Investing Architect

Author: Erion Shehaj

A two word mantra for Blueprint real estate investing

Lately I have been thinking at length about what is at the core of our Blueprint real estate investing strategy. There are many moving parts and elements to consider when putting together such a strategy: Location of properties, assets specs, financing, asset protection, tax implication, exit strategies etc.

But as crucial as are all those aspects, at the end of the day, the Blueprint real estate investing strategy can be summarized in a simple two word mantra:

Buy Quality

When you buy quality, you are really buying good tenants that take care of your investment and pay rent on time. When you buy quality, you are really buying low turnover rates, long term leases and low vacancies. When you buy quality you are buying more options, more flexibility and top dollar exit strategies.

And last but not least, when you buy quality, you always outpace those who buy cheap.

March 27, 2013
Houston real estate market roars into spring + Introducing HIGR chart
It’s as if someone flipped a switch on January 1, 2013.

The market has not been the same ever since. During the previous two years (2011 and 2012) the Houston real estate market reversed course and started its steady climb of recovery. Sales started to come in at double digit increases year on year and prices rose slowly but surely. Inventory levels were dropping but there was sufficient supply to serve the growing demand. Rental prices were rising as tenant demand soared in response to population growth and strong job creation numbers in Texas.

Real estate investors responded in kind by acquiring more properties to serve that demand. Up to this point, nothing out of the ordinary. After the slow and lethargic sideways market we experienced after the 2008 recession, the daylight of recovery came as expected. Until this January.

The consumer confidence that had been the missing ingredient for the robust recovery that ultracheap money should have created, was finally here. Job numbers started to look better as employers put behind the uncertainty of a three year old election campaign. Most people didn’t have to constantly worry if the next week could bring the dreaded pink slip. And it’s as if they looked around and realized that with mortgage rates this low, there would be no better time to buy in a very long time.

So, sales grew at an accelerated pace and carried prices higher with them. Bank owned properties made up an increasingly smaller part of total sales as the much speculated about “shadow inventory” never materialized. In addition, default rates of homeowners that bought after 2008 have been much lower than those who bought before. The reason is simple – 2006’s subprime mortgage became 2009’s 30 year fixed FHA loan with a low interest rate. And guidelines were tighter, so fewer people qualified. So fewer foreclosures in general have translated to fewer bank owned properties. Inventories struggled to keep up with the spike in demand and hit a 13 year low at a skimpy 3.6 months in January. Say hello to listings sold in a matter of hours with multiple offers and bidding wars. Bid adieu to negotiating leverage.

Houston Real Estate Market Report for February

February brought more of the same for Houston’s real estate market. Below is a distillation of the numbers for you:
1. Homes sales were up 15.5% over same month last year
2. Home prices (average) were up 9.6% year over year
3. Inventory held at the lowest level since 1999 of 3.6 months
4. Active listings for sale fell by 21% to 33,361
5. Rentals of single family homes fell by 16% while prices were up 7% at an average of $1515
Introducing Houston Investment Grade Rentals (HIGR)

The monthly press release from the Houston Association of Realtors that covers the Houston market statistics does a pretty good job of providing great home sales and inventory data. They fall short in the rental market department which usually gets a one liner and not much else. Case and point:

Rentals of single-family homes fell 16.3 percent compared to February 2012 and year-over-year townhouse/condominium rentals were down by 4.5 percent.

That’s great but it’s hardly enough information to make a good decision regarding the state of the rental market in Houston. For instance, without knowing the number of rental listings active on the market at the beginning of the month it is impossible to determine whether the drop in number of properties leased is due to a lack of demand or lack of inventory. Or for that matter, excess of inventory.

So, since I was tired of wondering, I built a chart that better indicates the state of the rental market for investment grade properties. For this purpose, I pulled data from the MLS for rental properties that meet the following criteria:
- Single family homes
- Located in good school districts
- Built after 1990
- At least 3 bedrooom and 2 car garage
- Square footage between 1300-3000 SF
So far, I’ve collected and aggregated data going back to 2007 but I plan on extending it to 2003 to give you a 10 year birdseye view. The idea is to take a focused look at what the rental market is doing for investment grade properties that our clients are mostly interested in.

Below is the summary of data for February 20013:
1. Investment grade properties leased: 490 (that’s 2% lower than 2012)
2. Average lease price for investment grade properties: $1492 (represents a 5% increase over last February)
3. Average days on market for investment grade properties: 29.44 (down 28.49% year over year)
At this point we don’t have active listing data for the month of February but starting in March we will start collecting it and reporting it here on our market reports posts in the coming months.

