Erion Shehaj

The fiscal cliff: How will it impact the real estate market and investors?

December 15, 2012 By Erion Shehaj 2 Comments

These days you can’t turn on your TV or radio without hearing something about ~~Armageddon~~ the impending fiscal cliff. And in hearing these pundits and newscasters and their lame, over stretched metaphors you would swear that the cliff must’ve been what the Mayans were talking about – they just missed it by a week and a half. But recently, some of our clients have called and asked me about the potential impact of the fiscal cliff on the real estate market as a whole and real estate investing in particular. Because of their concern, I think it would be beneficial to do take an objective look at the scenarios that could unfold and their real estate implications.

Scenario #1: No deal to avoid fiscal cliff

Under this scenario, if Congress does not reach an agreement to avoid the fiscal cliff, taxes increase on everyone (tax cuts expire) and deep spending cuts are applied across the board. The real estate market as a whole would suffer deep negative consequences on several fronts. First, a study by a leading commercial real estate services provider cited in a recent article on TheStreet shows that spending cuts from sequestration in 2013 would hit hard government contractors and their demand for commercial office space. The same study predicts that if these cuts were allowed to happen, office space the size of the entire Dallas office market would become vacant. Such an increase in the supply of vacant office space would put downward pressure on prices as buildings compete to lease out their vacant space. On the other side, higher taxes across the board in 2013 mean everyone’s tax bill will be higher and their take home pay will decline. Everyone that’s ever done a family budget on the kitchen table will tell you that you budget based on your net income – not your gross. So with less money to spend on housing, potential buyers will opt for lower priced properties or worse yet, hold off on a purchase they were planning on making. So even the residential market would not come out unscathed from this scenario. Last but not least, an overwhelming majority of economists agree that the combination of cuts and tax increases would push the economy back into recession. And a receding economy is never good news for real estate markets.

But as gloomy as all that sounds, there’s no need to worry. In my opinion, this scenario has worse odds of becoming reality than snow in Cancun. That’s because in order to have a real negotiation, leverage has to exist. When it comes to the fiscal cliff Republicans have exactly zero leverage. If they do nothing, taxes go up. If they agree to a deal, taxes go up. The reality of it is that taxes are going up and everything else that’s going on is just political theater. In the next week or so, you will see how “very reluctantly and unwillingly” the parties will agree to an increase in tax rates on incomes over $250k per year.

Scenario #2: Fiscal cliff deal is reached along the lines of the Democratic proposal

Under the Democratic proposal put forth by the Secretary of Treasury, the deal would involve raising just over $1T in revenue over the next 10 years by raising tax rates on incomes over $250k. The plan also involves some spending “cuts” – mostly mathematical maneuvers of inflation adjustments and reductions in planned increases. The plan would leave the current tax deductions and most importantly the mortgage interest deduction largely untouched.

The effects of such measures on the economy as a whole can certainly be debated but it is not the purpose of this article to create and address a political debate. As far as the real estate market is concerned, this proposal largely preserves the status quo. The luxury real estate market will be impacted somewhat as the income tax bills of higher income earners rise. But as much as sending the IRS a bigger check hurts like hell, higher earners can economically absorb such a hit better than a lower income earner with much less disposable income. That’s not an endorsement of higher taxes – god knows I’ve never met a tax bill I deemed too low 🙂 – but rather a statement of fact. However, when it comes to investing, this will produce two counter currents. On one hand, higher income earners are usually active investors and now they will have less capital to invest because they had to send it to Uncle Sam. On the other, higher tax rates will push higher income earners to seek more tax sheltered investments like real estate.

