We often counsel our clients  through the frustrations surrounding loan requirements; the anxiety from this scrutiny can be intense, especially when borrowers are asked to submit the same information over and over again.

To prepare yourself, here is a summary of (unexpected) documents your lender may request from the article and our own experience:

• Divorce Decree – to verify deposits by a former spouse
• Income Change Proof - written proof of recent raises or bonuses
• Credit Inquiries – One our clients had started a $500 pay later account with Pay Pal and this raised a red flag with the lender.
• Credit Checks – Beware retail stores and car dealership that may check your credit as part of the sales process.  Even if you paying cash for a purchase (e.g. a car), the dealer may check your credit when you are on the lot.  Be prepared to prove method of payment.
• Social Security Verification -  Lenders have requested a written statement to verify that their social security payments will continue – this seems comical given the current state of politics, and uncertain future of social security.
• College Transcripts or Diplomas – to verify employment history. This applies to younger borrowers who may not have two years of concurrent employment.
• Credit Card Late Payment Disputes –Even if the  credit card payment was made, you may be asked to remove the dispute notice from your credit report.

So what happened to old fashioned underwriting?  It may be a thing of the past, at least for now.  The easy credit from the housing bubble has banks under intense scrutiny from both the Federal Housing Administration (Freddie Mac and Fannie Mae) and the newly formed Consumer Financial Protection Bureau.

So as you seek the incredible real estate investment opportunities now available in certain sectors of the real estate market, steel yourself for the rigorous financial examination ahead.  It is also helpful to work with a trusted team of other investors who can coach you through the escrow process. With patience, determination, and occasionally gritted teeth, you’ll be glad to have gotten in the market at a time when few have the patience (and the paperwork) to qualify.

Our company was recently featured in a CNN Money  article discussing real estate investing in college towns, and while this is not a topic that is central to our investment strategy, it can play an important role in determining the economic stability of a town or a region. Below are five factors investors should include in their consideration before investing in collegiate markets.

First, check the rent ratio. And then the price.

We invest in Memphis for a number of reasons, but integral to that market is the ability to find great rent ratios. Even more important is that this market has strong ratios in the median home price, a feat that is almost impossible on both coasts and many popular real estate markets.  The median price in Memphis is around $115K, and quality homes in that range can rent for $1100-$1200.  Any time the rent ratio is 1.0% or higher, there is the potential for strong positive cash flow. If you invest in a coastal metro (e.g. UCLA), rent ratios like this are no existent in the median home price.

Second, carefully consider the tenant pool.

Think about the type of tenants you want in your property.  Generally, stable, long term tenants offer the most consistent and predictable return on investment, since they will have the lowest vacancy and maintenance rates in a given rental pool.  Look to see if there are affiliated healthcare, professional schools, and research facilities that connect to the college or universities.  Often, the best renters are not pulled from the undergraduate population (short term, transient, and hard on the property), but from the older and longer term graduate/professional student, post-doc researcher, and professor pool.  In cases where you consider undergraduate age students, having parents co-sign the lease can add some extra rent receipt security.

Third, take an objective stance on the location.

Often, people look at investing in college towns based on where their own child, or children, may attend college.  While this may seem like an attractive motivation to take advantage of college housing costs, carefully consider all of the factors.  Some of these include:  what if your child decides relocated and change schools?  Is your child mature enough to collect rent from peers and care for the property if you are employing a roommate strategy?  Is there a retail exit for your investment (e.g. after four years, could you sell to a home owner at retail price instead of another investor at a bargain price)? Lastly, is that neighborhood saturated with rentals, which is often an issue with areas surrounding colleges.

Fourth, factor in vacancy and maintenance.

In my personal investments, and the ones I track for my clients, our vacancy and maintenance levels average 5% each. On the vacancy side, this averages out to about 18 days/year.  If you have a revolving undergraduate tenant pool, this can be much higher, especially in the summer. Consider this, does your college student sublet his room out during their break? Or even worse, ask for a reduction or even break the lease? On the maintenance side, consider the increased maintenance costs that may accompany a geographic location (snow state, tornado alley, coastal storms, etc.) as well as the check the local cost of labor which will affect your repair costs.

Finally, find a good property manager

One of the challenges to renting to college students is management of the tenants. Everything from rent collecting to ensuring that the people in the house are actually the ones on the lease.  A well-qualified property manager is key to this process and is especially crucial if you are investing out of state. My mind set here is, once I am able to find a trusted manager, and know that an expert is managing my asset, not only are they are always more competent (lower vacancy, objective decision making) than I would ever be, they are well worth the cost of their employment for my additional free time.

