Tag Archives: real estate

When to buy residential real-estate …

Posted on by
8

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

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

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

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

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

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

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

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

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

The reality is a little different:

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

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

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

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

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

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

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

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

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

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

1. To live in

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

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

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

2. To protect yourself

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

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

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

For protected rents.

What do I mean by ‘protected rents’?

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

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

But, people still need somewhere to live …

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

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

How to buy a business with No-Money Down

Posted on by
Reply

You’ve heard of ‘no money down’ deals for buying real-estate, but you probably have never done one yourself. But, did you know that it’s much easier – and, more profitable – to do ‘no money down’ deals in business?

[Originally published on Biznik, the small business online network: http://biznik.com/articles/how-to-buy-a-business-with-no-money-down]

You’ve seen the late night infomercials on cable: “buy my course for only $149 (plus S&H) and learn the secrets of how to buy 52 properties this year with NO MONEY DOWN”.

Naturally, you’re sceptical – and, so you should be because ‘no money down’ deals on real-estate are far more rare than the infomercials would lead you to believe [AJC: post-financial crisis, now almost impossible] … and, some of the ways that they are done are ‘on the edge’ of ethical business practices to say the least.

That’s why I have purchased a lot of real-estate over the years, but have NEVER done a ‘no money deal’.

But, did you know that it is possible to do ‘no money down’ deals on businesses? And, not only are these deals ethical, but they can be win/win for everybody involved?

And, they can be so easy to put together that my 13 year old son [AJC: this was a few years ago, now] put  one of them together for himself!

1. Let me start with my son’s example, as it is a good illustration of how simple the process can be:

My son started a small e-Bay business, but he didn’t have the capital to meet the minimum order requirement of $100 from his online wholesale supplier.

So, he asked me to put up half the capital for that first order for him: $50. In return, he offered me 45% share in the business, which I accepted.

He made that order and sold the stock within one month and promptly bought me back out!

[AJC: he handed $50 back to me and said he wanted his 45% back; I didn’t have the heart to say “son, it doesn’t quite work like that …”]

Not quite ‘no money down’ … but, close.

Now his e-Bay business nets him a cool $30 a week (not bad for a kid who only gets $26 a month in Allowance)

[AJC: Now I’m extra sorry I handed back my equity for $50, because his latest online/part-time business – he’s still at high school – makes him $150k a year]

2. I had the opportunity to take over a defunct family business: it was a finance company that needed both working capital and bank funding (a lot of it!) to run.

Unfortunately, at the time, I had neither the capital nor the access to bank funding … in fact, I was $30k in debt. But, I did have a customer list.

So, I used the same ‘no money down’ technique that my son used: I found an investor (who happened to be a competitor, often the best place to go for help) who put up the 25% capital that the business required to get started.

I then found a bank willing to finance the remaining 75% simply secured against the ‘paper assets’ of the business.

If you think about it, this is very similar to a ‘no money down’ deal on a property: find a partner willing to put up the deposit money in return for, say, a 50% share of the future profits, and a bank to lend you the balance as a mortgage over the property.

If the business is growing, my advice is to buy your partner out as soon as you can afford to … that’s what I did: we parted good friends. Make sure you always do the same.

3. Another way to do a ‘no money down’ deal for a business is where you have an asset that a larger company needs for their own business (preferably a non-profitable division of a larger company … believe me, there are plenty out there).

Most people are happy to sell this ‘asset’ to the larger company, or perhaps consult to them, for a fixed fee. Instead, consider ‘trading’ what you have for equity. Here’s how I did it:

I had some software that I used in my business that made our operation quite profitable; I found a Fortune 500 company that had a division operating in the same niche, but in another non-competing location, and discovered that they were still operating on older technology, hence, were unprofitable.

They offered to buy my software and consulting to help turn their own business unit around. However, we instead proposed a joint venture. For the ‘price’ of the software and our expertise, we received a majority share in that business unit. No money down!

It only took us two years to make the business profitable (using our software) and, we on-sold our share soon after for a huge return. We made about 7 times more profit by trading assets for equity than a simple software sale would have provided.

4. These are the types of ‘no money down’ deals that you should be looking for if you want to get into business or if you want to expand your existing business. But, there is an even simpler way:

If you want to buy an existing retail business with an existing lease … no matter what the asking price: ALWAYS start by offering No Money Down. Simply offer to take over their lease.

