Caren Chesler - Resume and Articles

March 2010 issue

Real Estate Horror Tales

Investors tell how their dreams of making money went from bad to worse when they started renting their properties.

By CAREN CHESLER

Shane Fischer, a Florida attorney, was tired of watching everyone else make money in the markets. His stocks and 401(k)s were going nowhere, and he didn’t own any property. After reading a series of books called Rich Dad Poor Dad that teach people how to escape the proverbial rat race and begin living a life of financial freedom, he decided he had to own real estate. So in March of 2006, against the advice of his girlfriend, a real estate attorney, he bought an investment property in Sanford, Fla., with plans to rent it out, then later sell it and make a small fortune.

“My girlfriend said the property was in a bad location. She said I would have cash flow problems because the income would not be enough to pay outgoing expenses, but I foolishly figured everything would work out,” Fischer says. “I had dollar signs in my eyes.”

The realtor who sold him the property said it was in a great area and that the school system was excellent, but after he bought the property, he found out that neither of these things turned out to be true. He says potential renters would call up, and when he’d tell him where the house was located, they’d say, “Oh, my gosh! Over there?” When he’d tell them which school system, some would scoff.

“I did no research and foolishly relied on my real estate agent’s representations,” Fischer says. “Of course, I bought at the top of the market, in an undesirable neighborhood, with a two-year ARM, and I couldn’t rent it out for months.”

After six months of watching the property sit vacant, he became so desperate he took in a tenant with bad credit, at a rent that only covered about 60% of his monthly costs. The tenant wound up stiffing him and then leaving. He ultimately lost the house in foreclosure.

“Now, my credit is ruined, I have a judgment against me, and I will likely owe thousands of dollars on forgiven debt since the property sold for about $150,000 less than what I paid for it just three years prior,” Fischer says.

Such is the pitfall of real estate. It’s an investment that can seem like a slam dunk: Buy low, rent the property out, sell high, make $200,000. And it has seemed even more alluring for much of the last decade, when conditions in the real estate market were almost intoxicating—interest rates were at historic lows and property prices seemed to do nothing but rise.

But like sailors mesmerized by the sirens’ songs, thousands and thousands of novice real estate investors have found their boats crashing into rocks. They are left holding properties they simply can’t find tenants for. They’re paying mortgages they didn’t expect to be paying. Or they’re renting out properties at rates so low they can’t cover the mortgage, property taxes or insurance. And some are renting to tenants they wouldn’t dream of considering in a better market, just to fill the vacancy.

“People are lowering their credit standards,” says Robert Eisenstein, president of Homerun Homes, a Ronkonkoma, N.Y., company that helps home owners find renters who will eventually buy the houses. “A lot of people aren’t even running credit checks or background checks.”

The reason people run into problems when they invest in real estate is that they approach it from an emotional perspective rather than a rational one, says financial advisor Rich Arzaga, the founder and CEO of Cornerstone Wealth Management Inc. “People like it, instinctively, because they’ve seen other people get rich from it,” Arzaga says, “or because it never seems to go down. It always goes up. Or because you can feel it. You can touch it. Everyone gets really excited, emotionally, about real estate.”

Tracy O’Connell, 57, owns a home in Humboldt County, Calif. a region she fell in love with while taking a sabbatical from teaching a few years ago with plans to eventually retire there. When she stumbled upon a cheap property in the area, she snapped it up before heading back east to a teaching job in Wisconsin, where she currently resides in a house she bought using the equity of the California property.

She had been renting out the California place for four years without a hitch—until last year, anyway, when her tenant went “off the rails,” as she explains it. He was growing marijuana in the house. It wasn’t unusual for Humboldt County, but he also had a lot of unsavory visitors and a trailer parked in the side yard that made the neighbors complain. He ultimately stopped paying his rent altogether and was evicted.

But he trashed the place before leaving and then tried to break back in several times. In the end, O’Connell paid $5,000 to replace all of the carpeting, repaint the entire apartment and clean up the mold, then she boarded up windows and changed the locks so that the tenant couldn’t break back in.

“By the time he was evicted and the property repaired, I was out $17,000,” O’Connell says. “In the meantime, the economy tanked, there’s a glut on the rental market, and I’ve been told I can only rent out the home for a third less than before—which is significantly less than my mortgage payment.” If that weren’t enough, her sewer system failed, costing her $1,200 more in repairs.

She had to put her Wisconsin house on the market to get out from under the debt burden caused by the California property, but she hasn’t had a nibble.

“I’m laughing,” she says. “You just have to. You have to just go with it.”

