The timeless secret to making money in real-estate!

OK, so if the ‘secret’ to making money hasn’t changed in 50 years …

[AJC: if you didn’t read yesterday’s post, it’s simple: buy a rental property with about 25% down; renovate; trade up and start again; repeat until rich!]

… why are there so few people doing it?

It could be market fever: “the market’s too [insert excuse of choice: hot, cold, near, far, etc.]”; but, I suspect it’s the age old reason: you simply don’t know HOW.

Ok, so let me make it simple: save up a reasonable deposit (15% to 25% works for me), and do the most cost-effective renovation (also called remodeling or rehabbing, depending on what country you live in) possible.

The question is, what are the best ‘bang for buck’ renovations to do?

Well, here is a national summary of typical renovation/remodeling projects (including their average cost and how much resale value that they add to the project):

Despite this, I would not go about replacing all of the wooden front doors in my condos with steel doors! In fact, I would still look at:

1. Repaint / recarpet,

2. New blinds, door handles, light fittings (all of these can be quite cheap, as long as they work/look OK),

3. Kitchen remodel (you may be able to resurface the existing cabinets)

4. Bathroom remodel (you may be able to resurface the existing tiles, baths, and vanities)

5. Also, if it’s a house (not a condo), then you should paint the exterior and fix up the garden

6. Again, if it’s a house, perhaps the MOST ‘bang for buck’ rehab that you can do is to add another bedroom (especially to change a two-bedroom house into a three-bedroom house).

If you think it’s expensive, think again … just be very wary of your budget!

Here’s how it panned out for us:

We purchased one condo a street or two away from the beach:

– We bought for about $220k,

– Spent $15k on a rehab (paint/carpet, kitchen/bathroom remodel, door knobs and light fittings),

– Rented it out (we didn’t need to sell it).

It’s now worth $450k to $550k a mere 6 or 7 years later.

We then repeated with a block of 4 condos:

– Bought all 4 for $1.25 million,

– Rehabbed for $200k ($50k each condo), including the fees necessary to retitle from apartments (rental) to condos (rental or individual sale)

– It’s now worth $1.8 million to $2.25 million, a mere 6 years later.

For the four condo’s, we spent $50k in renovations (each condo: $200k total)), which bought us: paint inside/outside, new kitchen bathroom carpet, light fittings, security entrance for the building AND conversion of the front of the building into a private courtyard for one of the apartments, and conversion of the rear laundry into an ensuite bathroom for another condo in the block!

If you think the work is hard and/or time-consuming, we didn’t do the rehab on either project and didn’t even see the second project until 5 years after it was finished! We believe in outsourcing everything 🙂

How successful are they?

You’ve  heard the pitches, seen the ads, and even read the books …

… but, how successful are those ‘best-selling’ real-estate authors, anyway?

John T Reed is the guru-basher – rightly or wrongly, he reads, judges, and publishes his views on his web-site. Click on this link to read what he has to say about some of those real-estate gurus, then come back here.

You see, I want to point you to the very first ‘guru’ that he mentions: it’s William Nickerson. William Nickerson was unique in that he really was successful, and interesting for two reasons:

1. He actually wrote a best-selling book on real-estate that is the genuine article, and

2. He wrote (or commissioned) perhaps the very first real newspaper ‘advertorial’ (see the image, above).

According to John T Reed, an accomplished and genuine real-estate investor in his own right, William Nickerson:

… told the truth – but he did that back in 1959. His book, which is excellent, says to save money, put 25% down on rental property, renovate it, and exchange up to a bigger one and repeat the process.

Simple, but effective!

BTW: I now remember that Rich Dad, Poor Dad was NOT the first personal finance book that I ever read. It was, in fact, an old book that I found in my Dad’s book shelf. It was called something like: How I Made $1 Million In Real-Estate and was written by a Hungarian ballet dancer who either moved or defected to the USA and somehow found a lucrative ‘hobby’ in real-estate.

