Investing Architect

Author: Erion Shehaj

  • Paper tigers

    At some point or another, every real estate investor has experienced temptation. You could be the new real estate investor just getting started that gets his head turned by an obscene cash on cash return rate. Or you could be well on your way after purchasing several quality assets and questioning your direction when you see higher cap rates or lower prices elsewhere.

    Analytical minds love simplicity. I know because I’m the proud owner of one. We hate ambiguity, it’s “maybes” and “it depend”s. Instead we seek factual benchmarks, hard statistics that show what’s what without a shadow of a doubt. It’s simpler that way: A cap rate of 9 is better than 6 or a cash on cash return of 20 is better than 13.

    The problem is long term real estate investing is much more complex than that. When you try to reduce in depth analysis down to the myopic perspective of an indicator or two, it leads to wrong answers.

    Ceteris paribus – all else equal – a higher cap rate and cash on cash return is better than a lower one. Thing is, all else is rarely equal. Higher returns on paper typically reflect a higher level of risk. Think about it this way. In order to acquire a property in a great location you will generally have to pay more than if you were to acquire the same in an inferior location. In addition, properties priced lower tend to have lower property taxes, insurance costs and HOA dues. When you pay less to acquire the same income stream, your rate of return on paper increases substantially. So it follows that to get off the chart returns you have to settle for lower asset quality. Since the property “picks” the tenant, that leads to lower quality tenants which leads to higher vacancies and turnover and lower actual returns. Defeats the purpose, doesn’t it?

    So when you read that pro forma income and expense statement the question you should ask yourself is: Am I looking at a paper tiger? Because in the end, the only returns that matter are the ones you get to keep.

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  • Your most important wealth building tool

    I’m writing this from Terminal D of Houston’s Intercontinental airport so I’ll be brief. Brevity notwithstanding, the concept I want to talk about today will deeply affect your success with real estate investing.

    Most aspiring real estate investors think that success in this business looks like a series of home runs. You know, you buy a house, flip it, double your money – then rinse and repeat till you get to your desired number of millions. Or the other popular choice: Buy five dozen homes, leveraged to the neck, rent them and walk to your mailbox to collect your wheelbarrows of money.

    What I want to share with you today is this: Real estate is where you come to put your capital to work not where you create your capital. You see, you already possess the most important wealth building tool. It’s your income. Think about that for a second. When put to work properly, your income provides the savings that become the capital you invest. In addition your income provides the support that allows you to leverage that capital and acquire a higher asset value than you would paying cash. And most importantly, your income helps you pay off your properties faster so you can retire sooner.

    Knowing that your income is your most important wealth building tool is one thing. But realizing that how you choose to spend that income can make a difference between retiring a millionaire and working till you’re 90 is the very heart of my point. When you increase your overhead by taking on debt payments – credit cards, cars, furniture etc – you are impairing your ability to build wealth.

    Look, I have a “live and let live” kind of mentality. I won’t sit here and tell you how to live your life and how to spend your money. However, it’s important to understand that there’s a huge opportunity cost to debt payments. When you take on that $800 car payment, you aren’t just agreeing to pay that amount every month for 5 years. You are also forfeiting the wealth that that chunk of your income could build for you.

    Success in real estate investing isn’t a series of home runs. It’s a well planned long series of hits. And the “bat” you need to get those hits you already possess. It’s up to you how you use it.

  • Everyone is a genius in a rental bull market

    Everyone is a genius in a rental bull market

    The rental market in Houston Texas is hot. Rents have been rising steadily for the last 4-5 years with average time on market dropping to under 30 days. Landlords are in the driver’s seat and the high demand for their properties allows them to ask for longer term leases, higher credit tenants and rent escalations built into the deal. What’s most important is that this rush of demand is fueled by real economic and job growth, not some artificial inflation. Under the current conditions you could literally close on any property on Friday and have a long term tenant in place the following Friday. And he probably had to fight off four or five other applicants to get accepted.

    In the current market, it is easy for an investor to feel invincible – feel like they can’t go wrong. All the talk about quality of neighborhood, school district, amenities, upgrades etc. seems irrelevant. After all why would you go and spend 40% more money on a “better property” when you can buy cheaper, lower grade assets for a fraction of the price. With rental demand as strong as it is now, they will both rent out quickly and your ROI will be much higher on the lower end stuff. Right?