Example:   Jane Investor owns a 50-unit apartment building that she bought in California in 1990.  Over 20 years, she finally paid off the building, and can now sell it for $5,000,000.  Her property is in a 5% cap.  Unhappy with her cash flow (5% of $5,000,000, or $250,000 per year), Jane wants to improve her passive income since she is about to retire.

Jane decides to buy another 50-unit apartment in Idaho for $4,000,000 where she will get an 8% cap rate, or income of $320,000 (8% of $4,000,000).  In order to avoid capital gains tax of $750,000 (15% of $5,000,000), Jane decides to do a 1031 exchange.  But her problem is that since her replacement property is being bought for less than her relinquished property, she will have a “boot” of $1,000,000, liable for capital gains tax of $150,000 unless she does something about it.  Unfortunately for Jane, she did not realize that she was going to have a big tax bill on the boot until she was 160 days into her 180-day Exchange Period.

She only has 20 days to solve her tax problem on her boot.

In a panic, Jane calls her commercial broker looking for guidance.   Luckily, he referred her to us.  In Jane’s case, she needed to secure purchase of ten assets (properties) at about $100,000 apiece, enough to eliminate her $1,000,000 boot and defer paying capital gains tax.

Since we had inventory readily available and sold in a cash transaction, Jane closed ten properties with us  in ten days. Each of the $100k properties yielded an average of $1000/month rent, and a 9% cap rate (net of all property management, tax, insurance, vacancy, and maintenance expenses).

With these additional investments, Jane would receive additional cash income annually of $90,000 from these properties (9% of $1,000,000).  That $90,000 when combined with the $320,000 from her replacement apartment building, totaled $410,000 per year in income, a huge increase from the $250,000 she was getting before her 1031 exchange.

By working with a qualified 1031 Exchange Replacement Property Program Jane not only avoided the $150,000 tax hit from her sale, she was also able to increase her income by $160,000 annually.

Jane was thrilled.

Real Money featured an article today on the housing market recovery.  The article by Doug Kass states that the "U.S. residential real estate market is about to launch a broad and sustainable multiyear recovery."  He cites several leading indicators that point to a turnaround including housing affordability, an uptick in construction, and unemployment's downward trend.

Why then are so many potential investors sitting on the sidelines trying to time the bottom?  I think back to my own behavior during the stock market run up and crash of 2000.  As much as I would like to say I timed the market, I lost big just like many others. When stocks were riding high, everyone was jumping on the bandwagon and share prices responded by flying up to unsustainable heights.

The housing market was the same way.  I remember cocktail parties in the early 2000's where everyone was excited about appreciation and flipping homes. Recently, most cocktail parties (at least here in Southern California), involve people bemoaning their under water mortgages and shying away from real estate investments.

If you are a savvy contrarian investor, it's time to get back in the game.

Remember Robert Shiller's Book Irrational Exuberance?  The data was there that the bubble would burst, but people continued to buy.  Now, his partner, Karl Case, is discussing that we are on the road to recovery, the economic indicators are encouraging, and people are still trying to offload or walkaway from their properties.

Everyone knows the old adage, "buy low and sell high."  The problem is that this feels counter intuitive at the time.  Those people who sold during the housing bubble run up and preserved their cash are the same investors buying up property now.  Even Warren Buffett has publicly stated that he would buy thousands of single family homes if he could.

I tell my clients often that the houses you purchased in 2010-2012 will be the best houses they ever purchased.  I expect more and more folks to get in the game as the recovery continues.  As more people realize the gains to be had from real estate, the ROI will be reduced, and good inventory will dry up. When the retail market is fully recovered, those investors who bought at the bottom will have a menu of options and a secure financial future.

So take a look at the data and make smart investment decisions now and get in the game. Unlike a time when we were at dizzying heights with high home prices and low availability, it can only go up from here.

Why all the press?  Interest rates are at an all time low, prices are bouncing along the bottom, and there is a glut of inventory.  And all of us have had a bittersweet relationship with our stock portfolios over the past 10 years, with high volatility and flat returns.This is the perfect storm for investors who can qualify for financing or purchase properties all cash that produce monthly income.

As people research how to enter this asset class, I would suggest that they consider a few key points. First, most people don't know what they don't know. Investment real estate is part science and part art, and there are many factors that new investors don't consider. So, how should one start the process?

1) Choose a trusted team.  Malcolm Gladwell in his book Outliers asserts that it takes 10,000 hours to become a successful expert in any field.  Even though people may just be warming up to investment real estate after the sting of the housing bubble, it is critical to partner with a team of experienced experts (brokers, insurance agents, contractors, and property managers).

2) Cheaper isn't always better. Consider all of the income factors.  New investors often look at the cheapest houses they can find.  They are focused on appreciation first.  This is old model, "bubble" thinking.  Consider rent rations, cash flow, appreciation potential, and equity pay-down.  All of these factors are key factors to a successful investment.