His system was very similar: buy one rental property, rehab, and trade up for a duplex. Repeat and trade up to a quadraplex. And, keep going!

I can’t believe that I forgot about this book, as it was the one that really fired my imagination, after which I promptly did NOTHING towards investing in real-estate for at least the next 10 years 🙁

Punch Buggy Blue!

Let’s say that you do agree that real-estate is one of the best MM301 (wealth preservation) strategies … although, many of my readers would disagree …

[AJC: I’m happy to meet all the dissenters in, say, 50 years – at a very cheap restaurant, as they won’t be able to afford much more – to discuss how they went with their TIPS, bonds, cash and stocks-based retirement strategies. Then I’ll meet Scott, Ryan and all the other RE and business-based retirees on their private golf-course in Palm Beach for a second debrief 😉 ]

… but, what type of RE would fit the bill?

After all, many of my readers, Evan included, have had mixed experiences with RE:

I have watched my dad deal with C R A P for years. He owns 2 properties:
1) CASH COW – 2 family residential unit income exceeds mortgage payments. They always pay on time and there mostly are no problems

2) 2 family unit with a bar attached. I have listened to him say for YEARS, that if the bar paid its rent things would be different. I feel like the stress associated with this property is going to kill him eventually, and that is the commercial part.

In NY it takes 9 to 18 months to get someone out, so even if you try to evict you are looking at legal and time costs that could literally eat 6 months profit.

As I said to Evan:

That’s why we keep TWO YEARS’ buffer 😉

But, we all have a Reticular Activating System (RAS) that attracts us to whatever it is that has caught our attention … for example, have you ever played the Punch Buggy / Slug Bug game with your friends and / or kids?

If not, it’s a bundle of fun – and, pain. Actually, mainly pain 🙁

It works like this: who ever sees a VW ‘bug’ first calls out “Punch Buggy [insert color of choice: yellow, green, red, etc.] !!” and gets to whack the other person on the arm … as hard as they like [AJC: usually me. ouch!] …

It’s amazing how many VW Beetles there are on the roads, these days!

We used to play a similar game – many, many years ago – when I was on the school bus: we used to look for Chrysler Chargers, and whomever saw one first would yell out “Hey, Charger!” and hold up their hand with a Richard Nixonesque V-For-Victory sign.

The winner for the day was the one who scored the most ‘victories’ …

It’s amazing how many Chrysler Chargers there were on the roads, in those days 🙂

Of course, what’s happening is that our RAS is simply filtering IN Chargers (or VW Beeltes) and filtering OUT other types of vehicles, making it SEEM as though Chargers / Beetles are everywhere … of course, there are no more / less than there were before we started looking out for them.

Similarly, with RE – or other – investments:

Our view tends towards our first direct – or, even indirect – experiences; which helps to explain why my generation is more conservative (we went through some down cycles in the late 80’s and early 90’s) and younger folk were more bullish, having had 15 to 20 good years … until resetting their RAS’ in the current cycle.

Similarly, Evan’s views may be colored by his Dad’s experiences albeit mixed.

But, Evan’s Dad could have avoided many of his RE problems by buying well … now, for MM301, buying well is NOT the same as buying well for MM201:

While we are still building towards our Number, we need to buy RE that will appreciate strongly, with rents just covering cashflow (of course, we wouldn’t say “no” to more!) …

… but, when we have reached our Number, we need to generate INCOME, so buying well really means that we need to:

Buy to protect our future income / rental stream

As I have shown you, it’s easy to get a positive cashflow from RE; just pay cash!

And, live happily from 75% of the rents (less taxes), knowing that the other 25% will cover all of your ‘normal’ costs (management fees, vacancies, repairs and maintenance, etc.), and will keep up with inflation.

