A real estate investment trust (REIT) is a form of collective ownership, similar to a mutual fund, in which a corporation offers securities representing an asset base of real estate properties. REITs can own residential and commercial property. Publicly traded REIT shares are sold on exchanges, whereas other types of REITs are offered via private placements, secondary markets or broker/dealer transactions.

Equity REITs purchase properties to generate rental income and capital gains on property sales. Mortgage REITs purchase mortgage notes to collect interest and principal payments, and which act as liens allowing holders to foreclose on properties in default. Hybrid REITs share characteristics of equity and mortgage REITs.

A REIT must meet the following standards:

• Must be organized in an entity that is taxed as a corporation, with a board of directors and at least 100 shareholders. No more than half of its shared can be held by five or fewer persons.
• REITs must pay at least 90 percent of their annual taxable income as dividends to shareholders.
• Invest at least 75 percent of its assets in real estate
• Earn at least 75 percent of its income from sales of real estate, interest on mortgages and rents.
• No more than 5 percent of income can be derived from non-qualifying sources, such as non-real-estate business or service fees.
• REITs can’t own more than 10 percent of the voting shares of non-REIT corporations. Such stock can’t comprise more than 5 percent of assets. Stock of taxable REIT subsidiaries cannot make up more than 25 percent of the REIT’s asset value.
• REITs must annually mail shareholders to gather information about beneficial ownership of shares.

Meeting these requirements allows REITs to avoid taxation, instead passing income and capital gains through to shareholders, avoiding double taxation.

Public, Exchange-Traded REITs vs Private REITS

Publicly traded REITs are registered with the Securities and Exchange Commission and are first distributed through an initial public offering (IPO). The shares trade on national stock exchanges and are available to the general public. These are not to be confused with unlisted REITs, which are SEC-registered but trade away from the exchanges, through broker/dealers and private treaties.

Private REITs are exempt from SEC Registration and are available via private placements and/or crowdfunding portals. SEC Regulations A and D provide mechanisms allowing sponsors to exempt securities from SEC registration requirements that apply to publicly traded securities.

Benefits of REITs

Some benefits include:

• Instant diversification: Shares represent a portfolio of properties that has little correlation with the S&P 500, thereby reducing overall volatility, increasing returns and decreasing risk.
• High yields: The MSCI REIT Index has provided an annualized return of more than 20 percent during this period, compared to a 15 percent annualized return by the S&P 500. Moreover, in the last 15 years, REITs have been the best performer, returning 12 percent per year on average.
• Simple tax treatment: These are pass-through securities that do not pay corporate income tax.
• Professional management: REIT managers are specialists who must provide competitive returns to attract shareholders.
• Liquidity: Public REIT shares are easy to trade, and stock is much more liquid than are the underlying properties. Non-listed and private REIT shares can trade on secondary markets, although private-REIT shareholders must wait a year before publicly selling their shares.

 

An individual retirement account allows you to save and invest for your later years. A self-directed IRA gives you wide latitude in your investments. The only two investments explicitly off-limits are life insurance policies and collectibles, although certain precious metals are acceptable. IRA rules prohibit self-dealing.

Prohibited Transactions

IRA rules prohibit any transactions in which you use your IRA to buy items for personal use. This extends to the business you run, including a property-flipping one. You are not permitted to use the assets of an IRA to benefit yourself or your family prior to retirement. The rule also applies to fiduciaries, which are individuals that have discretionary authority over your IRA, such as a trustee. If you buy property for your own use with IRA money, the Internal Revenue Service will dissolve the account and you’ll owe taxes on the account balance as it stood on Jan 1 of the year in which you performed the prohibited transaction.

Unrelated Business Taxable Income

Your IRA normally cannot own a profit-producing business without creating unrelated business taxable income, which the government taxes. The purpose of this tax is to prevent entrepreneurs from using their IRAs to give them an unfair tax advantage over their competitors. For example, if your IRA owns a cattle breeding operation, you wouldn’t have to pay income tax on the profits until you withdrew them from your IRA. The UBTI tax removes this incentive. The UBTI tax also applies to income-producing property financed with debt.

Rental Property

Despite the restrictions described, your IRA can own rental property without creating UBTI. This requires that the IRA trustee be responsible for paying all the bills, directly or indirectly managing the property and collecting all the income on the IRA’s behalf. You cannot use non-IRA money or your own labor to assist a rental property owned by your IRA without incurring UBTI. You cannot live in the rental property owned by your IRA. The same restriction applies to your relatives..

Incorporating

You might be able to use your IRA to help finance your business. If you set your business up as a C corporation, you may be able to have your IRA buy shares from the corporation through a private placement. This can be risky if not performed properly and the only good way to eliminate the risk is to request pre-approval from the IRS. You will have to pay a fee for a private ruling from the IRS and you’ll probably also incur legal fees preparing the request. Another way you might use your IRA money for your business is to roll over the IRA to the corporation’s retirement plan and invest this money in the corporation’s stock. However, this technique might be a gray area, so check with a lawyer or CPA before proceeding.

