Flipping real estate ... without getting burned
By Jane Hodges
Special to The Seattle Times
Investors fed up with stocks are scooping up property
In December, Paul Galasso quit his Costco management job to join his wife, Evelyn, as a full-time real-estate investor.
The leap from salaried manager at a $48 billion public company to residential real-estate entrepreneur wasn't impulsive, Galasso said. The couple made more than $100,000 from five Eastside deals they completed during 2004.
Galasso, 38, is among the growing ranks of weekend real-estate investors in the area who, encouraged by a housing market that continues to sizzle and buoyed by the success of initial deals, have decided to pursue the practice full time.
Galasso is a member of the Real Estate Association of Puget Sound, or REAPS, a nonprofit real-estate education group that has tripled its membership to 900 since 2003. He and his wife have spent more than $20,000 on investor "boot camps" and seminars to learn how to make deals — and he says every dollar has been worth it.
The National Association of Realtors in Washington, D.C., released survey results in March indicating that 23 percent of all residential real-estate transactions in the U.S. last year went to investors, rather than to buyers looking for a place to live.
Association spokesman Walt Molony said he believes this level of investor activity would apply to a market like Puget Sound's. Glenn Crellin, director of the Washington State Center for Real Estate Research in Pullman, agrees.
Investment tips
For those thinking about investing in residential real estate, experts offer these tips:
Do your homework: Stick to one particular part of town and get to know it like the back of your hand.
Start small: Find something you can live in while you fix it for resale. Avoid something needing massive renovation.
Buy low: Know the market to help avoid paying too much for a property, the mistake that most often leads to losing money. Some experts recommend that investors buy properties at 30 to 50 percent below their market value after they're fixed up. Often, this means looking for properties owned by motivated sellers — owners facing foreclosure or people who don't have the time or money to fix up their homes.
Choose a quick flip instead of a wealth builder: Before buying a property with the intention of reselling it quickly, look for at least a 20 percent profit margin after subtracting rehab expenses, taxes, commissions, financing and other costs. A 20 percent profit is something of a break-even point because most interest-only loans available to buy investment properties cover 80 percent of a home's expected market value.
Rely on experts: Seek out mentors and experts, including a good banker and an accountant, who can help you avoid costly mistakes. Consider Nashville-area investor Toby Hildabrande and his wife, who thought they were getting a great deal until their inspector discovered the property was once a gas station and probably had environmental issues.
Get an accountant: Taxes on investment properties can get complicated quickly. Anyone remodeling a home must have builder's risk insurance, and rental owners must have a fire-insurance policy with large liability limits.
Keith Russell, The Tennessean
Galasso said his bosses were shocked when he left. But among his peers, the move to real estate isn't unusual. Galasso said he knows people just like him in Georgia, Texas, California and beyond now investing in residential property.
"The hard part is knowing where to start," he said.
Many also say it's important to do research first because novices can lose a lot of money if they don't know what they're doing.
Why real estate?
The real-estate market has been booming locally and nationally for years. Around Puget Sound, the combination of low housing inventory and low mortgage-interest rates has created a seller's market. The average price of houses and condos combined has risen more than 24 percent in King, Snohomish, and Pierce counties between 2000 and 2004, according to data from the Northwest Multiple Listing Service.
But rising property prices aren't the only thing driving folks like Galasso into the business: The dot-com crash and stock-market declines of 2001 made many investors rethink their reliance on stocks and seek alternative investments. Since then, they've been doing their homework on how to invest in property.
"I lost a ton of my portfolio in 2001, and that's happened to a lot of people in America," Galasso said. "It spurred my interest in learning that there was a better way out there. I'm the last of 11 children — the oldest is 21 years older than me, so he's 59, and he's still working hard."
He believes the retirement of baby boomers will drain the market and that Social Security's uncertain future means diversifying now is crucial. He's serious about moving away from old-school stocks and mutual funds: Around the time he left Costco, Galasso and his wife fired their financial planner and shifted 75 percent of their retirement resources from regular equities and mutual funds held in a traditional IRA into a "self-directed" IRA that they can use to fund real-estate deals.
