Category Archives: real estate

How much capital do you need to start real-estate investing?

Posted on by
9

Rick is keen to start his real-estate investment career and is worried about two main subjects – I would say THE two main subjects 🙂 – Time and Money.

I answered Rick’s ‘time’ question here, but now he asks the key question about ‘money’:

What is the minimum practical amount of capitol to start real-estate investing?

The answer is $0.

That’s right …. ZERO: the world of No Money Down is not dead, and is not even a dirty word (or, phrase to be precise).

No Money Down has lived and died a thousand times and will continue to do so; to prove it, here is the best book that I have found on the subject – and, it was written in 2001 by two of the best-credentialed real-estate investors that I could find: Richard Powelson and Albert Lowry, who purport to have used these techniques since the 60’s or 70’s.

But, that is the ‘minimum’ as asked by Rick – and the book reference is to prove that it also meets Rick’s ‘practical’ requirement (not that I’m so sure that the bond strategy that Richard Powelson gets so worked up about in the latter parts of his book count as ‘practical’).

Now, if Rick had asked what I ‘recommend’ that might be a little different:

While it’s true that No-Money-Down probably provides the best Return on Investment (and Internal rate of Return, as well), I would rather avoid asking the seller to carry a note (the number one ‘no money down’ technique) and screw them down to a better price in the current market …

… equally, I would like to avoid taking on a partner (the number two ‘no money down’ technique).

Therefore, what I would recommend instead is that you look to the type of property and market that you want to invest in (I usually recommend finding the neighborhood next to the new ‘hip’ neighborhood, and buying a property in the median-to-just-under-median price range for that area … with some potential for easy cosmetic fix-up) and having enough money under your belt to:

1. Put up a 15% to 20% deposit, and

2. Pay the likely closing costs (nothing wrong with financing these, if the lender will let you), and

3. Hold at least 25% of the first year’s expected rents as a contingency against vacancies, repairs & maintenance, and other costs that might come up just when the property is vacant.

That could mean $10,000 or $100,000 depending upon the area and property type …

… if you can’t afford that, time to dust off the old Formulas For Wealth book, after all 😉

… but, if you don’t want to practice any of the creative funding techniques recommended in this older (but, still excellent) book, you want to target properties in the median-to-just-below-median price range in your target area and have 15% for your first deposit + enough for closing costs + 25% of the expected value of your first years rent as a buffer (minimum).

The world is your backyard!

Posted on by
4

For most people, their backyard is their investment (OK, you can throw in the front yard, the kennel, the house, and the above-ground pool, but that’s it!) …

… for others, the only place that they invest is near their backyard – well, their neighborhood or those close by.

And, it seems to make sense: you understand the area; you can manage your investment; you can (almost) ‘touch’ your investment … lots and lots of ‘warm fuzzies’ around that one.

That seems to be the thinking behind Ryan’s question:

I have a question on real estate investment when you’re nomadic. My concern is I’m young (28) and my girlfriend and I have a list of places we’d like to try living before we settle down (west coast, gulf coast, a big city, etc). Do you tend to only keep rental property near where you live? Or are you comfortable owning property across the country? And if the latter, do you run into any problems with doing that?

My concern is that, if I have enough income/capital to own property, would I be better off waiting 10 years until we decide where we’re going to live long term? Or might I be better off, when we decide to move somewhere, in buying a house, then when we move, trying to keep it as a rental, or something along those lines?

Any tips or thoughts you could throw at me about real estate investing when your location isn’t static?

Ryan, the best place to invest in real-estate is where you will make the greatest return. Seems obvious, but it opens up so many questions about:

– Location: where to invest

– Type: what class of property (residential, commercial, etc.) to buy

… as well as all the usual questions around how much to invest, funding, etc.

I have real-estate in Australia and in the USA, and I happen to be right in the middle of a big ‘argument’ with my accountant at the moment about where I should invest: he thinks locally (easier to manage, handle taxes, etc.) and I think globally (spread risks; greater potential returns; etc.).

Now, you might say that’s OK for me with a portfolio of real-estate, but the reality is that we also have a single condo overseas that we have held on to, as well as a quadruplex, and until recently we kept our old house and rented that out.

In all of those cases, good property managers ensured that we could manage the investments as easily as if we lived next door – almost 🙂

In fact, by investing away from home, you remove the temptation to manage the properties yourself … you focus on increasing income and finding the next deal; let others do the ‘grunt work’ on the existing properties for you.

As to the second part of your question: if you do want to invest in R/E and you see that as your main path to wealth … start now!

Let others wait ‘until’ …

The Perpetual Money Machine begins to wind itself up!

Posted on by
12

————–

I’m about to find out if I can make money on-line … read the latest installment (just posted) here!

————–

Your Perpetual Money Machine begins to wind itself up (in the case of selecting RE as your ‘income capacitor’) simply when the property portfolio that we discussed on Wednesday becomes cashflow positive …

… this is a critical point in time, because now we can exponentially accelerate the size of our pool of capacitors!

