. Differences
such as these occur not just from mistakes but because no “square-footage
police” prescribe or enforce measurement methods.
When you read or hear a property’s room count or size, do not
blindly trust that information. Judge the quality, size, and desirability of
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the space. Here’s another example. I once owned a lakefront house with a
large master bedroom (MBR) that faced the lake through a full wall-sized
window. In valuing that house, an appraiser rated as equivalent another
lakefront home—only its MBR was much smaller and faced street-side.
In his report, the appraiser made no note of that huge difference
(as perceived by most would-be buyers). To compound his errors, the ap-
praiser also rated the “lakefront” lots equivalent—even though one (mine)
was 40,000 square feet with 165 feet of frontage versus the “comp” site at
20,000 square feet with 100 feet of lake frontage. Never accept—without
verification—an appraiser’s comp data or feature adjustments.
The cost approach recognizes that you can either build (or buy) a new
property or buy an existing one. Replacement cost typically sets the upper
limit to the price you would pay for an existing property. If you can build
a new property for $380,000 (including the cost of a lot), then why pay
$380,000 for a like-kind existing property located just down the street? In
fact, why even pay $380,000 for that older property? It suffers (at least
some) deterioration.
Calculate Cost to Build New
To follow the logic of the cost approach, refer to the appraisal form. First,
calculate the cost to build the property using dollars per square foot. Use
a figure that would apply in your area for the type of property you’re
valuing. To learn these per-square-foot costs, talk with local contractors or
consult the Marshall & Swift construction cost manuals in the reference
section of your local library or on the Internet.
Because replacement costs correlate directly with the size and quality
of buildings, accurate measurement precedes accurate valuation. Notice,
too, that you add the expense of upgrades and extras (crystal chande-
lier, high-grade wall-to-wall carpeting, Italian tile, granite countertops,
high-end appliances or plumbing fixtures, sauna, hot tub, swimming pool,
garage, carport, patios, porches, etc.) to the cost of the basic construction.
Deduct Depreciation
After you calculate today’s building costs for the subject property, deduct
three types of depreciation: (1) physical, (2) functional, and (3) external.
As a building ages, it becomes less valuable than new construction
because of physical depreciation (wear and tear): The property is exposed to
time, weather, use, and abuse; it deteriorates. Frayed carpets, faded paint,
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cracked plaster, rusty plumbing, and leaky roofs bring down a property’s
value when compared with new construction. Exactly how much remains
your call. To fill in a physical depreciation figure for a building in good
condition, estimate, say, 10 percent or 20 percent; if the property appears
run-down, you might justify 50 percent depreciation or greater. Or instead
of applying a percentage depreciation figure, itemizethe costsof the repairs
and renovations that would restore the property to like-new condition.
Itemized repairsdo not work as well as percentage estimates, because
you can’t economically upgrade an eight-year-old roof, four-year-old car-
peting, or a nine-year-old furnace to like-new condition. Nevertheless, in
one way or another, figure how much you think the subject property has
depreciated relative to a newly built property of the same size, quality, and
Next, estimate the amount of functional depreciation. Unlike wear
and tear, which occurs naturally through use and abuse, functional depre-
ciation creates loss of value due to undesirable features such as outdated
dark wood paneling, a faulty floor plan, low-amperage electrical systems,
out-of-favor color schemes, or weirdlyunique architectural design.A prop-
erty may show little physical depreciation but still suffer large functional
obsolescence. The features of the property just do not appeal to potential
buyers or renters.
External (locational) depreciation occurs when a property fails to
reflect the highest and best use for a site. You find a small, well kept house
located in an area now dotted with offices and retail stores. Zoning of the
site has changed. More than likely, the house (as a house, per se) may not
add much to the site’s value. The investor who buys the “house” would
likely tear it down or renovate it and create a retail store or office building.
