So you'd like to be a real estate investor.

Who, me? Well, yeah, sort of. With interest rates as low as they are, I can either leave my cash under my mattress or invest it in real estate. But I've been reading on the Internet that the outlook for real estate is uncertain, that it may go down in value even more this year. What do you think?

First of all, are you reading reputable news outlets or economists (not that I have any faith in either), or are you reading bloggers with no understanding of real estate and too much time on their hands? Second, ponder this: almost every investor wants certainty and won't invest in something until it's a “sure thing”. Which means that as soon as it's a “sure thing”, almost every investor scrambles to get a piece of it, which means prices skyrocket. These fair-weather investors may not understand markets, but they're a huge force in any market.

I’ll give you an example, a certain Campbell fourplex that the owners paid $885K for in April 2005, when real estate was a “sure thing”. Now they can’t sell it for $759k. Smart investors don’t wait for certainty, because they know that a) as soon as most investors are certain something is a sure thing, it's about to collapse, because markets run in cycles, and b) you pay a premium for certainty, which, to add insult to injury, is often just the illusion of certainty.

I can also tell you that when certainty comes back to real estate, it won’t be a buyer’s market and you won’t be getting 5% rates.

I'm thinking there are many REOs and short sellers (which are future REOs) on the investment property market. Compared to regular sellers, banks can afford to give a deeper discount (if they want to). So I'm more interested in REOs because the cheaper buying price will protect me if the real estate market doesn't improve much. Maybe that's why so many people are chasing REOs. But I've noticed that most REOs are in less desirable locations.

There are five drawbacks to chasing REOs, and I could probably think of more with a little more time. First, as you say, everyone is chasing REOs because they think they’re bargains. These days REO is a strong “brand”. Second, again as you say, REOs tend to be in management-intensive areas. Third, REOs are more likely to have deferred maintenance, because when money is short you don’t spend it on the building, even if spending money on the building was ever part of your business plan, assuming you ever had a business plan and weren't buying investment property on a wing and a prayer just to make a quick buck. Fourth, the contract addendum that banks make you sign after they accept your offer typically gives you a very short time to do your inspections—five days was one I just saw, and that’s not enough to check out a condo, let alone a 3000 sq.ft. building. But it varies from bank to bank. And fifth, banks tend to be more realistic about their pricing, less likely to be willing to wait for the “right buyer” to come along and pay too way much, something that happens only in a seller's dreams. Sharper pricing means you’re more likely to have competition for REOs.

I’m going to disagree with your contention that banks are able or willing to give deeper discounts. I’ve found that banks are maybe the toughest sellers out there. For one thing, no one has any skin in the game except that fictitious person called the corporation, and fictitious persons seem to have infinite patience. The non-fictitious persons involved—the asset manager and the committee that reviews your offer—don’t care whether the property sells or not. At least that’s how they act, and apathy is a powerful negotiating strategy. Second, banks have very deep pockets, so they can afford to take a harder line on price and other terms than a regular seller. All things considered, I think you’re better off dealing with a regular seller who wants to get out of the property either because he or she is exchanging into another property or because they’ve decided they don't like landlording anymore. But REOs can be okay. They’re just not the great deals everyone thinks they are.

You value investment properties using something called the Gross Rent Multiplier. You describe the GRM as "the number of dollars you pay for each dollar of gross annual rent you'll get". As I understand it, if a property that generates $69,000 in gross annual rent sells for $759k that means it sold for an 11 GRM, and if it sells for $1.035M it sold for a 15 GRM. I get that part. What I don't get is why anyone would pay $15 for a dollar of annual rent when they could get that same dollar for $11.

Because there's no free lunch. Gross Rent Multipliers are influenced to some extent by the health of the market: supply, demand and available financing. But aside from these economic factors, GRMs are based on four property characteristics:

· Location

· Size

· Unit mix

· Condition

In other words, GRMs are based on the amount of work a property is expected to require, or, put another way, the amount of owner headaches it's expected to generate. Fixers sell for a lower GRM than pride-of-ownership properties. Large properties sell for a lower GRM than small properties. A building comprised entirely of studios with highly transient tenants will sell for a lower GRM than a building with larger units more likely to attract families or at least tenants who aren't just passing through. And a building in a marginal area will sell for a lower GRM than one in a highly-sought after area.

