Erion Shehaj

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

July 24, 2012 By Erion Shehaj Leave a Comment

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.

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How is income from investment real estate taxed?

July 22, 2012 By Erion Shehaj 4 Comments

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.

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How to minimize turnover and maximize returns in your investment real estate

July 21, 2012 By Erion Shehaj Leave a Comment

Few things affect the results of a long term real estate investment strategy like turnover and vacancies. During the time a property is not leased it becomes an expense rather than an asset to the investor. Turnover has similar effects – every time an existing tenant leaves and a replacement is found, the investor incurs make ready and lease out expenses. If high turnover and vacancy cause investor returns to decrease, it follows that taking measures to minimize them as much as possible will increase and maximize investor returns. That sounds great – so how can we make it happen?

High turnover and vacancy have one common solution: Great tenants. So when you ask how do we reduce turnover and vacancies you are really asking, how do we find, screen and keep great tenants. The purpose of this post is to answer that question.

Finding great tenants requires three ingredients: Strong marketing, a great property and clearly defined standards. You need strong marketing to let great tenants know that you have a great property they should consider and to make them fall in love with it. We list our properties for lease on the MLS and syndicate to every online site that has rental real estate like Zillow, Trulia, Hotpads etc. We take great care in listing our lease properties – we take plenty of photographs with professional equipment, write descriptive copy and portray the property in the best light. In addition to that, we write an article (blog post) on our website to give it the exposure of 10k monthly visitors. Last but not least we run daily Craigslist ads to drive traffic to the property. But all the great marketing in the world couldn’t help you unless the property you acquired is up to snuff. Great tenants look for properties that have nice upgrades, good floor plans, neighborhood amenities and most importantly excellent schools. And the condition of the property has to be immaculate: professionally cleaned, freshly painted, carpets shampooed, air filters replaced etc etc. If your property doesn’t fit that profile, you made an acquisition mistake. Last but not least, you have to have a clear idea about what a great tenant is and you will have that idea when you have clearly defined criteria that the tenant must fulfill. From our lease listings as an example:

Looking for a good long term tenant with great rental history, good stable employment (2+ years) and income (Approx. $4700/month income to qualify salaried, not on commission) and no background check issues. Minimum two year lease. Credit score of at least 600 is required with rare exceptions

As you can see from that description, what defines a great tenant for us are rental history, employment stability, income sufficiency, clean background and long lease term. In that order. Credit is secondary for us and we would be willing to overlook it if the tenant fits all the other criteria. But do you see how well defined is the profile of the tenant we seek?

Screening great tenants is vital to insure that the applicant truly fits that well defined criteria we just discussed. As part of our standard screening we do the following:

Obtain and review rental history verification. Contact previous landlord, ask verifying questions and get an idea about what kind of tenants the applicants were.
Obtain income documentation (checkstubs and tax returns) and verify that it’s correct by requesting an employment verification.
Obtain and review credit report and background check.
Check references if any.
Run cross check verifications to make sure the information provided is correct – Is the landlord they’re listing on the application the owner of the property they were leasing or some family friend of the tenants?

Keeping great tenants is achieved by setting up the right expectations from the start, keeping communication lines open and showing care. Most disputes between Landlords and tenants stem from parties not being clear about what the other expects from them. We solve this issue by clearly defining expectations in the lease agreement and in the Rules and Regulations document and going over these expectations before the parties sign papers. Make it easy for the tenant to pay rent, submit a repair request and get repairs done in a timely fashion. Do what you said you were going to do. Keep lines of communication open at all times so wrinkles can be ironed out before they become problems. Finally, show that you care – about your property and the tenants. If a tenant sees that you don’t even care about your property, why should they? Schedule quarterly inspections of the property, provide air filters for replacement, make routine maintenance tune ups of your systems when they aren’t broken to extend their life and prevent unpleasant experiences for the tenants.

