Is this a $6,900 home bargain?
Detroit's four-figure home prices are unusual, but investors around the country think foreclosed houses are too cheap to pass up. How to tell a great deal from a money pit.
By Lisa Gibbs, Money Magazine
October 22, 2009
For a foreclosure, the house at 15461 Kentfield St. in Detroit needed surprisingly little work. The new owner, an investor from the Chicago area named Kevin Holmes, slapped on a coat of paint, pulled up the dirty carpets, and replaced the stolen water heater. The car stashed out back, he learned soon enough, belonged to a neighbor, not a thief using the three-bedroom as a makeshift chop shop.
The simple brick home really wouldn't look out of place in any middle-income Midwestern neighborhood. But in distressed Detroit, the Kentfield house sold for less than half the sticker price on a new Chevy coupe: $6,900.
Giveaway-priced homes are in danger of becoming as much a part of Detroit's identity as Motown, the Red Wings, and the Arsenal of Democracy. Real estate agents in America's 11th-largest city (it used to be No. 5) say they get calls from all over the world asking to see rock-bottom listings.
Surreally, despite a hollowed-out job market and the continuing flow of new foreclosures, Detroit is abuzz with real estate deals. Foreclosed homes in decent condition can sell within hours.
This city is the extreme end of a boom within the bust popping up all over the country as investors try to take advantage of prices not seen in years. (Nationally, home prices are down 31% from the 2006 peak.) Lots of the sales are foreclosures, although just about anything that's moving is cheap.
The activity is centered primarily in fading manufacturing hubs (such as Detroit and Cleveland) and the famous bubble cities (like Miami, Phoenix, and Sacramento). But investors are sniffing around for cut-rate deals just about everywhere from Memphis to Philadelphia.
So maybe you've thought about it too -- whether it was after watching another news story about Detroit real estate, or driving by a house in your town that used to cost $300,000 and now lists somewhere south of $200,000. As you'll see, though, squeezing a profit out of a house, even one as cheap as $6,900, is far from simple.
In this story you'll learn what it takes (besides iron guts) to be a successful investor in this market and how to avoid the rookie mistakes that can leave you stuck with a money pit. Detroit provides the examples, but the lessons of the Motor City apply to would-be investors in any down market.
Despite its economic free fall, Detroit has not become a wilderness where the rules of capitalism no longer apply. To the contrary, they are at work here with a vengeance.
Lesson no. 1: Forget about flipping: this is the landlord business
Holmes, the new owner of the Kentfield house, was born in Detroit but now lives in Aurora, Ill., where he recently retired from the police force. He came to Detroit looking for a house he could rent out for income. After closing costs and renovations, he'll spend around $15,000 on a property for which he expects to get $800 per month.
Minus the ongoing taxes and maintenance, plus 10% of the rent for a professional property manager, Holmes will pocket more than half the rent. That would earn him his money back in less than three years. He hopes to eventually own five properties, both to supplement his pension and, he says, to help the city where he grew up.
See how Holmes did it
Buying to rent used to be at the core of real estate investing -- and with good reason: As Yale economist Robert Shiller has shown, in many periods there has been very little real price appreciation in houses. Historically, residential real estate is often less like, say, a zippy tech stock than like an old-fashioned utility share that pays out regular income (in this case, rent) while, with any luck, gradually rising in value.
That changed in most of the country during the boom. With prices climbing 10% to 20% in a year, speculators bought property to sell within months or less for a profit. Rental income was barely a factor. Struggling Detroit actually saw a little bit of flipping, but that's now out of the question. None of the investors Money met in Detroit were assuming any kind of price appreciation, even when they paid something close to pocket change.
In the traditionally speculative markets, too, investors are thinking more about rents than they used to. Yes, you might have a better shot at a price gain in Las Vegas than in Detroit. (Automakers may never come back, but people always want to live in a warm climate.)
But that thinking is reflected in prices, and while the rate of decline in those cities has slowed substantially -- typically the sign of a bottom -- economists say that the constant stream of foreclosures and short sales could crowd the market for years, keeping prices in a holding pattern at best. You'll want some cash coming back in the meantime.
So a lot of the investing action around the country is in lower-end homes, which have a ready market of renters and are often priced low enough to be purchased for cash. That often means condos. A one-bedroom in the suburbs of Miami can be had for as little as $50,000 these days.
And rents, although down, are generally holding up better than prices. For one thing, they didn't get out of hand in the first place, and all those people who lost their homes still need places to live. In Miami, median apartment rents now exceed the monthly costs of owning a condo. The same is true in Phoenix and Las Vegas, according to CBRE Torto Wheaton Research.
Lesson no. 2: The purchase price is just the beginning of your costs
On Patton Street in the Mayfair Park neighborhood, real estate agent Scott McClue opens the door on a pleasant-looking three-bedroom house. The view inside is a would-be owner's nightmare. Thieves stole the hot-water heater here too -- but they also took the furnace. One of the back windows is gone, and the rest are old and poorly insulated. The cracked kitchen ceiling reveals water damage from a leaky, blackened bathtub upstairs.
As amazing as it sounds, $14,900 is way too much to pay for this house. An owner would have to spend at least $30,000 to make it livable.
One of the biggest investor mistakes is underestimating renovation and closing costs. Buying a property sight unseen is the quickest way to fall into that trap -- and it's a real temptation when other investors are snapping up foreclosures. If you do have a chance to look around, low-end properties can still have all sorts of problems you may not be able to spot immediately.
Unless you're really handy, take a contractor with you when shopping to give an estimate. As a rule, you should make a sale contingent on an inspection. But investors in the Detroit market say that this is sometimes impossible: There are enough buyers for foreclosed homes at these prices that many banks won't accept offers with conditions.
