Author: Erion Shehaj

A large number of Investing Architect readers get here after googling “how to buy investment properties with no money” every week. Once arrived, they read extensive articles about our Blueprint real estate investing strategy in which long term real estate investors employ their hard saved capital to build a solid stream of retirement income using quality real estate investments. At first glance, the two are thoroughly incompatible – on the one hand, there are aspiring investors who seem to want something for nothing and on the other an investment strategy that requires extensive resources they don’t possess. But things aren’t always as they seem.

First, let me start by saying that the beauty of our human ability to dream is that it doesn’t require the possession of resources necessary to fulfill that dream. In other words, just because you might not have the capital to invest in real estate and assemble a sizable portfolio, that shouldn’t prevent you from aspiring to it. In fact, this country was built on its people’s incredible ability to make something from nothing. To take a humble beginning and transform it into a success story that boldly defied its initial odds.

But there’s a fundamental difference between wanting to make something from nothing and wanting something for nothing. There are strategies and detours that investors in the first category can take to better their position – and I will share one of those strategies later in this post. But for those that feel entitled to something for nothing – to “investing without investment” – I’m afraid that I have nothing to offer but an attempt to change their mind and their course.

So let’s get deeper into the details. Let’s say that you want to invest in real estate but you have very limited capital. You’d love to purchase a quality investment property in a good location and hold it long term but you don’t have enough money for the required down payment. What are you to do? First, you must understand that real estate, when properly employed, is an excellent vehicle to take your existing capital and make it grow and produce a solid income stream. It is not a great vehicle to create your capital despite what investing books from various gurus will tell you.

Your menu for investing in real estate using the proverbial “other people’s money” is made up of very limited options – none of which are very good for you. For instance, you can try wholesaling: Find a property being sold below market value, get it under contract then assign that contract to another investor for what you paid plus a profit for you. This is the least risky option although it is a overly saturated market and requires an amount of time you might not have unless you quit working. Or you can buy properties subject-to: Find a good property where the owner cannot keep up payments or wants to sell and control the property by taking over his payments. This works great until you discover that the loan whose payments you took over specifically prohibits such assumption without explicit permission from the Lender. If they discover it, they have the right to call the entire loan due on the spot and often do when the market softens. Finally, there’s the guru’s special – Start flipping houses using short term hard money loans at almost usurious rates and fees. Yeah that makes perfect sense for an investor with no money – said nobody ever!

Criticism is fine when backed by facts but it’s hollow when it’s not followed by solutions. So here’s a better strategy for the real estate investor who is just getting started with very limited capital resources. When money isn’t available, you have to bring other resources to the table: namely, time and flexibility. Let’s say you have managed to save $5-7k – not nearly enough to purchase an investment property with 20% down. However, you can acquire a primary residence with as little as 3-5% down (depending on the loan program for which you qualify) and get the Seller to contribute towards your closing costs. So here’s the plan: Purchase a recently built home as a primary residence with the minimal down payment but make sure that you’re picking that home for how it would perform as an investment when you decide to turn it into one. Also, make sure the home you purchase is as close to move in ready as possible – avoid homes that require work. Live in the home until you are able to save enough money for the next property but no less than 9-12 months. At that point purchase another property using the same criteria and rent out the first home. You can rinse and repeat this process 3-4 times over a 5 year period and accumulate a small investment portfolio using the same capital it would take you to purchase just one investment property with 20% down. Throughout the process, make sure you can comfortably afford the payments and that you keep an emergency fund for repairs. It’s a strategy that carries a higher risk than putting down 20-25% on each property but it’s much more sound than the “no money” alternatives. It requires your flexibility to move multiple times in a 5 year timespan and plentiful time but remember that those are the resources you bring to the table to compensate for the capital.

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A couple of years ago, an American friend of mine went on vacation to Italy with the family and he tried authentic Neapolitan-style pizza for the first time. He was speechless! The pizza amounted to a unique culinary experience and had nothing whatever to do with its gooey American counterpart he had taken out thousands of times. “How is it possible – he asked the shopkeeper – that something made the same way from the same ingredients, can be so deliciously different?” The shopkeeper’s answer was as brilliant as it was obvious (feel free to read this in an Italian accent in your mind) :

Well, there can only be three reasons why the pizza is better: The ingredients, the oven and the cook.

