Credit: Shutterstock photoWant a good way to build wealth? Own commercial real estate. But only if you are willing to undertake due diligence that may not be readily available online, make a big hands-on commitment to mind the investment and exercise enormous patience.
Real estate is one of the largest asset classes in the world. The family home is the largest asset many middle-class Americans own. And real estate makes up a significant portion of the net worth of many wealth accumulators.
Directly owning real estate is not an investment for the faint of heart, the armchair investor or the uneducated. Most wealth accumulators do well to leave direct ownership of real estate to the pros and invest in real estate investment trusts (REITs) instead.
Still, the lure of investing in a tangible asset like real estate is enticing for high-risk tolerant investors who need a sense of control and interaction with their investments. If you are among them, here are a few guidelines that may keep you on a profitable path.
1. Don't attempt to purchase investment real estate without the help of a commercial property specialist who is a fiduciary, bound to look out for your best interest. Engage a Certified Commercial Investment Member (CCIM) with years of training and experience in analyzing and acquiring investment real estate to advise you. To find a CCIM near you, go to http://www.ccim.com , under the "networking" tab, where you click on "find a professional."
2. The broker you work with should be a member of the National Association of Realtors , which has a code of ethics. You must receive a disclosure agreement that tells you who the Realtor represents. Be sure the Realtor you engage represents you and not the seller or both parties.
3. Never trust the income and expense data provided by the seller's Realtor. While a seller represented by a CCIM has a greater chance of supplying you with accurate data, most will significantly understate expenses and overstate your investment return. Selling Realtors often understate the average annual cost of repairs and maintenance. I estimate this annual expense at 10% of income.
4. Another often-understated expense is management. Many owners manage their own properties, so the selling broker doesn't include an estimate for management expenses. They should. Real estate doesn't manage itself, ever. You either need to hire professional management or do your own management (always a scary proposition). Even if you do it yourself, you have an opportunity cost of your time, so you must include a management fee in the expenses. Most small residential apartments and single-family homes will pay 10% of their rents to a manager.
5. You must verify all the costs presented to you by the seller's Realtor. Demand copies of at least the last three and preferably five years of tax returns. Research utilities, property taxes, legal fees, insurance costs, repairs, maintenance costs, replacement reserves, tax preparation and management fees. As a rule of thumb, expenses average 40% of rental income on average-aged properties where the tenants pay all utilities except water. Newer properties may have expenses as low as 35%, while older properties can be as high as 50%.
6. By subtracting the vacancy rate and stabilized expenses from the rent, you find the net operating income. This is the income you put in your pocket - assuming the property is paid for. Divide the net operating income by the purchase price, and you find the return you receive on your investment, called the capitalization or "cap" rate . In Rapid City, where I live, the cap rate tends to be 4% for single-family homes, 5% to 8% for duplexes to eight-plexes and 8% to 12% for larger residential and commercial properties.
Yes, you can build wealth with real estate. You just need to educate yourself, work hard, start conservatively, think long-term, and be prepared for lean years. This is not a quick or easy path to riches.
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Rick Kahler, CFP, is president of Kahler Financial Group in Rapid City, S.D.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
