Help a reader: the results are in!

Readrer Poll

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

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

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

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

For example, Zach is emphatically FOR buying the building:

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

Whilst, Victor is equally AGAINST:

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

So, Jason is right back where he started 🙁

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

do both. Every single time.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

A quick real-estate buck!

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

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

OK, so I invest in real-estate …

… but, I’m not in love with it.

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

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

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

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

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

RE - 2

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

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

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

RE - 3

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

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

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

2. The assumed rent is VERY high.

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

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

Help a reader out …

Should this reader buy his building or reinvest in his business?

View Results

Loading ... Loading ...

What should this reader do?

Read his story, make a selection, and leave a comment:

We are renting the commercial condo that our business is in for $1,800 per month, we can buy it for $160,000 should we?

We like the building, the location is a bit hard to find, and with a 20% down it will really cut down on the monthly expense but I will eat up $32,000 that we could use to expand the business. I don’t have $32k but I have a friend who offered to lend me half of it, I do have half.

We currently average $15k a month in sales, other than rent we have about $1000 in fixed expenses, I pay myself $2500, and we average about 25% for costs of goods sold. We currently have staff that costs about $2000 per month. This gives us about $4,000 of extra money at the end of each month….so far with this extra money we have bought lots of extra inventory to the point that we have enough, we have bought a commercial truck, the business is 100% debt free and has about $5,000 in liquid assets saved up (And we personally have over $10k), along with 30k in inventory and 10k in tools and equipment. Personally we are debt free other than the house, student loans and car….but with the house at 2% interest and the car at 2.9% and the student loans at 3.25% I don’t see any reason to send any of them more then the minimum because we make 4 times on most inventory that we buy.

So is now a good time to get the building? Or should we keep our cash free to keep buying things that are our core business? We are not in the business of real estate so should we own or rent?

Now, I’m not yet sure exactly what advice to give him, yet, so leave a comment and help us BOTH out 🙂

The ideal portfolio for successful investors …

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

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

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

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

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

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

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

Let me explain.

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

You see, in order to:

– Become wealthy, and

– Maintain your wealth along the way

… you need two things:

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

2. A place to invest that cashflow that compounds.

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

Portfolio - 2

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

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

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

But, why real-estate?

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

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

Tin Stacker or Kite Flyer? Which one are you?

money kiteI fly kites and I stack tins. But, I mainly fly kites. And, it’s all because I understand the true value of money.

Do you? Let’s find out …

The money that you save has a value today and a value in the future.

Aside from money that you save as a short-term buffer against emergencies, or to pay for a trip or other expense coming up soon, the real value of money that you save today is the value that it can provide tomorrow.

But, the ‘tomorrow’ that I am talking about is the one that comes on the day that you decide to begin Life After Work. Some call this retirement; others call it semi-retirement; I call it early retirement … but, that’s really up to you.

So, a dollar today is exactly that: One Today Dollar.

But, in the future, two things happen to that dollar:

1. Inflation erodes it – robbing it of roughly half its value every 20 years, and

2. Investment returns grows it – increasing it according to the annual compound growth rate of that asset class.

With inflation pulling one way (down), you need to find an investment that moves the value of your savings the other way (up); how fast you need to move depends on (a) how much money you need (your Number) and (b) when you need it (your Date).

So, how fast do different types of investments grow?

Well, according to Michael Masterson in his book Seven Years To Seven Figures:

Screen Shot 2013-03-09 at 6.48.05 PM

[AJC: The greater the returns – that is, the lower down the table – the more ‘actively’ this table assumes you will manage the asset e.g. you may only be able to achieve 15% returns on stocks if you follow a system such as Rule #1 Investing. And, without active management – e.g. rehab’ing, flipping; leveraging; etc. – real-estate may only keep pace with inflation]

That’s why the Future Value of $1 could be $100, in just 10 years, if you invest it in a business.

But, that same $1 could be worth only $1.45 in 10 years, if left in CD’s. Now, that’s before inflation …

If inflation runs at its historical average of 4% $1 is only worth $1 in 10 years, 20 years, or 40 years!

So, when Brooke says:

create the proper mindset. then its time to move on to more advanced lessons.

I whole-heartedly agree.

EXCEPT that the “proper mindset” that she – and most others – talk about is saving, paying off debt, saving, living frugally, and … saving.

Which is great, if you value every Today Dollar exactly the same as a Future Dollar.

But, I don’t.

And, neither should you … and, here’s why:

The very first thing that you should do when you are thinking about saving is think about:

How many Future Dollars do you need, when you stop work / retire?

I’m guessing that Number’s at least 20 to 40 times your current expenses, doubled for every 20 years that you are prepared to wait.

[AJC: Ironically, the less you are willing to risk to grow each Future Dollar now, the higher the multiple that you will need e.g. if you are content to keep your savings in mutual funds, then you will need closer to 40 times your current expenses, doubled for every 20 years that you are prepared to wait. If you are prepared to actively invest in some mixture of stocks, real-estate, and/or businesses, then you may only need 20 times]

How much is that for you?

I’m guessing it’s much more that you previously thought.

Now, what has any of this got to do with either flying kites or stacking tins?!

