Tag Archives: real estate

Anatomy of a Commercial RE Investment – Part 1

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I just answered a question on commercial real-estate investing and thought that there’s no better way to explain the process than by showing …

… coincidentally, I have been working on a commercial RE deal in the $2.5 mill. price range, so I thought that I should simply share.

Warning: like most deals, this deal could simply fall through at the first hurdle. Let me explain by sharing the story so far:

All good real-estate transactions, in my opinion, start with finding a good broker who is working for you.

As it happens, I have a close friend who is a commercial real-estate broker who meets the ‘trifecta’ that I mentioned in that last post: (a) I like/trust him, (b) he works with commercial RE in the area/s that I am interested in, and (c) he invests heavily in commercial RE himself (buy/hold).

I have been pestering him for the last 4 years to find me a deal … interestingly, and this is something that you should take mental note of, he says that he is asked by most people he meets to ‘find them a deal’ but almost none ‘pull the trigger’ …

… so, forgive your broker if they don’t fall all over themselves with excitement until you actually close on your first deal with them 😉

Anyhow, finally a deal came up that seemed to fit my criteria. I didn’t even request financials at that stage or see the property: on the strength of my friend’s recommendation (it was a deal he wanted, but the $700k deposit was a bit too steep for him) I authorized him to put in a written offer.

I don’t recommend that you do this, you will pick up where this post leaves off …

Anyhow, the current owners occupy the premises (they were planning a sale/leaseback i.e. they sell the property to me, then lease 2/3 of it from me on a 5 year lease) and decided to first see if they could simply refinance their loan and take some cash out.

Naturally, in the current market this has proved difficult, so they have put the property back on the market … my friend is the listing broker, so I have first ‘dibs’ on the deal.

So, I am now at Stage 1: I have a deal in front of me; presumably, motivated sellers (we’ll find out, if they accept the new offer); and, I need to decide whether and how to proceed.

In Part 2 I’ll step you through exactly how I decided this was the ‘deal for me’ …

Accumulating 7 million dollars worth of property in 7 years?

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I wrote a series of posts about how to build a Perpetual Money Machine, and Caprica asks:

I thought the title of this blog was called 7 million in 7 years, not 1 million in 20 years?

How do you go about accumulating 7 million dollars worth of property in 7 years and be in a net cash flow positive position by the end of 7 years?

Here’s how I made it to $7million net worth in just 7 years, Caprica:

http://7million7years.com/2008/04/25/my-7-million-dollar-journey/

But that’s not the question that you actually asked; you asked how to build up $7 Million dollars worth of PROPERTY (i.e. real-estate) in 7 years, and that’s another matter entirely.

For example, you will notice that I didn’t reach my 7m7y from real-estate alone (and, you’re not likely to be able to, either): my ‘energy source’ was a business (actually, more than one), but my ‘capacitor’ was (largely) real-estate.

If you are asking if you could build a $7 Million real-estate portfolio in 7 years, using just your income from a job (even a pretty high paying job) I would have to say “not bloody likely, mate” …

… your income just can’t ‘fuel’ enough real-estate deals to produce the annual compound growth rate that’s required!

To see what energy source and compound growth rate combination that YOU need, FIRST you must start with knowing your Number / Date:

If you need, say, “1 million in 20 years’ (and, let’s assume that you’re starting from, say, $10,000 in the bank instead of my $30k in the hole), a job (as your ‘energy source’) + real-estate together with stocks (as your ‘capacitor’) should do the trick.

But, if it’s “7 million in 7 years” you want (starting with the same $10k), then you’ll be needing a more aggressive set of ‘energy sources’ and ‘capacitors’ for your perpetual Money Machine, i.e.:

Your own business (excess cashflow) + real-estate.

It’s all in your required annual compound growth rate … find yours, and work backwards from there …

… but, Caprica – as I suspect do many of my readers, after all of this time – already understands this:

I realized after I posted my response I already knew the answer …, which was to start one or more businesses to help you generate enough money to buy your passive income source.

Commercial RE … first steps!