Now, we can take our 15%++ (continually growing as our income stream continues to grow) and ADD the excess cash spun off by our profitable property portfolio (assuming that we selected real-estate, as our ‘income capacitor’ i.e. storage device for money) …

…. this ALL goes into: new properties!

Now, Scott is building a whole bank of financial ‘income capacitors’ …but, for what purpose?

Aah, until the point in time that the income from these ‘capacitors’ is enough to replace Scott’s income from his inventions and movie royalties!

If you have been following the process, this can happen surprisingly quickly (5 to 10 years) IF the income stream that Scott is seeding with is large enough to purchase large ($1 million+ each) commercial properties.

If residential (incl. larger multi-family) you can expect it to take a little longer, as these tend to start more cashflow-negative, or grow too slowly.

At this point in time – assuming that the income-replacement is sufficient to satisfy Scott ‘forever’ (if not, keep working/building a few more years) – we have our Perpetual Money Machine!

You see, the real-estate will continue to grow, even if you no longer continue to ‘seed it’ with more income … in fact, it will grow (on average) at least according to inflation, producing an income that also at least grows with inflation (even allowing for keeping 25% aside as a buffer against repairs/maintenance/vacancies/etc.).

Scott can spend that entire income with impunity, knowing that his capital is never at risk … just like cash in the bank, only better because the capital also grows (at least) with inflation …. provided that your outlook is long enough.

On the other hand, if Scott chose to put his money into Berkshire Hathaway stocks, instead of the real-estate portfolio that we discussed here, which have grown at 21% compound for the past 20+ years (although, not even Warren Buffett suggests that that rate of growth will continue), then Scott can simply sell down enough stock each year to fund the next year’s income.

Different tool, hopefully a similar result …

In either case, when Scott’s royalty income stops, his Perpetual Money Machine seamlessly and automatically takes over.

Nice for some 😉

PS The mechanical/electronic Perpetual Motion Machine is impossible in physics (although, quantum mechanics may provide a solution) … the one depicted in the image above was built in 1996 and resides in a vault in a Norwegian gallery: it once ran as long as 14-days in a row without stopping … hardly ‘perpetual’ but pretty, damn good!

Pay cash for your house?

Posted on by
2

The best way to give up your ‘day job’ is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at http://ajcfeed.com ….

__________________________

We have dealt with the concept of how much ‘house’ you can afford while you are still working, but what about when you ‘retire’ (young … very young!); that is the question posed by Ryan:

Regarding “the number”. I know you’ve touched on this briefly before, but when considering a multi-million dollar home to live in during retirement, would you suggest putting in a number to rent or to pay for a mortgage? If for a mortgage, do we assume a certain percentage down? And what kind of interest rate can we assume we’ll get in 10-20 years?

We basically have three options when acquiring a house:

1. Pay Cash

2. Take out a mortgage

3. Rent

The rental optionn is actually not so dumb in the high-end bracket, as rents tend to fall way behind house prices (hence mortgage payments) … just check out what you can rent for $40,000 – $50,000 a year compared to what the same level of mortgage payment (assuming a reasonable deposit of only 15% – 25%) will get you.

But, let’s also assume that your idea of ‘retirement’ isn’t to pack up and shift houses every couple of years so that leaves us with paying cash or financing.

The first thing to realize is the fundamental difference with buying a house when you are working and when you aren’t:

When you aren’t working all the money that you have is what you have already manufactured …

… so, all you are doing by mortgaging or paying cash for a house is shifting money to/from your house from/to your ‘retirement nest egg’.

Let’s look at an example:

You decide that you need $100,000 a year to live off (before considering mortgage payments) but you want to retire into a nice $750,000 townhouse … your current house, after you pay back its mortgage will provide $250,000 of that, leaving you to ‘find’ $500,000.

Not exactly Ryan’s “multi-million dollar home” but it’ll do for the sake of this exercise …

Scenario 1 – Pay Cash for the House

Let’s see; we need:

a) $500k to pay the cash upgrade to the nice townhouse (on a golf-course, of course!)

b) $2 Million (according to the Rule of 20) to deliver $100,000 (indexed for inflation i.e. so next year it becomes $105k; and so on) living expenses.

So, we can afford to ‘retire’ as soon as we have built a $2.5 Million ‘nest egg’ …simple!

Scenario 2 – Borrow Money for the House

Now we need:

a) $2 Million (according to the Rule of 20) to deliver $100,000 living expenses

b) Another $1,100,000 (according to the Rule of 20) to generate the $4,500 monthly mortgage on the $500,000 townhouse balance (assuming 6.5% fixed interest for 15 years), plus $20k closing costs

Now, we have to wait to retire until we have built a $3,100,000 ‘nest egg’

But, it is actually a wash because we can afford to use the Rule of 10 on the mortgage payments rather than the Rule of 20 … why?

The mortgage is a fixed dollar amount: $4,500 every month for 15 years. If we consistently achieved 10% return on our investments, we would only need $540,000 set aside to generate the required monthly payment.