3) Remember the long term.  Think about a long term hold strategy.  This works best with newer construction homes in the market median that can be resold to homeowners (instead of other investors). Considering the exit strategy before you buy is critical to choosing the right market and the right property.

So of you wish to follow the "Oracle of Omaha," go for it.  But make sure you have all the tools you need to succeed.

This article is part two of our personal investment stories about  The Dark Side of Real Estate.

Several clients have contacted me over the last few days to discuss a recent article about investors picking up homes "by the dozen."   People are really intrigued by the idea of picking up $500 houses.

What could go wrong?

I see this all the time, and personally did this myself when I started.

It is a recipe for disaster.  One I’m personally experiencing to this day.  $500 houses are houses in the worst areas of town.  There are NO homeowners, but there are often many gang members.  Sadly, the poorest of poor live in these homes.  So one thinks they can buy it for a few thousand dollars, fix it up ($10-30k) then rent it.  One can.  Then the misery hits.   The tenant doesn't own a broom, vacuum, lawn mower, anything;  they are really poor.  They pay rent for a few months, sit and wait to be evicted, and put their 30 possessions into their pickup and move to the next place.  Meanwhile, you are out rent for 2 months during the eviction, and you have $1000’s in renovation costs to deal with from the damage they've done.

So now you have a vacant house, in the worse area of town, with a ‘For Rent’ sign in front of it.  In those areas, the ‘For Rent’ sign is translated to ‘I’m Empty, please come steal everything else’.  Your copper goes missing, the HVAC system is gone, the appliances, etc.

So now you pay another $3-4k to replace those items and now you have 30-40k invested in your little $500 house, and you start the cycle over.  At some point, perhaps after you've invested 40k-50k, you realize you've made a mistake, and you think about selling it.

 And you get an offer for $500.

I have some personal properties that I bought early on that fall into this category.  One has been vacant for three years (yes I continue to pay the note). So many things were stolen (Even the kitchen sink and cabinets) that I figured I’d be better off paying off the 40k note than fixing it and going through the issue yet again.  I have another that has had the copper and HVAC stolen no less than 3 times.  It’s a nightmare.

I’m selling them both for $500, no takers as of yet.  But maybe with the recent press, they'll be a hot commodity.

These changes will have profound effects on investors, notably those who invested in dividend-producing stocks for retirement monthly cash flow.  If the tax rate increases go into law,  real estate will be especially attractive because of its inherent tax advantages as an investment class.

The president’s tax proposal does not impact the returns on real estate cash flow.

Consider two examples:

Under current law, an investor who has $25,000 invested in a stock that produces a 4% dividend ($1,000) has an effective post-tax return of 3.4% (4% less 15% of 4% for capital gains taxes), or $850 in income before tax.  Under the president’s proposal, the effective post-tax return would be as low as 2.416% (4% less 39.6% of 4%), or $604 in income after tax.  That works out to a 29% reduction in the investor’s return after taxes, a very material drop.

Alternately, consider a real estate investor who purchases a property in  Memphis, TN for $105,000.  With a 20% down payment and $4,000 in closing costs ($25,000 total investment), the investor can reasonably expect at least a 10% return before taxes, net of all operating expenses (taxes, insurance, property management, maintenance, and vacancy) and debt service, or a total of $2,500 in cash flow per year before taxes.  Assuming that the land value as a percentage of the property value is 20% and the structure value is 80%, and the structure is depreciated over 27.5 years, the amount of depreciation is $3,055 per year.  The $3,055 in deprecation can be written off against the $2,500 in cash flow, so the net cash flow after tax remains $2,500.

The investment real estate return is almost 3X higher than the dividend example under current law.   

Under the president’s proposed tax law changes, that same return would be potentially over 4X higher.

The dramatic return difference between dividend-producing stocks and cash flow real estate makes real estate investing very compelling.  It will become even more so if the president’s latest budget proposal becomes law. In light of the looming  law changes, cash flow real estate is likely to become a more mainstream investment for millions of Americans.  Investors will be well-advised to act soon while high-return cash flow is still available.

One of our clients used a 1031 exchange to sell their former home in San Diego, and exchanged into four rental homes in Memphis. This exchange transferred their dead equity in to working capital and yielded much higher cash flow yield (3X  the annual cash flow on their investment).

The 1031 exchange provides investors with a legal means to defer capital gains tax liability associated with selling an investment property. To qualify, an investor must identify a replacement property within 45 days of the sale of the relinquished property, and close escrow within 180 days with the assistance of a 1031 exchange facilitator. The favorable tax treatment enables investors to sell current investment portfolio properties – which may be under-performing assets – and avoid the associated capital gains taxes.