The wise shopkeepers words make for great real estate investing advice. When you invest in real estate long term, the difference between success and failure also comes down to the ingredients, the oven and the cook.

Ingredients

At first glance, one might think that authentic pizza has the same ingredients as its American cousin. But this couldn’t be further from the truth. From the hand kneaded and tossed dough, to the San Marziano tomatoes that make up the sauce and the fresh mozzarella di buffala – everything is superior. The unique textures and flavors that come as a result simply cannot be replicated without using similar quality ingredients.

In real estate investing, the “ingredients” are the properties inside your portfolio. As in the pizza example above, a fleeting glance at two portfolios might lead you to believe that they’re one and the same. But a closer look will reveal that properties inside a successful long term investor’s portfolio are at an entirely different level. The quality of the school district and location is much higher in a successful portfolio. The neighborhood amenities and proximity to thoroughfares and shopping are better. And most importantly, they are that way on purpose. A successful real estate investor knows the type of tenant she is trying to attract and what those tenants look for in a rental property – and she buys properties that fit that profile and produce good returns. No matter how knowledgeable an investor you might be – there is no way to replicate the performance of a quality real estate investment portfolio by using inferior properties. So, here’s a guide on how to find great investment properties.

Oven

But ingredients alone aren’t sufficient to make an authentic Italian pizza. In fact, if you took those same ingredients and tried to bake it in your home oven, the results would be underwhelming. Authentic pizza requires an oak fired, stone oven that heats up to 905 degrees Fahrenheit.

In real estate investing, your oven is your overarching strategy. We call ours, The Blueprint. Without a solid strategy that is tailored to your goals, you won’t reach them even if you manage to buy the right type of properties. What makes a real estate investing portfolio tick is how all the assets within the portfolio work with each other. If you buy good properties but they aren’t weaved in a good strategy you lose the synergy that compounds the success. As a basic example, if you purchase 40 year old properties in good locations with good school districts, you won’t reach retirement by the target date because the increasing capital expenditures (major repairs) will eat up the cash flow.

Cook

And yet, even with the right ingredients and the right oven, there’s one more piece missing. You still need a great cook with the know-how and experience to make great pizza. The speed and pressure during the kneading process, the hand tossing, the thickness off the dough etc. are all dependent on the skills of the cook. The final result won’t be the same if the cook is an amateur.

In real estate investing, the cook is the person advising you about your real estate investments. Or it could be the investor herself if they’ve chosen the DYI route. So let me ask you, who’s advising you about your real estate investments? Is it someone who’s just a couple of chapters ahead of you in the book, or a true pro that brings value to the table every step of the way? And if you’ve been flying solo, how’s that been working out for you? Are you on track to achieve your goals or have they been swept aside because you don’t think it can be done? I’m here to tell you that it can – but you need the right “cook” alongside you.

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When I started Investing Architect a couple of years ago, I wrote a controversial post called Why Equity doesn’t matter that caused quite a stir. It was inevitable. A conservative, prudent, “low and slow” real estate investing guy (by his own admission) was advising his readers that built in equity was irrelevant. How could this be, considering what happened to real estate markets in 2008 with millions underwater on their mortgages? Wouldn’t it be more conservative and prudent to only purchase properties with built in equity – in case you have to sell the property due to another deteriorating market?!

There’s a powerful, fear-driven myth among long term real estate investors that says: Buying an investment property with built in equity is the best and only way of minimizing risk and playing it safe. In today’s post, I will dispel that myth.

1. Before we go any deeper, it’s very important that you have a clear understanding of equity’s true nature. Equity is a Snapshot that tells you what you would make if you were to sell the property today – and nothing more. This short term indicator provides zero information about what that property will do in the future. Don’t believe me? Most of those people underwater on their mortgages post recession had plenty of “equity” in their properties just a few short years prior. And sadly, the equity they thought they had, didn’t minimize their risk of being underwater in the future.