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strip-mall-gilmer-rd

I am working on my first US commercial real-estate deal right now and by coincidence received the following question from MoneyMonk:

I plan to buy commercial Real Estate (strip mall) in the near future within the next 4 yrs. I want your advice on some things.

I want a property between 350-400k, I plan to put down $80K <- which will take me 4 yrs to save/invest

I want a commercial re agent to search for me, Im think Im looking at 8-10% commission to give the broker;
I want to form an LLC for my company, apply for a federal id, get a good CPA, a lawyer to form the LLC, umbrella insurance for about 1 million (u never know, The U.S. like to sue).

For as cap rate I want something above 7%. Am I’m missing something???

I also want to visit a banker and ask about financing. Is commercial re different from personal RE? for as terms?
I know any decent bank want you to show a good income, credit and some cash in the bank. What are good questions to ask a banker?

First I would like to congratulate MoneyMonk on being so forward thinking; it doesn’t hurt to talk to a Banker upfront, but my suggestion as to the very first place to start is with the following four steps:

1. Identify the type / location / price ranges of properties that you want to buy – MoneyMonk is targeting “strip malls … between 350-400k”.

2. Start researching the types of properties in the areas that you are interested – with 4 years to go before MoneyMonk has saved sufficient deposit, nothing else matters right now other than the research: LoopNet and RealtyTrac are great places to do this research.

That’s it for now; when the deposit has been saved:

3. Find a real-estate broker – you’re looking for the trifecta: (a) a broker that you like/trust, (b) one who works with commercial RE in the area/s that you are interested in, and (c) somebody who invests in commercial RE herself.

Keep in mind that the best deals are NOT usually on Loopnet /Realtytrac – they are what the brokers haven’t been able to offload, so are probably NOT the best deals around – the best deals are still probably with the brokers. It’s still an “old boy’s club”, so don’t expect your broker to bring you these deals first time around … your first acquisition is unlikely to be your best!

4. Find a property that you like / can afford / that meets your criteria and put a refundable deposit down (subject to: finance, partner’s approval even if you don’t have a partner, and due diligence).

… then approach the banks for funding.

The reports of real-estate's 'death' are greatly exaggerated …

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The reports of my death are greatly exaggerated

The text of a cable sent by Mark Twain from London to the press in the United States after his obituary had been mistakenly published.

Just like Mark Twain, I think that real-estate has been prematurely ‘written off’. Do you need proof?

Just check this often-cited graph (I think that it’s from Irrational Exuberance by Robert Shiller) floating around the internet:

It purports to cover a period from 1900 to 2005 in a linear fashion … a clear bubble-spike, right?

What could one reasonably conclude from this?

A long downward trend and/or an even longer flattening until house prices catch up with, say, 3% – 4% inflation?

Now, take the period covered by the red line beginning roughly in line with where the ’10’ starts in the phrase on the graph that says “Yields on 10-Year …” – got it?

That’s roughly 1987 until today …

Now, let’s look at an a national index of housing prices covering that same period from a source that I trust – Standard & Poors (the same rating agency that produces the S&P500 stock price index):

This picture tells a slightly different story, doesn’t it?

One reason is that this one, I don’t think, is inflation-adjusted whereas I believe the Schiller one is (or at least ‘adjusted’ for something … any of our readers know what that might be?). In either case, a definite ‘bubble’ can be clearly seen in both charts from, say, 1999 to 2007.

But, have a look what happens when you break this second chart into three sections:

1. We see the tail end of a rise from (we don’t know when, because S&P apparently only started collating this data in 1987) to the end on 1989 … the extent of this rise is pretty important, because we then see …

2. … a ‘flat’ line (or worse) from the end of 1989 to roughly the end of 1998, then …

3. … all hell breaks loose from the beginning of 1999 to somewhere towards the end of 2006 when a clear crash occurs.

So, was the flattening in 2. a correction for 1. OR was the growth in 3. an over-correction of 2.?