    Mark Cuban said: “Everyone’s a genius in a bull market. Recessions are the great equalizer”. These are good times for investors but they’re also dangerous times. The euforia produced by the rental bull market can fool shortsighted investors into dropping their guard and skimping on asset quality. Incoming rent will cover all the cracks in your asset selection for the time being. There’s a funny thing about cracks though. No matter how often you patch over them, sooner or later they always show through in times of great tension. So ask yourself this: What would happen to your portfolio if the rental market weren’t this hot? If there were fewer tenants looking for properties and competition among assets, would they pick yours? In other words, would your portfolio withstand the test of time and all the changes in market conditions it brings?

    If you are a long term investor, the number one factor you have to seek when building your portfolio is Quality. Don’t listen to the siren calls of cheap properties in cheaper locations. Build a portfolio that will perform no matter the market.

    Creative Commons License Miguel Angel via Compfight

  • Essential real estate investing lesson learned from Starbucks

    Essential real estate investing lesson learned from Starbucks

    Do you ever wonder about the decision making process that a company like Starbucks goes through when deciding where to put their new store? Think about it for a second. Opening a new store involves tremendous costs: hundreds of thousands spent on building out the store, millions of dollars committed to a long term lease and thousands of man hours spent on hiring and training the new staff. Needless to say, it’s a pretty big decision that the company HAS to get right. But as any commercial real estate broker will tell you, every retail space owner wants to lease to Starbucks. So with all these options at their disposal, on what do they base their decision? Do they just wing it or “play it by the gut”? Not a chance.

    In a much smaller scale, that’s a very similar problem that a real estate investor faces when trying to decide where to invest their hard earned capital. A real estate investor may not spend millions of dollars on a property like Starbucks does, but relative to the investor’s means, this decision is just as crucial if not more. Even within a single market, like Houston, there are hundreds of different ways to put that capital at work. Does the investor put their money into cheap properties that are riskier but cashflow well or is it better to invest into premium locations that have higher appreciation rates but lower cashflow? What about a middle ground solution? And that’s not even all of it. Do you buy older properties or new construction? Suburbs or Inner Loop? Decisions decisions. Problem is, unlike Starbucks, many investors do wing it. Either because they didn’t get the right advice or didn’t get any advice they end up squandering an opportunity that if utilized correctly would get them to retirement in a decade.

    Back to Starbucks. So they have all these options – how do they make the right choice. They put the horse before the cart. Before deciding on the supply (store) they get to know their demand (customers). They know their customers’ demographics: Their age, their employment, their income, their family composition. But they also know their customers psycho-graphics: Their spending habits, their disposable income,  their drive time to get coffee etc.  Once they know their demand, they analyze potential sites to see how they fit their customer base. Will there be enough potential customers within a 5 minute drive time to meet sales goals for the store? If not, they move on to the next site until they find the right mix of demand for the supply they’re providing.

    Most real estate investors do this backwards. They find a cheap enough property, buy it then try to figure out how to get their desired great tenants into that property. They never bother to figure our their demand. Sure, they want great tenants who will lease their property long term, pay rent on time and take care of their property like it were their own. However, unlike Starbucks, they don’t know their customers and what they’re looking for in a rental property. They don’t know their demographics or psychographics and they have no idea if there’s enough potential tenants that might be interested in that particular location. And if they got the location right by chance, they don’t know what level of upgrades and amenities these tenants expect in a rental property.

    The moral of the story is that your real estate investing results will always outperform if you learn your demand first then supply it than vice versa. By the time we advise our clients on a particular location, we have already done rigorous research on the property and determined that the demand is there for the supply we’re trying to acquire. Case and point:

    Above is a tapestry study of a property we recommended to one of our clients to purchase. This is a psychographic analysis of people that live within 0.5, 1 and 1.5 miles of the property (circles). In the immediate vicinity of the property there are three lifemode groups:

    L7 High Hopes: Young households striving for the “American Dream”

    L2 Upscale Avenues: Prosperous, married couple homeowners in different housing

    L1 High Society: Affluent, well-educated, married-couple homeowners

    So if I’m purchasing an asset located in this area, does the psychographic profile of the population match the type of tenant I’m looking to find? Take that one further:

    The above demographic report provides even more information on the demand aspect of the equation. For instance, it tells me that over 70% of the population in the area makes between $50k and $150k. That info is very important when you compare it to the rent you are going to ask for the property. Do people that live in the area generally make enough to support the rent?

    Last week I asked you a question: Who’s advising you about your real estate investments? The quality of the advice will determine the results you get. And the quality of the advice is dependent on the research your adviser does even before you take a look at the property to answer the questions you didn’t even think to ask.

