Investing Architect

Author: Erion Shehaj

The invaluable lesson a Roger Federer video taught me about long term real estate investing
Roger Federer, arguably the best tennis player in the history of the sport, visited the Google campus in Mountain View a few weeks back along with his coach Stefan Edberg (one of the game’s greats in his own right). During that visit, they put on Google Glass and shot a fascinating video that showed a tennis match from the perspective of these two great players. Take a look:

As I was watching that video, an interesting thought crossed my mind. As good as Edberg was in his day, he never reached Roger Federer’s level in terms of skills, trophies won and excellence in general. And yet, Edberg coaches Federer. This isn’t a phenomenon that happens in tennis alone. Every top performer, no matter the field, uses a coach to elevate their “game”. In fact, one could argue that top performers would not reach the same heights without their coaches’ help.

This sounds almost paradoxical. Why is it that a supremely talented and skilled performer needs the mentoring of someone that often does not possess the same capabilities?

The reason is that skills and talents only go so far in the road toward success and excellence. How many times have we seen history repeat itself with naturally gifted athletes that never reach their full potential? Often, talents and gifts are prerequisites for but not guarantees of success. For example, if you are to be the best player in the NBA you must be of a certain size and build. But if you possess that size and build, you’re not necessarily going to be the best player in the NBA.

So what are the missing pieces?

Vision, mental fortitude and the ability to practice simple disciplines.

That’s why Stefan Edberg coaches Roger despite the fact that he may have never been at Roger’s level skill-wise. His vast experience can provide invaluable vision and mental strength in clutch moments. His coach has “seen the movie before” and knows what’s coming up ahead. So he can supply his protege with those simple disciplines that sharpen the top performer and allow him to excel. Furthermore, when the game comes so easy due to natural gifts, it’s easy to take the foot off the gas and coast. A coach can help keep the focus and the intensity on at all times to defeat the mortal enemy of “great”, known as “good enough”.

Real Estate Investing Lesson

Real estate investing is no different.

Look, I’ll be the first to tell you that it takes a talented person to work hard, climb the ladder, lead a fiscally disciplined lifestyle and as a result save the capital to invest for the future. That’s not easy to accomplish so never take it for granted.

But now that you’ve accomplished it, you face some critical choices. Namely, how are you going to employ that hard earned capital to achieve financial freedom and live the life you want to live (not the one you have to live)? Certainly, your talents play a part and demonstrate financial acumen. But like the example above, natural talent is a prerequisite of success but never a guarantee. In real estate investing, success is determined by a few simple (but not easy) factors:
1. Do you have a roadmap that shows an overview where you are, where you want to be and the path to get there?
2. Do you have the experience to know what makes a good investment you should pursue or a bad one you should avoid?
3. Do you have a plan that shows you the exact steps you must execute to reach your goals?
4. Do you have the mental strength and disciplines to stick to your plan and avoid jumping from bandwagon to bandwagon?
I don’t know what your answers are to those questions – That’s for you to take an honest assessment, ponder and decide. But I can tell you that in my experience, most long term real estate investors, as talented as they usually are, need help with at least half of those factors. They might have the mental strength and disciplines but not the experience. Or they might have a good grip on their current situation and goals but don’t know how to create a plan that will bridge the gap between where they are and where they want to be. And the main problem is that most of us can’t afford to get this wrong as we aren’t usually given many chances to get it right.

So today, I want to leave you with a quote from one of my favorite authors and speakers that has had a profound effect on my life, Jim Rohn: We could all use a little coaching. When you are playing the game, it’s hard to think of everything.

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If you would like to know more about how our Blueprint can help you maximize the potential of your talents by providing a clear roadmap to reach your financial goals, contact me or if you are reading this in your email, just hit reply.
May 28, 2014
Case Study: Small multifamily investments in growing Texas market

When market dynamics change, long term real estate investors have to adapt their approach to stay on track and accomplish their goals. Previously, I articulated the case for branching out into other growing markets and different property types when market conditions restrict supply to the extent that it threatens the investor’s acquisition needs. Today, we are going to get deeper into the nuts and bolts of purchasing new construction, luxury small multi family properties (duplexes) in a growing Texas market with a detailed case study.

