Investing Architect

Author: Erion Shehaj

Houston Economy strength in numbers: GHP Report for 2013
Every year, the Greater Houston Partnership publishes a detailed report on the Houston economy which is a great chance for a numbers geek like me to sink my teeth on an ungodly amount of data.

Below are a few highlights from the report.

As of November 2013:
1. Unemployment rate: 5.6% (vs. 7.0% national unemployment rate)
2. Employment: 2.8% Job growth – Greater Houston area added 86,200 jobs during the previous 12 months (Number #1 in the State of Texas). During 2014, the GHP predicts that the Houston area will experience 2.5% job growth and add 69,800 additional jobs.
3. Affordability: Living costs in Houston are 6.5% below national average for large metro areas
4. Home Sales: 87,635 homes sold during the previous 12 months for a total volume of $20.8B (+19.4% and +31.9% respective increases over 2012)
Or feel free to download the complete reports below:

Full Reports:

Houston Economy Report for 2013 – Greater Houston Partnership

Population_Employment_Forecast- GHP 2014

Employment-Forecast 2014 GHP
February 11, 2014
On our need for structure and escaping the affordability mentality

Most of the articles I have written for Investing Architect revolve around strategies, ideas and plans you can apply and reach your retirement and wealth goals. But I am a firm believer that even the most brilliant of strategies would not be executed properly in the absence of the right mindset.

So, I’ve been thinking about a couple of concepts that can substantially influence our mindset and I’d like to share those thoughts with you.

On structure

First, let’s look at an instance that most of us have had some experience with in their lives. You are in the market to purchase a car so you walk into a dealership. A couple of hours later you shake the hand of your salesperson and drive out of that dealership with your new car and a promise to pay $450 per month over the next 60 months for the privilege. Over the next five years you make that payment diligently by the due date and fulfill your promise by paying a total of $30,602.

So far so good.

But I’m really interested in what happens during the next 5 years. You would think that over the next 60 months that you don’t have a car payment, you should be able to put that monthly payment diligently into your savings and accumulate over $30,000 during that time. Right?

The truth is that almost never happens. And I am fascinated by the reason why. How could it be that we are more loyal and diligent to a bank or a car company but not ourselves?

The principal reason is structure. A secondary but still important reason is automation.

You might not have realized it at the time but when you walked out of that dealership they setup a clearly defined structure for you. They gave you a five year target to hit and interim monthly targets that you had to meet. The engine of achievement in our brains needs that structure, those targets and the “burn the ships” requirement to follow through. That’s the first reason why you didn’t manage to “save the car payment” over the next 5 years.

Now let’s take it a step further. What happened when you received your first payment letter? You signed up for autodraft or entered the car payment on your Bill Pay. In other words you automated the process and removed the burden of decision. When the next payment came due, it got withdrawn from your account regardless of how you “felt” that day. You probably didn’t even notice that it was gone till you looked at your statement later. That’s how automated the process had become.

The real estate investing lesson in all of this is that if you want to achieve lofty goals, you need structure. You need a Blueprint that gives you targets to hit and actions to take. When there is a lack of structure, you end up with a couple of rental properties and some Starbucks money each month but nothing more. And in the process you expend the most valuable resource you have: Time. Last but not least, real estate investing requires capital – in other words it requires your ability to save. How do you hit your savings goals? You make them automatic and you remove the burden of decision. Setup an autodraft for you, on the first of each month, before anything else is paid. And deposit the money into an account where you don’t have easy access to make withdrawal more cumbersome.

On escaping the Affordability Mindset

Let’s take it one step further still. It’s the moment before you leave the house to go to the dealership in the previous example. You need a car and you don’t have the option to pay cash for it. What’s the thought process in considering the potential car loan you’re about to take on later that day? Well, you make $90,000 a year and take home about $6,000 a month so you can easily afford the $450 per month payment. And you would be right. But it’s the right answer to the wrong question.

Sorry to break it to you, but the “affordability mindset” that is so ingrained in our culture, is simply the result of successful marketing campaigns. Companies selling anything from cars to furniture have succeeded in getting your attention away from the fact that you are paying a lot of money for something that goes down in value and toward the “affordability of your monthly payment”. They have succeeded in getting you to ask “what’s my payment” instead of “what’s the price”.