I can’t say for sure, but I can say this:

If you draw a compound growth curve between two points: a 20 year period when the market moved from an index of 75 (roughly at the end on 1987) to an index value of 200 (roughly at the end of 2007), we can see that that represents an average compound growth rate of just on 5%

Given that real-estate compounds at 3% to 6.5% annually, depending upon which source you believe (I’m firmly in the 6%+ camp), here’s what all of us as investors have to decide …

Buy now (or soon) while the going is cheap (particularly, if you think that interest rates will also start to go up soon), or wait because you believe that real-estate is still overpriced.

Be warned: if you wait too long (is that 6 months or 6 years?), the ‘real estate discount party’ might be over!

How do you manage real estate risks?

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My most recent post – of a long series – on 401k’s v real-estate (which is a dumb comparison: like comparing the container with the drink that you might put into it … when, what we are really trying to compare is Mutual Funds v Real-Estate) sparked a long series of detailed comments about the risks and rewards of real-estate …

… I encourage you to read that post and the associated comments here. The discussion culminated in a great series of comments/questions by Jeff who also asked:

I agree, the “technical risks” need be manageable. But, how much does the management of these risks (infusion of cash when necessary) reduce your return?
For instance, do you keep a safety net for possible negative cash flows (high-yield savings account, CD)? Do you then bundle the two investments (investment property return plus safety net return) to determine the actual return of the investment property?
Do you pull cash out-of-pocket to cover short falls? Since you don’t receive any additional growth from this new cash and the new cash is added to your capital investment amount, it drastically reduces your present and future return from the investment.
Do you borrow more money to cover the cash flows? Since this borrowed money provides no additional return it puts you in severe negative leverage situation. Further, that loan has to be paid back with future cash flows from the investment property that you were expecting to give you the return your initially expected–for lack of a better term–compounding the damage of the negative cash flow.
Do you use a cash flows from another property to cover the short falls? This seems to be the best solution for the property receiving the infusion of cash, but to what extent doe sit reduce the return of the other investment property–by reinvesting its cash flows in an investment that provides no additional return? Put differently, it is a loss of opportunity to invest those cash flows in something that will bring additional return–rather than saving your RE investment from foreclosure.

When you experience short falls in RE investing, which one of these options is best? What did you do when you experienced cash short falls, and why? …and what effect did/does it have on your annualized return?

As I said, great questions, but the first comment that I would make (actually, did make) is:

I would caution you to remember the phrase: “paralysis by analysis” … in a practical sense, once I satisfy myself that (a) a certain type of investment is within my skill/interest level, AND (b) is LIKELY to meet my investment targets, AND (c) I can cover the risks – usually through a ‘reserve’ which may or may not be sitting in a shoebox with the word ‘RESERVE’ etched in the side, then … shoot … I’ll close my eyes and just go for it!

In other words, if you are going to be a success in real-estate investing – indeed, any endeavor where you expect to achieve more than the average person expects/can achieve – then you need to have a bias for action.

Often, we have to proceed in a world of imperfect information …

… magically, once we jump in a lot of these types of questions just seem to fall away!

But, to try and answer Jeff’s question:

Technically, YES the ‘reserve’ is part of the investment and lowers the returns e.g. if you are earning 20% on the investment and only 4% on the CD’s sitting in ‘reserve’ then obviously the actual return lies somewhere between the two.

BUT pulling ‘free cashflow’ out of one property to help service another, doesn’t actually reduce the return of the first … but, the amount of cash that you put IN to the second property affects ITS return.

But, at the end of the day, it’s the COMBINATION of all of these returns that counts: will you, or will you not make your Number, or whatever target you set?

The only real benefit of analyzing the return on each individual investment once you have made it is if you then intend to do something about it e.g. trade it for something better …

The Sensible Flipper …

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No, we are not talking about sweet, intelligent, trained TV dolphins – for those of you old enough to remember the show …

… we are talking about people who buy a piece of real-estate, merely to (perhaps clean it up a little or even do a ‘gut rehab’ then) resell it at a (hopefully) decent profit.

On a larger scale, ‘flippers’ are called ‘developers’ or ‘property speculators’.

In all cases, we are not talking about a Making Money 101 – or even a Making Money 301 – INVESTMENT strategy, we are talking about a Making Money 201 INCOME strategy a.k.a. a true BUSINESS.

