Investing Architect

Author: Erion Shehaj

In the path of growth: Exxon’s mammoth campus under construction in North Houston

During the acquisition phase of your Blueprint real estate investing strategy, the temptation is to focus exclusively on well established neighborhoods. But as a neighborhood becomes more and more established, home prices rise and returns drop. So how can you get better returns without sacrificing quality?

You buy properties in the path of growth.

That well established neighborhood of today was at one point not so well established. Needless to say, investors that purchased properties in the neighborhood during that period paid considerably less money for them that you’d have to pay today. It makes perfect sense: At that time, the investment was riskier since no one could know for sure how the neighborhood would turn out. Therefore it was only right that the return should be higher as well.

So, how can we determine which locations and neighborhoods are going to be the popular neighborhoods of 10-15 years from now? More importantly, how can we avoid the misstep that the location we thought had promise doesn’t turn into a dog instead? To get the answers to those questions, let’s take a look a current case study.

Exxon Mobil’s mammoth campus

. There are over 20 structures being constructed on a 386 acre site west of I-45 just south of the Woodlands in what the Houston Chronicle is calling a “mini downtown”. The completion of the project is expected in the middle of 2015. When completed, the complex will house 10,000 employees, 2000 of which will be transferred from Fairfax, VA and the rest will be repurposed Houston employees. The company has already sold its Downtown tower and has put their Energy corridor facility on the market.

That’s great, but what’s that have to do with residential real estate? How does a commercial project of this magnitude impact future growth?

It’s Economics 101. Employment drives demand which in turn drives growth. At the moment, there are about 3000 construction workers dedicated to the project. When the project is complete, 2000 Exxon employees will be transferred from out of state and 8000 Houston employees will probably need to move closer to the area. But that’s not all. Because there are two kinds of employment: Basic and supplemental employment. Two thousand new Exxon jobs are basic jobs which in turn create a multiple of supplemental employment. Here’s how it works: When new jobs are created those families add to the local demand for housing and services. The need homes to live in, grocery stores to shop in, restaurants to frequent etc etc. So, builders will build more (and hire more construction workers), additional commercial shopping centers will be developed and businesses will lease more space. So, the added employment will create added demand which leads to local growth and higher home prices and rents over time.

I’d say the area around this massive project will look very different 10 years from now, wouldn’t you? We can’t know for sure as no one can tell what the future holds but we can be assured that big changes are coming. And we can get on the “train” before it leaves the station and prices get out of reach. We can do that a couple of different ways. We can purchase recently built resale and bank owned homes within a few miles of the project. Or we can build new and take advantage of the warranties and low hassle of a new home. The opportunities are still there even though they’re thinning out as builders and sellers alike try to take advantage of the very thing we’re talking about.

If you’d like to discuss how you can take advantage of buying investment properties in the path of growth as described above, you can call my cell at 713-922-2702 or contact me.

Steve Snodgrass via Compfight

April 25, 2013
Houston housing market: Inventories Shrink Further Pushing Sales and Prices Up in March
The housing market in Houston strengthened further and posted higher sales and prices during the month of March fueled by an ever shrinking inventory of properties. As usual, I want to give you the “espresso” version of the report with the numbers you need to know:
1. Total sales came in at 7006 properties (19% increase over March 2012)
2. Active listings on the market were 32,704 (down 22%)
3. Pending sales were 4433 (up 6%)
4. Average price was 236,195 (up 4%)
5. Median price was 172,000 (up 6%)
6. Inventory shrank to 3.5 months (down 38% over last year, and down from February’s 3.6 months, too)
I also want to share with you a couple of interesting statistics.

When the sales numbers are broken into price brackets, the only bracket that experienced decline in sales were properties under $80,000. Every other price bracket experienced double digit increases. Why is that? Well, it’s NOT because homes in that price range aren’t selling as well. It’s because homes in that price bracket are becoming fewer and fewer as the market as a whole rises.

Furthermore, when you think about homes under $80k, what’s the first thing that comes to mind? Foreclosures, right. Not all properties in that price range are foreclosures but most of them are. And there’s the second statistic I wanted to share with you. Bank owned foreclosures as a percentage of sales are declining substantially. During March, foreclosures accounted for just 12% of total sales – that’s down from the 15-19% levels we’ve seen this year and the 25% that’s been the norm during the period after the 2008 recession. And even the properties that banks are bringing to market usually come with higher price tags as banks seek to take advantage of the increased demand.

The biggest story these numbers tell continues to be inventory. At 3.5 months this is the lowest inventory level since 1999 and 34% lower than the national average of 4.7 months. The big question remains: What’s going to happen in the coming months? Can the Houston housing market continue to gallop at these levels and keep the inventory at current levels or will it level off and allow supply to catch up with demand? In the short term, I suspect that I will be writing similar articles about the market through the summer. Then I think the market will take a breather and slow down to a more sustainable pace. It certainly feels like demand is realizing that the train of low interest rates is leaving the station soon and no one wants to be left walking.

