It is not surprising that we are seeing larger audiences at real estate investing programs.  People are looking for ABS investments – Anything But Stocks – after watching their 401(k) plans drop 40% in value.  Housing prices have plummeted, and rates are historically low.  It’s a great time to invest in real estate.  But how does one get started?

The task can seem confusing.  There are so many variables, the decision process can be overwhelming.  First, there are several different ways to invest in real estate:  buying rental property, purchasing tax liens, options, and notes, even hard money lending and investing in REITs.  There are different types of real estate:  single family homes, condominiums, apartment complexes, commercial properties, and raw land. 

There is simply not enough room in this blog to do justice to the entire scope of information necessary to explain real estate investing, but a few key points are worth mentioning.  For more information, I strongly recommend that the new investor attend real estate investment seminars, talk to other investors, and yes, read the books and articles on real estate investing.  Most importantly, I urge the new investor to choose a small, low-risk investment and try it for a short duration. You will truly learn more “by doing” than what anyone else can ever hope to teach you!  You will also learn more about your tolerance for risk!

First Step:  Make a Plan.  The first and most important step is to consider both your personal and your financial objectives, and develop a plan based on these two factors.  You can do this while you are reading some books and attending seminars.  Just be sure to make a Plan before you write your first check!  For example, your personal goal may be to focus on raising your family, taking more vacation time, and getting more involved in community activities.  Your financial objective may be to earn enough through a combination of salary and investments to support your chosen lifestyle, and set aside enough for a retirement at a specified age.  Your financial objective should support your personal objective, not the other way around.

From this important step, you can start to determine how real estate investing can help you achieve your goals.  You need to consider how big (or small) a project you want to tackle, so that you can achieve your financial objectives without sacrificing your personal goals.  You also need to consider how involved in the process you intend to be – it’s the difference between “involved” and “committed.”  Think “Ham and Eggs.”  The chicken is “involved;” the pig is “committed.”  New investors who become Landlords quickly start to learn a lot more about plumbing, eviction procedures, and dumpsters than they ever thought they would.  One of reasons many people choose not to become Landlords is because they don’t want to be dealing with “toilets, tenants, and trash.”  It can be time-consuming, frustrating, and if you don’t manage it properly, the investment project can take over your life!   (Hint:  Hire a good Property Manager!)

There are basically three ways the investor makes money by investing in real estate.  The first – and some would argue the most important – is cash flow.  The formula is simple:  Income minus Expenses = Cash Flow.  Income from rents or leases need to be enough to cover your costs, which include your mortgage payments, taxes, insurance, maintenance and management fees.  The second way that the investor makes money investing in real estate is through appreciation – assuming that the property value increases over time.  An increase in value combined with the amount you are able to pay down the mortgage results in “equity,” which is simply a measure of the difference between the value of what the property is worth and what you owe on it.  The third way that an investor makes money investing in real estate is through depreciation – a pro-rated tax deduction that you use to offset a portion of the income over time.

Most real estate investors focus on the first two factors:  cash flow and appreciation.  As it turns out, you generally get one or the other – not both.  In areas where housing prices tend to climb steadily over time, purchasing at any price will result in a gain in value just by holding onto it for a long enough period, provided that the cash flow is not too negative.  It’s a relatively simple math problem, provided you factor in the tax considerations.  (Hint:  Learn to do some math and get a good tax advisor on your team!)  In some housing areas around the country, especially where there is good job growth, rents will be strong enough to generate positive cash flow.  Even if the value of the property does not increase all that rapidly, an investor can realize regular income from cash flow.  (Hint:  if the amount of rent is equal to or greater than one percent of the purchase price, it generally will have a positive cash flow.)

For a quick primer on some of the other factors you should consider before investing in real estate, I recommend that you read my article “The Five ‘P’s of Prudent Real Estate Investing.”  I also suggest that you find a real estate investment group or association in your area.  Many of these groups provide a wealth of information, advice and networking opportunities.  You will meet others like yourself, as well as experienced investors willing to share their knowledge and tips.  (Hint:  Be careful – everyone is different.  What works for one person may not work for another.  Listen and learn.)  Some investment groups provide bus tours of investment properties in your area, and teach you how to make simple investments.  Still others allow you to pool your money into investments, if that is what you would prefer to do.  Mostly, these groups give you the unique opportunity to meet and talk with experienced investors, learn about investment opportunities, and connect you with the key people who can help you:  lenders, brokers, financial planners, attorneys, tax specialists, and accountants.