Many times that will be enough to do the deal … people need to sell their businesses for many reasons (marriage, divorce, moving) and are tied to their leases. By offering to take over their lease, you are removing a major headache for them … no money down!

Now that you have seen how easy it is – and, how lucrative it can be – to buy any type of business with No Money Down, maybe you will give it a try?

If you already have, please let me know your experiences …

Real-estate: can you tell the difference?

Posted on by
8

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

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

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

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

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

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

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

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

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

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

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

They will produce roughly the same investment return over time.

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

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

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

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

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

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

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

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

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

What do you think they key difference is?

How to guarantee a higher return on real-estate …

Posted on by
2

About 10 years ago, my wife’s two nephews came to visit their “Uncle Adrian” to discuss potential investments.

They had decided to buy two apartments (in the USA, called ‘condominiums’) together – I advised them to buy one each, but they decided to go 50/50 on one, then another one a short while later.

I remember being quite proud of them, because they were both still in their early-to-mid-twenties at the time and were already investing in real-estate rather than taking the easy options of either not investing at all or speculating on stocks.

My wife’s nephews have since each married, and they each have two children under the age of 5 …

… and, they still own the two condo’s together.

I was taking one of my grand-nieces [AJC: makes me seem VERY old; I’m 53, which is only SLIGHTLY old] swimming this morning, and we got to discussing how the apartments are going.

My nephew-in-law said: “we’ve made a profit, but I don’t think they’ve been a very good investment”

Let’s examine this in a bit more detail, because I think it explains my last post quite well …

He (and, his brother) bought 2 apartments for about $200k each about 10 years ago; they are now worth about $400k each (they were worth as much as $500k each about 12 months ago, but prices have pulled back from their peak).

The apartments are still generating a small loss on a monthly income v costs basis, but he’s comfortable with a small level of negative gearing … and, he has an interest-only loan, so has not paid off ANY principal in the ~10 years that he’s owned 50% of each apartment.

He has calculated his return as about 7% (before tax) compounded, which I feel is pretty good but he feels that “opportunity costs” are such that he could have done a little better, elsewhere.

All in all, it doesn’t sound impressive …

… to him.

To me, the return is outstanding and explains what my last post is all about!

You see, I asked him how much (a) his loan is, and (b) how much cash he has put in so far (since the property has been making a small loss each month for 10 years).

He says that he put in a 25% initial deposit (interest-only loan), and has put (including the deposit), about $100k in cash (before tax costs/benefits).

This is how I think it breaks down (these numbers are now approximate):

– Property purchased for $200,000 (let’s assume this includes closing costs) with a 25% (i.e. $50k) deposit.

– Loan is interest only, so still stands at $150,000

– Total cash put in to date is $100,000 (made up of the $50k deposit plus another ~$50k negative-gearing losses over 10 years)

Now, let’s look at the analysis:

Cost to my Nephew-in-law:

1. $50k deposit

2. $50k losses

Profit if property sold today:

3. Property is worth $400k

4. Property purchased for $200k

5. Loan to pay off is $150k

Total Return:

6. Cash OUT is: 1. + 2. = $100k

7. Cash IN is: 3. – 5. = $250k

[AJC: notice that the price that he paid for the property doesn’t even figure – directly – into the equation; all that matters is what he owns (current value) less what he owes (current loan + the cash he puts in)]

This is no different to putting $100k in the bank (or some other investment) and getting $250k back after 10 years.

Using a compound growth rate calculator, this is  a 9.5% annual compound return, not 7% as first thought!

You see, he was making the common mistake of thinking that the apartment ‘only’ doubled in value in 10 years (from $200k to $400k, which is a still amazing 7% return in today’s depressed investment climate).

But, you simply need to look at how much cash you put in, against how much cash you get back out when you eventually sell (or, you can still do this calculation on the likely selling price, if you want to keep the investment) to find your real return …

… i.e. the less cash you put in, the greater the return.

It’s usually as simple as that!

.

How to manage your life with just $19 Billion …

Posted on by
Reply

After the recent Facebook float, how did Mark Zuckerberg fare, and – more to the point – how is he going to live?