It’s the last part that is key: since we are never selling these properties [AJC: lucky kids!], we don’t really care how much/little the RE itself appreciates, we just care how much the rents appreciate, and our benchmark for this is:

The rents must appreciate at least as much as inflation

That is through both UP and DOWN markets …

… so, I would keep away from bars and other retail EXCEPT for counter-cycle retailers such as dollar stores, groceries / food stores (food staples only), and – of course – Walmart and Walgreens [AJC: if I could get my hands on the freehold!].

Remember, we’re not looking for extraordinary capital growth (any more), but protection in down-cycles.

[AJC: oh, and if you were going to buy stocks (again, for retirement capital protection and dividends); these types of retailers and food businesses would be great ‘protection stocks’ to own, as well]

And, moving away from retail, I would also happily buy small offices, say, housing a number of separate professionals (e.g. doctors, attorneys, etc.), as these professions are required in all markets and my risks are well spread.

But, I would avoid large offices – or industrial showrooms and warehouses – housing SME’s, as these are prime candidates for simply shutting shop in a down cycle, and I may only have one tenant per property (even though buying 6 or 7 of these would certainly help to insulate the ‘shock’)

And, you might be surprised to find that I am not all that excited about residential (even multi-family) for MM301, simply because the rental returns are usually not that great (but, they can make a fantastic MM201 strategy).

Remember, RE isn’t the only MM301 Wealth Protection strategy that you can base your retirement (or, life after work) around, it’s just that I am struggling to find another one that has both income and capital that can keep up with inflation, fairly consistently, through at least the 30 to 50 years that I still plan to be around …

… can you?

The Ideal Perpetual Money Machine …

So,  it seems that creating a mix of bonds and stocks and then picking some magic withdrawal rate (e.g. 4%) is not the ideal way to plan our retirement (a.k.a. life after work) after all …

… instead, it seems that we need to create our own Perpetual Money Machine: a renewable resource of cash 😉

The ideal Perpetual Money Machine – at least, according to my liking – is Real-Estate (more wealthy people build their own Perpetual Money Machines using real-estate that any other investment, even more so than cash, CD’s, bonds, mutual funds, or stocks):

1. Real-Estate (particularly commercial real-estate, when purchased well) protects your capital and keeps pace with inflation; it will last as long as you do, and then some!

2. Real-Estate (when managed well -and, this is something that you CAN confidently outsource) protects your income (i.e. net rents; they will grow with inflation).

3. The bumps in your real-estate road can be managed with insurance and provisions: you can insure against most catastrophic losses (and, you can spead your RE investments to minimize even those risks), and you can keep a % of your rents (and, starting capital) aside to help smooth your income stream (against vacancies, repairs and maintenance, etc.).

For example, with $7 million (aiming for a $350k per year gross income – indexed for inflation – which should net $200k – $250k after tax), you could:

1. Keep $500,000 as a two years of living expenses cash buffer (one year to allow for the rents to start coming in, another year “just in case”),

2. Invest $6.5 million CASH into 5 x $1.0 million to $1.25 million dollar properties (allowing for closing costs, etc.),

3. Which should provide 5 x 7.5% x $1.0 million to $1.25 million = $400,000 gross rental income

4. Of which you would pay tax of 30% (say) and divert another 25% of the remainder to your ’emergency / provision fund’ leaving $215k (PLUS, tax benefits such as depreciation, tax deductions of cars, certain travel and other business expenses etc.).

After every few ‘good years’, you can trim your provision fund back to two years of living expenses, allowing you to buy some more real-estate (therefore, providing the basis for another future pay rise!).

If you don’t like real-estate, then you can always lower your spending expectations and dust off your bond-laddering books 🙂

Business for Cash Flow and Real Estate For Wealth

I don’t know these guys, but I do like what they have to say: “our philosophy on creating and sustaining income without a job: Business for Cash Flow and Real Estate For Wealth” …

… it pretty much sums up how I achieved my $7 million in 7 years; maybe it’s how you’ll also make yours? 🙂

So, you want to invest in commercial real-estate …

… but, you don’t know where to begin?

