By buying a fixer-upper rental, you can get positive cash flow and a fast increase in equity. The downside? This can be a fair amount of work, and you have to be a landlord.

It is getting tough to have positive cash flow from rental homes, due to real estate prices going up faster than rent in most areas (as of 2005). One way to deal with this problem is to buy cheaper homes, to keep the loan payments down. These homes will usually need some fixing up.

What you want is houses in nice areas that are dirty and ugly. The more they scare off the usual buyers, the more likely you are to get a great price. However, you want to find homes that mostly need “quick fixes,” like cleaning and painting and new carpet.

Let’s suppose you are in an area where two-bedroom homes are selling for about $115,000, and the rents leave most new landlords breaking even or with slightly negative cash flow. This is a tough place to make money on rental homes.

On the other hand, suppose you buy a fixer-upper for $75,000, and after $12,000 in repairs and $3,000 in other costs it is ready to rent. Even if you refinance to get some of your cash back out of it, you will be borrowing $25,000 less than for similar homes in the area (you’ll have a total of $90,000 into it versus $115,000 for other homes).

What does this mean? Your mortgage payment will be about $160 less per month (based on current rates of interest). That can mean positive cash flow. You also have created $25,000 in equity if the home is now up to the standards of the other homes around it, and so worth $115,000. That means that if being a landlord doesn’t suit you, you can sell the house for a nice profit.

Another way to boost that cash flow is to now lease the home and give the renter an option to buy. You can likely get as much as $150 more in monthly rent, which helps the cash flow. You may be able to sell at a higher price than market as well.

Bottom line? When cash flow seems impossible, start looking at those fixer upper rental properties.

The television program, “Flip This House” was very popular for a while. Each episode usually followed a new investor or couple as they bought a fixer upper, renovated it and sold it – hopefully for a profit. That strategy worked well when prices of homes were still rising rapidly.

If you watched the program, though, you saw that the process can be very stressful. There are always unexpected challenges involved in real estate investing, and this is especially true with homes that need a lot of work. But buying, repairing and selling a fixer upper is just one of the ways people flip a house.

Another strategy is the true “flip” in which you never own the home. The idea here is to make a low offer on a home that needs help and, once the offer is accepted, sell the contract. This involves writing the offer in such a way that you have the right to assign it to somebody else. You also have to be sure that the property has a lot of potential, so you can get paid say $5,000 or more and still leave plenty of profit for the investor who will actually fix and sell the house.

The advantage of this strategy is that you risk almost no money of your own, unless you can’t complete the transaction and you lose your earnest money or “good faith” deposit. Most investors who do this have found ways around even that potential risk. The downside is that like the former plan, this works best when home values are going up rapidly – something we may not see again for a while.

So how do you flip this house now, when times are tough? How do you do it even in the worst of areas, where houses are sitting empty and prices have plummeted? You use a different strategy altogether – one that is especially effective in the poorest neighborhoods.

You may not know this, but there are places where houses are selling for a few thousand dollars. Look around the country and you’ll find these pockets of “real estate poverty.” Try towns in Kansas or Oklahoma, for example. For the sake of this explanation, we’ll look at Detroit, Michigan, where many homes sell for less than a thousand dollars.

You read that right, by the way. As I write this (2009) there are homes listed for as little as $25. In fact, I just checked and found a duplex for $99. There were dozens for a few hundred dollars or less. As you might guess, these are in terrible neighborhoods.

This new strategy starts with cheap houses where people still live and rent. The idea is to buy a home for say $2,000 cash, and then sell it for $12,000 to any renter in the area who has a job. You do nothing to the house at all, selling it strictly “as is.” What you provide for the buyer is cheap financing with almost nothing down.

From the renter’s perspective, this is an opportunity to buy for less than the cost of rent. Prospective buyers may be paying $400 per month for rent on the same block as your house, and you can sell to them for payments of $200 per month. Of course you will have some defaults, even with payments this low. But if you are risking only a few thousand on each home and quadrupling your investment (not counting interest) on those that work, you can afford to do a few foreclosures – and then immediately resell the house the same way.

According to my research, several investors are using this strategy. As long as you have the cash, and you can sell for a great profit and still finance the deal for the buyer with lower-than-rent payments, it is a workable strategy. Even a home that you buy for $30,000 might be sold for $45,000 and still be cheaper than rent for the new owner. A quick clean-up might help, but the fact that you can quickly sell the house as-is (and without risking too much) makes this a more attractive plan than the stressful “flip this house” strategy from the television program.