Then our total nest-egg would be $2,560,000 or a virtual ‘wash’ either way … but, this is heavily interest rate dependent:

– if interest rates are low and investment returns are high: mortgage.

– if interest rates are high and investment returns are low: pay cash.

Since you won’t know which way to expect the interest / investment markets to be aligned when you do retire in 5, 10, or 20 years, my advice is to plan to pay cash …

… calculate your Number using Scenario 1.

That’s what I did … then when I get the urge to invest a little of my home equity, I simply turn up the juice on the HELOC that I have sitting there ‘just in case’ and hop in / out of the investment markets as is my desire.

More on Emergency Funds …

Posted on by
Reply

The best way to give up your ‘day job’ is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at http://ajcfeed.com ….

__________________________

Recently I wrote a couple of posts on Emergency Funds; my goal was to blow a hole in the standard “save a 6 month Emergency Fund” myth … that’s right: myth!

Most of the comments (and, they were really good) related to my suggested use of HELOCs as a possible replacement for 6 month’s cash slowly wasting away in a CD – and, I have just posted a follow-up to address this.

But, Meg comments from a slightly different angle that I think addresses the core of my original post:

I hate having loads of cash sitting around earning less than the rate of inflation. And I consider 3 months of expenses for me to be loads of cash. Plus I have tons of liquidity in the form of a total stock market index fund. This is from where I have drawn money when I totaled my car unexpectedly (ins only covered half the value of a comparable newer car), when I needed a down payment for real estate purchases, etc.

That has worked great over the last 5+ years of a bull market. But 2 weeks ago I was presented with an unexpected real estate investing opportunity, which I jumped on. I was of course going to put 20% down (to minimize the rate, avoid PMI, be conservative, etc). Then the market began its tumble. I was AGONIZING over the loss (it would still technically be a gain to sell, but still it sucks to sell at a market cycle low).

Then Meg, found a fortuitous solution:

Luckily for me I have a wealthy and generous grandfather who volunteered completely unprovoked to lend me the money for the down payment rather than have me sell stocks at a cycle low. He has plenty of money sitting in bonds and cash that he doesn’t have any better use for, I suppose, than to thrill a granddaughter with a 2.5% loan.

Lucky for Meg, indeed. But, an anti-climax for those of us who are not so fortunate!

So what would you do? Rich relatives aside, I see three choices:

1.  Put 6 Month’s cash into CD’s as an emergency fund

2. Put 6 month’s cash into an Index Fund and let it sit

3. Put 6 month’s cash into an Index Fund, sell at a 20% ‘loss’ to buy the real-estate

Now, these aren’t exactly comparable choices (we really need a table: do/don’t buy the property across the top, and CD’s/Index Funds down the side … and to be really fancy, we’d need a cube adding emergency/no emergency along the edge), but we can at least illustrate some key thoughts by examining them mathematically.

And, I will consider a 30 year investing horizon, because that allows me to guarantee an 8% return for the Index Fund (it will probably do better, maybe even 12%, but then there could be fees and commissions to consider).

Put 6 Month’s cash into CD’s as an emergency fund

If Meg is on $100,000 and paying 25% tax, she would need to sock away $37,500 to provide a 6 month after-tax salary emergency fund.

This might take some time, so let’s pick up at the point where she achieves this monumental milestone: over the ensuing 30 years, her salary will increase, hopefully at least in line with inflation (let’s average that to 4%) so she will need to keep topping up her Emergency Fund such that it reaches $117,000 by the end of the 30 year period (I didn’t increase her tax rate to 35% … I guess I should have).

Assuming that her CD’s keep pace with inflation – and, she doesn’t need to draw down on the fund at all during the 30 year period – she will have $247,000 at the end of the 30 year period.

Before you sing Ode to Joy on this, remember that the CD’s are just keeping up with inflation, so the $247,000 is ‘worth’ no more and no less than the money that Meg actually put away … there is NO investment here at all.

Now, CD’s actually bounce around between 3.5% (actually for a bank deposit with WaMu) and 5.5% in the current market (and, who knows what they will average over the next 30 years?), so Meg could technically get a point to a point-and-a-half above inflation, but we are only talking $90,000 ‘gain’ over 30 years, if she gets the max.

Put the 6 month’s cash into an Index Fund and let it sit

OK, now that we have the cash ‘baseline’ set, let’s see what happens if we ‘amp up’ the savings rate a little by putting our Emergency Fund into an Index Fund instead:

Assuming the 30 year ‘guaranteed’ return for the ‘large cap’ stock market of 8%, Meg will ‘gain’ $335,000, after her inflation adjusted deposits are factored out … or, nearly a quarter of a million more than the $90k gain that she made by putting her money into pretty much the highest-performing major bank CD’s out there!

So, that was the premise of the original post: is the ‘peace of mind’ of having 6 month’s cash put aside for emergencies ‘worth’ $250,000 to you … put another way, would you pay a $8,333 a year (that’s $250,000 divided by 30) to ‘insure’ yourself against an emergency – on top of the insurances that you already do pay?!