2. Next, the reason why investors feel that equity minimizes their risk is because it gives them an Exit. In the event that the stuff hits the fan, they have a better chance of cutting bait and getting out from under the property. There’s one major issue with that line of thinking: It doesn’t reflect the mentality of a long term investor. That is, when you assemble a long term real estate portfolio, that implies that during your hold period there will be some good markets and some not so good ones. As a matter of fact, that’s one of the few things you can count on. So if your first tendency during a trough in the market is to sell and get out, I have a much better strategy for minimizing risk to suggest to you. Don’t make the investment in the first place. If the risk that’s involved in holding an asset during a bad market is too much to handle, the best course of action is to not take that risk to begin with.

3. Further, let’s consider the reasons why a property might have built in equity. Typically, a property will sell below market value because it’s distressed. This could be because it’s a bank or government owned foreclosure, short sale, or simply a motivated seller in distress. In all those cases, you can count on the presence of deferred maintenance. And I’m not just referring to items that are in immediate need of repair but also to systems that will break faster because they have not been maintained well up until that point. This will lead to two things: Reduced returns due higher out of pocket investment and the evaporation of that built in equity you thought you had.
Since equity was the master criterion for selecting your investment property and not quality of location, neighborhood, floorplan and maintenance, you actually increased your risk and lowered your returns. And all that for “the equity” – most of which disappeared eventually anyway.

So, if equity won’t reduce risk, what will? That’s simple: Cashflow and Quality.

1. Here’s an illustration how positive cashflow minimizes the risk to the investor. Say you own an investment property worth $125,000 that while rented for $1325/mo produces $400/mo in positive cash flow after expenses and mortgage payments. Think about that for a second. Rents could plunge by 30% – and you’d still be breaking even. Talk about insulation against a seriously depressed market. Or look at it a different way – in a market with scarce tenants, you could drop your price by 30% and the property would still be paying for itself. But what if there’s no tenants? There’s no such thing as “no tenants” – just no tenants at a given price. People have to live somewhere regardless of the economical situation. But what if Armageddon strikes… In that case my friends, we have bigger problems than our real estate investing portfolio. 🙂

2. Quality is the ultimate risk minimizer. When you buy quality properties at a fair price – without overpaying – they stay rented to good long term tenants producing the kind of income stream that allows you to ride a bad market while making double digit returns and exiting the investment when it’s most beneficial for you. In short, when you buy quality, you buy patience. If you’ve got patience, you can invest on your own terms with lower risk.

Finally, there is one important idea with which I want to leave you. There’s nothing wrong with buying a property below market with built in equity – on the contrary, it can be quite nice. The problem arises when long term investors use equity as the primary reason to select (or avoid) an investment property. That’s where they go astray believing the myth of risk reduction through buying below market. Purchasing quality properties in great locations that have solid positive cash flow is the best way to minimize risk in your long term real estate investing portfolio. Equity is mainly a nice additional bonus if you can get it.

One of the first things people tell you about investing is that you must diversify. And by people, i mean your Uncle Ralf, who took a finance class once. Then comes the proverbial “Don’t put all your eggs in one basket” accompanied by the mandatory wag of the index finger. After you put some thought into it you realize that Ralph might be on to something here. It’s commonsense – when you put all your money in one thing, if that thing goes bust so do you. So spread your money around and while you might not make as much, you won’t lose as much either.

Aspiring real estate investors and experienced clients alike always bring up the diversification question during our conversations. So in this post I want to go over two main types of diversification. The first type is diversification between different asset classes. For instance, you can invest some of your money in real estate, another portion in stock market mutual funds and the rest in CDs. The second  is diversification within the same asset class. As an example, if you invest in real estate you might spread your holdings in different locations. Or you can purchase a mix of multifamily and single family properties or commercial and residential assets.

But whether you diversify between or within asset classes, the principal at work is the same. Diversification at its very core is about hedging your bets by spreading the risk over assets that will counterbalance each other. If the value of an asset falls, a well diversified portfolio will have assets in it that will gain or hold steady therefore softening the blow. And of course when things are good you just aren’t making as much as you could for the same reason. But since fear of loss is a much stronger motivator than the desire for gain, that’s a trade most of us are willing to make. In many ways, it makes us feel prudent, measured and restrained.