  • On Cashflow – How to build real estate investment income the right way

    On Cashflow – How to build real estate investment income the right way

    In the word of long term real estate investing, cashflow is the holy grail. Everyone wants it, searches for it and wants to know how to get it. And who can blame them? Build enough positive cashflow without undertaking excessive risk and you’ve made it. Free to do whatever you wish with your life without worrying about that monthly overhead “anchor” that keeps you tied down for decades. But most real estate investors have a mathematical understanding of what cashflow is but not a conceptual one. They see cashflow as the difference between incoming rent and expenses. That definition is correct – but it doesn’t explain what cashflow is at its very essence. And in the end, that essence makes the difference between a strategy that achieves your goal and one that falls short.

    In a nutshell, positive cashflow is the yield on capital – similar to the interest you earn on your CD without the sorry rate. The more money you put in, the more interest you get out. Generally speaking, interest rates paid on CDs of the same term are about the same. So the only way for you to get more interest  is to invest a higher amount of capital upfront. Paid off real estate tends to behave in much the same way. If you were to purchase a property in a suburb of Houston for $140k in cash, it would produce approximately $11,000 in positive cashflow – 0r about an 8% yield. Want to make 10 times more money? You better figure out a way to grow your capital – or equity ten fold.

    It seems like I’m suggesting you need to have large sums of money to invest to be successful in long term real estate investing, but I’m not. What I’m suggesting here is that if you seek cashflow, your first and only priority going forward should be to grow your capital base. For example, say you have $100k to invest. Even by leveraging your capital, acquiring three properties with 20% down and creating a 12-13% return you’re looking at an annual income of $13,000. Better than a poke in the eye but certainly not retirement money. If your goal is to increase that to triple the size, you have to figure out how to turn that $100k into $400k between now and the time you retire. And you can do that by utilizing your cashflows and your job income. That’s the magic. The leveraged cashflow you create when you acquire your properties is just the tool you use (in conjunction with your income) to increase your capital base/net worth/wealth. So that when time comes to draw yield from that capital base, it’s big enough to provide sufficient income for you to retire. Subscribers to the perpetual leverage method will disagree with me on this but they’re wrong. Creating your cashflow by purchasing and accumulating 4x to 5x the number of assets involves increasing your risk ten fold. And having a portfolio with a boatload of homes leveraged up the nose for thirty years isn’t retirement – it’s an open invitation for Murphy to become your roommate.

    The way to an annual investment income that sets your free goes through “Build your Wealth First” city. Any shortcut and you won’t reach a place worth going.

    Eric Gjerde via Compfight

  • How is income from investment real estate taxed?

    How is income from investment real estate taxed?

    Investment real estate gets preferential tax treatment from the IRS -one that is not afforded to any other asset class. In a nutshell, if you hold real estate long term, you are allowed to deduct a “paper” expense called depreciation from an appreciating asset. It’s yet another way that real estate makes you money by letting you keep more of it after it goes through the government strainer. But in speaking with many investors (aspiring or active) there seems to be this gross misconception that due to the ability to deduct depreciation, cashflows from investment real estate are tax free. So, today I wanted to dispel this mistaken notion and give you a clear idea on how investment real estate income is taxed.

    You’re pretty much allowed to keep two sets of books – legally. One is the actual cash inflow and outflow set. The other is the tax inflow and outflow set. So let’s look at some numbers as an example:

    If these were the numbers on a different asset class and the investor was in the 30% tax bracket, they would owe $1327.65 in taxes making their after tax cashflow $3,097.85. But this is long term real estate, so here’s what the inflow and “outflow” look like for tax purposes:

    As you can see, for tax purposes, you are allowed to deduct just the interest portion of your mortgage payments as well as the depreciation expense, leasing commissions and loan cost amortization. This results in a much lower taxable income which in turn results in 36% lower taxes or $854.25. The depreciation expense that the IRS allows real estate investors to deduct shelters a portion of your cashflow from taxes. Put a different way, instead of paying taxes at your bracket rate of 30%. you’re paying taxes at a 19.3% rate. I don’t know about you but any steps closer to zero (my favorite tax rate) are fine with me.

    So back to the misconception. Investors tend to look at their cashflow figure then at the depreciation expense which leads them to believe that most (or all) of their income will be sheltered from taxes. However you aren’t allowed to deduct the portion of your debt service (mortgage payments) that goes towards principal and therein lies the rub. So it isn’t tax free but tax favorable. Something most other assets classes can’t claim.

    Creative Commons License John Morgan via Compfight