Scenario #3: Fiscal cliff deal is reached along the lines of the GOP proposal

The GOP proposed solution involves $800B in new revenues that would be obtained by not raising tax rates but by closing loopholes and eliminating deductions. The plan does not outline which loopholes and deductions would be eliminated but judging by the size of the revenues it seeks to raise, you can’t make the numbers work without eliminating the mortgage interest deduction – a darling of the National Association of Realtors and a pretty popular deduction overall. I was listening to the Diane Rheem program on NPR a few days ago and one of her guests that day was Lawrence Yun, chief economist of the National Association of Realtors. In his opposition to the elimination of the mortgage interest deduction he offered the following analogy and I’m paraphrasing:

One way to look at the mortgage interest deduction is as a dividend on your asset (your home). If the dividend on an asset is cut or eliminated, the value of that asset declines. So if the mortgage interest deduction is eliminated, property values across the board would decline by an estimated 15%.

That sounds like a solid, well thought out analogy. It’s too bad that it’s wrong. Your home isn’t an asset in the same way that a stock is one and the mortgage interest deduction isn’t the same as a dividend. Sure, there’s an investment component to owning a home. Most people buy properties in desirable neighborhoods because they want that property to be worth more in 10, 20, or 30 years than what they are paying for it. And if you itemize on your tax return, the mortgage interest deduction can result in substantial tax savings that certainly affect your decision to purchase that home vs the alternative of renting. But a property is a home first and foremost and the most important thing it does is to provide shelter. You couldn’t go live in your stock or bond, could you? So when you look at it that way, a home is worth what buyers have been recently paying for similar shelter in that location. The value of that asset to its owner isn’t exclusively determined by the income or yield it produces in the way of tax deductions. Because if that were true, when the mortgage interest deduction was created in 1986, property values should have immediately increased by the same amount Mr Yun is projecting them to drop now.

Now that we’ve addressed the issue of a drop in values across the board, there are still an unanswered questions: If a prospective homeowner cannot deduct the interest on their mortgage, does that change their decision to purchase? In other words, would the elimination of this deduction affect real estate demand? Could this elimination perhaps tip the scales towards renting? The short answer is: Not really. First and foremost, buying a house satisfies a need and the elimination of the deduction does not eliminate that need. People still have to have a place to live. But what about the alternative of renting? The truth is that rents have been increasing across the country for the past two years at the same time that interest rates on mortgages have plummeted to record lows. If you have the means and the ability, buying beats renting by a long shot right now, regardless of the deduction. Last the mortgage interest deduction can only be claimed if you itemize your deductions. According to the IRS, two out of three taxpayers claim the standard deduction instead and as such don’t deduct their mortgage interest. Of the remaining 30%, a large portion makes less than the $250k a year income threshold where the deduction would be eliminated. So the short of it is – only a very small portion of taxpayers would actually feel the effects of such an elimination.

But a real estate investor has a different perspective on this issue. To the long term investor, the asset’s worth is determined by the after tax yield it produces for her. Currently, the mortgage interest paid in a particular year is deducted from the income the investment property produced in that same year as an expense – not a deduction. So investors would not feel the effects there. But the portion of investors that make over $250k per year will see their after tax returns go down as their ordinary income tax rate rises.

I don’t have any means to predict the future as my crystal ball’s been in the shop for a few years. But something tells me that the deal that will be reached will not involve the elimination of deductions but rather an increase in income tax rates. We will find out in two weeks time if my hunch was right.

Jim via Compfight

How to find an investment property in a hot real estate market

November 12, 2012 By Erion Shehaj 2 Comments

Every real estate market brings its own unique set of challenges for real estate investors. Back in 2005-06, the foreclosure wave hadn’t quite made it to shore yet, but it was giving its first signals. Long term real estate investors could purchase investment properties with as little as 10% down on a conventional mortgage but interest rates were just under 7%. Fast forward a couple of years (2008-10) and the recession was in full swing, foreclosure deals were a dime a dozen and Bernanke’s quantitative easing (a mouthful, isn’t it?) had slashed rates to record lows. But there was “blood on the streets”, the end of the world was surely coming and no one was sure their job would still be there next week. These days, the Houston real estate market is hot, rents are increasing every year, vacancies are low to nonexistent and investment property interest rates are in the low to mid 4s. But at the same time, strong demand from owner occupant buyers coupled with disadvantageous “first look periods” and lower foreclosure inventories are making it increasingly harder to find and acquire investment properties. As any real estate investor who’s actively looking will tell you, competition is pretty brutal right now. Frustrated investors are throwing prudence to the wind and overbidding on properties just to “buy the damned thing”. And those that aren’t, are starting to get cynical and conclude that this real estate investing thing doesn’t really work.