According to the online business media:

The founder sold 30.2 million shares out of his entire holding, leaving him with a $US1.1 billion payout. It’s a huge amount of money, even after taxes, but it doesn’t come close to his final stake, somewhere in the region of $US19 billion.

So, the answer to the “how is he going to live?” question is: very well, thankyou!

Instead, let’s take a look at a hypothetical Internet business owner whose company IPO’d for mere millions in value, instead of Zuckerberg’s billions:

Let’s say that our hypothetical founder sold 30.2 million shares out of his entire holding, leaving him with a $US1.1 million payout. It’s a lot of money (let’s pretend that it’s after taxes), but it doesn’t come close to his remaining stake in his company, somewhere in the region of $US19 million.

How is our founder to live?

It would be tempting to say that he has $20 million, so a typical ‘safe withdrawal rate’ of 4% [AJC: which could be achieved through a combination of dividends and selling down small amounts of stock each year] would suggest that he has a massive $800k disposable income each year.

But, spending anywhere near $800k – even spending anything more than 25% of this amount p.a. – would be a huge mistake.

You see, the bulk of his money is in stock … and, risky stock at that: 5% of his net worth in cash and 95% in one relatively small, ‘hi tech’ company …

… and, we know what happens in tech: it can be boom/bust [AJC: remember MySpace, anyone?].

This is no different to an athlete trading off his contract, and spending money like it’s forever … except when it isn’t, which is why 78% of NFL players and 60% of NBA players are bankrupt within two years of leaving the game.

The second – less aggressive – temptation, then, would be to live off the dividends from the stock held …

…. let’s say that the company pays 2% dividends [AJC: which would not be unusual for a tech. company seeking to reinvest in itself, or acquire other companies, even though many – such as Apple – would pay zero dividends], which would deliver $400k per year.

But, again, what happens if the company stops paying dividends?

Instead, what our founder needs to do is realize that he is merely potentially very rich, but right now is a very valuable employee (and, controlling shareholder) of a company that is rewarding him with (a lot of) stock that may – or may not – one day convert to cash.

So, what our founder needs to do is count his blessings … I mean, assets:

1. He probably has a very healthy $400k+ annual salary, he should live off no more than 50% of this (indexed for inflation) and invest the rest.

2. He probably receives $400k in annual dividends; he should add 100% of these to his nest egg.

3. He has a starting nest egg of $1.1 million, which he should invest in ‘passive’ income-producing investments [AJC: real-estate is ideal for this]

As he starts to convert more stock to cash (i.e. through sale of small amounts of stock each year, as the law & his board may allow, and/or dividends) eventually, his nest-egg will grow to $4 million …

… which is his lifestyle break-even point i.e. the Rule of 20 says that your nest-egg should be 20 times your required annual living expense, which is currently $200k.

The good news is that anything converted to cash – hence, into passive investments – over $4,000,000 allows our founder to increase his annual living expense.

You’ll find that if you follow this system:

a) Sure, you’ll be living well below your ‘paper means’, but once you realize that your wealth is merely on paper, you’ll get over it, and

b) You’ll slowly-but-surely be transferring your ‘paper wealth’ into real wealth (i.e. passive investments), and

c) If you choose income-producing real-estate as your vehicle for holding your ‘real wealth’, you’ll pretty quickly find that you are able to support an even more quickly-increasing standard of living, no matter what happens to your tech company, and sooner than you may think.

This is how to bullet-proof your future …

… unless you’re Mark Zuckerberg, who can probably already survive on 4% p.a. of $1.1 billion 😉

.

.

How to ruin your return by paying off principal …

Posted on by
7

A while ago, I did a three-part ‘anatomy of a commercial real-estate deal’ …

Drew wanted to know:

You mentioned 63k income that you can spend, but I don’t see you including principle payments. Wouldn’t that cut into your cash flow?

You’ll need to go back and read the three-part article, but this question goes to the heart of whether to pay off your mortgage, and is somewhat the same argument whether you want to do this on an investment property or even your own home.

It boils down to return:

The building that I was looking at buying would have generated $255k in rents – $192k in expenses (including $130k bank interest) = $63k net ‘profit’ p.a.

Paying down principal doesn’t change that dramatically: it does lower my interest expense, which should increase my net profit, hence my return …

… in $$$ terms.

But, when you do the math, it can lower the % return  that I am getting on my money.