For such duck-out-of-water properties, external (locational) factors
make the buildings obsolete. External depreciation can approach 100 per-
cent. With or without the building, the site should sell at approximately
the same price. This principle also applies when neighborhoods move up-
scale, and well-kept three-bedroom, two-bath houses of 1,600 square feet
are torn down and replaced with 5,000-square-foot McMansions. Investors
and builders refer to these smaller existing houses as teardowns—even
though their owners may have lovingly maintained them.
Lot Value
To estimate lot value, find similarly zoned (vacant) lots that have recently
sold, or lots that have sold with teardowns on them. When you compare
sites, note all features such as size, frontage, views, topography, legal
restrictions, subdivision rules, and other features that can affect the values
of the respective sites.
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Estimate Market Value (Cost Approach)
As you can see on the appraisal form, after you’ve completed the steps
discussed (calculate a property’s construction cost as if newly built, deduct
depreciation, and add in site value), you have computed market value.
Because you can’t precisely measure construction costs, depreciation, or
site value, the cost approach won’t give you a perfect answer (of course,
neither do the comp sale or income approaches—reason and judgment
rule). But the cost approach will provide a reference point to use with the
comp sales and income approaches. Here’s a simple example of the cost
Property description: Six-year-old, good-condition, single-family
house of 2,200 square feet. The house includes a two-car, 500-square-foot
garage, a deck, in-ground pool, sprinkler system, and premium carpets,
appliances, and kitchen cabinets. Nearby vacant lots have recently sold for
Dwelling (2,200 × $108 per-square-foot base
construction costs)
Upgrades 13,500
Deck, lap pool, sprinklers 21,750
Garage (500 × $33 per square foot) 16,500
Total $289,350
Physical depreciation at 10% (28,935)
Functional depreciation at 5% (14,438)
Depreciated building value $245,978
Site improvements (sidewalks, driveway,
fencing, landscaping)
Lot value 60,000
Indicated market value, cost approach $324,728
Typically builders build only when they think they can construct
properties that will sell (or rent) to yield enough revenue to cover their
constructioncosts anddesired profit margin. Therefore,you canusually ex-
pect sales prices to go up when construction costs significantly exceed the
market values of new properties. Why? Because without expected profit,
builders stop building. When growing demand begins to push against a
scarce supply, eventually builder profits return. The real estate construc-
tion cycle starts anew. The opposite also applies. When builder profits
fatten, sooner or later, they overbuild. High expected profits lead to a
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surplus of new construction. Too much housing inventory brings down
market values for new as well as existing properties.
Did I hear someone say Las Vegas, Miami, coastal Spain, or Dubai?
Easy financing encouraged buyers to pay prices that (temporarily) sup-
ported inflated builder profit margins. Builders overbuilt. Buyers over-
leveraged and overpaid. Together they lit the torch for the current market
Investors rejoice. Overbuilding leads to underbuilding. During the
recent downturn, new housing starts nosedived to fewer than 400,000
units—down from 1,600,000 units in 2006. Only large price gains will
bring builders back into the game. Until market values significantly in-
crease, homebuilders will not build many new houses. As new supply re-
mains depressed—andas inventories of foreclosures and REOs are worked
down—the market generates the conditions to support the next cyclical
For houses, condominiums, co-ops, townhouses, and apartment buildings,
the comparable sales approach generally provides the most accurate esti-
mate of market value. If you want to know the probable price at which a
specific property will sell, find out the recent selling prices, terms of sale,
and physical features of similar properties.
As explained later, investors rely on the income approach to value
apartment buildings, shopping centers, and offices. However, to apply the
income approach requires good comp sales. The income approach does
not stand independent of the market.
Select Comparable Properties
The accuracy of the comparable sales approach depends on your ability to
find recently sold properties that closely match a subject property. Ideally,
find comp sales in neighborhoods or developments that resemble each
other in property size, age, features, condition, quality of construction,
room count, and floor plan. As a practical matter, you seldom find per-
fect comp matches because each property, each location, displays unique
Nevertheless, you don’t need a perfect match. When you find comp
sales that reasonably match a subject property, you ballpark a value esti-
mate by comparing price per square foot of living area.