Dustbusterz says:

i was just watching your video on what it takes to earn 1 million in 20 years and how time can be the determining factor. in that video, you mentioned flipping real estate. you said you could build up to where your flipping more and more properties(using this as a business). your warning said watch out because the market could crash leaving you high and dry. but i believe( and correct me if i am wrong here) those who are smart( read educated) in real estate should never have to worry about such things as crashing real estate, because they would know exactly where to buy and when to buy and how to buy to avoid this situation. you see, even when the market is crashing ( such as is happening now) you can still find deals areas that are appreciating not crashing.that might take you out of one stater or even out of the country. but you can always find property that is going up in value. that will make you money.

It’s funny, if we had read my previous article – or even this one – a year or two ago, we would be in one of two camps:

1. I like the idea of flipping: in which case, we would be nodding “yeah, yeah … be careful … yadayadayada” all the while looking for our first/next flipping deal, or

2. I don’t like the idea of flipping: we would be reading with the idea of confirming our already ‘set in concrete’ idea that flipping is bad.

But, sitting in the current market, we’re all nodding and saying “how could those idiots not see the crash … they deserve what they got …”

The reality is that those who DO flip put themselves at risk of loss …

… but, so do those who DON’T: they run the risk of loss of missed opportunity.

My point being that there is nothing inherently wrong with developing, or even flipping; they both serve a purpose, they both generate chunks of cash where none existed before; they are both legitimate businesses for those who are so inclined.

That just doesn’t happen to be me …

Just to remind you, the problem with developing/flipping is not one of lack of market knowledge – although, you HAVE to understand exactly what you are getting into to have any chance of success – it’s getting caught out by sudden market changes.

In essence, you are timing the market – hoping that the market stays on a flat-to-upwards trajectory for the whole time that it takes to:

– Close your acquisition

– Make whatever developments or improvements you deem necessary

– Re-market the property / properties

– Close your sales

This takes weeks to months to years depending upon the scale of the project … which leads to another point; the larger the project, the more risk because time is elongated. Markets can change dramatically in just months and certainly years (weeks is another matter, entirely).

The motivator for any flipper/developer is profit – in many cases, this is their INCOME, remember? And, they usually roll one closed deal into the next bigger open deal in a rising market …

… but, we know what eventually happens to rising markets.

However, eventually even the down cycles run their cathartic course … including the current real-estate crash.

Sooner or later, the time will be ripe in most US markets – and, is certainly ripe already in some – for the flippers/developers to come back out of hibernation … or bankruptcy.

Here’s how to do better next time:

1. If you are working on single deals – this one is easy: make sure that you can rent out the property and HOLD for as long as it takes, in case you aren’t able to flip it quickly. Your only risk then is lost opportunity: while you are holding this deal, you may not be able to get onto the next one.

2. If you are working on larger/multi-property deals – develop/rehab with the idea of retaining a proportion of the units for yourself (as long term, buy/hold rentals). Obviously, you are ‘buying’ these from yourself at ‘cost’, so a profit margin should be built in.

If you plan your largest deals correctly, you shouldn’t need to worry about the market ‘going south’ on your most recent deal … you should be protected (e.g. put each ‘deal’ in a separate LLC and offer no personal guarantees, if at all possible) … this may be possible or may not.

Assuming that you can protect yourself from catastrophic loss on your latest deal, then retaining some equity for yourself (i.e. by buying a few properties out of this deal and all previous deals) ensures your long-term wealth, so that you aren’t simply rolling up all of your profits each time …

… it’s like taking some money OFF the craps table each time, because you know you won’t be able to roll the same number over and over before a 7 or 11 eventually hits, wiping you out completely.

I like to think about it this way:

– Imagine that you start with $150

– Through your first deal, you double that to $300

– Instead of buying two new $150 deals and trying to score big again i.e. to make $600 ($300 x 2),

– You split your $300 into three piles: invest one pile outside of your next deal, and buy two new $100 deals

– You split the $400 profit from these two new deals into three piles … and, so on

The next time you try anything that is speculative, try the Double-Then-Divide-Into-Three Rule … let me know how it works for you!

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

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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!

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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’ …

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

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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?

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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!