So how does one find investment properties in a high demand Seller’s market?

You change your approach. The definition of insanity is doing the same thing over and over and expecting a different result. So if your search criteria and market conditions remain the same, your results cannot be different. I’ll share a geek story with you to illustrate my point: In college, I’d often work on a math equation and have issues solving it. I’d go over it over and over again making the same mistake every time. Then, I’d ask a classmate to review my work and when she’d look at it with fresh eyes, the mistake would be spotted immediately. So that’s my advice: Take a look at your property selection criteria with “fresh eyes”. Many real estate investors will look for properties under a certain price range and not even know why. They’ve just been told that I order to succeed at investing in real estate you have to buy cheap. Or they will chase Bigfoot and look for properties that are selling at 60 cents on the dollar less repairs like that investing book told them. As a result, you have a large number of investors chasing the same properties, driving up prices and not even getting that precious equity they bought the property to get in the first place.

Here’s a step by step plan to re-evaluate your investing goals and property selection criteria:

1. Start with having clear, written, well-defined and specific investing goals.

To quote Zig Ziglar, you won’t be successful in life as a wandering generality – you must become a meaningful specific. Even the best map in the world can’t help you if you don’t know where you’re trying to go. “I just want some extra income” or “I just want to start with a house and see where it goes” are to be frank, vague and mediocre goals that will yield equally mediocre and vague results.
“I want to retire in 12 years and need $75k in annual income to achieve that goal” or “I want to increase my capital base to $1M in the next 8 years” or “My kids will go to college in 11 years and that will cost 225k”. That’s what I mean by specific: it has time limit, an amount and a “why” associated with it.

2. Next, create a real estate investing Blueprint to achieve those goals

This Blueprint will address the all important questions: How many assets will you need to acquire, where, how and what strategy will you follow from now on to hit those goals in step 1. This is the most important step and I can help you with it.

3. Once the plan is in place, determine investment property selection criteria

Now that your goals are specific and you have a plan to accomplish them, you will focus on which properties will help you best achieve those goals versus “how much equity am I getting here”. Don’t get me wrong, equity may play a part in your plan but it won’t be your end all, be all selection criterion that is now disqualifying excellent properties from your consideration. If you could purchase a portfolio of properties at a fair price that would allow you to retire with the income you need, or build your net worth to the level you want, or pay for those college expenses, why wouldn’t you? Because some one size fits all investing “bible” told you so? Don’t kid yourself and keep your focus on what matters most: your retirement, your wealth, your kids education.

4. Acquire the assets and build your portfolio

Now that you’ve taken a fresh look and allowed yourself to get out of the corner you painted yourself into, you will notice something amazing happen: More investment opportunities, less completion and more assets in your portfolio. Patience will still be required as the current market conditions will affect property availability here as well. But it won’t be the lost cause of throwing tens of offers at the wall to see what sticks.

I know that my answer on how to find investment properties in a hot real estate market will probably disappoint those of you who read this post hoping that I would reveal a “secret list of properties, unknown to the general public that you can have access to today for just $39.95”. But unlike those useless gimmicks, the plan I’m talking about actually works. And isn’t that the point of this whole thing?

What it means to invest in real estate long term (and what it doesn’t)

November 1, 2012 By Erion Shehaj Leave a Comment

Investing in real estate long term has a nice ring to it, doesn’t it? It makes your efforts feel prudent, measured and planned. You can stick your chest out and proudly proclaim you’re a long term investor as opposed to a short term speculator of sorts. The problem is when you dig a little below the surface of many investors’ strategies they’re the same short term methods hiding behind long term jargon. So today I plan on laying out exactly what it means to be a long term real estate investor.