Parting thoughts

As far as the acquisitions market is concerned, the biggest risk to real estate investors at this point is nostalgia. What we used to be able to buy properties for in 2010-2012 is irrelevant for all practical purposes. Even more useless is waiting for prices to go back to that level when they’re going in the opposite direction. If you get hung up on nostalgia you might end up like those homeowners who won’t refinance their 6% a year mortgage down to 3.5% because rates dropped to 3.25% for 15 minutes four months ago. If nothing else, the current market reality is proof that timing the exact bottom is a fool’s errand. Pay a fair price for quality properties in the path of growth as long as the numbers make sense.

If I had to guess about the reasons behind the fewer rental properties leased in February, I’d have to go with two main ones. The first is that real estate investors are finding it harder to acquire investment properties in an environment where homeowner demand for properties is spiking. Remember that most homeowners have an advantage over investors due to the preferential treatment afforded to them by first look periods. The second reason is that during 2012, we started seeing longer term leases being signed by tenants. In fact our average lease term was 2 years in 2012. So as fewer properties come up for renewal, there are fewer listings on the market for lease. I don’t believe the drop reflects a symmetrical drop in tenant demand. If it did, the rental prices wouldn’t rise and days on market wouldn’t drop.
March 25, 2013
Asset protection strategy for long term real estate investing
Throughout ancient history, the most powerful monarchs in the world built grandiose cities that were the epicenter of trade, commerce, art and civilization.

Rome, Athens, Babylon, Constantinople just to name a few, all had a similar configuration. The center of the city was a reflection of the monarchs own power and wealth with its royal palaces, buzzing markets, amphitheaters and temples. But in the outskirts, there were always strong walls to protect the city from possible attacks from those who were after the riches that the center offered.

In my opinion, that is an excellent metaphor for the crucial importance of a solid asset protection strategy for your long term real estate investing. When you execute our Blueprint real estate investing strategy, the goal is to build something beautiful that allows you to accomplish extremely important goals. A net worth that’s large enough to produce an income that gives you freedom. Which in turn removes most obstacles so you can pursue the life you want, whatever that entails. Follow the time tested principles we outline and you will build your beautiful “city center”.

But that beautiful thing you built, requires a strong, impenetrable wall around it to protect it from outside threats. Neglect asset protection and all your disciplined efforts and sacrifices expended over a decade of investing could all have been for naught.

Liability exposure for real estate investors

Real estate investors face two major types of liability that a solid asset protection strategy can help combat. The first is liability associated with the asset(s) owned by the investor. Namely, one of your tenants can slip and fall on some unstable steps, hurt themselves and sue the investor for damages. Or one of the tenants’ kids has a friend in the neighborhood whom he likes to wrestle in the backyard of your property. If the friend gets hurt, their parents can sue the owner of the property for damages. And so on. The second type is liability associated with the investors themselves or their dependents. For instance, if the investor gets into an automobile accident and hurts another person, attorneys for that person could pursue assets owned by the investor to collect damages in the case. Similarly, if a dependent of the investor (i.e. son or daughter) causes harm to another person, the same thing could happen.

In either type of liability, if the investor owns property in their own name, the liability exposure could wipe out everything the investor has worked so hard to build including his primary residence and personal assets since there’s no separation between those assets and the investment properties. Since they’re owned by the same entity (the investor), everything is fair game.

Liability insurance

But what about liability insurance – Doesn’t liability coverage in your home insurance policy or in an umbrella liability policy dispel that exposure completely? No and for two reasons. First, I don’t know if you’ve heard but insurance companies aren’t in the business of paying claims. They’re in the business of collecting endless premiums while only paying a small portion of them out to claims. They achieve this by including several varieties of exemptions in their policies. More specifically, these are cases in which your policy wouldn’t cover you. And they’ve gotten so good at this premium collection business that they exempt themselves from liabilities that tend to occur most often. Second, are you sure you want to be involved in a lawsuit even if the liability policy ends up covering part of the damages? A side of lawsuit wasn’t exactly what you had in mind when you made this investment in the first place. So, while ample insurance coverage can sometimes treat the problem, a proper asset protection strategy prevents it from happening in the first place or from spreading further once it happens.

