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Don't buy that house -- yet

Not until you make sure all these factors are in place. A step-by-step guide.
August 11, 2005: 5:36 PM EDT
By Les Christie, CNN/Money staff writer

NEW YORK (CNN/Money) - You've fallen in love for the first time. Your instincts tell you to follow your heart, make a commitment. But would that be wise? After all, it does cost $400,000.

That may not be too bad for a three-bedroom, two-bath colonial on a half-acre plot in a nice part of town.

But it's still a lot of money, perhaps the biggest financial decision you'll ever make.So step back and do a simple exercise before you take the plunge.

Ask yourself: 

Do I have all my finances in place?

Crucial to buying at the right price is arranging for mortgage pre-approval.

"Cash buyers carry more leverage when it comes to negotiating a deal," says Tom Early, president of the National Association of Exclusive Buyer Agents. Pre-approval is almost as good as cash.

Pre-approval includes a verification of employment (which confirms the buyer's income) and a verification of deposit (which confirms the buyer's assets).

"We submit these pre-approval documents along with the offer," says Early. "We want the seller to think the buyer walks on water. The seller knows that, 30 days down the road, the buyer won't back out because he can't qualify for the loan."

Because pre-approved buyers also know exactly what their ceiling is, they can focus on properties they can afford. 

How do I know that the price is right?

Houses don't come with a "manufacturer's suggested list price" and comparable values are sometimes hard to establish. A real estate agent can arrange for a comparative market analysis (CMA), an independent appraisal of the value of the property based on other sales.

Try not to be so enamored of a particular place that you're tempted to overpay.

Keep a list of things you like and things you don't like about each house you see. That will help you make a more rational buying decision. 

Am I buying too much house?

Overextending yourself can cost years of grief. It could mean skimping on many of the other necessities of life -- and all of the luxuries.

Your mortgage payment should not exceed 28 percent of gross income and your monthly debt repayments should be no more than 36 percent. That means a household with income of $80,000 should keep their mortgage payment below $1,867 and their total bills should come to no more than $2,400.

Obviously, if you're paying heavy debt service on auto loans, credit cards, and student loans, that will leave less for the mortgage; you'll have to cut back from the 28 percent mark to keep total payments within the 36 percent maximum.

For a 30-year, fixed-rate mortgage, a monthly payment of $1,867 means you can afford a home costing about $410,000, given a 5.5 percent interest rate and a 20 percent down payment.

Many buyers who spend more than that count on mortgage options such as adjustable rate or interest-only loans to stretch their dollar, but these choices carry risks. The monthly costs of ARMs can leap after the initial low interest rate.

Right now, the average interest rate for a 5/1 ARM (which means its initial interest rate adjusts after five years and can change once a year after that) is currently about 5 percent.

By using a 5/1 ARM, you could afford a house costing up to $435,000, at least for the first five years. If you expect to be earning a lot more after that, an ARM might work well. Remember though, if rates soar, you may wind up ultimately spending a lot more for the house. 

What if there are problems with the house?

Every buyer needs to have the house inspected independently for defects and potential repairs before closing. "The choice is to have it inspected or to buy a pig in a poke," says Early.

Don't depend on real estate agents to recommend an inspector; they're trying to sell the house, not protect your interests.

You need someone working exclusively for you. Ask friends and relatives for recommendations, or go to the Web site of American Home Inspector for a directory of independent inspectors.

In some overheated markets, sellers sometimes balk at home inspection requests. In these circumstances you may have to make an exception and forgo the inspection. 

How long will I stay in the house?

People planning to live in an area for a very short time, say two years or less, should consider renting.

There's a host of buying expenses, many of which you have to come up with in cash, before you take possession of that front-door key.

There's title search and insurance, and attorney, recording and transfer fees. There may be flood certification and survey fees. You'll write a lot of checks at the closing and you don't recover these payments when you sell.

Swiftly rising prices could offset these expenses, even in the short term, but you can't count on that. Historically, housing prices have gone risen at a rate just a lttle faster than inflation.

Remember, like every other commodity, housing can go down as well as up.

NEW YORK (CNN/Money) - Real-estate investing is big business...and getting bigger.

Second-home purchases, mostly for investment purposes, last year accounted for more than a third of all single-family home sales in the United States, according to the National Association of Realtors.

Throw in sales of duplexes, apartment houses, and condos for investment purposes and you get some idea how many people want to play landlord.