How the deals work
Mark Schmale, president of REAPS, says that most people who join his organization want to learn about nontraditional investment strategies that they can use to buy single-family homes.
About 90 percent of members use some form of "looking to buy" marketing to find sellers who want or need to sell quickly, Schmale said. Those who want long-term investments focus on lucrative Seattle neighborhoods such as Green Lake, Queen Anne and Capitol Hill. Short-term gains can be found almost anywhere throughout the Puget Sound region, he said.
Among the techniques members and other investors use:
• Buying, holding and reselling fixers without repairing them;
• Buying and repairing fixers to sell at a profit;
• Wholesaling, or flipping — making an offer on a home and, before closing, finding a buyer who will pay more for it (this leaves the investor the profit);
• Signing lease-option deals in which investors rent out a property at above-market rent to a tenant who wants the right to buy the place at the end of the lease.
Doing the homework
Making money as a real-estate investor requires more than buying and selling properties using conventional mortgages and real-estate agents, Schmale said.
"A lot of people come into the market not knowing the true costs involved," he said. "Of course, [learning that] is the responsibility of each individual."
Real-estate investments
Many local investor groups are optimistic about the potential to make money in the current real-estate climate, but they all recommend doing homework — reading, attending seminars, networking with other investors before cutting deals.
Here are some of the techniques many investors use:
Flipping
Pros: You make an offer on a property and secure a new buyer before you close on the property, diverting the property to the new owner and pocketing the difference between your offer and theirs. In a hot market, this means you can make money fast.
Cons: You may end up closing on and holding the property if you don't find a buyer, which could tie up cash and lead to capital-gains taxes if you choose a short-term resale. If you have multiple wholesale deals in progress, you could get financially over-obligated.
Rehabbing a fixer
Pros: If you know how to do the work or have a network of inexpensive contractors, the likelihood of making a profit is high.
Cons: This can be capital-intensive, and if the home is in terrible condition, it can be difficult to secure a lender. Work — and the resale — can take a long time, tying up capital.
Lease-purchase options
Pros: You can charge higher-than-market-rate rent to tenants who intend to buy your home (and thus serve as quality renters), guarantee your sale price, avoid real-estate-agent commissions, and reduce capital gains by not executing the sale until a later date.
Cons: You will need a lawyer to learn how to structure an agreement correctly, and tenants attracted to this often have sub-par credit.
Foreclosure purchases
Pros: Properties are available at discount, and informed buyers can leverage some new loan products to bring more cash to auction and skirt some liens owed on the property.
Cons: Often you can't see a home's interior before buying it, meaning repair spending could skyrocket. You may also inherit liens on the property, adding to the expense.
Jeff Wolfson, a residential land-development specialist at Skyline Properties in Kent, is researching investment opportunities for himself and clients.
Wolfson, who has been in the industry for nearly 20 years, says many investors are overextending themselves on the assumption that the market will remain favorable. He believes low interest rates contribute to this, he said.
Interest rates on fixed 30-year mortgages haven't gone above 6.5 percent since late 2002, according to data from HSH Associates, a research firm in Pompton Plains, N.J. In Seattle, the typical 30-year fixed mortgage rate was 5.92 percent last week, HSH data show.
"I've been in the industry long enough to see how it operates in cycles — and it cycles on [mortgage] interest rates," Wolfson said. "I believe the market right now is in a bubble — people are putting 10 percent or 5 percent or zero down, or they're taking adjustable rate mortgages, but then one day their renters can't afford the rent, and the owners aren't prepared for that."
Wolfson's belief is reflected by Robert Shiller, the Yale University economist whose book "Irrational Exuberance" foretold the dot-com crash. Shiller's latest book ("Irrational Exuberance: Second Edition," Princeton University Press) was published in March and compares investors' current zest for real estate with their behavior during the dot-com bubble.