Metrics

Long term real estate investors make decisions on the assets they purchase today based upon their long term performance and their adherence to their long term goals. They ask questions like:

What will this neighborhood be like in 10 years when this investment property is free and clear?
What will this home be worth in 10 years when I plan to trade to a newer one with less hassle?
What trajectory will rents in this area follow in my investment time frame?
What will the net operating income be when I will need it the most – at retirement?
What tax shelter(s) will my assets have left when I plan on living off the income they produce?

They are not the least bit concerned with short term metrics like current equity or current cashflow – their focus is strictly on the impact those metrics could have on their portfolio’s performance long term. Here’s what that means: Current cashflow is part of the fuel that a long term investor uses to get to a free and clear portfolio that meets their income goals at retirement. But a long term investor will pick a quality asset in a premium location with lower current cashflow over a “cash cow” located in a dilapidated area.

Think about it this way: A junk house that produces tremendous cashflow currently, will still be a junk house when it’s paid for at retirement. Question is: How do you feel about a retirement dependent on a portfolio of junky homes? You don’t exactly get that warm and fuzzy feeling, now do you? Same thing with current equity – Unless you’re planning on flipping the home in the next year or so, this metric is pretty useless to a long term investor. And if you’re planning on flipping it short term, you aren’t really a long term investor. As an exception, if you’re able to obtain quality assets in quality neighborhoods at a price below market, that can help the performance of your portfolio long term. But be careful to not miss the forest for the trees. In your quest to get current equity at any cost, you might miss out on acquiring as many assets at favorable terms as you could have, leading you to a poorer retirement. A well executed real estate investment strategy builds more equity each year you own your properties than you could ever capture at purchase. Again: Focus on long term.

Quality

The ingredient that makes a long term real estate investment plan work is quality. Take away asset, location and tenant quality and all you have left is a high maintenance mess. A true long term investor never loses sight of and never compromises on the quality of his holdings. In fact, this is where the obsession with short term metrics like current equity and cashflow rear their ugly head. In an effort to get $20-30k in captured equity or $1000 more in cashflow per year, the investor has to sacrifice the quality of his properties, tenants and usually both. So when it’s all said and done, two things will happen:

The real life numbers those properties will do will be very different from those initial projections making the sacrifice of quality an exercise in futility
The long term investors who focused on quality to begin with will be so far ahead that the “current equity” investor will need professional binoculars to see her

This isn’t rocket science – Good tenants rent good properties. Nightmare tenants rent nightmare properties. And everything in between. The next investor who thinks they will bend this rule and fit a square peg in a round hole will be the first.

Returns vs. Results

Long term real estate investors are primarily concerned about one thing: The final results. Everything else is transitory and largely unimportant. Make believe long term investors on the other hand are mostly concerned about returns on investment – Percentages they can rattle off to their coworkers on their water break.

The only question that matters to a long term real estate investor is the following: Did the investment strategy I executed produce the results I sought when I first got started? If the goal was a six figure income when she retires in 10 years, is the portfolio producing that kind of income? If the goal was to build wealth and increase the capital based to $1.5M, did the plan succeed? If not, all the returns on investment, cash on cash, cap rates and the like were pretty useless.

That’s the reason a long term investor utilizes all tools at their disposal: positive cashflow from the property, additional investment from their job income and tax benefits to achieve the retirement they seek. That’s the reason that same investor pays off a portfolio of properties leveraged with low cost 4.25% debt and a poser asks a boneheaded question like: Why would you stop making 15% on your money and pay off debt at 4.25%? Because it’s about the final result. This isn’t some quixotic quest to “beat the market” or outpace the returns of S&P 500. Ultimately it’s about results for a long term real estate investor: Did your real estate investments do the job you bought them to do? All else is just talk.