0:00 /3:10Deals abound, but so does blight
There are other costs to watch out for. Liens don't apply to properties that banks have already taken back, but they could be a factor if you're buying from a distressed seller or at a courthouse auction. (Most investors say to steer clear of auctions, by the way.) You also need to find out about the financial health of any condo or homeowners association.
To get a handle on it all, you'll want to work closely with agents, property managers, or in many cities, nonprofit redevelopment organizations. Not only will reputable professionals steer you away from the worst properties, but they will also help you get the paperwork ready to do a quick deal.
Still, you have to know going in that there's an irreducible level of risk in this game. Detroit agent Christine Winans has seen plenty of people get hurt. "They don't understand what they're getting," she says. "They have no idea about carrying costs, closing costs. It's the amateurs who are getting into trouble."
Lesson no. 3: you'd better have cash (and maybe a strong back)
Banks, burned by speculators who walked away from their properties after the collapse, aren't doing much lending to investors anywhere these days. And they aren't interested in loans of less than $35,000, making many of the low-end properties in places like Detroit unable to be financed, says area mortgage broker Brenda Brosnan.
And if you could get a loan, you'd lose out to buyers who have cash. That's true even if you offer more money: In Sacramento, agent Alan Wagner says a property recently drew 13 bids, and the sellers accepted a $140,000 cash offer rather than a $159,000 financed one.
Some would-be investors are tapping their retirement accounts or borrowing against the equity in their primary residence (if they still have equity), but clearly those strategies carry significant risks. Others are raising money from family and friends, and putting in old-fashioned sweat equity to keep other costs down.
Steve Morris, an automotive engineer renting out homes in the Detroit suburb of Warren, started out using his own cash but quickly figured out that he wanted to buy more properties than his bank account would allow. So he borrows money from friends and local investors, paying them interest rates as high as 11%. The financing means that it'll take longer on average to recoup his investment in a home. It also puts him on the hook for every mistake.
Morris saves money by managing his own properties: He spends his lunchtime and a couple of hours after work most days, plus about two weekends a month, on his real estate business. He has learned a few tricks that help him save, such as using the same paint and carpeting at every home so that he always has supplies in stock. For rehab work he employs friends who lost their auto jobs.
Lesson no. 4: know the town
Especially if you are buying in a place you aren't familiar with, it's all too easy to see a depressed market as one big clump of cheap houses. But even in Detroit, neighborhoods run the gamut.
And an investor there needs to spend a lot of time driving around to get a feel for an area, because the changes come street by street. The fact that a house is in a better-than-average neighborhood is little help if it's on a block spotted with vacant, crumbling homes. (The city says more than 30,000 unsafe properties ought to be demolished.)
Look for anchors such as a hospital or university campus, which will provide a regular base of renters, a plus during an economic downturn. Many investors in Detroit like the area around the University of Detroit Mercy, which is filled with brick homes set in well-manicured lawns. A house there can be had for $20,000, and may rent for $1,000.
Other investors are targeting close-in commuting suburbs, with their well-maintained streets and, compared with some of the newer, far-flung subdivisions, solidly built homes. Mike Sarwari, a California-based buyer, is focusing on such cities in suburban Memphis and parts of Texas.
Steve Morris is doing much the same in Detroit. His houses are in a suburb that's home to a General Motors tech center. He has picked up three-bedrooms there for as little as $9,000. Many of his renters are families leaving Detroit.
Lesson no. 5: know the tenants
Maybe the toughest part of real estate investing is that you are going to have to deal with tenants. And in a bad economy, that relationship can get especially messy. If your tenant can't pay the rent, not only do you lose money but you may also have to evict a person or a family from their home.
How can you avoid these problems? Moses Shepherd, whose real estate firm has bought more than 100 properties in Detroit, describes an intensive screening that begins with a detailed phone interview. Those who pass that test bring four weeks of pay stubs and other documents to his office. He talks to their current landlord and visits their residences to see how they care for their living space. That tells him more about a tenant than any credit report. "Who has good credit these days?" he says.
That said, some investors in former boom cities, particularly in south Florida, say the pool of tenants has actually improved in the past year, even if their credit scores haven't. It stands to reason: Three years ago almost anyone with remotely decent credit was buying, not renting.
Be realistic about the rent you're setting. Investigate what similar homes are going for, checking newspaper ads, websites, and Craigslist. Newbie landlord Holmes would rather keep rents affordable and give up some profit than risk the cost of an eviction. "Don't be greedy," he says.
If you'd rather not deal with those issues, you can hire a property manager, as Holmes has. That will cut into your returns -- managers typically charge an upfront fee plus 10% of the rent -- but the expense can eliminate a lot of hassles. It can also keep your home from sitting vacant.
Lesson no. 6: Investing brings responsibility as well as rewards
Unlike stocks, an investment in real estate turns you into a businessperson. Your actions affect your tenants' lives, and you're becoming part of a community. In a region that's struggling, absentee owners who buy a property and then don't take care of it only worsen the situation.
Detroit native John George, president of the nonprofit redevelopment group Motor City Blight Busters, has seen too much of that. "We don't want to be taken advantage of," he says.
The best way to be a responsible landlord, says George, happens to be the best way to ensure a good return: Know what you're buying, and be sure you have the resources to do it right. Too often outsiders think they're getting a good deal, and then discover that liens and repairs cost more than they have to spend -- and they walk away.
Burton Leland, the commissioner of Wayne County (which includes Detroit), is lobbying for a new law that would prevent owners from buying more houses until they've paid up taxes on the one they own. But he doesn't want to scare responsible investors away. A buyer willing to do the work can bring a neighborhood one small step closer to recovery.
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