The book argues that investors have shifted their money from stocks to real estate and that, en masse, they are using the same mentality that created the hyperactive dot-com economy. Only now they're using a different asset: housing. Such a marketplace, the book argues, must eventually correct itself.
Mix-and-match portfolios
To counteract the potential risks, many investors use a mix of strategies. They want to balance the benefits of holding a home long-term with short-term deals that allow them to keep more cash on hand.
Roz Burton, 32, of Bothell is a club member who invests with her husband, Kerwin Burton, 33. She said they have closed six deals since July 2004, and they are working on more. She now works full time on real estate; her husband, part time.
The Burtons have experimented with several types of transactions. After they married two years ago, they began renting out the two condos they had lived in. They sold one condo to buy a house in Mill Creek that they will rent out.
They're selling their other condo in Kirkland through a lease-option deal. The two-bedroom unit in Kirkland would rent to a regular tenant for $1,000, but in a lease-option they're able to charge $1,500 ($1,200 for rent, and $300 a month toward the tenant's down payment).
After a year, the tenant can either buy the unit or the Burtons can start the process over again — making $2,400 more a year from rent than they would have without the lease-option deal. (The tenants get the down-payment money back if they don't buy.)
The Burtons also have flipped properties, such as the fixer they found in Burien for under $90,000 that they sold to an agent for $100,000.
The Burtons spend much of their time looking for sellers — cold-calling, knocking on doors or mass-mailing — or trying to cut deals without real-estate agents who charge commissions. They pay scouts a $500 reward if a lead becomes a deal.
For investors, the key to a good deal may be tracking down people like the Canadian who had neither the time nor the money to repair a Queen Anne fixer. He sold his house to the Burtons for a bargain; they made a profit selling it to a builder.
Foreclosures
The Puget Sound investment organization isn't the only group teaching investment techniques.
In 2003, three Windermere agents and a partner formed The Foreclosure Group, a resource for investors that offers property photos, financial history, comparable properties in the area, and status updates on the home's auction, said Christopher Hall, one of the partners.
Kerry Hemmingsen, another partner, told the 20 or so investors who came to an April 21 meeting that 1,400 foreclosures take place each month in King, Pierce and Snohomish counties combined, the majority because of divorces.
Hemmingsen and other partners lead investors in weekly information sessions to outline the different types of foreclosures and how his company's service and commission fees work. Investors who decide to bid on a particular property attend a huddle the evening before the property they want goes to auction. On Thursday nights, it's all about discussing strategies.
Michelle Dickerhoof, 35, attended the April 21 session to learn more about how the company operates. Dickerhoof quit her corporate-affairs job at Starbucks last fall to collaborate full time with her contractor husband to find fixers to invest in.
The couple already own an investment property in Edmonds and plan to use their primary home in Magnolia as a rental down the line. Having contracting know-how, she says, gives her and her husband confidence about dealing with the uncertainties of a foreclosure. (Unlike normal listings, buyers can't walk through or inspect most foreclosures before purchase, so it's hard to predict repair costs or the home's true condition.)
Right now, Dickerhoof is working on buying one of two Magnolia foreclosures set to be auctioned before May 6. She's just secured a home-equity line of credit on her primary home to pay for the new properties. She expects the two properties she's eyeing — a 1960s home with a starting bid of $238,000 and a 1950s cottage with a minimum bid of $224,000 — could be resold for around $400,000 after they're fixed up.
Different sort of investment
Schmale, the Puget Sound investment-group president, says investing in real estate is fundamentally different than investing in stocks and mutual funds: Real-estate investors are more actively involved in influencing their investment than those who put money into stocks.
The investors who flock to real estate, in the end, may like the participatory aspect of it the most — doing the research, overseeing renovations, cutting deals.
"In real estate I can do a lot to increase the price and value of my holdings, which isn't true of having stock in some large company," Galasso said. "By the end of this year, we'll be doing two to three homes a month."
And he doesn't regret leaving his management job. "This is so much better than being in a cubicle."
Jane Hodges is a Seattle freelance writer.
Rogue