Bonus: What it doesn’t mean to be a long term investor

Employing short term real estate strategies for a really long time, isn’t long term real estate investing. Flipping properties for decades is very admirable – whoever is able to achieve it has my respect. I know how hard it can be to make it work in that arena for extended periods of time. But the fact remains that the investor is still speculating – much like a mechanic that buys a beater, fixes it up and sells it for a profit or a furniture restorer. Same thing with wholesaling. When you stop flipping or wholesaling, these methods stop working. They don’t produce income – they produce capital gains when they work. I often hear investors who are just getting started that “they don’t want to restrict their investing to just one thing” – that they would rather keep their options open and look at all alternatives. As nice as open mindedness sounds, it can be disastrous in real estate investing. There’s nothing wrong with picking a path or another – but know yourself, pick the best method that suits your goals then stick with it.

A Guy Taking Pictures via Compfight

Houston’s hot real estate market and its impact on real estate investors

October 22, 2012 By Erion Shehaj 1 Comment

Houston’s real estate market is scorching hot. The latest statistics on Houston’s real estate market we’re released last Friday and I wanted to share with you some interesting highlights:

Real estate sales rose for the 16th straight month. Higher sales were recorded in all price points except for properties priced under $80k. Any guesses on what the majority of properties are in that price range? (Hint: They’re owned by banks)
Inventory of properties for sale is 4.7 months! That’s the lowest that statistic has been since 2002. The market is tight and sellers are back in the driver’s seat due to high buyer demand.
Average and median sales prices are rising, too. So this isn’t the end of 2010 where sales were creeping higher because of lower selling prices.
Foreclosure sales are down double digits: Now they account for 16% of sales when in January of this year they accounted for 28%. So if banks are holding the infamous “shadow inventory”, it must not consist of Houston properties.
Last but not least, rentals of single family homes rose again while average rents remained high, although off July’s back to school record highs.

Market’s Impact on Real Estate Investors

The latest data is yet another indication that the strong Texas economy and its job creating prowess are contributing to a strengthening real estate market. But what does it all mean for real estate investors? How does it impact their quest to find quality investment properties? Well, if you’re a real estate investor of the “you make your money when you buy” variety that worships at the altar of “built in equity”, there will be scarcity in your future. Discounted properties won’t exactly be extinct but they will be so few and far between that competition will drive up prices eating up that precious equity that drew you there in the first place. The reason for this scarcity is that the owners of discounted properties are well aware of the new market reality as well. With inventories down to less than 5 months, first time home buyers fresh off the proverbial fence and primed to take advantage of ridiculous interest rates are scooping up the dwindling foreclosure inventories. After all they do have first shot at most foreclosures through protected first look periods. And then the scraps that are left over are fought over by aggressive investors trying to acquire as many discounted properties before the window closes completely.

If instead you believe that you truly make your money when you successfully execute a sound investment strategy over a long period of time (10+ years) as we advocate on this site, there are good news for you in these latest figures. First, the rental market continues to strengthen with rents holding strong at record levels. So if execute your Blueprint strategy and acquire well located properties that are new, newer or well maintained for a fair price, there will be a strong income stream to support the growth of your capital base through the aggressive pay down of the property’s mortgage. Second, in a tight market such as this one where demand dominates supply, prices rise which increases your internal rate of return exponentially. Last, as the wide majority of equity investors fight over a very limited supply of properties, you can pursue a fair deal in a calm and profitable fashion.

References: HAR Press Release

Photo Credit: Jody Sticca via Compfight

Flipping vs. Long Term Investing – Why it’s not even a close contest

October 3, 2012 By Erion Shehaj 2 Comments

When a new real estate investor sits down and looks at one of our cashflow analysis for the first time, she usually has a puzzled look on her face. And it’s understandable – Here she is looking at a financial projection where she invests $30,000 of her hard earned capital for an annual return of $3600-$4500 per year. Sure, 12-15% cash on cash return is nothing to sneeze at but in the end $4k per year won’t exactly change your life. It isn’t the lucrative, rich overnight image projected when people speak of real estate investing. It’s not the sexy buy-renovate-resell-double your money kind of strategy. So inevitably, the question comes up: Wouldn’t it make more sense to purchase a home to flip with that capital and earn much more money in a very short term? This is the part where I smile.