Finding, screening and keeping great tenants is the ultimate solution to the turnover and vacancy problem. Every time you manage to put a great tenant in one of your properties, you are actually putting money in your pocket and minimizing stress. So do it right, or hire pros who can.

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Houston Rental Market Update: Double digit climb plus highest rents on record

July 18, 2012 By Erion Shehaj 1 Comment

Long term real estate investment strategies are founded upon the investor’s ability to secure continuous incoming rent over the term of the investment. That’s why the most frequently asked question by real estate investors has always been: How do I know the property will rent quickly and stay rented? In that spirit, I want to keep you updated on the state of the rental market in Houston Texas. Fresh off the Houston Association of Realtors presses:

Strong activity persisted in Houston’s lease property market in June. Rentals of single-family homes climbed 15.9 percent compared to June 2011 and year-over-year townhouse/condominium rentals increased 13.5 percent. Rents in Houston are at their highest levels ever, with the average rent among single-family homes reaching $1,641 per month in June and the average rent among townhouses/condominiums coming in at $1,408 per month.

Average rents reaching the highest level on record is not doubt good news. But what’s even better news is the drop in price to rent ratios that this causes. High rents by themselves don’t guarantee that there will be cashflow. Look at New York – extremely high rents but they’re coupled with extremely high property prices that don’t allow the numbers to work. In Houston, you can purchase quality investment properties in good locations for 6-8 times annual rent. The true magic lies in the combination of affordable prices and increasing rents. That’s where a lot of investors miss the boat: They think it’s all about buying cheap enough properties. Actually, you can purchase a more expensive higher quality property where the price to rent relationship is much more favorable than in a lower priced property.

Rents are rising while opportunities for well priced quality assets are plentiful. That’s what makes the Houston market one of the hottest markets in the country to invest your hard earned capital.

Who is advising you about your real estate investments?

July 17, 2012 By Erion Shehaj 3 Comments

When you invest in real estate long term, what’s really at stake is your retirement. In the end, the path you take will either lead you to the retirement you want or it won’t. All the metrics us investment guys like to talk about so much – your returns on investment, equity positions or positive cashflows won’t matter at all if they don’t get you over the finish line. It’s a pretty brutal and unforgiving situation, if you think about it. Intentions, efforts and the such are completely irrelevant and worthless if they don’t lead you to the retirement you sought when you started investing.

So that brings up the question: Can you afford to get this wrong? The path you take today, the decisions you make on how, where and when to use your capital today will be the determinant of how far and fast you go. And in the end, the decisions you make are as good as the real estate investment advice you get – or don’t get. So, who’s advising you about your real estate investments?

If you were to ask any real estate agent if they work with investment properties, the answer will almost always be a resounding YES. After all, you’re just buying a house or two and they know how to sell you a house. They can send you a list of properties for you to look over and let them know when they should write up a contract for it. They might even use general and shallow investment terms like: “You will make a lot of money with this” or ” The ROI of this property will be off the charts”. The truth is they don’t know the first thing about real estate investing. And most importantly, they can’t offer you the most important necessary ingredient for success: A well-founded cohesive investment strategy. One that mitigates risk and maximizes long term returns. One that gets you over the retirement finish line. Remember this: Regardless of the vehicle you use – real estate, stocks, bonds, annuities etc – this is ultimately about protecting your principal and growing your capital to a point that the yield on that capital gives you enough after tax income to retire. If you’re just buying a couple of houses, you’re not investing – You’re just buying a couple of houses.

Another alternative for advice is to go to an investment club that offers “educational” seminars about how to invest well. There you could even network with seasoned investors that have a deal or ten you could buy today. These deals have tons of equity that these members are just passing on to you because they like you so much and they’d rather you make the profit off the deal than them. Next thing you know, you’ll be driving Hummers, wearing a lot of hair gel and dark shades. Sounds like a late night infomercial doesn’t it? Look I don’t mean to be cynical – there’s nothing wrong with folks wholesaling deals to each other. It’s a market that’s been around for a hundred years. But this is your retirement we’re talking about here. Do you think you should take advice from someone whose goal is to “flip” you a deal so they can make some profit that month?