What if you were able to buy a decent two bedroom home for about $30,000, fix it up a little and put it on the market for $80,000? Do you think you could make some money that way? This is the story of a man who lost it all that way, followed by a few lessons to be learned from his sad tale.

The story takes place in 2002, in a mountain town in Montana, where the last of the good jobs had left town twenty-two years earlier when the copper smelter closed. It is a beautiful town, but the resulting economic decline caused a population decline of more than 30%, down to about 7,000 or 8,000 people. My wife and I bought a great little house there for $17,500, so home prices had obviously tumbled along with the population.

A neighbor, at eighty-years-old, decided to become a real estate investor. He bought the house next to us for around $30,000, and borrowed more from the bank to fix the place up. Given the price of our own home and the fact that this other house wasn’t nearly as nice, I wondered if he had overpaid. He seemed sure that he had a good deal though, and thought he could make some money.

As the weeks went by, he did get the place looking better. He put in an incredible fireplace, and new carpeting. The electricians worked on the old wiring on and off for a long time, always finding something else that needed to be done, and then taking their time doing it. The old guy was paying by the hour, with no contract, of course. The heating system needed replacing, at which point our neighbor mentioned, “I didn’t know the house had so many problems.” At some point his enthusiasm started to fail.

His bank account started to fail too. Eventually he admitted to me that he had over $65,000 into the place (with the $30,000 purchase price), but still seemed certain he could sell the home for $80,000. I politely nodded. It was too late to say anything anyhow. He didn’t even have money to fix up the rusty iron fence around the house. In fact, from the outside, the appearance had hardly changed at all, since all his money went into the interior.

The sign went up, though I am not sure why the real estate agent wanted such a listing. Perhaps it was with the hope that he would maintain the listing when the bank took the house and dropped the price. In the end, that is exactly what happened. “I gave the house back to the bank,” the old guy told me one day.

A Few Real Estate Lessons

I like this story because my old neighbor did so many things wrong. This makes it a great teaching story. Often real estate success consists as much in avoiding common mistakes as knowing intricate techniques. Here, then are some of the mistakes he made.

1. He had no plan. He had only a vague idea about what he would do and how much the home would sell for.

2. He had no idea of how to value a house. If he had compared the home to recent sales (like our $17,500 purchase next door) he would have realized that the most he would get for the home was probably around $30,000, if that.

3. He had no concept of his market. This was a two bedroom starter home. Buyers for these homes are not looking for a fancy fireplace.

4. He had no contracts or firm quotes from contractors. He let them find as much as they wanted to do and charge him by the hour.

5. He didn’t get an inspection. Had he gotten the home inspected, he might have had some idea of how many problems it had, and how much it would take to correct them.

6. He didn’t understand the concept of return on investment. Even if buyers liked the fireplace and other features he put into the home, these features probably increased the value less than what they cost.

7. He didn’t have enough money or financing lined up. This was a fortunate mistake, perhaps. Since the project was doomed to fail, it may have been good that he ran out of money.

Why not learn from the mistakes of others? As a side note, we selectively put $1,900 into our home there for a total investment (with purchase price and closing costs) of about $20,000, and sold it for $28,000 four months after we bought it. We might have been lucky, but we also avoided some common real estate investing mistakes.

A fixer upper home seemed like a good investment, but we had little experience. We had bought, fixed and sold a home in Montana for a profit, and completed the project in only a few months. However, we were new to the Tucson area, and didn’t quite have a grasp on the values. In Tucson, two identical houses can be $50,000 apart in price if they are three blocks apart.

Then there was the fact that the styles are different from anything we had in Michigan. They put corrugated steel fences (walls) around expensive homes here, and the people talked about how pretty they are! If we were to do a fixer upper, it would be good to have some help figuring not only home values, but also what buyers want.

We went to the Arizona Real Estate Investors Association meeting, and I announced that we had money to invest in a fixer upper home. We were looking for partners. Our names and phone number were written down on the overhead projector along with the others, and about three days later we got a call.

Bill and Diane were nice people. They had an accepted offer on a house, and looking at the comparison sales they had found, it seemed like a good buy. They had rough estimates of the rehabilitation and remodeling costs, which is what they needed our money for. A third couple was involved, so the expected $75,000 profit would be split three ways. We agreed in principle to the deal, and arranged to meet the other partners at the house after closing.