Look, I’m not here to tell you how you should spend your money. In earning the money, you have earned the right to use it however you see fit. What I’m here to do is offer a different mindset, a cashflow and wealth mindset. In the previous example, we looked at how a car payment saved for 5 years can amount to over 30k even with modest returns. We didn’t mention that the average family carries two such payments averaging about $800 per month! If this same family owned a rental property (140k, 20% down at 5%) and applied the same amount of those car payments (in addition to the cashflow) to aggressively pay down the mortgage, they could have the whole thing paid off in 6.5 years producing $1000 a month in income to boot! So, in roughly the same amount of time as the car payment plan, the same amount of money can accomplish so much more when applied to a different structure.

Those that adopt the cash flow and wealth mindset don’t play the game using the same affordability rules peddled by banks and companies. They ask about the real cost of things that includes the opportunity cost of not investing the money in a different structure that can make the difference for them in the long term. They understand that affordability doesn’t stop until every dollar they earn is already owed to some company before it hits your bank. They refuse to play that game and that’s why they accomplish different, much more ambitious goals.

February 5, 2014
The biggest challenge of 2014 for long term real estate investors

Sometime around the summer of 2013, the investing landscape in Houston began to change at a rapid pace. Demand soared, inventories shrunk to record levels and the Houston real estate market lit up like a wildfire.

Bank owned foreclosures, the perennial sweethearts of investors everywhere that had accounted for one in four sales just a year ago, now barely contributed six or seven percent. The few properties that banks were bringing to market were either inaccessible to investors (in favor of owner-occupants) or priced at market prices despite the need for repairs.

Meanwhile, builders started ramping up construction to complete subdivisions that had been developing at a snail pace and break ground on new communities. But as one builder told me, “after five years of increasing construction costs and stagnant prices the market was finally allowing them to raise prices”. And raise prices they did. Same subdivision, same property that had been selling in the high $140s, first went to the mid $150s then mid $160s in six months’ time. Fortunately, rents kept on rising right alongside prices so it made sense up to a point. Then prices rose out of reach.

Finally, the owners of existing homes with plans to sell started setting their pricing sights ever higher boosted by anecdotal evidence of neighbors’ homes selling in a matter of days at full price and multiple bids.

As a result of this combination of higher demand and tighter supply, we ended up with record numbers in sales, prices and inventory for 2013:

So what does this mean for investors in 2014?

After that synthesis of the second half of 2013, the knee-jerk conclusion that some investors might draw is that the “train has left the station” and the prudent course of action would be to sit tight and wait for prices to come back down to the good old 2010-2012 levels. While I understand the impulse to draw that conclusion, I think it’s misguided on several levels.

First, the idea that if we just wait it out, prices will come down in short order is based on the assumption that we are currently in a bubble that will burst soon. That couldn’t be further from the truth and here’s why. From 2008 till the end of 2012, home prices in the Houston area were pretty much flat. They didn’t go down much (like California, Nevada, Florida and the like) but they didn’t go up either. That was during the 2008 recession. In 2013, prices went up 10% for a single year after five sideways years. If that constitutes a bubble, I’m Irish. In a real estate recovery, what do you suppose prices should do? Not only are prices not going to come down shortly, but they are likely to go up some more. In fact, Forbes (among others) predicts that prices in the Houston-Sugar Land-Baytown metroplex will grow about 24% over the next 3-4 years. So waiting on the sidelines will not help but rather hurt your efforts as an investor.

Second, if you are an all cash investor that does not utilize financing, the price you pay for a piece of property is the single determining factor in how that property will perform as an investment. But for the overwhelming majority of long term real estate investors, that’s not the case. They will put down a large down payment (20-25%) but will finance the rest. For that overwhelming majority, prices tell only part of the story. The terms of their financing tell the rest.

Here’s what I mean: Suppose there is a property that you can purchase for $150k today (and finance $120k of it at 5.25%) or you could wait a year and buy the same property for $127,200 (and finance 101,750 of it at 6.75%). Do you know that for cash flow purposes, the cost of both properties is exactly the same? And here’s the kicker – the scenario where interest rates rise 1.5% over the next 12 months is a lot more plausible than the possibility of prices dropping by 15% in the same timeframe!