Assume that you research three comp sales: (Comp 1) 1,680 square
feet, (Comp 2) 1,840 square feet, and (Comp 3) 1,730 square feet. These
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properties sold recently for the respective prices of $225,120, $213,440, and
$211,060. To figure the selling price per square foot of living area for these
homes, divide the sales price of each house by its total square footage.
Comp 1
$225,120/1,680 = $134
Comp 2
$213,440/1,840 = $116
Comp 3
$211,060/1,730 = $122
If the house you’re interested in has 1,796 square feet of living area, it
will probably sell in the range of $120 to $130 per square foot, or $215,520
to $233,480.
Approximate Value Range—Subject Property
$120 ×1,796 = $215,520
$130 ×1,796 = $233,480
Sales price per squarefoot helps ballpark your value estimate. To gain
deeper insight, compare and contrast similar properties to your subject
property on a feature-by-feature basis.
Adjust for Differences
After you, your real estate agent, or an appraiser finds appropriate com-
parables, adjust the comp sales prices up or down to compensate for the
features that appear inferior or superior to a subject property. Here’s a brief
example of this adjustment process:
Adjustment Process (Selected Features)
Comp 1 Comp 2 Comp 3
Sales price $225,120 $213,440 $211,060
Sales concessions 0 10,000 0
Financing concessions 15,000 0 0
Date of sale 0 10,000 0
Location 0 0 20,000
Floor plan 0 5,000 0
Garage 11,000 0 17,000
Pool, patio, deck 9,000 13,000 0
Indicated value of subject $212,120 $205,440 $208,060
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As you adjust the selling prices of similar houses to reflect their dif-
ferences as per the subject property, you move toward your best estimate of
the market value range for the subject property. Although our preliminary
price-per-square-foot estimated market value for the subject to be worth
between $215,520 and $233,480, after adjustments, a price range between
$212,120 and $205,440 seems reasonable.
Explain the Adjustments
To adjust for differences in size, quality, or features, you equalize a subject
property and each of its comparables: “At what price would the compa-
rable have sold if it exactly matched the subject property?” For example,
consider the $15,000 adjustment to Comp 1 for financing concessions.
In this sale, the sellers carried back a 90 percent LTV mortgage (10
percent down) on the property at an interest rate of 6.5 percent. At the time,
investor financing usually required a 75 percent LTV (25 percent down)
and a 7.75 percent interest rate. Without this favorable owner financing,
Comp 1 would probably have sold for $15,000 less than its actual sales price
of $225,120. Because the definition of market value assumes financing on
terms typically available in the market, the premium created by this OWC
(owner will carry) financing is subtracted from Comp 1’s actual selling
price. Here are the explanations for other adjustments:
Comp 1 garage at (+) $11,000. The subject property stands superior
with its oversize double-car garage, whereas Comp 1 has only a
single-car garage. With a larger garage like the subject’s, Comp 1
would have brought an $11,000 higher sales price.
Comp 1 pool, patio, and deck at (–) $9,000. Comp 1 is superior to the
subject property on this feature because the subject lacks a deck
and tile patio. Without this feature, Comp 1 would have sold for
$9,000 less.
Comp 2 sales concession at (–) $10,000. The $213,440 sales price in this
transaction included the seller’s custom-made drapes, a washer
and dryer, and a backyard storage shed. Because these items aren’t
customary in this market, the sales price is adjusted downward to
equalize this feature with the subject property, whose sale will not
include these items.
Comp 2 floor plan at (+) $5,000. Unlike the subject property, Comp
2 lacked convenient access from the garage to the kitchen. The
garage was built under the house; residents must carry groceries
up an outside stairway to enter the kitchen. With more conven-
tional and convenient access, the selling price of Comp 2 would
probably have increased by $5,000.