So is diversification a good idea? Does it have to be a necessary part of every wise investment plan? The short answer is: It’s complicated.

Let’s start by tackling the extremes. First, no wise investor would subscribe to an investment strategy that’s categorically against any type of diversification. If someone is trying to persuade you to invest everything you got on this one thing, run away as fast as you can. I don’t care how much of a “sure thing” you think it is. You are two M&Ms away from losing all your money. Then there’s also such a thing as extreme diversification. That’s when you’re so terrified of risk that you diversify and complicate things to no end only to discover that you could have just kept your money under the mattress and achieved the same thing. Except that you paid a guy in a suit and tie lots of money to accomplish nothing.

But what about the middle of that spectrum. Before I tell you how I really feel about it, I’d like to share some wisdom with you:

Diversification is protection against ignorance. Wide diversification is only required when investors do not understand what they are doing – Warren Buffett

Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results. – Charlie Munger

Deworsification – Peter Lunch

An investor should never have anything to do with that which he does not understand. Tell me what sense does it make to invest in several other businesses or assets you don’t understand to alleviate the risk from the original asset you invested in without understanding it? My thesis is that there are much more efficient ways to mitigate investment risk than diversification.

First, get educated to the point that you understand the risk-return dynamics of the investment. I’m not talking about being sold by advertorials that only shed positive light on whatever they’re selling that week. I’m referring to real education that will show you how that investment will make money, what’s the worse that could happen and what you can do to minimize that risk. That could come from the Institute for Hard Knocks and Past Failures or from a trusted advisor/mentor who can offer you their 10,000 feet view. It’s crucial that you get to know the real risks because once you do you can choose to either walk away or move forward after you do something to minimize it. The alternative is to eliminate this vague idea of “risk” by putting some money over there in case I get cleaned out here. That’s not risk mitigation. That’s reaction to fear and no way to invest successfully.

The biggest problem with diversification is dilution. In real estate investing as in most areas of life we achieve important things by executing well defined plans with focused intensity. In the wide majority of cases, our capital, our income and our time are limited. Most of us don’t have enough capital or income to try every investing strategy ever created. So when we take our limited resources and we spread them out to a number of different investments, we dilute it to the point of making it ineffective. So we end up with what Charlie Munger called “ordinary results”. And let’s be clear about it: When it comes to investing for retirement, ordinary results usually means working till you can’t to make ends meet. Listen, I’m not suggesting that you pick an investment strategy for your retirement and put all  your money into it to avoid dilution of your capital’s power to achieve great things. What I am suggesting is that there has to be a primary strategy that you adhere to and execute over long periods of time and that most your capital needs to go there. You must keep some of that capital in cash reserves so you can sleep at night. You should have some of your capital in other investments (i.e. index funds) . What you shouldn’t do is to take your capital and split it 100 ways. If your primary aim is to preserve your savings,  the best strategy is to keep your money in your savings account.

The absolute best risk mitigator is Quality. This is especially true for real estate investing. When your primary focus is the selection of quality properties in great locations that leads to quality tenants that pay rent on time and treat your properties like their own. That in turn leads to lower turnover, less make ready and  lower risk of default and evictions. By lowering turnover and reducing the risk and cost of property damage, defaults and evictions, you have reduced risk to its lowest level. And here’s the beautiful thing: At the same time, you’ve increased realized returns. Beats diversification like a red-headed stepchild, doesn’t it?

Diversification can be good when it brings an additional dimension to your investments while minimizing risk. For instance, by purchasing expensive properties in excellent areas rather than your standard assets, you accept a lower return for a lower risk profile. But most importantly, you give your portfolio another dimension by adding an asset that would perform better during an appreciating market. This way you add the potential of appreciation capture to your investments in addition to reducing risk. Diversification is useless and harmful when it’s done for its own sake. For example, a portfolio with some investment properties in good locations and others in bad locations would be diversified location-wise but it would hurt your chances of success tremendously.

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