At least, that’s the case for IJ who e-mailed me:

I’ve always wanted to find some sort of mentor.  It would be great that everyone had a mentor that can help with advice and bouncing ideas off of … [people who’ve] owned their own businesses, residential and commercial RE.  I want to get more involved in commercial RE and do not know of anyone who I could turn to on how to get started.

I’m a great fan of mentors; but, when you can’t find one then you have to make do with getting info. from a variety of sources: friends, accountants, attorney’s, investor’s clubs, and – of course – Realtors.

This takes time and energy, so in the meantime, you can refer to the resources on this site and others …

For example, you can start by checking out these posts;

If you are interested in property development:
 
http://7million7years.com/2009/09/09/ive-been-out-shopping/
 
http://7million7years.com/2009/09/16/can-your-real-estate-development-project-make-money/
 
http://7million7years.com/2009/09/23/how-much-money-can-you-make-developing-real-estate/
 
And, these posts if you are interested in how to analyze a commercial property deal (offices):
 
http://7million7years.com/2008/12/22/anatomy-of-a-commercial-re-investment-part-1/
 
http://7million7years.com/2008/12/23/anatomy-of-a-commercial-re-investment-part-2/
 
http://7million7years.com/2009/01/05/anatomy-of-a-commercial-re-investment-part-3/
 
And, you should follow up these resources if you are interested in multi-family-type ‘commercial’:
 
Dave Lindahl: (I bought and USED his ‘multi-family millions’ course to help me analyze 100’s of potential deal (but, in the interests of full-dsclosure, I didn’t end up buying any, although I already own millions of dollars of residential RE, but my largest is only a quadraplex)
 
Dolf de Roos: I have bought a number of his products, including his Commercial RE audio course and some s/w … more basic than Dave Lindahl’s course, but helpful nonetheless, especially for noob’s.
 
To be fair, a few others consider these guys to be ‘scammers’, but I don’t make any money from either – have bought their material at full price and found it useful, so what more can I say?
 
Oh, and here is a guy who is definitely NOT a scammer and has some useful stuff, too: John T Reed.

Of course, you could also try and do what IJ did:

E-mail me with your questions … I don’t mind, if you don’t mind if I [perhaps] choose your question for a future post 🙂

Free money at last!

Once my honeymooner guests agreed that purchasing a home would be a good investing goal, the question became how much equity to maintain?

I explained that if you have an empty glass, worth $100 (let’s say it’s a collectors’ item) representing your house then it makes no difference how much fine wine (also a collector’s item at $100 a glass) you have poured into it as to the future value of the glass …

… the glass can be full or empty, but if collectors’ glasses double in value every decade, it will still be worth $200 in 10 year’s time.

Of course, after consuming a few glasses of that fine wine, another question arises:

What happens if I put less money into the house (or other real-estate)?

Simple, you have to borrow the rest: less deposit, more borrowings/mortgage … more deposit, less borrowings/mortgage.

Then, in deciding exactly how much wine to pour into your glass, you think of the next logical question:

What’s the ideal amount (or %) to borrow against the property i.e. how much deposit should I put in?

Given the current ‘crisis’ in domestic RE values, it’s popular to imagine a high number: 20%? 50%? 100%?

But, it’s not so long ago (and, I wager it won’t be more than a decade before it comes around again) that it was popular to imagine a low number: 10%? 0%? Even negative 10% (as people borrowed 100% of the property PLUS closing costs)?

But, what’s the right number?!

Surprisingly, at least to me, there’s no magic ‘right’ number …

… once you realize that it matters not what equity you have in the house as to how your future wealth increases – based on the appreciation of such fine real-estate.

So, another question forms instead:

What does it cost/save me if I put in more/less money into the RE purchase?

Well, we know it does not cost you future capital appreciation, but it does cost/save you exactly what the bank would charge in you in mortgage interest and ancillary charges … circa 4% – 5% these days.