In this area, in this market, you’re only going to find an 11 GRM in a large building, or in a building that needs work, or in a building in a marginal area, or in a building that’s likely to have a transient population. Again, all these factors mean more management headaches. Real estate investors need to think seriously about how much time they’re willing to put into their properties. If it’s not much, they shouldn't buy something in the 11s just because it’s in the 11s. They’ll either end up spending far more time landlording than they want or, more likely, they won't spend the time the property needs and it’ll go downhill quickly.

Do cities in this areas have different types of tenants? Are, say, South Bay tenants better than San Mateo County tenants?

I don't think there's any question that people here vary widely by city. If you have any doubt, do as I did just before Christmas and go to two Bed, Bath & Beyond stores on the same night, one in Redwood City, the other in Santa Clara. And the price of real estate price is similar in both cities, so the differences aren't a matter of income. Despite this, it’s my experience that the type and quality of tenants is determined far more by neighborhood and building quality than by city or county. Which makes sense: this area’s real estate market is divided along price lines, not geography. San Mateo County’s Daly City, East Palo Alto and Redwood City east of El Camino have been hit just as hard by the foreclosure crisis as Santa Clara County's North Sunnyvale, Northside Santa Clara and Central San Jose. That's six cities, miles apart, in two different counties, but their real estate markets are similar because they're in the same price range.

I get the feeling that San Jose has a huge inventory of multi-family properties, and I think that might be bad for me when I need to sell the property, because buyers will have plenty of choices. Would it be safer if I buy in a city that has relatively less inventory? The downside, of course, is that properties in low-inventory areas may be more expensive.

2. There is a great deal of inventory in San Jose, but that benefits you as a buyer. But what works for you as a buyer works against you as a seller. If it's any consolation, they say you make your profit when you buy, not when you sell. Besides, you’re buying in what can only be called a buyer’s market. Just hope you sell in a seller’s market.

3. Should I buy one larger property or invest in two smaller properties, each in different areas? Diversification by area or price range might spread my risk.

A I doubt that you'll be able to diversify just by buying in different cities and counties, at least in this immediate area. All you'll end up doing is putting more miles on your car. I suppose it's theoretically possible to diversify by buying properties that appeal to different socio-economic classes, say, for example, a fourplex in a low-income neighborhood and a duplex or condo in a middle-class neighborhood, but I’m not sure it’s worth the effort. Maybe. The upside to this strategy is that different economic crises affect different economic classes. Dot-bust had a huge effect on the top-end market, a moderate effect on the midrange and little to no effect on the low end, because the dot boom generated wealth mainly for the venture capitalists and techies. The subprime crisis had the opposite effect. But the downside is that with two or more properties, you’ve got two or more places to keep an eye on and rent out. On the other hand, when we’re talking about only a handful of properties, maybe it's not a big deal. It would be if you were managing hundreds of rental units scattered throughout the mid-Peninsula, as I was. But I think the biggest drawback is that when you spread yourself out you don't get the lower GRM that one large property offers.

4. I'm comparing that really nice, fixed-up place you said would be great for me because I'm a beginner and don't have time to be a full-time landlord, with the place I liked, which isn't nearly as nice or in as nice a neighborhood, but is a whole lot cheaper. I understand that they're both selling for the same GRM, since the nice place gets higher rents that offset its higher price. But that extra rent still doesn't cover the higher mortgage payments I'd have. So my thinking is that I'm paying a premium for fewer tenant problems and better resale value. Am I right?

4. I like the nice place because I would have liked managing and renting it when I was in property management. I like the cheap place less because it reminds me of properties where I always had to worry about delinquencies, troublesome tenants and two or more families living in the same unit. But I'll admit that many owners of buildings like the cheap place don’t care what goes on, as long as the building is standing and the tenants pay rent. That’s partly why owning in an area like that is so challenging: there aren’t many (or any) “pride of ownership” buildings to set an example for the neighborhood. I was always more concerned about the appearance and habitability of the multi-family buildings I managed than my clients were. And, unfortunately, I understand their attitude. Whatever maintenance, let alone upgrades, you do to buildings in entry-level neighborhoods is often a) greatly appreciated by almost all the tenants, who don't get a whole lot of maintenance or upgrades in their lives, let alone where they live, and b) beat on by a few knuckleheads. So, yes, you’re paying a premium for a nice building that should attract nice tenants, make your life easier and keep you from turning into a cynical slumlord.

I favor this kind of building for you because you’re busy and live far away. But it’s up to you. I just don’t want you cursing my name under your breath every time you drive up to your investment property.