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Thanks to all of you who voted, especially those who backed up their vote with an opinion (via the comments section of my post)!

Jason asked whether he should continue renting the commercial condo that his business is in for $1,800 per month OR buy it for $160,000? When he asked his friends earlier he didn’t get much help:

I have asked a lot of people and get about half giving me one suggestion while half give me the opposite!

Unfortunately, as is often the case with these difficult decisions, our vote is split 3:2 …  but, in favor of buying the building.

For example, Zach is emphatically FOR buying the building:

More information would be helpful, but that seems like a good price for $1,800/mo rent. Business or no business, I would take that deal every time.

Whilst, Victor is equally AGAINST:

Don’t invest in something you don’t know much about, you know your business, invest in that, pass on what you don’t know.

So, Jason is right back where he started 🙁

My general advice in these situations, without having nearly enough enough info to give specific/personal advice, is to …

do both. Every single time.

You see, it comes from the advice that my Grandpa once gave me: I remember him recounting an argument that he had with Grandma when they were just starting out. Grandma wanted to buy a modest home, instead of renting what amounted to little more than dumps, being all they could afford as poor immigrants, but my grandfather had other ideas; he said:

From a business, you will always be able to buy a house. But, from a house you will never buy a business.

Sound advice (it certainly guided me), but how does it help in this situation?

Well, it applies in reverse: when you have a business that’s generating cashflow, you have to start thinking about external investments, and buying your own premises is often the best place to start. Of course, you still have to keep the reinvestment needs of the business in mind … after all, that’s what’s generating the cash!

But, what happens when it seems you don’t have enough capital to do both?

That was the situation that I found myself in when we outgrew our last rental office:

I found a building that we could rehab for our purposes, but that I felt had good future capital appreciation value: in other words, a building that I thought – first and foremost – would be a good investment.

It was way over budget (e.g. when comparing old rent v new mortgage), but it seemed too good an investment opportunity to simply pass up.

I had no idea how to value it properly, and it was going for auction, but I found out that the only other serious bidder was a property developer. I knew that he would only pay land value, not much more.

This was a trick that I had employed successfully once before: find a property that developers are interested in, but that you want to own/occupy and pay $1 more than they are willing to bid.

And, that’s roughly what happened (cost me $1k over his losing bid of $1.36m) …

Then the worry started: how was I going to pay for this monolith? How was I going to find the deposit?

I dealt with the second issue (finding the deposit) by employing a tried-and-tested short-term funding method: shorten the time to receive payments from clients and lengthen the time to pay suppliers.

This (temporarily) reduces the amount of working capital tied up in the business at the (hopefully, manageable & short-term) expense of happy customers and suppliers.

I dealt with the first problem (plus, the new problem of quickly replenishing the working capital situation) by not eating for 6 months 😉

This means, maximizing the profits of the business to help cover mortgage costs and rehab costs, whilst quickly rebuilding the working capital of the business.

Tough – very tough for a while – but, manageable.

And, that’s how I made my first real $1 million: I sold the building just a few years later for nearly $2.5m. It remains one of the best real-estate investments that I have ever made.

The only catch, if Jason were to employ this strategy, is that his building doesn’t look like it has much upside potential – with “32 units, of whitch 24 are currently vacant shells” in the complex.

Perhaps, Jason is better off using the month-by-month lease time, when his lease expires, to give him time to find something with a little more upside potential?

 

 

A quick real-estate buck!

RE - 1Beware those who love stocks. Beware those who love bonds. Beware those who love gold, oil, futures, and so on.

Most of all, beware those who love real-estate!

OK, so I invest in real-estate …

… but, I’m not in love with it.

Take a look at the above infographic [click to enlarge]; a picture (with numbers) tells a thousand words:

This person claims that they (or a client) bought a single-family home for only $35,000 and now clear (fees, insurance, and property taxes) $680 a month in rent.

Since they put in $7k in closing costs and rehab when they bought it, they are really returning $8k a year, which is 19% a year.

The key to real-estate is that you can add value.

To see what I mean, check out the highlighted items in the enlargement, below:

RE - 2

By spending just $5k in rehab, the purchaser immediately increased the value of the property by $18k, from $42k to $60k. Presumably, this similarly increased the rents.