Income and Expenses

Annual Rental Income: $31,800 ($1325/side/month)
Operating, Management, Vacancy and Leasing Costs: $11,534* (36%)
Net Operating Income: $20,266

Purchase Price: $279,000
Down Payment: $69,750 (25%)
Loan Amount: $209,265 (4.75% 30 Yr Fixed Conventional)

Debt Service: $13,099.50 ($1091.63/mo)

Positive Cashflow: $7,166.50 ($597.21/mo)

*Breakdown of Operating/Management/Leasing/Vacancy

Vacancy: $1590
Property Taxes: $5400
Insurance: $800
HOA: $200
Management : $2544
Leasing fees: $1000

Total: $11,534.00

Investment Scenarios

Let’s begin with a basic example and build from there. Suppose you acquire one duplex that performs as outlined above. Next, you follow our advice and decide to grow your capital base first so you can maximize cashflow at retirement. Therefore, you utilize current positive cashflow to aggressively pay off the debt on the property. If you just use the property’s own cashflow without any additional investment from your job income, the mortgage will be paid off in 170 months or (14.2 years) at which point, if rents haven’t risen a penny in that decade and a half (chances of August snow in Houston are higher), your property would produce a pre-tax income of just over $20,000 per year. That’s in addition to your capital base growing four fold from the $70k initially invested to $280,000 of paid off real estate (if we assume zero appreciation). Suppose you need to get this done in 10 years vs 14 – how much would you need to contribute monthly from your job income? Roughly $500 per month! That’s lower than most people’s monthly Starbucks “contribution”.

Now what if your income needs far exceed the $20k/year produced by one duplex. Let’s look at a scenario where you acquire 3 such small multi family properties. It’s commonsensical that if you are able to pay off one duplex using its own positive cashflow in 14.2 years, you will be able to pay off 3 in the same amount of time since you’d be working on all three simultaneously. But what may not be as self evident is that if instead of using each duplex’s own income to pay off its own mortgage, you use the combined income to pay them off one at a time, you will start seeing results sooner. More specifically, the first duplex would be paid off in roughly 7 years, the second in just over 4 years and the last in just under 3. So, while the total time to pay off all three is the exact same, the investor that has one duplex completely paid off after 7 years has a lot more options on her menu than the investor who has the same mortgage balance spread over three properties but none paid off. And more options lead to victory. Similarly, if you want to shorten the time in which they’re paid off, a small contribution from your monthly job income could shave about 30% of the time to get to retirement. In this scenario, the investor would end up with pre-tax income of $60,000 per year and a paid off portfolio of real estate worth just shy of $1M if rents and values don’t go up one penny.

Concluding thoughts

In these case studies, I intentionally omit to consider any rent or price appreciation as part of the analysis due to my conservative nature. But you don’t have to be a real estate expert to know that over long enough periods of time both prices and rents go up (excluding markets where prices are artificially inflated by bubble conditions and rents are controlled). Even under the most conservative of appreciation assumptions (I.e inflation rate), the investor that controls the highest asset value (3 duplex scenario above) reaps the largest benefits on both the income and net worth front.

Finally, any investment performance must be judged relative to other available alternatives. So in that sense, I want to end this with this question:

When we take up the case of investing $70k to purchase one small multifamily (or $210k to purchase three), can you think of any other investment alternatives that in 14 years would turn your capital into $280k (or $840k for 3) AND produce $20k (or $60k for 3) per year respectively?

Or let’s make it a bit more fair. Can you think of an alternative that can do HALF as well?

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In the next post, I will discuss the Top 5 qualities that make this property type and it’s growing market a solid investment for a long term real estate investor. So please stay tuned.