Now, the stock market has actually averaged 12% over all but two 30 year periods in 75 years of history so what would ANOTHER $900,000 do to your decision-making process?!

That’s why you find another way … any other way … to dealing with an emergency rather than wasting the earning power of 6 month’s salary!

Put 6 month’s cash into an Index Fund, sell at a 20% ‘loss’ to buy property

Now, so here’s where it gets tricky: would you sell down your stock holdings, at a potential 20% ‘loss’ to move to another form of investment?

Basically what we are saying is this: you don’t know when an emergency will crop up, so while a CD will at least keep it’s value – year in, year out – an Index Fund may return more now, but at some stage (Murphy’s Law says in EXACTLY the year that you need the money for some emergency!?) the stock market will drop 10% or even 20%.

OK, let’s see …

Let’s assume that we have been rocking along nicely, still working on our 8% returns then at Year 10, this opportunity comes up just as the market tanks to the tune of 20% … what would you do?

Well, firstly, we are going to assume that the market eventually recovers and we get back to our long-term 30 year average of 8% for the Index Fund (after all, there have been NO 30 year periods when this hasn’t occurred, hence my suggestion to use 8% rather than the oft-quoted long term ‘average’ of 12% for the market … this higher ‘average return’ just isn’t guaranteed). So, we are still talking $250,000.

But, if we divert our funds to the real-estate option after 10 years (and, let’s assume that we use all of it as a deposit after taking that one-off 20% ‘hit’), we would have a $1.2 Million net gain by suffering the loss and acquiring the property (assuming that we find one that averages only a 6% capital gain, plus some rental income).

Why the huge advantage to real estate?

It is the only leveraged investment that we have considered (for example, try running a margin loan on your Index Fund and see what that can do).

Also, keep in mind that we don’t stop ‘topping up’ our emergency fund after the 10 year mark when we bought the real-estate, we simply keep putting our salary increases aside after year 10, so we could afford another, smaller, property (say, a $350k condo) at year 20 that would boost the 30 year returns markedly, again.

But, if it’s now in the real-estate, how do we handle an emergency? Simple: with a HELOC or refinance or sell the investment if a real emergency arises and the bank calls your HELOC in.

And, if you think that’s all-too-risky, then keep your money in the Index Fund and forget about the real-estate idea …

Here’s what Meg would do:

I would never have counted on such generosity and would have still sold my funds for this RE investment.

So would I, Meg, so would I … now, what about the rest of you?

The 401k revisited …

Posted on by
Reply

I’ve written a series of posts about 401k’s with the intention of encouraging each and every one of you to assess why you are choosing to ‘invest’ in your 401k over-and-above any other investment choice.

I received a comment from Timmers that I wanted to address here because he raises some interesting points … I will break up his comment into the relevant pieces:

As a person who invests in both 401k and Roth IRA as well as residential real estate …

Let’s stop it right there and understand that we are talking about three totally different things here:

1. 401k is not an ‘investment’ as I have previously defined it … it is a limited, tax-efficient savings strategy with benefits (e.g. employer match). Limited because the underlying investments are usually (not always) costly and relatively inefficient ‘products’ packaged for the employer by their 401k provider.

2. A ROTH IRA is not an ‘investment’ … it is a tax-advantaged vehicle in which it may be possible to make investments. Interestingly, you can usually use one to invest in a wide variety of means including: funds, stocks, real-estate.

3. Residential real-estate may be a good or bad investments, depending upon where, when and how you buy … coming off the top of the ‘bubble-and-bust cycle’, I doubt whether I need to explain this further, here. However, it is important to realize that residential real-estate is not the only form of real-estate investment available to you.

Anyhow, on with Timmers’ comment:

… I have to also add one other Major argument for real estate as a retirement strategy. That is, if investing right and long-term, real estate is much more of a sustainable investment. That is, if you have held it long enough to pay down the mortgage, you simply can live off of the rental income. After drawing out the rental income for one year—guess what? It hasn’t gone down in price but usually up—at least maintaining parity with inflation if not more (sometime much more if you invest right). AND…(the best yet)….you still have the same amount of money available to you as the year before plus a little more (if you haver raised the rent).

This is a masterful strategy of the Making Money 301 kind i.e. something that you want to consider when you have already made your pile of money and are considering (a) how to keep your principle (‘nest egg’) safe and (b) have a safe amount that you can withdraw to live off every year without worrying about inflation OR your money running out.

However, paying off the principle as a Making Money 201 strategy (i.e. building your ‘nest egg’) may not be wise as you then need to think about what you are going to do with the excess cash that the property is spinning off … you will need to invest elsewhere anyway.

That is, the simple difference between real-estate as a wealth-building activity and a wealth-sustaining activity is how much equity you allow yourself to have in each property that you own:

i) Wealth-building: more properties, with less equity in each.

ii) Wealth-preserving: fewer properties, with more equity in each.