The problem with this type of example is that it is unrealistic: this example assumes that you paid cash for the property.

Instead, I’ve made a ‘more normal’ example from this one, to show you how cash-on-cash returns really work, and why RE really is such a good investment:

RE - 3

[you can download the full spreadsheet here:  https://www.dropbox.com/s/ujuqaptgrr8hssv/Simple%20RE%20Analyzer.xls]

This analysis confirms that it is possible to get a 19% Cash-on-Cash Return, but:

1. You need to have a 15 year outlook; the first year produces a loss,

2. The assumed rent is VERY high.

The reality is that most residential real-estate tends to produce negative returns in the early years, and capital gains over the longer term. Whereas commercial real-estate tends to produce higher earlier returns but lower capital growth.

Still, by purchasing well, adding value (e.g. through a clever & economic rehab) it is possible to produce fairly reliable (when compared to the up’s and down’s of the stock market) cash-on-cash returns that blow away most other consumer-grade investments.

The ideal portfolio for successful investors …

Portfolio - 1I came across this excellent infographic that talks about real-estate and its place in your investment portfolio:

It (rightly) questions the typical “Wall Street” view that (a) asset allocation is important, and (b) that a 60/35/5 stocks/bonds/cash mix is the only way to secure your financial future.

Of course, a ride through 2008 fixed that view for a lot of folk …

So, I was quite impressed that a site that provides financial / portfolio allocation advice actually considers real-estate to be a viable investment option, and an equally important part of your portfolio.

The suggestion is to use real-estate to provide the real diversification that you need.

And, it may even be the right for successful investors (although, I prefer a portfolio that is more like 90/5/5 real-estate/stocks/cash) …

… but, it is not the right approach for investors who want to become successful.

Let me explain.

The balanced portfolio may help you retain your wealth if you already have it (i.e. if you are already a successful investor), but is unlikely to make you rich on your own.

You see, in order to:

– Become wealthy, and

– Maintain your wealth along the way

… you need two things:

1. An Income Driver: i.e. something to provide an ever-source of cashflow, and

2. A place to invest that cashflow that compounds.

The good news is that you can achieve this simply by modifying the second, larger section of the pie-chart, somewhat:

Portfolio - 2

Your own business is the best way to provide a rich vein of income that you can then tap to fund an ever-growing investment empire in real-estate.

Now, you can certainly grow income in other ways besides having your own business: you could look for a sales job that pays very high commissions (hundreds of thousands per year; or, a management job (preferably, c-level: ceo/cfo/cmo/cto) that pays the same, or better; or, take on a second job or a part-time job; and, so on.

But, nothing has the earnings-growth potential of your own business (although, the ceo’s of certain Fortune 500 companies might – quite rightly – argue that point).

But, why real-estate?

Because both the capital value of the asset (i.e. the amount that you paid for it) and the income stream grow at least in line with inflation, given a long-enough investment horizon … so, you get a double-whammy of increase in your net-worth (i.e. the building grows in value) and the ever-growing rental income stream – if you save it rather than spend it – will eventually help you buy another, and another, and so on.

Keep this up for long enough, say 7 years, and my experience says you can become rich 🙂

When should you take a loan instead of saving?

debt v savingsHere’s a commonly asked question:

In which cases should you take credit or a loan instead of saving up?

Len correctly answers:

When the price of whatever you are looking to buy is rising faster than the interest on the loan.

But, the answer that I want to focus on is that by popular financial blogger, Pinyo who says:

Buying a house at today’s interest rates is a good example of where taking a loan could be more beneficial than saving up.  You’re amortizing over 30 years and inflation would counter the interest expenses you paid over the life of the loan. In the mean time, you get to enjoy the house much sooner.

Whilst what Pinyo suggests is correct: real-estate is a great hedge against inflation; and, borrowing to purchase your home is probably the only way that most people will ever get to buy one …

… his comment actually fails to mention that it’s also a pretty good investment. Even your own home.

Let’s take a look at a simplified case of somebody purchasing their own first home (house or condo) for $100k, including closing costs. They put in a 20% deposit and take out a 30 year fixed loan, locking in at 3% interest.