And why not? Not only do you rake in rent money every month, you can also reap profits from soaring housing prices.

As any landlord will tell you, however, it's not as easy as it looks.

Erwin Jackson, who owns about 300 units in the Florida panhandle, has done well swooping in and buying from disillusioned landlords. "The best deals I ever got were from new landlords who six months in realized," 'This is a lot more work than I thought.'"

Ken McElroy, a founder of MC Companies in Scottsdale, Arizona and author of a bestseller, "The ABCs of Real Estate Investing," said too many buyers of rental properties look at is as an investment, not as a business. "But it's both -- the business part takes much more time than they imagined."

McElroy said the only properties he buys anymore are mismanaged ones, and there are plenty of those. The prices they command are low enough that he can spend some money to fix them up and turn them around -- and still rent them at a profit.

The biggest single mistake new landlords make, according to McElroy, "Is who they put in the asset. That's where the problems come from." 

Keep up the cash flow

The pressure to fill vacancies can be intense. Matthew Martinez, a landlord and real estate investor from Massachusetts who has a book coming out in a few months entitled, "Two Years to a Million in Real Estate," said, "Any vacancy is an attack on your financial prosperity. When I think about the money I lose every day I have a vacancy, I feel sick to my stomach."

Landlords have to screen renters carefully. "We run a credit check, a criminal background check, and now a sex offender check on every applicant," said McElroy. In addition to making sure tenants will pay their rent, there are liability issues involved. Landlords can be sued if they negligently rent to criminals.

These checks, however, are far from foolproof. "You can do a great background check, even have a perfectly wonderful tenant for a year or two," said Martinez, "and still, all of a sudden, get in trouble."

Martinez rented a Boston apartment to a woman who, after many months living there, began to "date the wrong person," he said. "She started using drugs, then she started dealing drugs, although I couldn't prove that."

Evicting her took five months, and she paid no rent that entire time. And if he hadn't gotten her out, it could have caused more problems. What if another tenant had been injured because of the criminal activity?

Lawsuits of all stripes prey on landlords' minds. Jackson said his company provides many services to his renters just to avoid legal hassles.

"Early on," he said, "one of my tenants borrowed my lawnmower. He hit a piece of metal in the grass. His roommate was sunning himself nearby and the metal flew up and opened a gash in his forehead. The roommate sued me. Now we do all the lawns, replace fluorescent light, repair the windows; I don't want tenants doing anything." 

Day by day

Besides these acute problems, there's the everyday hassle of managing the paperwork, overseeing contractors, paying the ever-increasing taxes, collecting rents, and looking after the properties.

Getting called in the middle of the night to fix someone's clogged toilet is not for everyone.

Even when you can afford to let others handle the day-to-day headaches, there are other rough seas to navigate.

Gary Cherry farms out the management duties of the three properties in Tallahassee, Florida he owns, two small and one medium-sized multi-family sites with a total of 75 units.

The largest, a 66-apartment building, was the latest purchase and has proven the most difficult. "The building had a lot more problems than I thought," said Cherry. "Afterwards, you scratch your head and say, 'Why didn't I notice that.' You have to look the structure over very carefully." 

 Doing the math

Buyers of investment properties must make dispassionate assessments of the benefit they'll derive from their investments and the downside risk involved. Landlords can't afford to fall in love with a property like an owner of a primary residence can. It boils down to a numbers game: How much cash will flow from the investment? For many landlords, cash flow is essential because they can't really count on housing prices to continue to soar.

One key calculation is the "cap rate," annual rents you can collect versus the property value.

For a property that costs $500,000 dollars and generates $3,300 per month in rent, the cap rate would be nearly 8 percent ($39,600 divided by $500,000).

"Anyone who gets less than 8 percent cap rate is going to be out-of-pocket every month," said Martinez.

That's because out of that $39,600 in rents, the landlord must pay the mortgage (at recent rates of about 5 percent for a $400,000 loan, that would come to about $3,167 a month) and pay for repairs as well. At 8 percent, even just routine repairs and replacements can wipe out your profits.

Then too, if a landlord finds himself spending for repairs of structural defects that he didn't identify before the purchase and didn't plan for, it can really wreck his budget.

As Erwin Jackson said, "Everybody wants to try it and I would encourage them to do so. Just make sure they have my phone number so they can get in touch when they're ready to sell."



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