Third, it’s very important to understand what happens to an investment’s returns in an environment of rising prices. There are two dynamics at play – On one hand, paying more for the same stream of income puts downward pressure on cashflow returns. If before you could get 12-16% cash on cash returns, now you’d be looking at 9-10%. But, on the other hand, suppose you acquire a property for $150k in January 2014 investing $35k out of pocket in the process. If by the end of the year prices rise a modest 5%, your return on investment from that appreciation for the year is over 20%! How? Well, when you purchase the property with 20% down, you invest only 20% of the amount out-of-pocket but reap 100% of the price appreciation. Therefore, that $7,500 increase in asset value (5% of 150k) represents a return of over 20% on your invested cash of $35k in addition to the cashflow return you realized. So, the same factor that compressed your cashflow returns is the same factor that caused your appreciation returns. To be fair, cashflow returns are different in the sense that they are reaped every year whereas appreciation returns require the sale of the asset to be reaped. But the goal of a long term real estate investor is maximum cashflow at retirement facilitated by capital growth until that point. In that context, this new environment of slightly lower cashflow returns and higher appreciation returns accomplishes the same goal via a different path.

The Biggest Challenge

That brings us to the crucial point of this article – the biggest challenge of 2014 for long term real estate investors. One Word: Supply. From where I stand, the ability to find and acquire assets to assemble your portfolio will continue to be the principal challenge for long term real estate investors this year. Over the last six months or so, my principal focus has been to find solutions for this challenge. And I am happy to report that I will be sharing some of those solutions with you in the coming posts. So stay tuned – it will be worth it.

Note:

After an avalanche of a fourth quarter and a major life event (we had a healthy baby boy in December), I have been absent around these parts for quite some time. I really appreciate that many readers have reached out and missed the regular writing. I can’t begin to tell you how much I miss it myself. Although mildly sleep deprived (sleep is overrated, anyway), I’m back on the saddle and I look forward to the discussions on the blog. Thanks for sticking around –

Investing Architect

February 3, 2014
How to find and screen tenants for your investment property
When you are trying to reach your retirement goals using a long term real estate investing strategy, there is a multitude of factors can make the crucial difference between success and failure. To mention a few, the quality of the location and school district, the price to rent ratios in your portfolio and the terms of your financing are all factors that lead to underwhelming results when compromised.

But if I had to pick one factor that all successful long term real estate investors must get right, one ingredient that is necessary for your portfolio to achieve its full income potential, I’d have to go with the ability to find and keep great tenants. Without great tenants, your dream retirement unravels into a hassle laden, vicious circle of vacancies, evictions and problem calls that typically keep skeptical inventors from investing in real estate in the first place.

With that in mind, I’m convinced that one of the greatest services we provide for our clients on a daily basis is the procurement of great long term tenants. So today, I wanted to share with you some pointers on how to find and screen potential tenants to find the hidden gems that will pay rent on time for a long time and take care of your property like it’s their own.

Before I begin, I want to point out something of outmost importance. The investment properties you buy generally attract (and essentially pick) the type of tenant you will eventually have. If you buy a property in a bad location, with high crime rates and low quality schools your applicant pool will consist of tenants that would want to live in that property. There’s no magic wand that would allow you to find great tenants for a low quality property. So, what follows assumes that the property itself is an investment grade property in a good location that would attract a well qualified tenant.

Now that we got that out of the way, let’s say you just closed on a great investment property and are anxious to find a great tenant (as 100% of investors are). How do you go about finding and screening applicants in a methodical and proven way?