Let’s also take Pinyo’s line that the interest rate just happens to offset 30 years of inflation (i.e. inflation also averages 3%), which is almost spot-on, based on the past 30 years’ average inflation rate.

Whereas Pinyo suggests that you are (a) offsetting inflation, and (b) enjoying your house …

… I think you are also making a great investment.

Here’s why:

– Over the 30 years, at just 3% inflation, your $100,000 home would have grown in value to $237,000

– Of course, in that same 30 year period, you would have also paid your bank $52,000 interest on that $80k loan

– Don’t forget that you put in a $20k deposit, which could have been earning interest elsewhere; let’s say that you would have averaged a 5% return on this investment, so your $20k could have grown to $86k.

The bottom line is that you will make an additional $17k profit, if you buy the house instead of just ‘saving’ the $20,000.

To me, this is a clear and tangible case where borrowing (to buy your first home) is better than merely saving …

What about the repairs and maintenance cost, you ask? And, the insurance, and the land tax?

My feeling is that these would be a lot less than the rent that you no longer need to pay …

… after all, you did just buy your own first home didn’t you? 😉

 

The Myth Of Passive Income

I see a lot of people chasing the dream of passive income.

Like unicorns, the Tooth Fairy, and – sadly – Santa Claus, truly passive income does NOT exist!

The only true ‘set & forget’ passive income comes from sub-standard investments such as bonds, CD’s, mutual funds, dividend stocks, and the like.

All true income-producing investments require at least some work in selecting/maintaining the income source

e.g. Rental real-estate requires work to locate the best deals, then requires further work to locate and retain the best tenants, and requires even more work to maintain the property.

Of course, some of this can be outsourced to Realtors and property managers, but you cannot outsource your worry (e.g. if the property lies vacant and your mortgage payment falls due).

Even more, a business can never truly be passive: you will always have to worry about staff, clients, and finances.

Even if you hire staff to manage all of these areas for you, you will still have to oversee – and, worry about – them!

In my experience, the higher the return you expect, the less passive is your investment.

Why I don’t manage my rental properties …

Managing your own rental properties sounds like a good idea; you get to save some money – and, you hand choose / hand manage your tenants.

The World Of Wealth (blog) puts it nicely:

Manage your properties yourself!

Reason Number One – It’s Valuable Experience
Managing my rentals has taught me numerous life skills from how to negotiate with a contractor to the best way to (attempt to) collect rent from a deadbeat tenant.

Reason Number Two – You WILL Do A Better Job Yourself

First of all, your property manager may not actually be very experienced. Secondly, your problem may be worse if the manager IS highly experienced and recommended. In that case, you will probably find yourself be at the very bottom of their priority list.

Reason Number Three – You’ll Save LOTS of Money

Property managers and leasing companies don’t come cheap. You’ll pay 6% – 10% of gross rental income directly to the manager. A rental property with 6-10% of cash flow is rare and precious indeed, so hiring a property manager is all but ensuring your cash flow will be negative.

Reason Number Four – You Won’t Save Yourself Any Stress
One of the main reasons I hired a leasing company this summer was because I didn’t think I could effectively handle 3 vacancies while I was traveling in and out of town. But I was more stressed out than ever before! I still worried about when I’d get a new tenant in each unit, how I was going to make the cash flow work in the meantime and how much the repairs were costing.

I can’t comment on how much less or more stressful it would be to manage my own rentals …

… because I have used a property manager since the get-go.

But, my case might be different to yours: my properties were investments, not my source of business income. So, for me, time was more precious than money.

Even so, Dave Lindahl – well-known property ‘guru’ – makes the case for NOT managing your own properties, at least not after the first 3 or 4 that you own: burnout.

Handling all of those “Reason 4” issues that The World of Wealth blog mentions (dealing with tenants, vacancies, defaults, etc.) will stress you out more than you can imagine, then burn you out pretty quickly.

Also, the argument that properties return 6% and property management costs 6%, therefore all your profits go to the property manager, don’t hold water … because, commercial properties (for example) return 6% after the costs of property management are factored in (or, so they should) …

… and, even residential property may return the same – if you purchase cheap and add value (e.g. paint, add a bedroom, etc.) before you rent expensive.

By all means, manage your own rentals, if that’s the way you want to roll.