If you would like a detailed cashflow analysis of the numbers discussed above, please email me or if you’re reading this from your email just hit reply.

May 22, 2014
Branching out to solve the Biggest Challenge: Small multifamily properties
In an article I wrote at the beginning of the year, I summarized the biggest challenge of 2014 for long term real estate investors in a single word: Supply. Now that the second quarter of the year is almost coming to a close, that prediction has become reality. And as we go into the summer months, supply historically shrinks even further as demand rises. In the meantime, your financial goals are still there, calling for acquisitions to be made to build income streams that lead to financial freedom. On one side of the coin, you don’t want to acquire assets that don’t make sense from an investment standpoint simply for the sake of acquiring them. But on the other, you don’t have the luxury of simply taking a year or two off in an environment where prices and (eventually) interest rates are expected to rise further. So how should you navigate under these circumstances?

Market “gravity”

In life and investing alike, there are issues that are rightfully up for debate and then there’s “gravity” – a law that applies equally across the board regardless of our beliefs about it. In long term real estate investing, a gravity-type law says that you take what the market gives you and build your strategy around it. Many a fortune have been squandered by investors on a mission to disprove that simple law. While in midair, many such investors actually think they have outsmarted the law – on the way to the eventual pavement.

However, one major distinction is that, unlike physics gravity, which is constant and applies to all equally, the real estate investing market is an ever changing landscape. Today’s market “gives” investors a much different set of circumstances than say it’s 2008 counterpart. So while the law always applies, there’s a variable dimension to it and you must be able to adapt your investing strategies to reach your goals. That’s not to say that you switch strategies as the wind blows – the principles must remain the same. But you shift your investing approach while abiding by those principles.

Principles to assets

Investing principles come first and assets follow. I know it sounds like a Captain Obvious proclamation but you would be surprised to know that the majority of long term investors get that important order completely backwards. Without first devising an overarching strategy and distilling from it investing principles to live by, they make an arbitrary decision on the type of real estate assets they will pursue. They buy “cheap single families and rent them out” or “small apartment complexes at $X per door” or “small condos with a max price of $X”. And all the while there’s no rhyme or reason to it. And most crucially, there’s zero consideration of the fact that the market “gravity” may have changed the landscape to extinguish the opportunities in the asset type they’ve arbitrarily chosen.

The alternative approach: Start with the end in mind (goals), devise a plan to achieve them (Blueprint), come up with clear criteria the asset must fulfill (principles) then look at the market and the asset types it offers that are the best suited vehicles to get you across that finish line.

Asset principles of the Blueprint Strategy

Our Blueprint strategy’s approach to determine investing principles for the type of asset to acquire is very simple. Our investors reach their goals when they own the right size portfolio of real estate leased to great tenants. Great tenants lead to low vacancies, low turnover and profit maximization. In our experience, great tenants look for properties located in good school districts in great, safe neighborhoods with easy access to employment centers through highways and great amenities and low hassle. Constant repairs in a property represent a great hassle to a great tenant (and the corresponding investor which has to foot the bill to boot) and they’re a direct result of the age of the property. It’s better to purchase an older property in a great location than a new one in a bad location but it’s so much better to purchase a newer property in a great location. Real estate investors should be concerned with two types of returns: returns on investment and returns of investment. The way to protect your invested capital and make it grow through appreciation over time is to purchase a property that can be sold for top dollar should the investor decide to exit. No one pays top dollar for average, run of the mill properties so investors should be looking for a property that will have appeal to the eventual buyer to whom they will sell the property eventually. And last but not least, the property has to have a good price to rent ratio as to provide an adequate return on investment.

So, to sum up, long term investors following the Blueprint strategy look for newer, quality properties in top locations with good price/rent ratios to provide an adequate return on investment.