The mortgage meltdown of 2008 triggered the Great Recession, which prompted banks to tighten credit and raise underwriting standards. This in turn gave impetus to alternative, or non-bank, lending, a sector that includes commercial lending companies, payday lenders, peer-to-peer marketplace lenders, and hard-money real estate lenders. Each type of lender has its own characteristics, but four differences between bank and non-bank lending form a common thread:

1. Credit ratings: Banks predominantly rely on credit ratings and credit histories to evaluate loan applications. Consumers with less-than-good ratings or scant credit histories have virtually no chance of receiving a bank loan. Non-bank lenders are in general much more willing to provide loans applicants with low credit ratings by adjusting interest rates, demanding collateral, and/or using alternative underwriting methods. Hard-money lenders typically lend up to 70 percent of the value of the underlying real estate, with the borrower supplying the remainder. By concentrating on the property rather than the borrower, developers can receive hard-money financing quickly even when they have less than stellar credit scores.
2. Speed: Banks are notoriously slow to approve loans. They require voluminous paperwork and extensive credit checking as the process slowly grinds through the bank’s loan committee. Non-bank lenders usually offer a streamlined application process and rapid approval/funding, often depositing loan proceeds in as little as one business day. For hard-money lenders, the underwriting process evaluates the property under construction/rehabilitation, and for all intents and purposes skips the borrower credit check. This tremendously speeds up the loan process. Experienced hard-money lenders know their local real estate markets well and can often arrive at a property value in less than a day.
3. Size of loan: Many banks have a minimum size loan threshold that bars small loans. A bank’s bureaucratic overhead costs preclude it from extending loans that are not “profitable,” which is how it sets the minimum loan size. Non-bank lenders are typically lean operations with much lower operating costs, allowing them to offer small loans, as low as $100 in the case of payday loans. Commercial loans as low as $5,000 are widely available. You can expect a hard-money lender to provide up to $1M in financing, and sometimes more.
4. Interest rates: Banks can afford to offer the lowest interest rates because they lend only to applicants with gilded credit ratings. Non-bank lenders charge higher interest rates in return for greater loan access. Some commercial and hard-money lenders offer fairly low interest rates, whereas payday lenders charge astronomic rates. A good hard-money lender will offer bank-competitive rates to borrowers who are near-miss, non-bankable candidates.

When looking for a good hard-money lender, pick one that has a variety of loan programs, such as fix-and-flip/rehab loans, acquisition loans, condo conversions, bridge loans, private flexible loans and long-term loans. By choosing a well-rounded hard-money lender, you’re sure of getting the right program at the right price.

If you’ve chosen to be a house flipper, you’ll need to know about renovation permits before you begin rehabbing a property. Obtaining the right renovation permits will help you save money and time during the rehab, so once you’ve finalized your work plan, you need to ensure you get the right permits.

When you receive a permit, you are establishing that the workers, including yourself, are professional and insured. That’s a good thing, because it can help you avoids headaches down the road. Permitting also helps protect you against safety problems dealing with structure, electricity, etc., and keeps you on track regarding local building codes. Even if you are under time pressure, remember the rueful saying, “We never have time to do it right, but always have time to do it over.” Permits help you get it right the first time.

Failure to get the right permits can have many ill effects. It may even prohibit you from selling your property. A smart buyer will always insist on seeing the permits and signed inspection reports before daring to purchase a flipper property. In some areas, if problems show up after a sale and the work was done without a permit, the new owner will be responsible for getting a permit, fixing the problem and possibly paying a fine.

Flippers should welcome permits, because an inspector will have to sign off on the work. These approvals mean a qualified third party approved the work, which should help the flipper if a dispute arises.

Another motivation to follow the permit procedures is that a buyer’s bank might not release a mortgage loan if you can’t produce the permits and inspection reports. You will then have to get retroactive permits and perhaps require rework. It might even sour the deal.

If you’re a rehabber, you need to know the building codes and permit rules for the local municipality. A professional flipper will fill out and submit all the required forms before starting the work. If you haven’t previously purchased a rehab house in a given municipality, you might want to call the local building department first and get the lay of the land. In some cases, there might be some significant costs that affect a project’s economics. In some cases, you might need to post a bond or deposit to the local municipality for specific work.

Generally, the following items will require a permit:

• Adding area to the house
• Removing a load bearing wall
• Adding new electrical wiring
• Installing fences or decks of certain sizes
• Putting a dumpster on a public street
• Modifying a public sewer line

Some other types of work, such as installing a new roof, flooring, doors and windows, siding and countertops, as well as plumbing and painting, might require a permit.

The permit issuer will inspect the property when you alert them that the work is ready. If you don’t pass inspection, you’ll have to do additional work. In some cases, other work, such as installing drywall, will need to wait while electrical or plumbing inspections are pending.