But, have the expectation (and, build the cost into your calculations from the start) that you will employ a property manager sooner rather than later, because managing your own rental properties simply isn’t any fun 😉

A financial path well-trodden?

A short while ago, I received an e-mail from a reader who said:

I’m on the same path as you once walked.  I have a small business that is making good money and just started into real estate.  So far I have 7-9 houses and I’m looking for my first commercial building.

Michael told be that he started a consulting company with his partner about 7 years ago, and ventured into real-estate investment after he realized how much hard work it was and how little the consulting business returned (Michael’s business only had $80k in the bank after 5 years of hard work). I guess that situation has finally improved …

Michael and his business partner stumbled onto the idea of real-estate investing when Michael realized that the one rental property that he had owned for years had halved in value!

For most people this would be a sign to run away from real-estate, instead Michael took the Warren Buffet line (“be fearful when others are greedy, and greedy when others are fearful”) and ran towards it …

… but, he quickly realized that he could find other houses that had halved in value since the ‘crash’ and maybe pick up some real bargains.

This is the sign of a true investor – Michael had found his niche.

He began by making a ‘low-ball offer’ that was “too low to accept” on one property … yet, it did get accepted and Michael had made his first (actually, second, since he still owned that rental) real-estate purchase.

Except that Michael forgot to mention the deal to his business partner; so, his next phone call to his business partner that went something like this: “I got this great idea!”

Fortunately, his business partner shared Michael’s vision, so that first purchase followed with a flurry of other purchases and after just one year they now own 8 single family rental houses!

I asked Michael to share with you how he invests in real-estate:

The residential real estate market has been a boom to investors.  It seems that everyone now is cashing in on the housing downturn.  Here is a breakdown of the steps that I use to determine which houses to invest in that will turn a profit; here are my basic criteria for a good rental house:

  • At least 1000 sq ft
  • 3 to 4 bedrooms (3 bedrooms that can easily be converted into a 4 bedroom house)
  • Garage (no one likes to park outside in the winter)
  • Split level house (this configuration tends to be popular with rentals in my area)
  • Decent sized yard
  • Has sold or been valued for at least 100k or greater in the last 10 years based on Zillow.com
  • Property taxes around 2k

I use Zillow and Home path to find properties in my desired zip code.  I run the available houses through my criteria and start to narrow them down.  I then will call up my realtor and set up appointments to look at the houses.  It honestly takes me about 2-3 minutes to walk though a house and figure out what the house is worth (to me), how much it will cost to fix it up and what it will rent for.

The houses that I typically buy are about 45k.  Some more, some less.  My target is to have no more than 65k in each house total.  That allows me to rent them between $945 and $1095 depending on the property.  I try and average at least $1000 in rent per property.  Once the house has been renovated I usually create 20-40k in instant equity.  Here is a real world break down of two houses that I have.  One was paid for with cash the other was purchased with a mortgage.

Cash property

  • Asking price: 35k
  • Purchase Price: 25k
  • Approx renovation total: 30k
  • Total investment: 55k

 

Month

Year

Property Taxes

$138.76

$1665

Property Insurance

$37.83

$454

TOTAL

$176.59

$2119

This house rents for $995 per month and the tenants pay all of the utilities.  I manage this property myself so there is no management fee and they deposit the rent directly into a bank account setup for that property.

The net income that I receive from that property is $818 per month [$995-$177] or $9821 per year (not deducting personal income tax).  This represents about 18% cash-on-cash return per year [$9821/$55,000].

Mortgage property

  • Asking price: 65k
  • Purchase Price: 47k
  • Approx renovation total: 15k
  • Total property cost: 62k
  • Mortgage: $32,830
  • Cash down payment: $12,713
  • Interest: 4.773%

Month

Year

Property Taxes

$135.44

$1625

Property Insurance

$40.08

$481

Mortgage Payment

$167.80

$2014

TOTAL

$343.32

$4120

This house rents for $1095 per month and the tenants pay all of the utilities.  I manage this property myself so there is no management fee and they deposit the rent directly into a bank account setup for that property.

The net income that I receive from that property is $752 per month [$1095-$343] or $9020 per year (not deducting personal income tax).  This represents about 71% cash-on-cash return per year [$9020/$12,713].