Enter the mighty LLC

The consensus amount asset protection specialists is that a Limited Liability Company (LLC) is the best vehicle in which to hold long term investment real estate. An LLC is a standalone legal entity so it offers adequate separation between the investors personal assets and her investment portfolio. But unlike some corporation structures it doesn’t come with the burden of double taxation. When you hold investment assets under the umbrella of an LLC, your liability exposure is limited to the assets owned by that LLC. For instance, if someone slips and hurts themselves on a property owned by an LLC, only the assets held within that same LLC are subject to being pursued for liquidation of damages but not the investor’s personal assets or assets held in different LLCs.

Okay then – You’re sold on this LLC idea. Let’s buy all your assets in the name of your LLC or transfer ownership of your existing assets into an LLC. Two major problems with that plan:
1. No Lender will allow you to buy properties in the LLC from the start because they want you to be personally liable for the mortgage loan.
2. If you transfer the ownership of your assets into an LLC after closing, your Lender will view that transfer as a sale. And in your mortgage note there’s a “due on sale” clause that gives your Lender the right to accelerate your mortgage (read: require you to pay full amount right away). This transfer triggers that due on sale clause which you really don’t want to do.
So you must purchase the property in your own name to satisfy Lender requirements, then transfer ownership to the LLC without triggering the DOS clause. But how?

The Land Trust Workaround

The vehicle that allows the long term real estate investor to enjoy the protection offered by the LLC without getting on their Lender’s bad side is the land trust. They’ve been around since the Roman empire with widespread use during the reign of Henry the VIII with the primary purpose to conceal the ownership of property. So if you were an aristocrat in the fourteenth century and didn’t want people to know you owned a piece of property, you would hold it in a land trust of which you were the beneficiary. If someone were to look up the property records they’d see the property was owned by the trust and they would be unable to know who was the true owner of the property.

Land trusts are the best antidote to triggering the due on sale clause. For this to happen, the investor hires an attorney to set up a land trust of which she is the beneficiary – then deeds the property to that land trust. This transfer is not viewed as a sale by the Lender and as such does not trigger the due on sale clause. Afterwards the investor assigns the beneficiary rights of the land trust to the LLC through an attorney drafted document. So the investor owns 100% of the LLC which is the beneficiary of the land trust in which the property is held. Asset protection plus no due on sale trigger.

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One important note to consider is that I’m not an attorney (nor do I play one on TV) so always consult an attorney before you execute an asset protection strategy.

Phillip Capper via Compfight
March 19, 2013
What is the return on investment for the Blueprint real estate investing strategy

After a workload-induced two week hiatus from writing, I’m back to answer one very frequently asked question. What is the return on investment when you execute the Blueprint real estate investing strategy?

Investors that ask that question are usually trying to compare and contrast investments in different asset classes (stocks, bonds, commodities, life insurance, real estate etc) to make an allocation decision. After all, every investor has a finite amount of hard earned (even harder saved) capital and the quality of their retirement depends in large part on their decision to invest that money wisely.

The final decision depends on four things: The return on investment, the risk involved, the investor’s tolerance for risk and her available investment timeframe. If the investment offers a sky high rate of return but there’s a good chance to lose all your principal, you might want to pass if you have a low tolerance for risk (or possess common sense). If instead, the principal is relatively safe but the return on investment looks up to inflation, you better hope your accumulated capital is enough to hold you as you cannibalize it in your retirement years. Last but not least, the direction you take in your investing is very different if you are 20 years or 24 months away from retirement.

Put a different way, it’s crucial to strike the right risk-return-timeframe balance. And that’s much easier said than done.

Having said that, the question is a fair one. Inquiring minds want to know: If you invest a dollar of capital in a quality asset and hold it long term what should you expect your return to be on that dollar? Real estate investments have the potential to “make the investor money” from four different sources.

Cash on Cash

Cash on cash returns are the perennial investor favorite: Simple and to the point, easy to understand and relatively reliable. The cash on cash return on investment is calculated as the positive cashflow produced by the property (after paying for operating expenses and mortgage payments) divided by the cash investment in the property (down payment and closing costs). Think about it this way – the positive cashflow is the “interest” (or dividend) paid by the investment on your cash invested. When we analyze investment properties for acquisition daily, the projected before tax cash on cash return for each property has to be at least 12%. And this is after we take a conservative approach on incoming rent and operating expenses so in many cases your actual return ends up being higher than what’s in our cashflow projections.

A close cousin to the cash on cash return is the capitalization (or cap) rate. This is the rate of return earned by an investor that owns the property free and clear. For quality locations in good school districts with high tenant demand, we are seing capitalization rates in the 8-9.5% range.