Getting started in investing in real estate is really all about getting started.  Thinking about getting started won’t accomplish anything.  Take action.  Go to the library and check out two or three books on real estate investing.  (Hint:  Focus on learning the terminology; ignore the editorializing.  Many authors tend to promote the “one best way” to make money – there is no “one best way.”  And, Big Hint:  most of these books were written before the very recent housing crisis and market crash in 2008.)

One final piece of advice:  Invest, don’t spend, your money.  If your ultimate plan is to make money investing in real estate, invest in real estate.  There are several promoters who make a fortune selling seminars, software programs, CDs, books, and even cruises and board games about investing in real estate.  Some of these are excellent for learning about real estate investing, but choose wisely.  Some people spend all of their money into programs about real estate, rather than invest in real estate itself.  Ask yourself:  will the seminar, books, or materials teach me how to make more money than the cost of the program (including the cost of your time)?  Now, you’re starting to think like an investor!  Get started!

Important:  This brief summary is provided as a quick guide only; a link to the official details and an online eligibility assessment tool provided by the U.S. Dept. of the Treasury is provided below.

UPDATE:  On March 5, the House passed the “cramdown” legislation, which would allow Bankruptcy Judges to modify the mortgage on a owner-occupied home, provided the homeowner first made a good faith effort to complete a loan modification with the lender.  The measure now goes to the Senate where it is expected to encounter stiff opposition from lenders.  See Washington Post article.

As promised, the U.S. Dept. of the Treasury released the Homeowner Affordability and Stability Plan (HASP) Guidelines on March 4, 2009, to take effect immediately.  There are two basic components of the Making Home Affordable plan:  refinancing and modification.  Most of this discussion will focus on the Home Affordable Modification Program, but first a quick comment about eligibility for the refinance component.

To be eligible for the Home Affordable Refinance program, the property must be owner-occupied, the borrower must establish they have income to support the new mortgage debt, and the amount of the first mortgage cannot exceed 105% of the current market value of the property.  Junior lienholders must agree to subordinate, borrowers may not take cash out, and borrowers who are delinquent will not qualify.  Details for the new refinance options for existing Fannie Mae Loans are set forth in FannieMae Announcement 09-04, released March 4, 2009.

To be eligible for the Home Affordable Modification program (HMP), the property must be owner-occupied, not vacant or abandoned, the current mortgage payment must be more than 31% of the borrower’s gross monthly income, and the borrower must have experienced a significant change in income or expenses to the point where the current payment is no longer affordable.  The borrower need not be delinquent, but they must be at risk of “imminent default.”  Jumbo conforming loans up to $729,750 are eligible for the HMP.  Participating servicers are required to follow specific steps in the Guidelines to attempt to reduce the monthly mortgage payment to as close to 31% Debt-to-Income (DTI) ratio as possible.

The modification process, referred to as a “Waterfall” process, starts with a determination of Monthly Gross Income, then validation of total First Mortgage Debt — monthly PITIA.  Servicers are then required to capitalize all arrearages, and target achieving a DTI of 31% by incrementally reducing interest rates down to a minimum of 2% for a five-year period.  (After that, the rate will increase by no more than 1% per year until it reaches the Interest Rate Cap.)  The next stage in the “Waterfall” process is to extend the term up to 40 years, starting with the date of the modification.  If this is insufficient to achieve a DTI of 31%, the servicer is expected to forebear principal, to be due upon maturity date, sale of the property, or upon payoff of the interest-bearing balance.  No interest will accrue on the forbearance amount.  Under no circumstances may the modified balance due be lower than the current market value of the property.

No principal reductions are required under the HMP, but lenders may, at their option, elect to reduce principal if necessary to achieve a 31% DTI.  The program will reimburse servicers for a portion of the cost of a principal reduction.  Each borrower will undergo a 90-day trial period.  No incentives may be paid until the 90-day trial period has been completed.  Lenders may not charge the borrower any fees or charges for this modification process.  Junior lien holders will be required to subordinate to the modified loan, and the HMP provides an incentive payment up to $1,000 to pay off junior lien holders, and an additional $500 incentive payment for efforts to extinguish  second liens.

If, after going through the process, it is determined that modification is not an option, the Guidelines suggest that all loss mitigation options be considered, including any possible refinancing options available outside of the program, and if homeownership retention is not possible, program counselors should discuss short sales and deeds in lieu of foreclosure as ways to help the borrower transition to more affordable housing.  Incentives for participating services are available for alternative approaches, and borrowers may be eligible for relocation expenses to effectuate short sales and deeds-in-lieu of foreclosure.  The ultimate objective is to minimize the impact of vacant and abandoned properties on local communities.