Finally, Timmers switches back to 401k’s:

The problem with 401K investments is that unless you have enough to live off of the dividends (out of the question for the vast majority of people), you are drawing down your investment every year. It is not sustainable like real estate. Granted, you must maintain your residences, which is an ongoing cost, but a smart investor always plans for the major repairs/renovations and has money set aside for the smaller ones. To be honest, I am so tired of the constant 24/7 blather of the stock market investment complex that has its tentacles in every media outlet. They want to keep spinning a song that hasn’t produced for most mainstream investors the past ten years (but has for their jobs and income). I am grateful for AJC’s contrarian and no-nonsense approach to most of their blather.

To this, I can only say ‘thanks’ and add some recent comments from the Tycoon Report:

If this market were a horse, I think we would have shot it already to spare it further misery … we have to readjust our perspective of the US equity markets. This is not a buy and hold the S&P 500/DOW 30 market, and it probably won’t be so again until about 2015 – 2018. This is a sector driven market brought about by a slowdown in profit growth and driven by spiraling commodity costs. Index investors get crushed in markets such as these …

If you are a diversify-and-save-via-your-401k kind of ‘investor’, this Kind of makes you sick, doesn’t it?

Good Luck!

Should you lend money to others to buy real-estate?

Posted on by
1

A member of Networth IQ asks:

I’m debating on loaning a friend around 30k that I will dervire from a HELOC on my primary residence. I will recieve a flat 16% interest over the 6 months of the loan, and an extra 3% per month for every month if it’s not paid within 6 months. This moeny will be used for remodeling expenses on his investment property. We are in the process of creating a promisory Note and mortgage note for the loan.

Now, I know this is risky for a few different reasons but I don’t know how else I could generate $4,800 over 6 months for an investment of 30k.

Is there any glaring reason not to move forward with this loan?

D’ah, yeah!

Don’t go into business with relatives or friends … and, don’t lend money to them – which is pretty much the same thing, anyway …

… unless they are collateral damage and you are prepared to foreclose on them or sue them at the drop of a hat.

But, for the sake of this post, let’s put aside the “friends” issue and focus on the underlying ‘investment opportunity’ laid out in the question:

This goes to a debate that I was having on another topic about Trust Deeds …

[AJC: worth reading just for the entertainment value … you get to see how closed minded and rude some people can be when encountering contrarian thinking] just scroll back to see it)

… my contention is – all other things being equal – is that if you are going to take the risk, why not take the upside as well?

We don’t know the outcome of the remodelling of the investment property. For example, is this ‘friend’ going going to remodel then flip? Or hold?

Let’s take these two scenarios one by one:

Rehab/Flip

You have to ask yourself what the chance of success is in the current market?

Because, if you lend the money and the flip is not successful, how do you get paid back without suing/foreclosing? And, you presumably stand behind the bank, so what chance do you have of getting your money back, if you do foreclose?

If you are going to take this risk, you may as well be in the full-hog and hold equity in the deal to get the full upside, as well.

On the other hand, if the flip is successful, you have taken a major risk for limited upside: if the property can be sold to (a) pay you back your principle, and (b) pay you the interest owed to you, and (c) give the ‘friend’ their required profit, why don’t you just take a split of equity in the deal instead of (as well as?) the interest.

In fact, I would be asking for a split of the profit or equity in a rehab/flip deal, with a minimum payout of the interest component that I would have expected … a kind of cake-and-eat-it approach. Friend or no friend … take it or leave it offer.

Buy/Hold

There are only two ways that I see this as a likely scenario:

1. The Rehab/Flip scenario didn’t work, so the investor/friend team are forced to hold on to the property (foreclosure being the ugly alternative, as discussed above), or

2. The friend intends to approach the bank (or another one) to refinance on the new post-rehab, presumably improved, valuation and use some of the proceeds to pay out investor out … in the current market, a lot of if’s and but’s in there!

The safest approach for both parties in this scenario is to borrow the unimproved value from the bank, add in the $30k from the HELOC as ‘equity’ and hold the property together under some agreed equity split. Paying HELOC interest the whole time doesn’t make sense, so the partnership agreement should spell out the requirement to at least try and refinance every so often.

The advantage: the property increases in value over a sufficiently long hold period (in the current market, who knows how long ‘sufficient’ will be … which is why buy/hold, at least as a backup option to flipping, is so attractive) and you get the negotiated % of the upside.

So, in both cases, by lending the money, you take on significant risks associated with the underlying investment, without access to the underlying capital returns. Why do it?

One final note: by using a HELOC to invest in this new property you are gearing to the max.

This, of course, is a good thing ifyou are (a) certain to flip at a profit, or (b) able to hold and cover the costs of the HELOC long term (or refinance out of it) … pretty big if’s, if you ask me 😛

Flipping / flopping?

Posted on by
6

On Wednesday, I pointed out that “if I don’t have direct experience in the specific area of a question, I will say so”.