I’m already acquiring equity in these properties at a deep discount.  In 5 years the gross rents will average close to 60k.  Again some more, some less.  At that point my plan is to sell all of these houses for an average of 100k (I have 8 houses) and cash out with about 2.5x my money invested.  Ideally it looks like this:

60k rents over 5 years + 100k selling price – 65k total purchase price.

Now I don’t get caught up in all of the cost of my time, turnover allowances or maintenance of the property arguments.  If you are busy constantly crunching those figures you have lost focus on the big picture.  In the end a few thousand one way or the other doesn’t make ANY difference.  Remember focus on the BIG PICTURE.  Spend money up front on quality renovations and tenants and these will be insignificant expenses in the end.

Michael says that his average cash-on-cash returns, even in the current market, average 20-22% which is outstanding. And, if the real-estate market recovers in the near future, he should expect a tidy capital appreciation, as well.

But, not one to rest on his laurels, Michael is currently negotiating to buy not one, but two multi-million dollar commercial properties:

 Today was the first day that I made an offer on a commercial property.  It is a type “A” building with a 10% cap rate.  I’m pretty excited.  Our real estate company is small but growing rapidly.  We have the down payment for the property which is priced at 4.25 million … I understand that 4.25 million is a big jump but the property will be professionally managed and cash flows very well.  We are contacting about 8 different commercial banks.  This will be a big step for our company.  We just have to have a bank take a chance on us.

Michael actually ended up negotiating a ‘smaller’ $2.8m commercial property that he is purchasing with $250k down and the owner carrying $250k, which would leave them with sufficient cash in the bank (~$500k) allowing Michael and his business partner to pick up another property at about $2.5million.

A $5m + property portfolio puts Michael and his partner into the ‘big league’ …

Now, it’s not the value of the portfolio that you own, but the cash that you can realize if you sold it all off (or, the net income that it generates) that determines how well-off you really are, but I’m guessing that it won’t be much longer before Michael and his business parter can write their own “how I made $7 million in 7 years blog”.

I like reader stories like these … good or bad, rich or poor, heep ’em coming 🙂

 

The biggest mistake in commercial real-estate …

You might pay too much for commercial real-estate, but it will probably still bring in a reasonable return.

You might forget to look into the taxes and take an extra few years for the ratchet clauses in your leases to catch up.

You might find that the tin roof leaks, but it should only cost you $’000’s to fix and time and tax deductions (and rental increases) will help to catch up on that.

No. The biggest mistake in commercial real-estate is the one that Tyler is about to make:

I’ve been thinking quite a bit about commercial real estate lately, but have been so discouraged with all of the vacant properties in my area (and I am a bit skittish about looking outside my area, as I don’t like buying something I’ve never seen in person). My residential properties, though, have been consistently producing income in both good times and bad.

With the vacancies, compressing cap rates, and the headaches of financing, maybe it’s just not the right time to jump into the commercial space.

Where’s the mistake?

After all, Tyler has identified a cyclical low point in the market … the sort of market that Warren Buffett salivates over:

We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

But, Warren is talking about public markets.

These are the kind of markets that are driven by short-term investor sentiment i.e. the stock market.

When the market is ‘down’, it usually corrects to a long-term mean of an 11% pre-tax return [AJC: it remains to be seen what will happen with the current down market, but it’s only a matter of time – who knows how long – before it corrects].

So, then the market is fearful – and, stock prices drop – Warren jumps in, knowing full-well that (sooner or later) things will correct themselves and he’ll be sitting on windfall gains.

That accounts for 30% or 40% (my estimate) of his $40b fortune …

…. it’s the other part – the major part – of his fortune that holds the real lesson for Tyler:

You see, what most people don’t realize is that Warren Buffett is actually a business owner.

The main purpose of Berkshire Hathaway (Warren Buffett’s company) is to buy operating businesses. Here, he doesn’t look for short-term, contrarianism …. he simply looks for solid businesses that have been around for a long time already, and will be around for another 100 years.

And, he buys them, if he can get a discount to what he believes is fair market value. The bigger the discount, the more likely he is to buy.