Asset types

Notice how in the above summary, there’s no mention of specific property types. No “single family homes”, “small multi-family”, “condos” etc. That’s an omission of crucial significance because different markets “give” investors different asset types that can accomplish the goal. For example, in North Carolina, new (or new-ish) attached townhomes offer everything the asset principles above call for at a more favorable price/rent ratio than single families. In Texas, single families substantially outperform townhomes. In some cities, there are newer small multi-family opportunities in great locations while in Houston they’re virtually non-existent – they’re either older properties in good locations or newer ones in bad locations.

That’s the reason most of my case study articles that discuss investing in the Houston market involve single family homes. It is not because, that’s the type of asset we favor but because in this particular market, that’s the best asset type the market gives us to help investors accomplish their goals.

Solving the Biggest Challenge

Let’s come full circle to the initial premise of the article: Rising prices and increased competition for single family homes in the Houston market have reduced the supply of opportunities for long term investors. But if your Blueprint still calls for further acquisitions in a climate of reduced options, what are we to do? We need to look for additional options elsewhere – in markets that have most of the same strengths that perhaps “give” investors access to property types that just aren’t available here at this moment. That’s what we’ve been diligently working on since the second half of last year and I’m excited to say that what we’ve found abides by the asset principles above and gives us some additional benefits to boot.

I plan to present a specific case study with hard numbers in a subsequent article but I’d like to end today’s post with a summary of strengths that this new opportunity offers:
1. New construction, luxury small multi-family (duplexes) zoned to great schools
2. A growing Texas market with a population growth rate 9 times the national average
3. Quality property management company in place providing a true turnkey investment
4. Maximization of asset value per conventional loan
5. Low property taxes, hazard insurance, HOA dues
6. Attractive price/rent ratio and low days on market/vacancy rate
7. Luxury low maintenance finishes (brick exterior, granite counters, 11-12ft ceilings, oil rubbed bronze fixtures, no carpet anywhere)
8. Builder warranties (1 year wall to wall, 2 year HVAC/electrical/plumbing, 10 year structural)
Next time, I will present the hard numbers and show you how you can weave these small multi-family properties in your Blueprint strategy and utilize some of the strengths above to propel you towards your goals. Until then, take good care of yourselves for me.
May 16, 2014
To Domino or Not to Domino? That is the question

A very interesting debate has sprung up in a BiggerPockets Forum about my article on how to build a six figure income using real estate investing. In that discussion, the participants make different pro and con arguments over the use of the Domino Method to accelerate the payoff of debt in your portfolio. I think it would be beneficial for our readers here as well as the participants of that discussion if I addressed each argument in greater detail.

Not sure if I like this method… takes 149 months over 12 years to start seeing your income. If you’re looking for a retirement plan, well that’s a different story.

When we first sit down with an investor to discuss what strategy they should pursue, I first ask you about your investment goals. Inevitably, you tell me that you’re looking to build an income stream or create positive cashflow . Then comes the crucial timing question: When do you need this income/cashflow? If you are looking for income now, I’ll be the first to say that the Domino Method won’t do much for you. The strategies and methods I write about are suited for long term investors that are looking to build large income streams in the future (read: retirement) and in so doing are willing to give up small income streams in the present. If you are looking for income now and don’t have a scary amount of capital at your disposal to start, I would argue that real estate as an asset class is not a good vehicle to accomplish that goal. To create current income, you would do much better if you deployed limited capital into starting and operating a business.

Now, I’d like to address the point that this simply takes too long. I come into contact with plenty of people that have been investing for 12 years or longer without a particular plan. Just buying a property here and another one there as the opportunities came around. I’m yet to meet someone in that group whose performance during the last 12 odd years can even come close to the results they would get if they applied our Blueprint strategy over the next 12. The fact of the matter is time will pass for us all one way or another. But what we can control is how we spend that time and the results we reap are dependent on the soundness of our plan.

I don’t think that 100k (six figure income created by strategy) is net. The true net of that is probably more like 50k after vacancy, repairs, taxes and insurance.