This was the case with my response to Joshua (coincidentally, another 7 Millionaires … In Training! Final 30 applicant) who used a recent post to ask me a question about ‘flipping’, which I have never done …

… at least not for real-estate (there’s a strong case to be made that a year or two ago I ‘flipped’ a business for a rather large profit … but, that’s another story).

[AJC: Josh, I didn’t mention it then, but I would consider Dave Lindahl an expert in this area – I haven’t met the guy, but I have studied a lot of his material and consider it good-to-great, as is John T Reed’s stuff on real-estate in general … not sure what John has to say specifically about flipping: you should check]

But, Josh, I do have some advice for you:

Treat flipping as a business …

… it’s probably closer to real-estate development, than it is to real-estate (long-term buy-and-hold) investing.

The downfall of many a flipper (or developer) is when the market suddenly turns and you are holding inventory that you can’t afford to cover the holding costs on.

Since we are closer to the bottom of the current cycle than to the the top, this will become less and less of a fear as the market eventually (and, inevitably) starts to rise again … it’s the next ‘correction’ that will catch you out!

Here’s what happens:

You buy your first property – it might be a house that you intend to live in for a while – you fix it up … and, you sell it at a profit. Maybe you pick up $10k – $50k in the process … maybe more.

Wow!

So, you do it again … then you buy two.

Pretty soon, you are earning a nice little side income buying/rehabbing/flipping houses all over the place … you don’t even bother to rent them out – you are purely looking at this equation:

Profit = Selling price – (Buying price + materials used + interest + closing costs + reselling commissions)

The problem with this formula is that you now have a second job!

Your time isn’t factored into this, since you are doing the work yourself … but, your ‘salary’ is actually included in what you call profit. In a great market, you are earning a great salary … in an ‘average’ market, you are probably not really earning all that much.

Here’s what to do:

Treat the rehab. business as exactly that … a business. Go and get a contractor’s estimate or two and add that cost into the formula (don’t forget to inflate the estimate by 20% to cover contingencies) to get:

Estimated Profit = Estimated Selling Price – (estimated Buying price + contractor estimate + interest + closing costs + reselling commissions)

Now, if the ‘profit’ that you estimate makes the project worth while, then you just may have a nice little ‘business deal’ going on here …

… and, it’s then up to you if you decide to hire yourself as the contractor!

But, there is a problem that I see with this ‘business’ … and, it’s a problem that arises out of too much success!

Yes, success makes you more aggressive … makes you do more and bigger deals in order to grow your little business into a bigger and bigger business (buying more/bigger properties to rehab).

That’s when you need to do a couple of things:

1. Move into multi-family properties,

2. Outsource the work,

3. Have a buy-and-hold contingency

The first two are obvious: these are the steps that will pave the way to unlimited growth in your (now, real) business … ALL businesses need to remove obstacles to growth, because a stagnating business is an (eventually) dying business.

The third one will (hopefully) protect you against the inevitable selling problems and market ‘corrections’ that will come up from time to time.

Which brings us to the subject of developers (those developing ‘on spec.’ to then sell ‘in pieces’ to investors and owner-occupiers):

Developers have all of the same issues as flippers, only on a larger scale … many flippers, in fact, end up growing to become developers themselves.

As developers become successful they tend to make two major mistakes:

1. They move into bigger and bigger developments … max’ing out their financial capabilites in one or two large ever growing deals. One market correction can sink them.

2. They start bringing teams of ‘helpers’ in house (architects, designers, builders, etc.) and they have to ‘feed the team’ with a constant stream of projects … it’s very hard to wind back if the market starts to tighten up a little.

So, while I can’t tell you much about the business of flipping or developing, I can tell you that like all businesses you have to be able to handle:

a) Growth, and

b) Contingencies

…. both very hard to do in a business that requires taking huge financial risk for each project.

Here’s what the smartest flippers and developers do: they start off buying to churn …

… this churn (i.e. quick reselling) generates chunks of cash; instead of investing all of this chunk of cash in their next (bigger) project, they divert some to buy-and-hold real-estate.

For example, they might rehab. and reposition an apartment building as condo’s …

… they might then sell most condo’s, but try and keep a couple for themselves as rentals. Do this a few times, and you just might have something left over when the next crash wipes your ‘business’ out (assuming that you have set up your business in the right legal entities so that your ‘hold’ portfolio can’t be touched).

All in all, what can I say?

Some people make huge fortunes (and others lose theirs) in exactly these types of businesses, so who am I to say that this is something that you should/shouldn’t do to start making your own fortune?

Good Luck!

Which side of zero to gear?

Posted on by
4

The best way to give up your ‘day job’ is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at http://ajcfeed.com ….

__________________________

A couple of weeks ago I wrote a pair of articles about real-estate: the ‘$7million Real Estate’ Question and Rule.

The first part of the shared title was an obvious reference to how I made my first $7 mill. of which the majority was made in real-estate … not directly in business, as many assume – but, certainly ‘fueled’ by an income generated by two (then mediocre) small businesses diverted towards RE purchases and mortgage payments rather than to my spending ‘wants’.