Presently, housing prices have been declining sharply as millions of homeowners work through the foreclosure process.  This drives market demand for rental properties as former homeowners are forced to become renters. Investors should take advantage of these conditions by exchanging into higher-performing properties without capital gains tax consequences.

The current crop of performing single-family properties can permit investors to increase their cash-on-cash returns to as much as 10%-15%. In addition, the average rate of appreciation for single family homes has been more than 5% annually for the last 60 years, which has helped create internal rates of return of greater than 20% per year using leverage when acquiring a property.

Properties not currently performing at these levels should be carefully analyzed to see if better returns can be created through disposing the property and utilizing a 1031x to acquire new assets.

In order to see returns of this magnitude, investors should locate 1031 exchange properties in regions of the country where rents are high relative to property values (= high positive cash flow), and where the appreciation outlook is strong as property values stabilize. Many of the best opportunities currently lie in the midsection and southern regions of the U.S.; places like Memphis, Tennessee.

The conditions are perfect for investors to seize this unprecedented opportunity and do so without capital gains consequences by utilizing a 1031 exchange, but the time window will be brief to acquire the best properties. Now is the time to act.

Who is driving the real estate investing future?

This past year, we profiled our own investors and came up with some interesting data.  We have always assumed that our products (single family homes with cash on cash returns of >10%)  generally appeal to conservative Baby Boomers, who are looking for ways to exit the stock market, preserve capital, and create a passive monthly income stream.

However, what we found was somewhat surprising.

Although we do have large number of Baby Boomer investors, the bulk of our investors from 2011 are Generation X and Generation Y, in their 30s and 40s.  Being one of the first generations looking to create their own retirement plan, these investors have a longer term investment horizon and different motives for investing.  These Gen X and Gen Y investors tend to be out of the box thinkers looking for ways to build wealth with creative alternatives to 529 plans and the stock market. They also tend to be very resourceful and more open to taking some calculated risks with their investment portfolios.

Pair the Gen X and Gen Y investors with the generation behind them and a larger picture emerges.   According to RE/MAX CEO Dave Liniger's predictions a large driver for why housing will begin to turn around in 2012 is pent-up demand.  He mentioned that on average there are 5 million young people, in the 18-30, year range are living at home.

Currently, that number is 29 Million.

Eventually many of those "boomerang" kids will get jobs, pay off some student loan debt, and want to move out on their own. When this demand is released, there will be substantial upward pressure on rents, and a flood of retail buyers in the primary home market.

Since my friends and I fall squarely in the Gen X age group, I know well that this generation may best be known for the movie "Slacker," but they are also independent, entrepreneurial, and will be a major driving force in the future of real estate investing going forward. Gen X and Y are being clearly motivated by low interest rates and the large housing supply to make some creative long term decisions for their own nest eggs. And when the economy turns around, you may find us as your new landlord.

Or, even better, as the seller of your next home, which we purchased in 2012.

Why Memphis? Memphis is a successful hub because of its four Rs; runway, road, river, and rail.   The runway, thanks to FedEx (who settled in Memphis in 1974)  has transformed Memphis' airport into the largest U.S. and the world's second largest cargo airport  (Hong Kong is #1).  Seven interstates pass through the city's unique geographic location at the nexus of U.S. transportation routes and population centers.  Memphis' mid-south location also places it within a 2 day trucking route to most major US cities (see image).  Finally, the Mississippi River bank location boasts the U.S.'s 4th largest inland port for goods that still travel by river.

The freight that moves through Memphis, the packages they process, and the logistics-based industries have created a 21st century economy that cannot be outsourced. Online commerce is growing, and more and more companies find that building or renting warehouse space in Memphis allows for swift expedition of goods to clients. This creates a strong demand for logistics workers and provides liveable wage jobs in the new global economy.

Two years ago, we cashed in our daughter's 529 Plan and purchased our first investment property in Memphis. It is a very nice three bedroom, two bathroom median priced home.  It cost us $99K and we rent it for $995/month.  Our tenants work for the Williams Sonoma warehouse in Memphis. They are a family of four and have been excellent tenants. This last summer, we purchased a second  home for $110K that rents for $1050 per month.  One of the tenants in our second home (a couple) also works for FedEx.   We feel good owning these quality homes, in safe neighborhoods, with fair rents.  It is also great for us as investors. Net of all expenses, these houses provide us with >10% annual return on our investment.

So, thanks Memphis, for storing and shipping my presents, providing much needed jobs in this economy, and creating a healthy rental market good for renters and investors alike.  And with the little bit of extra money in my pocket this year, I might just add something small for myself to the shopping cart.  17 million one, and counting.

Happy holidays from the Meridian Pacific Team.