The cashflow figures we are using to pay off the mortgages as well as the cashflow figures used to calculate the income at retirement are net of all operating costs (property taxes, insurance, homeowners association dues, maintenance and repairs), vacancy provisions and leasing fees but before taxes. The reason why I used before tax figures (especially in the case of income at retirement) is because the tax rate, tax deductions, tax shelter can vary wildly from investor to investor. Since we’re trying to present a case study that applies to the majority of investors, I thought that was the most prudent course.

Many investors have little capital to start. So they are looking for maximum yield and forced appreciation. Their jobs in many cases do not allow for much savings. Example if you make 75k a year a lot of that is used for living expenses. Even if you save 1,000 a month that is 12,000 in a year.

So it takes much longer to get going this way with slow build up.

This versus someone who has a business they own or a job with very high income can regenerate capital much faster to take advantage of market cycles where someone with limited capital might buy one property and be tapped out for awhile.

I would like to offer a different perspective this issue. I would agree that many people have little capital to start and struggle to accumulate large amounts of capital because their incomes won’t allow for such accumulation. But I think that by definition if you are going to be an investor you have to have capital to invest. That may sound a bit harsh but it’s a concept that’s well founded and proven. I believe that the sacrifices you make in saving that initial seed money (and it is very hard in the beginning, especially if the income isn’t very high) “temper” you and make you a stronger investor. On the opposite side of that spectrum, you have people that try to create their capital through inherently risky strategies (read: flipping through hard money loans) and unfortunately, the wide majority of them don’t make it. Yes, it’s going to be a slow grind saving the money for that first property. It will be easier to save it for the second. And easier still for the third. But you don’t let that difficulty keep you from getting started or even worse, going in a much riskier path of least resistance.

I’m not a big fan of the article for a few reasons. The first being that you need ~$180K in cash to be able to pull this off. He’s suggesting buying 9 ~100K properties which will require 20% down each.

He’s then suggesting taking 0 cashflow on that for 12+ years. Over that time, you’ll be paying taxes on ~$40K of income that goes directly to the bank to pay down your debt while only capturing about 30-35K of depreciation.

If you’ve got $180K laying around there are surely worse ways to put it to work…but this definitely isn’t the best way

As I mentioned above, if you want to do it right, you will need capital. I make no apologies for that. But sometimes a sense of chronology can get lost in a simplified, linear case study. For instance, in reading the strategy, you’d get the impression that you would need to have the money in the bank this very moment. In reality, most investors I work with build up to that level of acquisition. They acquire 2-3 properties per year and recycle the positive cashflow from properties they own in addition to savings from job income to create the capital for the next 2-3 acquisitions.

The next point made is that the Domino strategy I suggested asks you to forego the cashflow for 12 years, pay taxes on the interim income to pay down debt since depreciation doesn’t cover all the income. All these points are correct, but I’m not sure they make much of a case against the strategy. First of all, when you invest your capital in a property to create a present stream of positive cashflow, you’ve made your money make some money. When you invest the “dividends” to grow your capital base, you’re essentially applying compound interest principles. If you spend the “dividends” in the present, you miss out on the magic they can do over time. So, if you don’t need the income from your properties to subsidize any other income you may have, but you opt to spend the cashflow created by your properties, you are essentially killing the goose that lays the golden eggs. You don’t play by the bank rules when you aggressively pay off your debt. You play by their rules when you pay off your properties in the schedule your bank set in the first place. Do you think they set a 30 year payoff schedule because it was in your interest or theirs?

Finally, I would be happy to listen to any alternatives to invest $180k in capital and most importantly to compare results.

paying down and not using interest for your tax deductions is dumb in my opinion. But many people on here would disagree. So u own a fully paid off pile of bricks in a shape of a house… what’s so great about it? If u want to take money out.. u have to pay 4k to refi. Just dumb

Ah yes! Let’s spend a dollar to get back thirty cents. This deduction argument is so weak and without merit when used paying off your own home but it really reaches silly levels when we’re talking about investment properties. When you own a leveraged investment property, the interest you pay on the mortgage is deducted against your gross income to calculate your taxable income. But the reason it’s deducted is because you spent it and didn’t receive it as cashflow. When a property is paid off, you don’t have the deduction of mortgage interest from your income but you don’t have the expense either.