These articles seemed to ‘flush out’ of hiding the RE enthusiasts from the 7m7y Community!

One of those was Luis who is a 7 Millionaires … In Training! Final 15 applicant and he asked (as a comment to the first of the two articles):

How close to positive is close enough? How do you calculate against vacancies?

Should we expect 2 months out of the year which we would have to pay the entire mortgage?

Lastly, would you stay away from areas that are under rent control laws?

I should warn you in advance: I don’t always answer questions left by readers left as comments or sent in as e-mails; sometimes I let them know that I feel the question deserves a follow-up post, as I told Luis in this case, and sometimes I am simply not expert enough to proffer specific advice.

If so, simply diarize for 45 to 60 days (as I told Luis) and contact me if you don’t see a response within that period …

… I NEVER use “I’ll get back to you” as a tactic to get out of answering … if I don’t have direct experience in the specific area of a question, I will say so.

Back to Luis …

The first part of his question relates to the whole concept of positive gearing and negative gearing … in my opinion, one of the worst-handled subjects in real-estate …

… in fact, I have never seen as much rubbish written about any investing subject (except maybe diversification and 401k’s) as I have about negative gearing!

Generally, the RE [Real-Estate] Guru’s fall into two camps:

The Argument For Negative Gearing

Those promoting negative gearing say this allows you to buy more real-estate for greater capital appreciation. The more property appreciates and the less that you put in, the greater your cash-on-cash return.

Here’s why:

Negative gearing implies that your expenses on the real-estate (your mortgage payments; repairs and maintenance; insurance payments; and the like) are greater than your income (rent received).

To a great extent, you can ‘control’ the amount of the ‘negatively geared’ short-fall simply by ‘dialling’ up/down the amount of capital that you put into the property (usually more quickly by way of a deposit, or more slowly through making larger Principle & Interest payments)

Lower deposits generally mean higher mortgage payments, therefore you are ‘controlling’ more real-estate with less of your own money.

This may mean that your cash-on-cash returns get higher and higher as property appreciates with less of your own cash (and, more of the bank’s committed). You can use that cash to buy more and more of these appreciating properties.

But, there’s a downside: as you borrow more and more from the bank against any specific property (by putting in a lower deposit yourself) your interest bill goes up … your rent stays the same (your tenants won’t pay higher than market rates just because you get a big interest bill from the bank!) … you may make a loss on the property.

But, you get it all back – and more – on the capital appreciation on the property. Don’t you?

Amazing how the proponents of negative gearing are suddenly quiet when the ‘RE bubble pops’ … not, to mention your ability to grow your portfolio will depend upon how much monthly loss you can fund.

The Argument For Positive Gearing

Those promoting positive gearing say “buying a property is an investment … investments should make you money, not lose you money”.

So they suggest looking in areas where rents are relatively high, stable and growing.

They recommend buying fewer properties, putting in a bigger deposit, and letting your rents cover the costs and pay down the property.

Not only do you have a buffer (and build an even bigger one over time) against market crashes, vacancies, interest rate hikes, and unexpected repair bills, but you build up a nice little pot of equity if these properties also rise in value (as they surely will, given a long enough holding period?).

The problem is that these types of properties (i.e. the ones that generate a decent rental return) don’t tend to be in high appreciation areas, whereas properties that appreciate nicely tend not to produce a great rental return.

So, it seems that real-estate investing is a trade-off: do you want faster appreciation or do you want a greater income?

If you are young and are investing to build great wealth – and, are prepared to take greater risk – then you may be chasing higher appreciation and may have the income to carry some short-term (you hope!) losses.

On the other hand, if you are approaching retirement, you may want to be selling some of your portfolio, using the proceeds to jack up the equity (by paying off some of the mortgage, hence lowering your largest monthly expense) – keeping some as a cash reserve against vacancies and expenses – of each remaining property so that you can live off the proceeds. An income that should rise roughly in accordance with inflation … nice.

Here’s how I look at it:

I am neither for nor against negative gearing … ideally, I see absolutely no reason to take a loss. But, this can come in two ways:

1. By buying a property that doesn’t produce enough income, when (if I just looked a little harder, negotiated a little better, added a little more post-purchase value, chose a different class of RE or a different location) I could have bought something with similar appreciation that didn’t produce a monthly loss, or

2. By passing on a property that had great potential because I didn’t want to suffer a little short-term loss.

Both are dumb reasons to buy (or pass) on an opportunity …

… to me, the monthly short-fall or excess (if i don’t actually need the money to live off NOW) is just a part of the investment in my future.

If negative, then I am just increasing the capital that I am allocating to that property … if positive, then I am calculating whether that return could be used better elsewhere by pulling some capital (by refinancing) out of the property.

In other words, to me, a monthly excess/shortfall is just ONE part of the overall investment equation and there’s absolutely no reason to be bloody-minded one way or the other.