When you acquire investment real estate, you have two basic ways to make money from it. The first is to rehab and flip it for a net profit. The gain in value is capital appreciation. The other alternative is to invest in a property that generates rental income, a long-term strategy. Of course, there is no reason why an investor can’t eventually sell a rental property and also reap capital appreciation. The differences in the two strategies can affect the type of investment property, the type of loan, and possible tax effects.

Purchase Considerations

If you are seeking short-term capital appreciate via a fix-and-flip strategy, you will probably be looking to buy a property selling for significantly less than its neighbors. This can arise from foreclosures, short sales, auctions or direct purchases of run-down properties. A small flipper operation might only be able to handle one property at a time, so it must be very careful in its selection process. The deal makes sense if you clear a sufficient profit after paying for the loan interest, closing costs, rehab costs, insurance and so forth. It depends on your belief that the neighborhood will maintain its value over the life of the project (not much of a risk) and that the economy won’t have a sudden shock (a la 2008-09).

If you want to pursue a rental strategy, you want properties that will likely rent out quickly and remain rented. The properties might require some degree of rehab. If so, you will have to evaluate the payback period in which rental income compensates you for the cost of the fix-up. You will likely choose properties in stable neighborhoods or gentrifying ones that exhibit a low rental vacancy rate. You also might want to diversify your rental properties across several neighborhoods to reduce your overall risks. This is a long-term buy-and-hold strategy that will generate cash flows to augment any other income you may have.

Financial Considerations

Most fix-and-flip projects are short-term, i.e., completed within one year. Hard money lenders like Specialty Lending Group specialize in short-term loans, though it does offer longer-term ones as well. As a flipper, the property is considered inventory, so any profits are taxes as ordinary income. That is, even if you hold the property for more than one year, you can’t take advantage of the lower long-term capital appreciation rates.

Rental strategies are by nature long-term. It makes sense to pursue a rental strategy on properties that produce a sufficiently high net rental yield – annual rental income minus annual expenses, all divided by the total cost of the property. Rental income is always taxed at ordinary rates. However, a little-known feature of individual retirement accounts allow your IRA to own passive rental properties as long as you don’t participate in the management of the property (and don’t live in your own rental). This makes the rental income tax-deferred, a significant benefit. Rental properties are usually financed by mortgages, although ones requiring prior rehabilitation might be purchased via a hard-money or bridge loan that is eventually replaced by a conventional mortgage. When eventually sold, any capital appreciation will be taxed as ordinary income. Unless shielded in an IRA, you will have to pay self-employment tax and quarterly estimated tax payments on your rental income.

Contact Specialty Lending Group to learn how we can help you finance your investment property strategy in the Washington D.C. region, whether it’s geared toward capital appreciation or rental income.

Fix and flip is a proven way to turn sweat equity into excellent profits. When you pick a suitable home to rehabilitate, you stand an excellent chance of making a high return in a short time. Your best investments will be in small, look-alike houses, because they are easier to sell and generate bigger profits. The faster you can sell your rehab home, the more flips you can complete in a year and the higher your income.

Like any other endeavor, it pays to put the odds in your favor. To that end, we review five types of homes that you should avoid for fix and flip projects, because each will be harder to sell and will provide less profit:

1. “Different” homes: When you see a home described as different or unique, you should smell a rat. It might be a “classic A-frame” at the forest edge that is selling for a phenomenal price. The price is low because nobody wants to live there! You can rehab the house into a little jewel and still get no prospects, much less buyers. What you want is boring, not unique. People feel comfortable in cookie-cutter homes, and they sell faster. Find a run-down one in a good neighborhood with many similar homes, and you’ll have better luck selling it quickly.
2. Too large: Every once in a while, you drive through a neighborhood of smaller homes and see the oddball big home sticking out like a sore thumb. The home will have the smallest price per square foot because and will take more time and money to rehab. Better to rehab a smaller home. You can get it done quickly for less money, sell it faster and move on to your next project.
3. Pre-1978 home: Homes built before 1978 suffer from a couple of defects. First, there are issues with lead paint that can cost you a fortune to fix. Secondly, these older homes frequently suffer from small bedrooms, tiny closets and cramped bathrooms. You are less likely to find older homes with the open floor plans favored by modern buyers. Of course, there are pre-1978 homes that don’t suffer from all these problems, but why bother? You should find plenty of homes built after 1978 that aren’t saddled with the kind of risks we’re talking about. If you can’t find newer homes, consider rehabbing in a different area.
4. Busy road: If you rehab a home on a busy road, you’re going to turn off parents with young children. That’s a substantial portion of the market, so why alienate them. Some folks will object to the noise and congestion right outside their front doors and will prefer being a few blocks removed from major roads. Don’t be tempted by discounted prices on these homes – they will be harder to sell and will make less profit.
5. Bad block: Some rehabbers want to flip a home on the worst block in an otherwise nice neighborhood. The block might have dilapidated houses that are not expected to improve anytime soon. It’s also possible that the block has experienced high crime, with perhaps drug gangbangers squatting in a foreclosed property. You can check with real estate agents for police reports to get a feel for the neighborhood.