If you own “a paid off pile of bricks in the shape of a house” you own an income producing asset that in alliance with other income producing assets can set you financially free. That’s what’s so great about it!

LOL, this “system” was bounced around in the 80s!

In financing this is a distribution of debt reduction and use of funds issue.

You’re paying off debt with expensive current dollars while reducing the after tax interest expense of cheaper money. In other words your real economic cost is greater with accelerating the payoff. The benefit is receiving future dollars with less value due to inflation. Keep in mind that raising rents does not effect the funds necessary to retire debt, increased rents are above amounts for debt service.

No one mentioned buying 9 properties with 25% down buys 2 properties free an clear and a third with 25% down. Property 1 could buy property 4 and property 2 can payoff property 3 or buy property 5. I’d say this could be quicker to the same end off hand.

In some cases this does have benefits depending on your age and retirement goals, wiping out any debt. Suffer now and enjoy later. 🙂

Actually this system has been around ever since mortgages and debt first appeared. The cashflow dollars you use to pay off the debt on your investment portfolio are (by and large) tax sheltered due to depreciation so I’m not sure how they’re “expensive dollars”. Again, you get to deduct the interest expense from your rental income because you’ve given those interest dollars to the bank. Interest expense is not some “paper expense” along the lines of depreciation expense. Yes, you will pay more taxes on positive cashflow from free and clear real estate but that’s because you’re receiving more cashflow than you would if the property was still leveraged. No matter how you split it, saving the expense is always better than deducting the expense for tax purposes. The future dollars you receive are subject to inflation (like everything else) but real estate is an asset class that is inflation resistant. The reason is that inflation makes 100k/year 10 years from now have less purchasing power than 100k/year today but it also raises property values and property rents. Generally speaking, you can’t built the same property 10 years from now for the same cost you can today because all the components that make up a property (bricks, roof materials, concrete etc) are subject to inflation as well. In the illustration of the Domino strategy, I eliminate value appreciation completely to keep numbers conservative and keep things simple. But if we were to account for likely appreciation, the discussion is over.

If you have $180k in capital and the properties we’re using for the sake of the discussion are $140k each, you could buy one property free and clear and have enough capital to purchase another with 20% down. The combined income of these two properties would be about 16,500 a year. Which means, you would need to wait 2.5-3 years till you could purchase the third. So, taking that alternative route would take you much longer than 12 years to just accumulate 9 properties – forget about having them all paid off in 12 years!

I’d like to end my take on the merits of the Domino strategy with this point: The factor that’s almost always missing from the arguments against this method is risk. I’ve said it before and I’ll say it again: Risk and return are best friends – they go everywhere together. A portfolio with 25 leveraged properties is inherently and substantially riskier that one with 9 paid off properties. So when discussing best use of funds and opportunity costs, it’s fine to consider the return but disregard its best friend at your peril.

March 24, 2014
How to properly calculate the return on a long term real estate investment
This may come as a surprise but in my experience, most real estate investors don’t know how to properly calculate the return on investment on a particular piece of property. Couple that with the fact that ROI is the metric most investors use to make crucial decisions about investing and you have a recipe for disaster. Or at the very least, a recipe for missed opportunities.

First, let’s illustrate how most investors calculate the return on investment by looking at an example. Suppose there’s a property in a good location, zoned to good schools with nice finishes on the market for $160,000. A look at rent comparables in the immediate neighborhood reveals that the property should rent for $1650/mo ($19800/year) within a 30 day timeframe. Operating expenses, vacancy provisions and leasing fees add up to 40% of gross rents. The loan on the property is a 30 year fixed conventional loan at 5% interest for 80% of the purchase price (down payment of 20%) so the annual principal and interest payments add up to $8,244/year. So after covering expenses and mortgage payments, there’s a projected annual cashflow of $3,636. To purchase the property, the investor would have to pay the 20% down payment ($32,000) plus loan closing costs ($3,000) for a total of $35,000.