Let me leave you with a couple of final thoughts:

i) For those proponents of negative gearing who justify their methods on the basis that “you get a tax deduction on the loss, so Uncle Sam is helping to pay for your future” … get a life. Let the tax deduction be an effect of a business decision taken for other reasons, not the cause! Why lose 70% just so that Uncle Same can ‘donate’ 30%?

ii) Sometimes a negatively geared property can become positively geared just through tax benefits: depreciation is a great one to have available as it is tied to this property (so, if one works; maybe 100 will work for you just as well?) whereas the deduction on negative gearing only works when you have enough outside income to make use of it, so it may only work on one or two properties at a time.

So, in which camp do you sit, and why?

Millionaire by 30?

Posted on by
5

The best way to become a Millionaire by 30 is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at http://ajcfeed.com ….

_____________________________________________________

Recently I wrote a post that I consider to be one of the critical “you either get it or you don’t” pieces that will determine whether you will ‘make it’ or not …. if you haven’t seen it yet, fully understood it, or hotly debated it (with me, yourself, or your mother) then I highly recommend that you go and get to it!

Anyhow, Jim wrote a comment:

This video was suggested from one of my posts and I think it gives a pretty good example of your premise. This is Douglas Andrew, author of Missed Fortune…

I watched the video … and, set it aside presuming that because it was so short, the one or two glaring errors (did you spot them?) would have been addressed in the full video (or a Douglas Andrews seminar) …

… then I saw an article on My Money Blog:

The overall moral of this book review is that even though a book finds a publisher, it doesn’t mean the advice is accurate or applicable to you. The book Millionaire by Thirty: The Quickest Path to Early Financial Independence by Doug Andrews & Company appears to be very similar to the other Missed Fortune books by the same author. In fact, from reading the reviews all of these books seem to contain the exact same material.

Housing Prices Always Go Up, Take Out Largest Mortgage Possible!

“Do you rent? Rent is like throwing money down a black hole. It doesn’t matter how much money you have saved or how long you plan on staying in the same place, you should always try to buy a home. If you aren’t going to stay very long you can simply get an adjustable-rate loan with no down payment. Housing prices always go up, so you can enjoy the low interest for a couple of years, and then sell and make a nice profit.

If you are really smart and disciplined, you can even get an interest-only or negative-amortization loan because then you won’t build up any equity at all. Accumulating home equity is bad. Anytime you have any, you should take out a loan on it and invest it somewhere else, like a second home.”

The above are all the dangerous generalizations about real estate contained in this book. Newsflash… Renting can be the best option for many people. Housing prices do not always go up. Thousands of people who bought a home and now have to sell after a few years will have lost tens of thousands of dollars compared to if they had rented.

Summary
Many of the books I read may not be brilliant, but they contain generally good ideas and target a specific type of reader. However, this book is one that could actually hurt more people than it helps. This book is just plain misleading. It would be wonderful if home prices always went up and there was an investment where I could never pay taxes, have no downside risk, and get stock-like returns, but unfortunately both are too good to be true. I’ve tried to lay out my arguments for this briefly, but if you want a better description read the detailed reviews here and here. Clever Dude also shared his thoughts here.

Short version: Don’t read it, don’t buy it, don’t even borrow it from the library

Firstly, I agree with My Money Blog on the home ownership issue to a degree … owning your own home is not always the smartest FINANCIAL option. 

However, here is where I differ: for MOST people, it’s the only way that they will get financially free for lots of psychological/emotional reasons, more than strictly financial. Also, I do agree with the ‘forced saving’ and ‘forced appreciation’ that it can give you (provided that you do something with the appreciation … you don’t want to die ‘house rich / cash poor’!).

The ONLY time you shouldn’t invest in your own home, is to invest in income-producing property instead*.

And, while it’s true that real-estate doesn’t always go up, if you have a 20 – 30 year outlook and can lock in circa 6% interest for up to 30 years (another reason why your own home can be a good idea) … I think the future is exceedingly bright.

So, it is with a little surprise that I find myself actually siding with Doug – warts and all (!) – on this one …

But, I don’t agree with Doug that you shouldn’t have ANY equity in your own home (again, strictly financially speaking, he is probably correct), but I have proposed the 20% Rule that says that you should have no more than 20% of your Net Worth invested in your own home at any one time.

This rule, when understood and applied properly, accomplishes two key things:

1. Let’s you get/stay invested in your own home, but

2. Ensures that you maintain enough of your Net Worth in outside investments.

… without the screaming holes in the get-rich-quick schemes promoted by the ‘nothing down’ brigade!

So, go back and read all the posts that I have linked to … as I said at the very beginning, this could be the key to your wealth …

* or to invest in some other high-reward activity (e.g. buying/starting a business; leveraged
  investments; etc.) ... although, I would still prefer that you ALSO buy you own home 'just in case'

Add to: | blinklist | del.cio.us | digg | yahoo! | furl | rawsugar | shadows | netvouz