When we start working with a new client, it’s usually the start of a lifelong business relationship that has one goal: Accomplishing the client’s retirement goals. Anything short of that, is utter failure and I don’t take that responsibility lightly. Whatever you do, make sure the quality of the advice you get is aligned with the goals you have. If you’re a long term investor, you owe it to yourself to work with a pro that will lead you down the path of success. Your retirement’s at stake.
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Location, location, location. But with a caveat…

July 13, 2012 By Erion Shehaj Leave a Comment

If there was such a thing as a real estate “constitution”, it would consist of three words: Location, location, location. It is the best known and most fundamental concept about real estate desirability. Nothing adds more value to a piece of real estate than a good location and there’s really no second place. But when in comes to long term real estate investing in Houston Texas, the old adage can sometimes lead investors astray.

Let’s take the Inner Loop as an example to illustrate my point. I don’t think anyone that knows Houston would disagree that the area inside the 610 Loop is one of the most desirable locations in town. And for good reason. The city’s cultural heart with its museums, theaters, opera house and ballet is there. So are the best parks in the city, the best entertainment venues etc. The Inner Loop is a great location because it allows its residents to have a great lifestyle. So if you live (and invest) by the “location, location, location” mantra, the Inner Loop would be a great place to acquire great real estate that will be desirable to both future buyers and tenants alike. However, there are some storm clouds in the sky of that strategy and here’s why. The ratio between the price an investor pays for the property and the annual rent the property generates is too high to make any money. In more plain terms, the higher the price you pay for a certain amount of rent, the lower your return. For instance, if you were to pay $140k for a Katy property that produces $18k in annual rent ($1500/mo) you’re paying just under 8 times rent. If instead you acquire a property in the Heights that costs you $300k which produces $30k in annual rent($2500/mo) you’re paying 10 times rent. That difference between the two means that the Katy property will cashflow very well while the Heights home will have negative amortization.

Be that as it may, negative amortization isn’t the end of the world. Pretty much every California property circa 2000-2005 had negative amortization. But it didn’t matter because the appreciation in real estate prices more than made up for the money you had to feed the property each month. For example, if a property that you buy for 400k, costs you $500/mo out of pocket over 5 years it doesn’t matter much if the property’s value would go up to 700k in that timeframe. Here’s where we run into a problem with this strategy in Houston Texas. We don’t have double digit appreciation rates here. We never have had and never will have. Our market has always been a 4-6% annual appreciation rate kind of market. So if your properties aren’t making you any money on a monthly basis and the appreciation doesn’t amount to much then where will your returns come from? Because I’m assuming you’re investing for returns, not ego, right? This would be a different situation if you were looking to purchase a property to reside in that also carries an investment component to it. But as a pure investment play, no cashflow plus slow appreciation is a bad recipe.

In addition to that issue, there’s Age. Most properties Inside the Loop are in older more established neighborhoods and they will require more attention and more hassle to maintain for a long term investor. Or, the alternative is to buy newer condos and we’ve already discussed why that doesn’t work when you invest in Houston.

So does that mean location isn’t important? Absolutely not. The principle is alive and well in our market as well. You have to look at it from the prism of what makes a property’s location great for a tenant. Based on past experience with the great tenants we’ve had on our clients’ properties, they are looking for properties in great school districts, in safe neighborhoods with plenty of amenities, with easy access to workplace, highways and shopping. When you look at it that way, most properties that fit that description aren’t Inside the Loop. Actually, the number one factor that drives tenant demand, school district quality isn’t that strong Inside the Loop.

Location is the most important factor in determining the desirability of real estate. But the quality of location for the long term real estate investor depends on what his desired tenants perceive to be a great location.

Have a great weekend!

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