First let’s tackle the “finding part”. At the outset you have to let the market know that you have this great property available for occupancy. Painfully obvious, I know. But you’d be surprised how many investors fail at this stage in a futile quest to save a few hundred bucks. In order accomplish this, your property needs to be listed/advertised/posted where potential tenants look for rental properties. That means your property must be listed on:
1. The MLS – A large percentage of the great tenant pool are relocations into the city where your property is located. These tenants are usually well qualified, have high paying stable jobs and they HAVE to move. So all the ingredients are there in a neatly wrapped package. Now the wide majority of these clients have agents who represent them that were assigned to them by the relocation company. Their agents aren’t going to drive by neighborhoods at random and see your red “For Rent” sign you bought at Lowe’s. If your property isn’t on the MLS, you essentially don’t exist for a large section of the very tenants you are hoping to attract.
2. Every Real Estate Portal – Your listing needs to be on every real estate portal that accepts lease listings: Zillow, Trulia, Hotpads etc. Do all these work all the time? Not really. But you are trying to cast a wide net and see what brings in the haul. The good news is that most MLS these days automatically syndicate to these portals. Or in the event the one in your city doesn’t, there are websites you can use to upload the property once and propagate it to all portals (i.e Postlets)
3. Craigslist – Finally, the godsend for landlords everywhere. After the MLS, Craigslist is the second largest source of tenants we have found. Your listing must be on Craigslist and it must be there as often as they will allow you to be there.
But the fact that your property is listed in these places, is as important as how it’s listed. In order for your property to stand out, you must have well lit, high quality pictures taken. If you don’t have a high quality camera and flash, hire a professional photographer. It will be the best Benjamin you ever spent. Pictures are crucial.

Last but not least, the ad for your rental property needs to resemble the ad for a job. Just like the employer paints a picture of the ideal candidate they would like to hire, so should you describe the exact tenant you are looking for in specific detail. Don’t be afraid to alienate the candidates that don’t meet your criteria (provided your criteria are reasonable and most importantly, legal). You’re not trying to generate interest for interest’s sake. You’re trying to generate targeted prospects that have a high probability of getting approved.

That brings us to the second part of the discussion: The screening process. Suppose that your marketing efforts have paid off and now you have lease applications from prospective tenants. What are the factors that will determine the eligibility of the tenant or lack thereof? In order of importance:
1. Rental History
2. Sufficiency of Income
3. Employment History
4. Background check
5. Credit Check
6. Pets
7. References
The prior rental history of the applicant is a great indicator of how they are likely to perform during your lease term. So in most cases, serious problems in the applicant’s rental history lead to the rejection of the application. What you are looking for here is at least a two year history of leasing properties with no issues. Any prior evictions, collections from previous landlords, lease breaches etc tend to indicate problems that are likely to repeat themselves so we avoid them every time. Other aspects of the applicants’ rental history that matter are the typical length of their prior leases and the rent amount they’re “used to paying”. If the history reveals a tenant that moves every 3-6 months, that might not be the best fit if you’re looking for a long term tenant. And finally, you want to avoid the effects of rent increase shock. A tenant that has been paying about the same amount of rent over a period of time is less likely to be shocked than a tenant that’s used to paying half the rent you’re asking.

Sufficiency of income is paramount to avoid future defaults, evictions and vacancies. In fact, one of the principal reasons that lead to evictions is the investors’ own carelessness in placing a tenant in a property they can’t afford. This may sound like overkill but what you need to do to determine sufficiency of income is to run a down and dirty budget for your tenant. How much of their gross pay do they take home? How much “disposable income” is left over after they pay your rent, utilities, food, gas, and monthly payments? If the answer is “not much” you’re one car problem away from not getting your rent paid. Why would you do that to yourself on purpose? So, to insure there’s enough income there to support the lease, we require tenants to make 3.5 times the monthly rent in gross income. Essentially, we want the lease payment to be no more than 28.5% of their gross pay. Last but not least, their income has to be reliable (salaried or base, not variable commissions) and documentable through pay stubs or tax documents.

Employment history addresses the probability that the income we’re relying on is likely to continue during the lease term. Typically, we look for at least 2 years in the same line of work (they can be at different companies as long as its the same job and level of income). Of course there are exceptions – for instance a recently graduated college student with a solid job offer letter for a reputable company.

The background check is another go/no go criterion. It must be clean of any issues that show character flaws (theft, violence, fraud, drug related issues and other serious criminal offenses). We look at small misdemeanors on a case by case basis. If its an issue that happened 20 years ago and the tenant has no issues since, that’s looked at differently than something that happened last week.

The credit check is a tricky one because investors tend to simplify the matter down to a credit score. I don’t agree with that approach. More important than the score is the story. Some credit reports tell the story of an applicant that’s always late on all payments. Others, tell you about a rough patch the tenant may have been through a while back due to a job loss or medical issues but also speak of solid payment history since then. The funny thing is, both candidates may have the same exact credit score. And I’d lease to the second (provided all the aforementioned criteria is in order) but not the first.