The debate over the merits of flipping homes versus investing in real estate long term is not even a close contest. As a matter of fact, they don’t even belong on the same debate stage and in this post I intend to show you why.

Our starting point is a look at the real math of flipping homes. Let’s look at the facts: even if you were able to acquire the property low enough, by the time you pay selling costs, closing costs, holding costs, rehab costs and Uncle Sam, your true return on investment isn’t exactly what you expected even in the most optimistic of scenarios. But let’s assume you are reasonably successful and don’t make any major mistakes. In normal times, reasonably successful flips take 100-150 days to complete – purchase to resale. So, assuming that you’re not running multiple crews (which most new investors don’t) you could complete two to three flips a year and make $35k-45k per year after tax. That’s if none of those flips end up being break even deals or worse, money losers. In a perfect world with no market downturns that wipe out more flippers than a Japanese tsunami, you could make $350k to $450k in a ten year period. No income. If you want to take a break from flipping homes, the money flow grinds to a halt.

Now let’s look at a similar situation where the investor executes a long term investment strategy instead. The investor methodically acquires nine investment properties in great locations with high tenant demand over 36-48 months. On our advice, she opts to go for capital growth first and income later. So, she grows her capital by aggressively paying down the mortgages on her properties according to our Domino Strategy using positive cashflow from the properties themselves and her job income. All in all, she invests $300-340k of her capital and ends up with a free and clear portfolio in 10-12 years. This portfolio is worth $1.2M without a penny in appreciation over that time frame. In addition, her portfolio provides our investor with over $100k in annual income thereafter. So let’s do some arithmetic: From $300k to $1.2M in 10 years is $900,000 of capital growth or $90,000 per year. And on top of that there’s $100k of annual income to boot? And you didn’t have to deal with contractors for 10 years of your life, nonstop? And you can take off to your favorite island for a month or two while income still flows to your account regularly? As I said, not even close.

Mitchell Joyce via Compfight

Big news for real estate investors: Fannie loosens lending guidelines

September 25, 2012 By Erion Shehaj Leave a Comment

It seems just before the ink dried on my last post about financing for investment properties, an update is required. And this is a very welcome update I’d like to write more often.

As I pointed out previously, long term real estate investors were restricted to a maximum number of 10 conventional mortgages they could have outstanding at one time. So if your investment goals required more properties, you were either up a creek or had to look at alternative less favorable types of financing i.e portfolio loans or lines of credit.

Well, as of today, Fannie Mae has expanded that number up to 20 mortgages provided that the investment property being financed is part of their own portfolio of foreclosures AND you use Homepath financing (from an approved Lender that offers it).. Starting with the 11th mortgage, real estate investors will be required to put down 30% of the purchase price, up from 25%. That should be a non issue since real estate investors have long been willing to commit more capital if they were allowed to finance more properties as the BiggerPockets/Memphis Invest survey showed last week. No indication yet of the interest rate premiums that will be charged on these loans although I would think there will certainly be some premium.

There are certainly some strong limitations to this policy change. Investors who purchase new construction or non Fannie foreclosures would not be able to utilize it and would still be restricted to 10 mortgages. This comes across as a move to clear Fannie Mae’s pipeline of foreclosures faster. It’s amazing that it took them so long to figure out that well capitalized investors are a common sense solution to clear up the glut of foreclosures. But I digress.

The demand for Homepath approved foreclosures is almost guaranteed to spike in response to this change in policy. If you need a list of approved properties in the Houston area or a lender recommendation, call my cell at 713-922-2702 or contact us up top.

Is this change perfect? Not really. But in real estate investor land, today was a good day.