Aldo says:

Continuing with the comment from the previous reader, can you elaborate a bit more on why principal payments would not affect this deal? On the previous article you mentioned going for a 7yr financing or so, which will represent about 250-300k of additional capital you need to put each year. After the first year you would have invested 700 + principal (let’s say 250k) = 950k. The 63k you make then will become a 6.6% return on your own money… Then down to 5% the next year… And so on…

Aldo has forgotten to allow for the reduction in interest expense as my equity increases (and, the bank’s loan decreases), but he points to the % return on my overall investment decreasing …

… whereas, an investor should generally be looking to increase their % returns.

In simple terms: if I can buy a $100k property with 20% down (i.e. $20k), when I find (e.g. by saving) another $20k, am I financially better off:

1. Putting it into this property to pay it off quicker?

2. Putting it into my home mortgage to pay my home off quicker?

3. Putting it into another $100k property that I can buy with 20% down?

In order of decreasing return, it’s generally 3. then 2. then 1.

I know which I would rather do. How about you?

 

 

Poor little rich doctor …

Posted on by
4

A couple of weeks ago, I responded to a reader request from a young doctor who is on what can only be described as an OMG level of income:

I am a young physician (early 30s) making approximately 800k per year. After expenses and taxes, I am left with ~300k to save/invest.

Never mind the fact that he is losing approximately $500k a year in “expenses and taxes”, a $300k take home is still pretty good in anybody’s language!

There was plenty of well-considered reader debate and advice for the young doctor, including this highly-reasoned argument from traineeinvestor:

I’d suggest he continue to focus most of his energy on maintaining or growing his professional income. Time spent on side ventures and investments should be limited so that it does not interfere with the $800K professional income.

In terms of investments, given his time constraints, I’d go with a Boglehead approach, possibly supplemented with some geared cash flow positive real estate (especially if he lives in the US and can take advantage of depressed prices and long term fixed borrowing costs).

I agree on both counts:

a) When you are earning a super-high level of salary, your primary goal should be to protect that source of income. It’s a river of money: you should do everything in your power to keep it flowing!

b) However, you shouldn’t just let the money flow into the taxman’s pocket, then into yours, and then out again by increasing your spending. Instead (and in keeping with our ‘river’ analogy) you should also build a downstream dam.

And, you should only open the sluice-gates to let off a much smaller amount than is going into the dam …

Why?

Because that’s the only way that the dam gets to fill up!

This way, when the river stops flowing (ideally, at a time of your choosing i.e. early retirement, but it could be forced upon you even earlier for a variety of reasons), you can keep the sluice gates open, knowing that there’s still enough water in the dam to keep the flow running for the rest of your life.

In other words: you don’t want the dam to run dry before you do 😉

But, this is much harder to achieve than you may think, so here’s where I differ – but, only slightly – starting by reversing the order of traineeinvestor’s otherwise excellent investment strategy:

I’d go with a geared cash flow positive real estate approach (especially if he lives in the US and can take advantage of depressed prices and long term fixed borrowing costs), possibly supplemented with some Boglehead-type investments.

The reasons are two-fold:

Firstly, I’m not accepting that 62.5% (i.e. $500k) of our doctor’s $800k earning capacity can simply be wiped off in “expenses and taxes” …

… professionals are just sitting ducks when it comes to taxes.

But, by implementing a nicely geared (and, maybe even cashflow negative after depreciation allowances) real-estate strategy, there may be deductions that can legitimately increase his super-high professional’s take-home income, without falling afoul of the tax man.

This is a clear-cut case of where a professional’s advice can add huge value [AJC: not in asking “is real-estate a good investment for me” but in asking “is real-estate a good tax-advantaged but highly legitimate investment vehicle for me?”], and our doctor should not take another step without seeking such professional advice.

Secondly, he should go through every single expense with his accountant and see what he can reduce or better manage. Nobody can afford to burn $500k worth of dollar bills …

… not even a super-high-income doctor.

Secondly, real-estate (especially when prices are depressed) is just a great long-term investment.

With his $300k (and, hopefully much more once he implements some of his accountant’s tax and cost-management advice) cashflow plus any income that he receives from his tenants, the doctor can afford to leverage quite a large portfolio of such high-quality, long-term, income-producing investments.