At this point the investor takes the positive cashflow of $3636 per year and divides it by the invested cash of $35,000 and conclude that the return on investment on the property is 10.36%.

The return calculated by the investor in the example above only reflects the cashflow return on investment or as it’s commonly known “the cash on cash return”. Essentially, this method looks at the real estate investment as a sophisticated CD or dividend stock. You invested X amount in the CD and it paid out Y at the end of the year so therefore your return is X/Y.

The method just described is wrong not because it’s incorrect but because it’s inconclusive.

Here’s why the cash on cash return does not tell the whole story – It does not account for:
1. The principal of the mortgage paid of during that year
2. The fluctuations in rent price during the holding period
3. The fluctuations in property value during the holding period
Let’s take them one at a time. Part of the debt payments on the mortgage goes towards paying down the principal balance of the mortgage. Therefore, ten years from the acquisition point the mortgage balance will not be the same as when you start. The cash on cash return figure completely neglects this very important benefit of investment real estate. That is, the ability to pay off the mortgage using rental income. Second, the cash on cash return calculation may be accurate during the first year of the investment since the rent and expenses are pretty much set. But as time passes and you change tenants, the rents don’t typically stay stagnant and neither do expenses. Rents usually follow an upward trend (they go up over time) but that’s not guaranteed. Sometimes rents go down – for instance, when there’s an oversupply of rentals and not enough tenants to go around. So the cash on cash return does not accurately depict what happens to your investment as rent prices fluctuate. Third, on a similar note, home prices don’t stay stagnant over the long term as the last recession duly reminds us. Remember, there are two returns we have to contend with: Return on investment and return of investment. If you acquire a low priced property in a neighborhood where values are likely to decline over the next 10 years, your cash on cash return is providing an inflated view of what your true return will be in the end. Because when the time comes to exit the investment, you will have to “give back” some of those returns by not being able to recover all the capital invested at the outset due to declining prices.

As a way to illustrate how poor of a measuring stick the cash on cash return can be, suppose for a minute that instead of a 30 year mortgage, the investor went for a 15 year mortgage instead to take advantage of more favorable terms. When the loan term is shortened, loan payments increase by about 40% wiping out any positive cashflow that was there. Does this mean this deal is not worth doing because now the cash on cash return is zero? More importantly, is zero the true return on this investment?

The short answer is absolutely not.

The proper way to calculate the return on a long term real estate investment is the internal rate of return. It’s not perfect, but it accounts for all those deficiencies I just went over. This method looks at an investment during the entire holding period and calculates an annual return. Take a look at the table below:

Internal Rate of Return Calculation

Think of this table as a chronological roadmap of your investment if you held it for 10 years then sold it. In the beginning, there’s your $35,000 investment (a negative number because it’s an outflow of cash) followed by ten years of cashflows and the cash you get back at the exit point if you sold the property for the same price you paid 10 years ago (zero appreciation over 10 years). As you can see, most investors just look at the first two numbers which don’t even cover half of the story.

Internal Rate of Return with 2% Annual appreciation

Now let’s assume that the property went up in value at the rate of inflation (as most goods do) over the next 10 years. Take a look at the illustration above – your cash on cash return is the exact same but your true return has increased by 25%.

This may seem like a nerdy debate about methods of calculation but it’s much more important than that. The rate of return is usually THE metric most investors use to make decisions on investment opportunities. If you pass up on a worthy investment simply because your numbers aren’t right, that will have a negative impact in your investing results.
March 11, 2014
The principal reason you won’t become wealthy investing in real estate

The majority of my writing here covers real estate investment strategies and mindsets you can use to become wealthy with long term real estate investing. In various case studies, I have shown you how to create a six figure income and how to retire in seven years etc. by making smart real estate investments tied by the common thread of a solid Blueprint strategy.