Pets are another issue that requires a lot of care. If you just purchased a quality property in a great location you might be tempted to categorically disallow pets to prevent damage to your property. The problem is, a large percentage of the “great tenant” pool have pets so by excluding them you’d be missing out on some great candidates. Besides, pets require a lot of care and dedication so in a way, the fact that your tenant may have a pet is a sign of maturity and stability. But on the other hand, some pets can cause a lot of damage to properties. So, it’s important to get this right. Usually, we go with a case by case approach on this. We place weight limits (40lbs) and total number of pets limits (2) as well as exclude breeds considered dangerous to eliminate liability. We also charge non refundable pet deposits for each pet to mitigate the risk.

Finally, you want to make sure that the information on the lease application is true and correct and has not been “enhanced” by the tenant to fit what you’re looking for. You do this by checking references. Check county records to make sure the listed landlord truly owns the property they leased and isn’t a friendly uncle. Then, call all previous landlords listed and ask open questions (not yes/no questions). After you’ve verified the information as correct ask them if they’d lease to the tenant again if given the chance. Repeat the process with their managers at work.

There’s no possible way to avoid all defaults and problems as they’re part of life (even qualified tenants can be laid off) but if you follow the advice I’ve just given you to find and screen great tenants for your investment property, you’ll reduce their occurrence to a minimum.

Juhan Sonin via Compfight
May 31, 2013
Houston housing market continues upward surge: Double digit gains in sales and prices
If you were expecting the Houston housing market to take a breather in April after the strong performance in the first quarter, you’d be very disappointed with the numbers reported by the Houston Association of Realtors. Instead of a pause, the market continued its uncompromising upward surge by posting double digit year on year gains in sales and prices. Below are the fundamental stats worth knowing:
- Single Family homes sold: 6482 (+ 27% from last April)
- Single Family average price: $253.9k (+14% year on year)
- Single Family pending sales: 4999 (+23% year on year)
- Months of Inventory on the market: 3.4 (-37% from last April)
- Bank foreclosures down 30%, now make up just 10% of total sales
- Townhouse and condominium sales + 31%
The storyline remains unchanged. In 2013, demand awoke from its confidence deficiency paralysis and realized that time was expiring fast on ridiculously cheap money. This awakening led to an acute inventory (supply) shortage which turned this market into a dog chasing its tail at a blistering pace and driving up prices in the process. The latest reported average sales price during April is the highest on record. To find a higher number of properties sold in a month, you’d have to go back to August 2007 and its pre-recession self. Just when you think suppliers of supply (builders, sellers and banks) might jump in, satisfy the demand and increase inventory, months of inventory on the market drop further to 3.4 months. And that’s citywide. If you zoom into smaller, popular pockets (i.e Woodlands, Memorial, Oak Forest/Garden Oaks), there’s even less inventory

Funny thing is, the Summer is just getting started.

Houston Association of Realtors press release

Jonathan Phillips via Compfight
May 29, 2013
April rental market report: Highest rents on record plus units leased soar 24%

Every year since 2007, the number of properties leased during the month of April had been 8-10% lower than the corresponding March figure.

This year, the Houston rental market shattered this well-established trend. According to statistics obtained directly from the MLS for investment grade rental properties, a total of 507 single family homes were leased during the month of April. That figure represents a 24% increase year over year and an 8% jump over last month.

The solid jump in units leased was certainly welcome news. But was this increase as a result of higher demand or lower prices? The numbers answered that question emphatically in April. Average rents climbed to $1578 per month – a 6% increase year of year and a 3% jump over March 2013. Not only that, but the April average rent is the highest rent on record. So clearly, organic tenant demand is the culprit not reduced rents.

Average days on market came in at a low 27 days – on par with both April 2012 and last month.

Available inventory of investment grade properties for lease dropped to 465 homes (down from 507 on April 1) on the back of the increase in units leased. When we look at the average units leased over the last 12 months, that number comes in right at 500 properties/month so there’s less than 30 days inventory on the market. The current supply demand relationship points to further strength in the rental market for investment grade properties in the months to come.

Houston Rental Market Report for April 2013

To view our interactive Houston Investment Grade Rentals (HIGR) Chart click on the chart image above.

May 2, 2013