And, it is this large portfolio that becomes his growing ‘dam’ of cash, trickling out at perhaps a $100k – $150k sustainable annual spending rate … one that he should be able to index with inflation and maintain for his whole life, whether he (one day, perhaps quite soon) chooses to work full-time, part-time, or not at all.

And, isn’t that the whole (financial) point of it all?

How to start with next to nothing in cash and build up from there?

Posted on by
1

Ken H asks:

I am just starting my journey to the concept of making money when you buy. Can I get more examples of what can be bought to use this concept? Where do I learn a strategy that I can start with next to nothing in cash and build up?

Great question, Ken!

The short answer is that you need a source of cashflow.

The long answer:

A high-paying job is ideal (but, only if you invest 30% to 50% of it after tax) …

… if not a high-paying job, then a second source of income.

I like the idea of starting an online business ‘on the side’ and reinvesting 100% of the profits (a) back into the business to help it grow and, whatever’s left over, (b) in income-producing investments.

The ideal investments, of course, are ones where you can get a silent partner to put up 75% – 90% of the money required. That way you can get more investments quicker.

Also, when the bank puts in 80% of the funds required to fund a real-estate acquisition, and it goes up in price by 20%, you have just doubled your money (less the bank’s interest).

And, the best ‘silent partner’ that I know is The Bank. But, the investments that The Bank likes the most – hence, they will lend by far the most on these – is good old-fashioned real-estate.

So, I would reinvest as much of my savings as possible into real-estate, and then wait 10 to 20 years (unless my business grows really fast, in which case I might wait 5 to 10 years.

Sure beats ‘working for The Man‘ for 40+ years, doesn’t it?

Why sell property?

Posted on by
1

Richard sent me an e-mail [ajc AT 7million7years DOT com] asking:

I have read through most of your past posts. 2 questions come to my mind. Hope you can clarify.

1) You always tag a 30% return for real estate. If one puts 20% down on a prop and add in all the closing costs, capital up front will be like 25%. Assuming a 6% capital appreciation like you like to use, I don’t see how you can come out with 30% return on capital. My assumption is that we breakeven on cash flows. I did the calculation a while back and I think 15% is about the max.

2) I read that you have sold off your commercial properties and are looking to get back in. Why do you sell it of if real estate investing is for the long term? Can’t you refinance to tap into the equity and use it for other investments? Why do you want to “time” the market? Transaction costs are heavy in RE.

Let’s deal with the first part of the questions first: 30% is a very hard ask for any traditional investment, let alone real-estate. But, it can be done … if you’re a highly geared and successful [read: lucky] property developer.

More typical maximum investment returns can be seen in the following table:

By putting Franchises into this table – which many would consider more business than investment (but, I treat as an investment IF you can be an absentee-owner and acquire multiple franchises under the franchisor’s rules) I guess that I’m framing that you need to do a lot more than simply buy your own home and pay off your own mortgage to get these kinds of returns.

Real-Estate sits in the middle of this part of the growth table and, I agree with Richard, is probably closer to the 15% compound growth rate end than 30%.

But, the key question is: how does this kind of growth occur?

It occurs because of leverage:

1. Financial leverage – You can use the bank’s money  to gain a ‘free additional compound return’. Here’s how it might work:

You put 20% (or $20k) down on a house that costs $100,000 (ignoring closing costs for the sale of simplicity).

IF property only increased by 6% per annum, as Richard suggests (it’s actually a historical, US-wide growth rate quoted by a number of analysts in the past), and mortgage rates are around 4%, then the house will increase in value by $6k, but your mortgage will cost you $4k (actually, only 80% of that, since you put in $20k cash). Fortunately, this is a rental, so let’s say that you earn another $4k (4%) in rent.

Your total return is $6k, which doesn’t sound like a lot for a $100k asset (but DOES sound like Richard’s 6%), but you forgot one thing: you didn’t put in $100k … you only put in $20k, which you have just grown to $26k (in some mix of cash and/or equity) which is an ‘easy’ 30% return.

Now, you may not have picked this up, but who said that you needed to put down 20%? If the bank, fair enough …

… but, what if the bank allowed you to go with 10% (or, $10,000) down? Then your return almost doubles.

Even so, because real-estate is rarely cash-flow positive in the early years and appreciation isn’t always all that you expect, you need to add other kinds of leverage.