Debt Amortization

Although the cash on cash return is easy, it’s incomplete because it does not account for other returns/benefits the investor receives besides the positive cashflow. One of these benefits is the debt amortization (pay-down) as the investors’ mortgage is paid every month using the incoming rent from the property. It’s easy to forget about this portion of the return since the investor doesn’t “see” this money until the property is sold later on. But that’s more a question of style over substance. Let’s say you acquire an investment property with $100k mortgage at 4% for 30 years. Your positive cashflow at the end of the year is $4700 (a 12% return). During that year, while you were enjoying your “dividend”, your mortgage balance is also paid down by $1761 which amounts to an additional 30% of that annual cashflow.

Capital Appreciation

Ah the good old “A Word” – something one ought not dare use lest they be accused of blasphemy. From 2008 on, disillusioned investors that had been counting on appreciation to right all their fundamental investing wrongs received a pretty harsh punishment from a market that had been pushed passed it’s inflation limit. It turns out that real estate cannot appreciate at 20% annual rates in perpetuity. Who knew?

When you purchase a long term investment property to hold, you effectively control that property and can reap the benefits of appreciation (when and if it happens) which could propel your returns even higher. While a real estate investment strategy that relies solely on appreciation is as flawed as last time it was tried, a more grounded approach that relies on solid positive cashflow and treats appreciation as a additional bonus return is the way to go. But since appreciation is less reliable than Lindsey Lohan on a film set – no one really knows when and if it’s coming, we assume no appreciation on our analyses. If it happens, I don’t think you’ll be very upset with me either way.

Tax Benefits

Finally, real estate investments are afforded special tax treatment in two ways by the IRS which indirectly contributes to your overall return. First, they allow you to take a ghost expense called depreciation, therefore making your cashflow for tax purposes appear smaller than what it was in real life. In so doing, they allow the investor to pay tax on that income at a much lower tax bracket than would have been the case with ordinary earned income. And second, they allow the investor to defer capital gains taxes on the sale of an investment property by rolling the proceeds into the purchase of another investment property. That’s a treatment not afforded to any other investment.

The comprehensive return on investment figure that accounts for all the four factors discussed above is the internal rate of return (IRR). In general, the properties that our clients are buying have IRRs in the 16% range – without accounting for any appreciation during the investment timeframe.

The Wrong Question

I hope that answered your question because I’m here to tell you that it’s a misdirected question altogether. Wall Street has conditioned us to be return centric and compare returns at the watercooler at work. But it’s all inconsistent with the number one rule of investing: Don’t lose the money! Tell me, what use is it to earn double digit returns consistently for years, only to see your principal ravaged by 40% in a major correction? As my mentor and friend Jeff Brown often says, investing is as much about return of investment as it is about return on investment.

Here’s a better measure of performance that aligns with your investing purpose. How about: Will your investment portfolio produce the income you desired when you started investing? If for every dollar you put in, you now own $3-4 in wealth 10-15 years later all while earning a great income, would you care what your percentage return actually was during that period? Take your Wall Street provided blinders off and focus on what’s in it for you. If your investing strategy produced the results you hired it to do, that’s true success.

Ralph Unden via Compfight

March 11, 2013
Appreciation play: How to make money in real estate when there is no cashflow
As most our regular readers already know, our cornerstone Blueprint real estate investing strategy relies on the long term acquisition of cashflow positive, quality assets to grow your capital base and reach your income goals at retirement.

So surely, many of you must be squinting at the title, rubbing your eyes in disbelief at the prospect of an investing strategy where cashflow is not present. But the fact is that many long term investors just like you, equate asset quality with location quality alone. The problem is that usually the more centric the location, the higher the price to rent ratios. Think of the price to rent ratio as an indicator of how much money you pay for each dollar of gross income. As the ratio increases, the cashflow first declines, then disappears and finally becomes negative.

So how can you make money in real estate where the location you have to have demands a price that won’t produce any positive cashflow?

You could apply our Domino strategy and pay off these assets using your job income instead of the cashflow (which isn’t there). That would work but it would amount to a savings program rather than an investing strategy.

The best viable investing strategy under these circumstances is the leveraged appreciation play. Here’s how it works: Suppose you buy a condominium for $100,000 in a great central location you put 20% down and you hold it for 15 years. As I have previously outlined in Why investing in condominiums doesn’t work in the Houston market, this property will break even and will not have any positive cashflow due to high maintenance fees. That makes it unsuitable for our Blueprint real estate investing strategy.