[AJC: contrary to popular belief, Warren doesn’t just buy bargains … he creates them! For example, he bought Sees Candy for $30m when he thought it was only worth $25m at most. However, it was Warren and his team who turned it into a multi-billion dollar business, making it a bargain at any original purchase price]

And, Tyler, if residential real-estate is like speculating in stock (it is), then commercial real-estate is exactly like buying a business …

… and, what’s the biggest risk if you own a business?

It’s simply that you will lose customers!

No customers, no sales. No sales, no revenue. No revenue, no profit. No profit, and you go broke 🙁

It’s much the same with commercial real-estate:

Your biggest risk is the risk of vacancy.

It can take a long time to find a tenant in commercial real-estate: businesses simply do not expand, contract, or move as often as a family looking to, say, upsize their home.

And, that’s also the attraction: once you have a commercial tenant, they tend to stick around.

So, Tyler, even though bargains no doubt abound in your area, it looks like you, too, may struggle to find a tenant.

Either look farther afield, or stick to residential R/E until you see signs of improvement in vacancy rates for the specific type/s of commercial R/E that you are interested in.

Alternatively, find a tenant first (make friends with the rental realtors in your area) then buy a building to suit. Or, knock on the doors of all the businesses in your area and see who wants to upsize and find/buy the building for them.

Another strategy, when talking to the business owners in your area, is to find the ones who own their own buildings and see who wants to “sell and lease back” to free up some additional cash for their business.

Any way you look at it, for success in commercial real-estate, the tenant is king.

When to buy residential real-estate …

Prior to 2008 in the USA, and still in many other countries (including Australia), residential real-estate, along with managed funds, had become one of the most favored forms of personal investment …

… one could say the opiate of the masses, as evidenced by the huge rise and fall of residential real estate (and stock market) values across the USA in 2008 and beyond.

Jackie L, cleverly likens investing in real-estate to doing leveraged buyouts in the world of business:

Housing is generally a poor asset class. Housing’s like a leveraged buyout. You put in a little equity up front and fund the rest of the purchase with debt. The real value from housing comes when you sell the property or refinance because you’ve increased your proportion of equity ownership through mortgage payments.

The idea of creating leverage (by borrowing) in residential real-estate investments, though, isn’t so that you can pay it down (which would merely de-leverage yourself, so why do it?), it’s so that you can grab a larger chunk of upside.

You see, the promise of residential real-estate is alluring: You buy a $100k condo with $70k of the bank’s money and $30k of yours. In 10 years, the property doubles in value and you sell it for $200k, giving the bank back its $70k and pocketing $130k for yourself.

You haven’t just doubled your money in 10 years (still a healthy 7.2% compounded return), you’ve actually grown your $30k investment into $130k (in just 10 years), which is an astounding 16% compounded annual return.

If you could keep this up for another 20 years, you would have built up a $2.3m fortune.

No wonder so many people see the allure in investing in residential real-estate … which, of course, lead to the boom leading up to 2008.

The reality is a little different:

On closer examination, you begin to realize that most residential real-estate investments aren’t cash-flow positive for many years, so you have to keep pumping cash in, and there are ongoing costs: mortgage payments, vacancies, taxes, repairs and maintenance, and so on, that your rents simply can’t cover – at least not for many years.

Even so, if residential real-estate doubles in value every 10 years, it’s probably still a great long-term investment.

But, and here is the second catch, in the current market most real-estate has dropped in value. And, in most ‘normal’ markets (i.e. over the history of recorded real-estate transactions in the USA), real-estate only tends to grow with inflation … which means it doubles every 20 years rather than 10.

So, this means that you need to find residential real-estate that will grow at about twice the rate of the average piece of US real-estate, which has been doable (at least until recently) for many, many years, and will most likely be doable again in the future.

In fact, now may be a great time to find those long-term ‘bargains’.

But, the problem remains: residential real-estate is not an investment.

You are gambling short-term losses on long-term price appreciation, therefore, purchasing residential real-estate (other than to live in) is speculation.

[AJC: Commercial real-estate is another matter entirely, as its current value is determined by its current and future ability to earn an income, as I explained in this post]

Yet, I own residential real-estate, quite a lot of it … why?