700-00074906Well, when you save, is it going to be so that you can line each Today Dollar that you collect by saving into a nice Today Dollar Tin with all of the others that you get, until you have enough to oil, salt and close … putting it away, with all the other tins that you collect in your working life until – in 20 or 40 years time – you pull all of those tins out of the Tin Storage Bank, dust them off, and find …

… exactly as many Future Dollars as you had Today Dollars, no more no less, and not enough?

Or, will you take each Today Dollar, and when you have enough, make a Future Dollar Kite (it can be a Business Kite, Real-Estate Kite, or possibly a Stock Kite) and let it soar?

And, if it crashes – when it crashes, because of storms and, well, kite-flying whilst you are learning is risky – will you then take a few more of your Today Dollars and make another, and another …

… until one flies, with each Today Dollar used in making it becoming 100 Future Dollars?

[AJC: Most likely, you will also be putting aside a few Today Dollar Tins of your own, for a rainy day – since it need not take many to make a few Kites, and you may as well save something whilst you are at it]

Tin Stacker or Kite Flyer? Which one you choose is up to you …

But, I must warn you – even though most of you are tin-stackers by nature, therefore, should not be surprised when your Future Dollar stock is well short of what I would consider a ‘nice retirement’ – I write solely for the kite-flyers out there!

 

The myth of the millionaire next door …

weep warning

This post will make you cry.

But, it is a post that I have to write.

It’s one that I have been putting off … and, off … and, off.

Why?

Because, I am going to tear apart one last (well, until the next) tenant of finance …

… one that even I have not dared touch until now.

But, I have finally decided to bite the bullet, because there has been a whole generation weaned on an aspiration that, in itself, is a lie.

Yes, I am talking about:

[shock]

The Myth of The Millionaire Next Door.

[horror]

In case you are too young to remember, The Millionaire Next Door is the title of a 1996 best seller by Thomas Stanley and William D. Danko that was touted at the time as revolutionary but, to me, produced a totally mundane and obvious conclusion:

Most of the millionaire households that they profiled did not have the extravagant lifestyles that most people would assume. This finding is backed up by surveys indicating how little these millionaire households have spent on such things as cars, watches, suits, and other luxury products/services. Most importantly, the book gives a list of reasons for why these people managed to accumulate so much wealth (the top one being that “They live below their means”).

[sigh]

The perception after this book was released, becoming an instant – and enduring – best-seller, is that the typical American millionaire is actually your neighbor, the small business owner who has been working for 20+ years on his business, investing (and, reinvesting) its profits rather than spending on lifestyle and luxuries.

In other words, somebody who slips under your radar; somebody you probably ignore; for good reason …

It’s all fine and dandy: like all “spend less than you earn and save, save, save”-driven strategies you, too, will no doubt become a millionaire by the time that you retire, but there are two problems:

1. What about inflation? Start now and, if you take 20 years to become a millionaire, you are really still only half of one in today’s dollars, and

2. Who says that you can wait 20 years?

I certainly couldn’t.

That’s why I call this type of ‘Millionaire Next Door’ business – an ATM business – little more than ‘a job with benefits’ …

… if you really do want to have one of these businesses, then here’s what you need to do:

Do NOT spend the spare business cashflow on personal lifestyle building (homes, cars, vacations, etc.); instead, use that cashflow to fund an aggressive investment portfolio, outside of your business: one that will one day grow to replace your personal income i.e. the amount of money that you DO take from the business to live off.

When the day comes that this passive income surpasses your personal business income, you become free.

However, this freedom does not come simply from saving and investing passively – otherwise, you are simply following the advice given in the Millionaire Next Door and you, too, will slave for the next 20+ years to get there.

Rather, this true financial freedom comes from investing your business profits aggressively and actively, with a mixture of your money and borrowed money, in things such as direct stocks (no funds for you!), and real-estate.

In this fashion, you may still need to work your business for 20 years before you shut it down, but at least you will retire a real millionaire (or better) in today’s dollars.

Far better, instead of starting a lifestyle business that relies on YOU being the front man (e.g. lawn-mowing round; accountancy practice; design studio; etc.), or a business that is tied to a single location (such as a car-wash; a restaurant; a corner shop) …

… start a business that can scale like McDonalds, invest aggressively, and you (too) may be able to do it in 7 😉

When should you take a loan instead of saving?

debt v savingsHere’s a commonly asked question:

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

Len correctly answers:

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

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

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

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

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

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

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

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

… I think you are also making a great investment.

Here’s why:

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

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

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

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

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

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

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

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

 

The Myth Of Passive Income

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

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

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

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

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

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

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

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

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

Why I don’t manage my rental properties …

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

The World Of Wealth (blog) puts it nicely:

Manage your properties yourself!

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

Reason Number Two – You WILL Do A Better Job Yourself

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

Reason Number Three – You’ll Save LOTS of Money

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

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

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

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

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

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

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

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

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

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

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

The biggest mistake in commercial real-estate …

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

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

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

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

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

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

Where’s the mistake?

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

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

But, Warren is talking about public markets.

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

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

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

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

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

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

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

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

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

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

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

It’s simply that you will lose customers!

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

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

Your biggest risk is the risk of vacancy.

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

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

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

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

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

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

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