But, if during that time, the property appreciates at the annual rate of inflation (roughly 3%), your return on investment for that timeframe was 15% per year. How? Your invested capital in the deal is 1/5 of the acquisition price – that means the return on your investment will be 5 times the rate of appreciation. More specifically, if your $100,000 condo appreciates 3%, your “return” for that year is $3,000 – a 15% “return” on your $20,000 investment. I put the air quotes around the word return because its only realized when you sell the property. So in effect, this is a future cash on current cash return.

However your total return on investment isn’t limited to the appreciation rate alone. During the holding period, even though the property is breaking even, the mortgage balance is being paid down slowly but surely every month. In the example above, over 15 years, the balance is reduced by $27,000 if no additional payments are made. That adds further to your return on investment.

Last but not least, there are the tax benefits from depreciation. Tax laws allow for the straight line depreciation of improvements (about 80% of the value) over 27.5 years. That means, you can deduct just shy of $3000 per year in your tax return resulting in a paper loss. This loss can be utilized in two ways depending on your income level: If you make over $150k a year, those paper losses are piled up in an accumulated account and can be used to offset gains when you sell the property later. If you make under $100k a year, those losses can be taken against your income and produce tax savings of the loss times your tax rate. Either way, this adds to your total return on investment.

Important principles to live by when investing for appreciation:
1. NEVER buy a property with negative cashflow. It’s one thing to purchase a breakeven property and hold it for appreciation. It’s another to dig a hole for years hoping that there will be enough dirt at the end to fill it up and overflow.
2. If you insist on taking this route as opposed to buying cashflow positive properties, make sure that the location is absolutely stellar. No compromises here. After all, this is the fundamental reason you chose this investment in the first place. It would make zero sense to buy a property that has no cashflow and an average location. In Houston, stellar location means Inside the Loop, Galleria or The Woodlands.
3. One major factor you want to pay close attention to when investing for appreciation is the absorption rate in the immediate vicinity. That means looking at how many listings are available and how many have sold in the last 6-12 months. Generally what makes prices go up, is an imbalance between supply and demand – more specifically, a shortage of supply coupled with high demand. You don’t want to buy investment properties for appreciation in a market where there are more listings available than demand for them.
4. Make sure you are prepared to hold the property long enough for this strategy to work. If you plan on buying it and selling it in a couple of years, that’s just speculation and I’d advise you against pursuing the property in the first place. Chances are that selling costs will erase most of your returns if you exit the investment that fast, anyway.
5. Last but not least, you have to be okay with the possibility that appreciation might not happen. This is crucial and there are no exceptions. Due lousy manufacturing, everyone’s crystal ball is cracked and no one can predict the future with certainty. Even though the current inventory drought in the Houston market ought to lead to rising prices, there are many factors that could counter that tendency (i.e. economy, interest rates etc). That’s why it’s important that assets of this kind make up at most, only part of your portfolio. If you put all your eggs in the appreciation basket, you might find yourself a decade or two later with no returns to show for it.
Esther Gibbons via Compfight
February 26, 2013
Houston market update: Prices and Sales up, inventory drought
Statistics for the performance of the Houston real estate market during January were released a few days ago and they point to a strong Sellers market. All the required ingredients are there: Strong sales, higher prices and inventory levels unseen since Bill Clinton was President (December 1999 to be exact). So let me give you the “espresso ristretto” version of the real estate market stats for January 2013:
Okay great, so what’s it all mean?

The statistic of most importance in this report is the inventory number because it will determine where the market goes from here. At 3.6 months, it’s approaching a level where it may be too low for the market to function normally and it’s likely to cause price increases across the board as Sellers find themselves in the driving seat. Also, this level of inventory is great news for home builders who are likely to benefit greatly from this supply shortage. In fact, they’ve already started to raise their base prices in reaction to these market conditions. Although Buyers may have to pay a little more for their home, this is ultimately good news for the local economy as it will likely benefit from the growth in residential construction.

December and January are typically the slowest time of the year for rentals as most prospective tenants have either completed their move during back to school time around August or they are waiting for Springtime. But the fact that rents rose despite this fact, is an indicator of continued strength of the Houston rental market. Even when compared to the previous three months (1552, 1517 and 1562) the average rent of $1548 in January shows a continuation of the upward trend.

Buyers and Sellers better buckle their seatbelts as the spring seems poised to bring with it a feverish market of high activity, sales, prices and rents.
February 22, 2013