Foreclosure actions will be suspended during the process.  Therefore, it is important that any person facing foreclosure initiate all steps necessary to start the process immediately.  Persons in this situation are advised to contact their lender, and to call the Homeowner’s HOPE Hotline at 888-995-HOPE.  To find out if you may be eligible for a refinance or loan modification under the Program, you can go online determine whether or not you are eligible.  This self-assessment tool is made available by the U.S. Dept. of the Treasury at www.financialstability.gov.

There are a number of lessons to be learned from a just-published decision by the Fifth Appellate District of the State of California, which held that a City’s demand for increased in-lieu fees from a housing developer was not “reasonably justified.”  When the developer initially obtained approvals to build 214 housing units, the City of Patterson (Stanislaus County) imposed a fee of $734 per house, to be paid “in lieu” of requiring the developer to build “affordable housing” in the subdivision.  The Development Agreement between the developer and the City specified that the fee would be due when the developer pulled building permits, and noted that the City was working on an updated analysis that would result in an increase to this fee.  When the developer went to pull the building permits, the City announced it had raised the fee to $20,946 per house.  The developer sued the City, lost at the trial court, and then appealed.  The Court of Appeal ordered the City to vacate the fee and remanded the case back to the trial court to determine an appropriate remedy.  Building Industry Assn. of Central California v. City of Patterson.

Looking beyond the inherent absurdity of the extraordinary increase in fees, there are several less obvious but significant lessons here.  First, for real estate investors, the case illustrates the level of uncertainty that lies beneath the routine process of securing entitlements and going through the development process.  The developer initially obtained City approvals and entered into the Development Agreement in January, 2003.  The increased fee was imposed three years later.  The trial court ruled in favor of the City on December 20, 2007.  The Court of Appeal reversed on January 30, 2009 (modified Opinion issued March 2, 2009).  Six years elapsed between the original “approval” and the Court ruling in favor of the developer, and the case still has to go back to the trial court for determination of a “remedy.”

Developers often argue that by building more houses, the costs are spread out so as to reduce the individual price of each home.  In other words, allowing greater density will increase affordability.  The Court noted that the average cost of housing in Patterson was rising from around “$157,000 in 2001, to $247,380 in 2004.  According to the City, this created an “affordability gap” that was used to justify the imposition of the $20,946 “in lieu” fee.  By the time the Trial Court heard the case, the average price of a home in Patterson had increased to around $350,000.  The City of Patterson has a population of around 20,875 and a median annual income of slightly less than $60,000.   In developing its Fee Justification Study, the City had determined that it needed 642 new “affordable” housing units, and based the “in lieu” fee on what it calculated to be the “affordability gap” for moderate, low and very low income families, based on housing prices at the time.  The Study concluded there was a “gap” of $73.5 Million, and estimated there were 3,507 “unentitled” lots in the City, or $20,946 per lot.

The Court ruled that the City’s determination of the fee was based on the estimate of the City’s need for 642 affordable housing units, and had no connection to the need for affordable housing generated by the developer’s market rate project.  Therefore, the fee was not “reasonably justified” as required under the law.  It is interesting to note that the average price for a house in Patterson has dropped to $168,166, and there are approximately 1,278 foreclosures out of slightly more than 5,000 dwelling units in that City.  In other words, the average price of a house in Patterson has dropped almost back to the levels that were in existence in 2001, when the City only imposed an “in lieu” fee of around $340 per lot, the the trend is clearly downward.

The Court case does not provide any detail as to whether the imposition of the extraordinary fee resulted in any delays in building, but the legal proceedings, which extended over a six-year period, certainly cost the developer and the City a fair amount in terms of resources, time, and legal fees.  Moreover, bringing the houses to market in 2007, when the average market price was over $350,000 — would yield a much different ROI than in 2009.  Assuming that the in-lieu fee would have been tacked onto the price tag means that the cost of an average house would have been increased by an amount equivalent to the amount of a down payment required to purchase the market rate home.  Instead of giving the City the funds, the developer could have contributed the down payment for each of the 214 housing units, and effectively provided “affordable housing” for over a third of the City’s estimated shortfall.  Instead, the imposition of the extraordinary fee only served to generate litigation, not housing.

As so often happens, an otherwise well-intentioned but ill-advised policy decision has resulted in what can only be expected to be a financial disaster for the budget and fiscal stability of another California municipality.  No one faults the City for seeking ways to create more affordable housing, but faulty execution of the policy failed to achieve the goal.  Investors probably lost a considerable amount due to delays, and the City of Patterson is faced with an adverse ruling, rising crime rate, and one-in-four of its houses in foreclosure.  Of course, the imposition of the unjustified housing fee was not the cause of the current recession, but one wonders if a more enlightened approach to solving the affordable housing dilemma might have cushioned the blow.