So, let me ask you two closing questions:

1. Do you think that you can do better than getting ‘free money’ by owning real-estate that appreciates, perhaps even doubling every 7 to 18 years (depending upon whom you believe), leaving you with virtually ALL the excess over the original purchase price?

2. Do you think that you can invest money that would otherwise cost/earn you only 4% – 5% for more than that [Hint: how about some more of that yummy real-estate? Failing that: stocks; business; P2P lending; etc; etc; etc? But, we covered this question last week ]?

… at least those are the questions that I put to our house guests 🙂

What do you think?

Call me … make it happen!

OK, so he wants you to buy five houses this year … and, he gives you the quick ‘hard sell’ at the end … but, the basic philosophy – to me – is sound:

– Houses are depressed in the USA, but so are interest rates,

– Unless the USA ‘double dips’ prices will begin to go up (when?)

– You can fix an incredibly low interest rate on your primary residence (can the bank rewrite the mortgage if you move?)

– You MAY be able to receive enough rent to cover most/all of the mortgage

– Who says you need to buy five houses (except for this Realtor!?) … just think about one for now

Do the numbers for your area/s of interest (price of house, monthly cost of mortgage, likely rental income, other expenses such as 6% – 9% property management etc.) … if you can even come close to breaking even, could you find a better return on your deposit plus the cumulative cost of any monthly shortfall (or gain of any monthly excess)?

Now, run the numbers again assuming that the US market stays flat for another 5 years before some sort of rebound … maybe it still makes sense?

Have you run the numbers? If so, what do you think?

A Vacation Question – Part II

But, what about the other financial question that my son asked while we were on vacation?

Well, we were walking along the beach and Bill, the shaved ice vendor, drove past with his little all terrain vehicle pulling his ‘shop’ behind only to stop a few yards up the beach to tempt my son – and, the many other children running along the sand and swimming in the warm surf.

Naturally, I  quickly became $3.50 poorer and my son had his paper cone filled with shaved ice with various color sweeteners poured over it (he chose ‘rainbow’ flavoring), which got us talking:

You see, it’s popular folk-lore that Bill, who has been selling his flavored shaved ice along the beach for 20 to 40 years, owns many of the apartments in the vacation rental buildings all around [AJC: check out the aerial shot in yesterday’s post] … if true, then Bill is the poster-child for the Wealth Alchemist i.e. turning temporary cashflow into long-term assets.

It’s not hard to see that Bill turns over thousands of dollars a day, most of it costing him nothing (little staff, few overheads, little-to-no-cost-of-goods-sold), after all, how much can ice cost to make?!

Instead of spending all of that money, it’s not a great leap to assume that Bill saves up enough for a deposit to buy a property every now and then; we figure $1 million worth of property each year (with 20% initial equity).

Here is my son’s question:

“Would he pay cash for the properties, or would he just save up enough for a deposit and borrow the rest?”

Now, this is a seemingly simple – yet terribly interesting – question; one that we could labor over for many posts … instead, we’ll look at this another way, by asking:

“Does Bill need the property for income now or for its future value (hence, future income)?”

The answer is clear: Bill has plenty of income now, but what does he do if his income stops?

Presuming that he can’t rely on being able to sell his business (for example, the council could decide that they no longer want people peddling ice on their beaches), then Bill will probably want his properties to generate a replacement income “one day”.

So, which would do that better? When Bill moves into MM301, it’s likely that owning the properties outright and living off the rental treams that they throw off will be best …

… until then, Bill has to (in my opinion) work on the strategy that will produce the most properties by the time he wants to retire.

So, I had to explain the concept of leverage to my son:

SCENARIO A: If you purchase a property for $100k CASH and it doubles in 10 years, then you have $200k of property. Well done!