Well, there are two compelling reasons why I own – and why you should own – residential real-estate:

1. To live in

I like security of tenure; that means that nobody can throw me out of my house. My house is even paid off, so I don’t have to worry about what the market does to its value, but this is a luxury that you can’t afford: you should have no more than 20% of your net worth tied up in the value of your house.

Once you have reached your Number, go ahead and pay off your house. Enjoy!

But, the real reason why you should own your own home is that, for most people, it will be the only way that you ever get off the batter’s plate when it comes to investing.

2. To protect yourself

A down-market, like now, is a great time to buy residential real-estate. When you are retired – and, can pay cash – is another time.

The reason is simple: once you realize that you are NOT going to speculate … you are NOT going to buy in the hope of a future increase in value … you are NOT going to sell, ever …

… then, you buy for one reason and one reason only:

For protected rents.

What do I mean by ‘protected rents’?

Well, residential real-estate tends not to produce the same returns as other classes of investments; that means $100k invested, for example, in commercial real-estate will produce a better rent, with fewer outgoings (costs), hence better overall returns.

However, in a ‘down market’ – worse still, depression – businesses go under leaving commercial offices, warehouses, factories, and shops vacant. And, the stock market tanks.

But, people still need somewhere to live …

So, good residential real-estate will always deliver some income. Not always great, but always some. That’s why a good chunk (but, not all) of my net worth sits in residential real-estate and, as you get closer to ‘retirement’, so should yours.

And, because residential real-estate tends to increase in value at least in line with inflation (given a reasonable time horizon), your capital is largely ‘inflation protected’, so your children should be equally happy 😉

Real-estate: can you tell the difference?

I know when it’s time to give up the game: when you start dreaming about it.

Last night I dreamed that I was telling a group of people the difference between commercial and residential real-estate … the one – key – difference.

Don’t worry, because I’m going to continue blogging about personal finance, but I guess I should at least bring my dream into the the real world by writing about these two classes of real-estate here:

So, what is the difference between the two? That one, key difference?

Is it price? Is it purpose (you can live in one, work in the other)? Something else?

I think it’s all of those things, and more, but I think one reason stands out:

This is residential real-estate, these two houses [pictured above] are the same in every respect:

They look the same; they cost about the same; they will provide a similar standard of living … and, they will produce roughly the same investment return over time.

This is commercial real-estate, these two properties [pictured above] are the same in one very important respect, yet:

They don’t look the same; they didn’t even cost the same; they are totally different types of properties (one is an office, the other a small showroom and warehouse) …

… but, here’s the one thing that makes them identical, at least to an investor:

They will produce roughly the same investment return over time.

You see, residential real-estate is bought/sold/valued on the basis of its utility as a home, not an investment. So, while you can choose to live in it or rent it out as an investment … ultimately, it’s all about its desirability as a future home, street, neighborhood.

Residential real-estate is roughly valued by comparison to others like it, and is ultimately favored by investors for its future value …

… even though residential real-estate is considered a ‘safe, easy’ investment, it’s a sham ; a false promise based on comfort: we all know and understand (to a greater/lesser extent) the value of residential real-estate, because we live in it. Or, if not in ‘it’ in something very much like it, probably even in a neighborhood very much like it.

But, this is false and residential real-estate is actually the most dangerous form of real-estate investment because is is largely speculation; most of the return from residential real-estate is based on capital appreciation.

[AJC: there are exceptions, of course: defence housing, rural areas, and so on … generally, though, you are trading future appreciation for lower rents now. Cashflow positive real-estate does exist, it’s just than most people don’t know how and where to find it]

Commercial real-estate has the reputation of being difficult. Of course, it’s not: you purchase a property, you find a property manager, you rent it out, you collect the rents … nothing could be easier.

And, you are rewarded in the short-term: commercial real-estate is mostly about the income that you can derive from the property. It’s current and future value are simply a multiple of that return [the capitalization rate].

The returns are usually higher, per dollar invested, than residential real-estate (although, the banks will lend less against it); capital appreciation more certain; and, it’s easier to manage (tenants generally don’t trash the place; they pay most of the outgoings; they shoulder the lion’s share of the maintenance burden on the property).

Since most people are too scared to invest in commercial (so, they fight each other – in most ‘normal’ markets – to invest in residential real-estate) overall returns, in my experience, are generally much better.

What do you think they key difference is?