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Comp 3 location at (–) $20,000. Comp 3 was located on a cul-de-sac,
and its backyard bordered an environmentally protected wooded
area. In contrast, the subject property sits on a typical subdivision
street, and its rear yard abuts that of a neighbor. Because of its
less-favorable location, the subject property could be expected to
sell for $20,000 less than Comp 3.
At this point, you may be asking, “How can I or anyone else come
up with the specific dollar amounts for each of these adjustments?” To that
question, there’s no easy answer. You accrue such knowledge by talking
with sales agents and tracking sales transactions over a period of months
and even years.
Nevertheless, even without experience, you still can weigh the opin-
ions of others against your own judgment. Ask questions. Explore their
reasoning. Verify their facts. As you look at properties, discipline your
mind to list and detail all features that make a difference. Before you at-
tach adjustment numbers to each property’s unique features, first observe
those differences.
Near the bottom of page 3 of the appraisal form, you can see a line labeled
“Indicated Value by Income Approach (If Applicable).” As shown there,
the income approach refers to an appraisal technique called the gross rent
multiplier (GRM).
To calculate market value using the GRM, find the monthly rents
and sales prices of similar houses or apartment buildings. For example,
through market research, you discover the following rental houses: (1) 214
Jackson rents for $1,045 a month and sold for $148,200; (2) 312 Lincoln
rents for $963 a month and sold for $156,000; and (3) 107 Adams rents for
$1,155 a month and sold for $168,400. With this information, you calculate
a range of GRMs for rental houses in this neighborhood:
GRM = Sales price/Monthly rent
Property Sales Price Monthly Rent GRM
214 Jackson $148,200 ÷ $1,045 = 142
312 Lincoln 156,000 ÷ 963 = 162
107 Adams 168,400 ÷ 1,170 = 144
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If the house you value could rent for $1,000 a month, calculate a
value range using the GRMs indicated by these other neighborhood rental
Subject House (Estimated Value Range)
GRM Monthly Rent Value
142 × $1,000 = $142,000
162 × 1,000 = 162,000
144 × 1,000 = 144,000
Thus, the value ranges between $142,000 and $162,000.
The GRM method does not directly adjust for sales incentives, fi-
nancing concessions, different features, location, property condition, or
property operating expenses. So this technique yields a rough appraisal.
Nevertheless, real estate investors use it as a quick rule of thumb. As with
the comp sales approach, the GRM works best when you find similar
properties in the same neighborhood.
For apartment buildings, the gross rent multiplier is calculated from
annual rent collections rather than monthly. For example:
Multi-Unit Income Properties
Property Sales Price Total Annual Rents GRM
2112 Pope (fourplex) $280,000 ÷ $35,897 = 7.8
1806 Laurel (sixplex) 412,000 ÷ 56,438 = 7.3
1409 Abbot (sixplex) 367,000 ÷ 53,188 = 6.9
The GRMs shown in these examples do not necessarily correspond to
the GRMs that apply in your city. Even within the same city, neighbor-
hoods differ in their GRMs. In the San Diego area, GRMs for single-family
homes in La Jolla can exceed 400; in nearby Claremont, you may find
GRMs in the 250 to 300 range; and in National City, GRMs can drop below
200. Even within the same neighborhood, GRMs for single-family houses
often exceed those of condominiums. In San Francisco, small multi-unit
buildings can sell with annual GRMs of 14 or higher. In Detroit, MI, I have
seen annual GRMs of less than 4.
As with all appraisal methods, search out relevant local data before
you calculate gross rent multipliers. To estimate market value, know the
local (micro) submarkets (type of property, neighborhood, features, and
condition). No set answer rules.
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To value apartment buildings, investors use the direct capitalization tech-
nique. Recall that the direct capitalization method applies the following
value formula:
V represents the value estimate. NOI represents the net operating
income of the property. R represents the overall<