SCENARIO B: But, if you purchase TWO $100k properties, putting $50k deposit into each and borrowing $50k for each from the bank, then in 10 years (assuming they both double), you now have $400k of properties, of which you owe the bank $100k (assuming that you haven’t paid down any of the loan in the meantime), leaving you with $300k of property … a $100k improvement over Scenario A.

At least, that’s what the property spruikers would have you believe …

… because, they have conveniently forgotten that in Scenario A, you also have some rental income (after, say 25% costs) coming in, whereas in Scenario B that income would be largely offset by interest owed to the bank.

The question is, is that differential in income ‘worth’ $100k over 10 years?

Let’s assume that we can get a 5% return from our Scenario A property (after costs), giving us $5k a year initially (when the property is worth $100k), increasing over time to $10k a year (when the property increases to $200k in value). It doesn’t take a genius to figure that this comes to less than the extra $100k that Scenario B gives us (if you assume an average $7,500 per year rent for the 10 years, we are comparing $75k in rent for Scenario A to $100k in additional capital gain for Scenario B).

Now, add the benefits of:

– 80% gearing (i.e. only making a $20k down payment in our example), which should buy you 5 properties instead of Scenario B’s 2 properties (cost = $500k; worth in 10 years $1 mill., less $80k loan on each = $600k v $300k for Scenario B and $200k for Scenario A. Get it?),

– Increasing rents offsetting fixed interest rates (possibly producing some positive cashflow from each of our 5 properties as time passes),

– Tax deductibility of any excess of interest over income in the early years (a.k.a. negative gearing),

– And, any additional tax and depreciation benefits of 5 properties v only 2

… and, it’s just possibly a ‘no brainer’, even if that does make some of those scummy spruikers right 😉

But, how does Bill pay his bills?

Well, that depends on how much excess of income the properties produce by the time Bill is ready (or has) to retire …

… if  insufficient to pay Bill’s bills, he can sell enough properties to pay off the bulk (or all) of the bank loans, thus forcing a positive cashflow situation (assuming the properties aren’t total dogs, which is highly unlikely in this well sought after tourist area, which boasts near 100% year-round occupancy) and that (after a reserve to cover costs of vacancy, property management, and repairs and maintenance) is his infltation-protected income for the rest of his life.

Then Bill can spend the rest of his days lazing on the beach … buying shaved ice from the next shmuck who chucked in his chance at earning a college degree for the life of a beach bum 🙂

Inspiration at the pump …

When your car runs out of gas, you go to the gas pump …

… when I run out of inspiration (as sometimes happens … not often, but sometimes) I go to the bloggers ‘gas pump’: Alltop.com, a compilation of articles from the best blogs on the web in almost any category that you would care to name.

I got excited when I saw the headline, there, of a CNNMoney article titled: Real estate in your retirement portfolio.

Excited, that is, until I read the first paragraph:

Question: How do REITs work? And is it prudent to have them in a diversified retirement portfolio?

This is the problem with the financial press in the USA: it’s directed to packaged financial products e.g. stocks, funds, REITS, and the list goes on … this is why average (and, 99% of  ‘above average’) Americans will remain relatively poor.

It’s ironic then that the wealthiest Americans (and, I would suggest this to also be the case in all developed countries) made their money in business (including the business of investing) and keep their money in real-estate.

According to an otherwise (and, unfortunately) highly flawed book that I reviewed some time ago, the rich keep their money for generations ONLY if they split their assets roughly one-third in a business, one-third in paper (stocks, bonds, mutual funds, etc.) and one-third in real-estate (incl. their own home) … since I called this “the most dangerous idea in retirement planning that I have ever read” (and, you will have to read this post to find out why), I had better give you my much simpler formula:

As I transition into Making Money 301 [protecting my wealth], I would happily keep 95% of my net worth in real-estate (incl. no more than 20% in my own home; remember The 20% Rule?) … and, I am NOT talking about REITs here, I’m talking buy/hold income-producing real-estate.

It’s certainly not the only strategy, but it’s one of the simplest and, IMHO still the best 🙂