Eisenstein says that some homeowners, desperate to sell or rent, are even offering cars or trucks as part of the deal, just to get someone into the houses. He says he has one client who owns 18 homes, a lot of them vacant. And those that are filled are facing rental reductions of 20% to 40%. People used to buy one- or two-month advertisements with his company, he says. They’re now buying six- or 12-month ads.

Mark Kreditor, a property manager for GTF Realty in Dallas, says he’s seen so many horror stories that the investment newsletter he’s been writing for 20 years can be summed up in just seven words: stay away from real estate in Texas. “The person selling you the real estate doesn’t tell you the number of tenants who don’t pay rent or will destroy your house,” he says.

The problem, he says, is that people think because Donald Trump buys and rents real estate, anyone can do it, and yet they know nothing about the local property codes in a city, the number of rentals there are across the street and what those tenants like, or the likelihood their own tenants will or won’t pay.

“It’s all about how much does it sell for, and how much does it rent for?” he says. “But that’s almost like asking what is a stock’s price on the busiest day of the year.”

According to Arzaga, when you ask buyers what they want from their rental property, they’ll say they want it to provide for their retirement, and that’s not necessarily going to happen, at least not from residential real estate, he says. Not only doesn’t it spit off a lot of cash, but people forget to take into account a lot of the hidden costs, like utilities, maintenance, property management and landscaping, which can cost thousands of dollars each year. Or they fail to account for the capital improvements that will be needed, which can cost $50,000 to $60,000 over ten years whether it’s a new roof or furnace. “When you do the analysis, it gets to be a real low return,” Arzaga says.

Kreditor suggests that people who buy real estate make sure they’re not paying more than fifty times the monthly rental income, as a rule of thumb. He says some people estimate the cost of repairs and loss of rental income at 5% of the yearly revenue, but he puts that figure at closer to 50%.

In fact, those who have used conservative estimates appear to have flourished. Amir Korangy has been buying and selling properties in New York City for years, and he’s always made sure that the building could carry itself, even if half of the units were vacant. He was working for Yahoo! making $48,000 a year when he made his first purchase: a property in Brooklyn that he bought for $210,000 and sold ten months later for $400,000.

Happy with his returns, he left his job and continued to purchase properties in the Brooklyn neighborhoods of Prospect Heights and Crown Heights because they were underpriced yet had good access to transportation into Manhattan and could be easily rented out. Over the course of 26 months, he bought and sold 11 properties, some of which he’d keep for as little as a month. He purchased one property, a Crown Heights townhouse, for $280,000. He spent $55,000 on renovations, and then sold it eight months later for $880,000. He has since expanded into Washington, D.C., and Boston, which have strong rental markets.

“I’ve thought the market was going to turn for some time, so whatever I purchased in the last couple of years, if the proceeds didn’t work out to what I needed it to, I wouldn’t buy it,” Korangy says.

Now 35, Korangy owns five properties—between his personal holdings and that of his company—one of which is his own loft. He also launched a real estate magazine called The Real Deal because he found there was such a dearth of good information out there about the market.

But even Korangy’s deals weren’t without problems. He once purchased a house because it was on a beautiful tree-lined street, and two months after he moved in, city officials came by and cut them all down saying they’d been eaten by Japanese beetles.

He once bought a townhouse for $675,000 planning to turn it around and sell it to a buyer for $1.1 million, only the buyer backed out, and he had to sell it for less than he’d planned.

Arzaga prefers commercial real estate because he says the fundamentals are much better. “It usually has a higher monthly cash flow, better tax benefits because you can depreciate for a longer period of time, you can get better leverage on the financing, and the capital appreciation relies more on the property’s cash flow than supply and demand in the market.”

Alan Brachfeld, CEO of KBK Wealth Management in New York City, says those dabbling in real estate should make sure they have a cash reserve equal to six months to a year worth of expenses in case they can’t rent it or a tenant leaves. “You don’t want to be in a situation where you’re strapped to pay the mortgage,” says Brachfeld, a CPA and CFP. “If it costs them $5,000 to run the property, they should have a minimum of $60,000 in short-term liquid money.”

It doesn’t hurt to live near the property. If a tenant calls with a plumbing problem, you don’t want to have to be driving three hours to look at it, Brachfeld says.

That’s for clients who insist on being in real estate. For now, he’s advising them not to be. He believes the market will probably fall further before it turns around. Unemployment is also still high, which doesn’t bode well for the rental market. And interest rates are only going to rise, which will put downward pressure on prices for some time.

“As an investor, I don’t think this is the most opportune time to buy,” he says.