Here are some examples:

2. Knowledge leverage: If 6% is the average increase in home values across the entire country, do you think that you may be able to do better with a little research? For example, could you choose an urban area rather than a rural area (urban areas typically grow faster than average, and rural areas grow less)? Could you choose an upcoming neighborhood to invest in (one with lots of new families moving in, rather than one with an aging population where people are moving out)? Could you choose a high-demand location (one near a beach, near a park, near transport, near schools, near a mall, and so on) rather than one near factories and warehouses?

3. Value-added leverage: Could you take the least-loved house in the street and add value by: adding a bedroom? Painting the house? Cleaning up the garden? Upgrading the kitchen and bathrooms?

4. Opportunity leverage: could you find a house that nobody wants and buy it at a discount before it even comes onto the market? Could you find a poorly managed rental and be a little more hands-on in terms of looking after the property and tenants in order to increase rents over time?

Any ONE of these factors could positively influence your compound growth rate well over the averages. Combining as many of these factors as possible could positively hit your real-estate returns our of the ball-park.

As to the second part of Richard’s question, he is quite correct: buying real-estate and holding for the long-term is usually the right strategy.

However, circumstances may arise where that strategy does not make sense: e.g. I owned my office building, but once the business was bought and the tenants (my former company) moved out, I didn’t want to hold the commercial property while I was overseas and look for tenants.

In hindsight, I should have kept it.

How to structure a real-estate partnership?

Posted on by
2

MoneyRunner asks:

A friend and I are in the process of writing an operating agreement for an LLC and I’ve got a question for you. We have raised capital for the down payment on an apartment building. I have raised $15,000 ($10,000 my own and $5,000 from family) while my friend has raised $25,000 (all from family). We both have a 50% ownership in the LLC. Once we start to produce income, is it fair to distribute funds according to initial capital invested? Is it even possible to do 50/50?

Firstly, I don’t like buying long-term assets in partnership … times change … longer times change even more 😉

For example, to help a friend out (really!) my wife talked me into buying a half share in a downtown property. In ordinary circumstances it would have been a great, long-term hold.

However, two brothers-in-law had gone into partnership to acquire it and some years later one of the brothers-in-law wanted OUT. The problem was, the other B-in-L couldn’t afford to buy him out, and didn’t want to sell.

These sorts of decisions break up families … and was threatening to do exactly that to this family. Our friend, the third brother-in-law (and the only one of the three NOT involved in the deal) asked us to help out by buying out the one B-in-L who wanted to sell.

And, that’s what we did: bought 50% of a building that we know that we can never sell without causing the same situation to erupt again. My wife talked me into in … that’s my only excuse 😉

But, if you still DO want to go into partnership, here’s what I suggested to MoneyRunner:

All is fair and possible in business and investing … as long as you both agree!
You will most likely need a shareholder’s agreement drawn up by your attorney, if the equity and/or profits are not to be split equally.
However, a simple way to deal with your situation is:
1. Both put in $15k as capital (it makes no difference HOW or WHERE you each got the money).
2. Let your friend put in the extra $10k as a loan.
3. Agree a rate of interest (say, mortgage rate plus x% e.g. if the current mortgage interest rate that you are paying on the property is 6%, your friend might get 10% for his $10k).
4. Split the equity and remaining profits (i.e. rent MINUS mortgage + interest owing to friend + expenses) 50/50
Here’s why you will still need a shareholders agreement:
– Rules as to how/if/when your friend’s loan is to be repaid,
– Rules as to who can force a sale of the property and how you deal with each other’s share in the property in the event of a dispute.

However, there are other ways to enter a ‘partnership’ that stop all of these issues:

My first real-estate purchase was with a friend of mine who found a new condo development in foreclosure; the bank was selling off the individual condos. My friend thought that we would get a better deal if we bought two condos together.

… and, we did!

We negotiated a price of $55k for each condo.

How did we deal with the partnership issue? Simple!

We each bought one codo in our own names. Then, when I stupidly decided to sell (I was still young and reckless, and this was my first ever real-estate purchase), I didn’t need to ask him. I sold it for just over $75k about 2 years later [AJC: But, it would be worth closer to $500k now, 25 years later] … not a bad deal, and no stress on our ‘partnership’.