And that’s all well and good. We all can benefit from a little more “big picture” insight to help us design and take charge of our own financial future. But when you get down to the dirty details, the execution of such plans usually ends up being a lot messier than those projections. It’s one thing to look at and intellectually understand the mathematical implications of a strategy that assumes flawless execution. It’s another to actually execute. Think about all the things you have to contend with when making an important financial decision. We all want to avoid risk where possible (risk aversion) which leads to uncertainty (indecision) about whether this is the right move (wanting the best deal possible) which leads to procrastination and paralysis by analysis (inaction).

Sometimes knowledge of the path that leads the opposite way can illuminate the path that leads to what we want to become.

In the context of building wealth through a disciplined approach over long periods of time this is not only true – it’s eyeopening.

You see there’s this massive myth in the realm of real estate investing that has been propagated by multiple books and has been accepted as truth by most. It claims that in real estate investing you live and die by your rate of return. You might have heard it put a different way in “you make your money when you buy the property” or “if your incoming rent is not at least X% of the purchase price, don’t buy the property”. They’re all different shades of the same idea:

Myth: Your ultimate success or failure in becoming wealthy investing in real estate is a direct result of your rate of return. Therefore, you should have a set return number in mind and use it as an acid test. Anything yielding a lower return is a nay, anything higher a yay.

Sounds sensible enough, right?

Let’s add on another layer of context to this discussion. In a free capitalist society the only constant you can count on is change. Case and point: The real estate market over the last 9-12 months has been experiencing rapid change from a sleepy sideways market to a “write your full price offer before you leave the property or you don’t stand a chance” Seller’s market. Obviously this has caused prices to rise and inventories to shrink substantially in most markets which leads to downward pressure on rates of return investors are able to obtain. Last week, I had a conference call with a client that had purchased several properties in 2007-09 and was mortified by the unrecognizable landscape.

With that in mind, you can see how “the number” you have in your mind for an acceptable return can change based upon your previous experiences (a new investor with no past frame of reference would view today’s market very differently than an investor that acquired property at the most distressed point of the 08 recession) and therefore influence your action (or inaction) going forward.

But none of that matters.

The idea that your wealth building efforts will succeed or fail based upon your ability to secure a certain rate of return is just untrue. Here’s an example that dispels that myth: Suppose you have two real estate investors A and B. Investor A puts together a portfolio of 9 high quality properties yielding 15% annual returns and Investor B purchases similar quality properties (9) that only yield 10% returns. Both investors employ a Blueprint strategy to aggressively pay off their properties over the next decade and end up with the same income at retirement. All else being equal, Investor A will get to retirement much faster due to the higher return on his investments but in the end both investors end up with a similar net worth and income. In other words, both end up wealthy. So the 30% difference in returns impacted the speed of success but not the ultimate result.

Of course, all else is rarely equal in real life.

Take the same example above and add the layer of context of a changing market I described above. During the acquisition phase their plans, the market shifts and now 15% return properties dwindle in numbers and Investor A only acquires 5 out of the 9 properties he was planning to acquire. Meanwhile, Investor B completes all nine purchases since his 10% rate of return is more readily available. Who do you suppose fares better in the end? Investor B portfolio crushes Investor A’s and his coveted 15% because he acquired and paid off a larger asset value becoming significantly wealthier in the process.

It’s not the rate of return that determines your success or failure on the road to becoming wealthy. It’s action. If you’re disciplined and have a solid plan, you will pay off and own whatever you acquire. But it’s the acquisition that sets everything in motion. Without it, you lack the target to hit and with it the structure you need to be able to execute.

Remember this: Far more wealth is lost by inaction than ever was lost by accepting a lower return. Don’t let an arbitrary number in your head back you into the corner of inaction. That’s the principal reason one fails at becoming wealthy.

February 28, 2014