Fixer Uppers Versus Remodels

Three couples with six opinions – this can be a problem. Why did the beautiful wood floors have to be torn up and replaced with carpet? Why couldn’t they at least be carpeted over without the expense of tearing them out? My wife and I thought it a crime to stucco and paint the beautiful brick exterior of the home, but we were assured that buyers here like it better that way. The ceiling in the add-on family room was a bit low, but raising it, as Bill planned, seemed too expensive and unpredictable.

Plans became new plans, and weeks of stressful anticipation evolved into stressful worrying. Houses in the area were selling for less than we initially thought, that the rehab cost would be more than we thought, and all the other partners expected to do much of the labor, rather than hire it out. Projected profits dropped from $25,000 down to $10,000 each, and we felt there might actually be a loss.

We dropped the deal. Fortunately, the other partners had procrastinated for weeks on our signing of the joint venture agreement. They would find a way to do it without us and split the profit two ways. We learned that this wasn’t a fixer-upper in any case – it was a remodel. As I write this, it is more than three months past the projected completion date, and the home still isn’t ready to sell. I hope they make a profit, but I am happy to have avoided the months of stress.

Other Fixer Upper Lessons

At another meeting of our investment club, a man told us about a fixer-upper he had bought years earlier, using credit cards for a down payment. He still hadn’t finished it, and it looked like he was going to lose a lot of money in the end. He had no plan, which broke rule number one of the list below:

1. Have a clear plan.

2. Make sure everyone involved understands the plan and agrees to it.

3. Know what the home will sell for before you even make an offer.

4. Subtract ALL the costs (purchase price, selling costs, repairs, loans, other holding costs) AND your desired profit from the expected sales price. This gives you the highest price you can safely offer if you want to make money flipping that house.

Learning what to do is a start, but learn what not to do too. Learn from our mistakes and those of others. That way, you won’t lose money on your fixer upper home.

Done right, flipping fixer uppers is perhaps one of the easiest ways to get into real estate investing. Usually you want to get in and out of the property as quickly as possible, because every day you own a house has costs associated with it. Interest on loans, taxes, insurance, electricity, heating, water, and other ongoing expenses can add up.

However, there is another way to invest in a fixer upper. It is a strategy that let’s you take your time. In fact, it requires you to wait two years before you sell. It also requires that you live in the house.

Your Fixer Upper Home

Since the tax law changes of the 1990s, you can sell your home and pay no capital gains tax on your profit. Have your accountant review your case and verify that you have met the requirements, but essentially you get to sell tax free if you have lived in the home at least two of the past five years, and you are allowed to take such a tax-free profit every two years. The total gain you can have without paying taxes is limited to $250,000, or $500,000 for a married couple.

Some of you may recall that you used to be allowed this capital gains tax exemption just once in your life. What’s more, until you claimed it, you had to always roll your gain from selling a home into another home, always buying-up. Now you can take the money and run, buy a cheaper condo, or do whatever you want with it. This is a major change.

How do you take advantage of this tax law? If you could predict appreciation rates on homes in various cities (good luck), you could move from one quickly appreciating home to another each two years and pocket the profits tax free. What if you don’t want to gamble on your predictions and you don’t want to move to a new town every couple years? Then look for a fixer upper right where you live.

You see, most investors “flip” a fixer upper quickly, meaning they pay ordinary income tax rates on the profits. They don’t even own the property long enough to qualify for the lower long-term capital gains rate. Depending on whether they get classified as business or an investor, this means they can pay as much as 50% out in state and federal taxes. They lose half of their profit!

The alternative? Let’s suppose you find a home in a neighborhood where homes are selling for around $180,000. It’s dirty and in disrepair, so the owner is asking only $136,000. You negotiate and eventually get it for $126,000. You live in the home, spending about $8,000 to clean it up and bring it up to the standards (and value) of the surrounding homes.

After two years home values are up 10%. Your home is worth about $198,000 ($180,000 plus 10% or $18,000), and you sell it for that. After all the costs of buying and selling and repairing it, you have a profit of about $50,000. You buy the next home and repeat the process. Note: perhaps $32,000 is a more accurate estimate of profit, since the same appreciation that provided $18,000 of your gain means you’ll pay that much more for the next one. In any case, this profit is entirely tax-free!

You can see how powerful this fixer upper strategy is. It doesn’t prevent you from pursuing other real estate investing plans at the same time either. You need to live somewhere in any case, so why not take advantage of the law and make some money from your home?