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Should I buy this house as an investment property? What is cash-flow?

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Question:

I am offered a great deal on a single family home in San Jose, before it comes on the market. It will be listed on the MLS (Multiple Listing Service) for $800,000. I can buy it from the owner with no real estate agents involved for $750,000. A comparable houses on the same street sold 2 months ago for $830,000. Should I buy this house as an investment?

Answer:

There are two reasons to buy an investment property.
1) for appreciation with the intention to sell or for a quick flip (you'd sell within a few months)
2) to use it as a rental and hopefully make some small profit on the rent. If you sell it years later for more than you pay now, that's the icing on the cake.

Let's first look into reason 1 – buying for appreciation.

Let's look at the numbers. Looks like you save quite some money, at least $50,000. Now imagine you want to sell in 3 months and assume you get a price of $830,000. Now the transaction cost of sale is going to bite you. The seller has to pay for the real estate agent commission. Traditionally that's 3 + 3% = 6%. On 830k a 6% commission would be $49,800 already! You may be able to find a seller's agent who works for 2 or even 1% (however, I found that the 1% guys are not worth calling them). Additional transaction cost is what you paid as a buyer at the time of buying the house like title insurance. Property tax on a 800k home is likely to be at least $7000 annually, pro-rate that for the 3 months and also do not forget the interest that you pay to finance the house for these 3 months. That most likely amounts to another $8000 in interest, to be taken off your imaginary $80,000 profit. Also you'll have a heavy tax hit if you sell within the first 2 years after the purchase.

At this point you probably see that the $750,000 was a good price but even if you sell for $830,000, you are just about to come out even. If you'd sell for $810,000 you would be at a loss.

The way to go is to ‘take the house under contract'. You tell the current owner that you will buy it for $750,000 and at the same time you look for a buyer who will buy it from you for $800,000, pointing out that the comp sold for $830,000. Never mind the fact that prices may have come down since then – yes, that DOES happen even in San Jose in 2005. Once you have the buyer, you bring them together and you personally never were on the title, nor did you get a loan to finance anything. No real estate agents involved either. You save almost all of the transaction cost and make a $50,000 profit.

The conclusion is that it makes no sense to actually buy the house for short-term gain.

Now let's look at whether it qualifies as a real investment property – reason 2).


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