Alex via Compfight
April 18, 2013
Fine tuning your asset protection strategy for real estate investing

A few weeks back I wrote about how long term real estate investors can protect themselves from liability exposure.

That article argued that a wise investor that builds a great long term real estate portfolio must also build a strong impenetrable “wall” around it for protection.

A properly constructed asset protection strategy protects you in two primary ways. First, it protects you and your other assets from liability that might arise from your ownership of investment real estate. In that sense, it creates separation between your “personal” assets (primary residence, cash, stocks etc) and your real estate portfolio. Second, it protects your real estate assets from liability that might arise from your ownership of other real estate assets. In other words, it should prevent “liability contamination” within your portfolio.

The proposed solution to these issues is the utilization of limited liability companies as a holding vehicles. And to avoid triggering the due on sale clause in their mortgage, investors should setup land trusts. So far so good.

But after several conversations with current clients on that very strategy, I realized that there were still many unanswered questions. For instance:

Should each property have its own dedicated LLC or should you hold your entire portfolio in one LLC?

If you setup dedicated LLCs will you need to file taxes for each LLC each year and is that practical?

Will you lose important tax benefits like depreciation and tax deferred exchanges if the property is held in an LLC?

Let’s address each of those questions individually.

From a purely asset protection standpoint, setting up dedicated LLC for each property is the optimal solution as it covers both bases. It creates a separation between your personal assets and real estate portfolio as well as insulates your real estate assets from each other.

But from a pragmatic or practical standpoint it may be a bit overkill. For instance, in investment blueprints that involve the acquisition of 9 or more properties, that means there are at least nine LLCs, nine tax ID numbers and nine bank accounts to setup, pay for and maintain.

On the opposite end, you could put everything into one LLC and it would be practical and easy to setup. But while you would create a wall of separation between your personal assets and real estate holdings, a liability issue with one property could take down your entire portfolio. And your retirement plans with it.

So a good middle of the road solution is to hold about two to three properties in a single LLC. That way you protect from liability contamination within your holdings and keep it practical.

What about tax returns? Will you need to file taxes for each LLC each year and won’t that get cumbersome and pricey?

Actually, no. When you setup your LLC you are given an option to make an election for “disregarded status”. That means, the LLC will be disregarded for tax purposes and will not be required to file annual tax returns. The gains or losses from the properties held in these LLCs will just flow through to your personal tax return. It’s important for you to make this election otherwise you will question the necessity of your asset protection plan come April 15. You will save yourself a lot of headache and dollars.

Finally, for those who are concerned about losing tax benefits by holding properties in an LLC – there’s no need to worry. Whether you hold a property in your own name or in an LLC, depreciation and mortgage interest expenses are used to offset the rental income the property produces in a given year. Then, the resulting gain or loss simply flows through to your personal tax return and there its treated in accordance with your personal tax bracket and particular situation. One item of concern is that LLC aren’t allowed to perform a tax deferred exchange by the IRS. So if you are holding the properties in a trust whose beneficiary is the LLC, you should transfer those beneficiary rights and close the sale under your personal name. Then perform the 1031 exchange in your own name and transfer the new property into a trust yet again.

tropicaLiving – Jessy Eykendorp via Compfight

Note: I am not nor do I pretend to be an attorney. Which is why I direct all my clients to an attorney that specializes in asset protection. You should always consult an attorney prior to executing any asset protection strategy.

April 11, 2013
Fine tuning your asset protection strategy for real estate investing

A few weeks back I wrote about how long term real estate investors can protect themselves from liability exposure.

That article argued that a wise investor that builds a great long term real estate portfolio must also build a strong impenetrable “wall” around it for protection.

A properly constructed asset protection strategy protects you in two primary ways. First, it protects you and your other assets from liability that might arise from your ownership of investment real estate. In that sense, it creates separation between your “personal” assets (primary residence, cash, stocks etc) and your real estate portfolio. Second, it protects your real estate assets from liability that might arise from your ownership of other real estate assets. In other words, it should prevent “liability contamination” within your portfolio.

The proposed solution to these issues is the utilization of limited liability companies as a holding vehicles. And to avoid triggering the due on sale clause in their mortgage, investors should setup land trusts. So far so good.

But after several conversations with current clients on that very strategy, I realized that there were still many unanswered questions. For instance:

Should each property have its own dedicated LLC or should you hold your entire portfolio in one LLC?

If you setup dedicated LLCs will you need to file taxes for each LLC each year and is that practical?

Will you lose important tax benefits like depreciation and tax deferred exchanges if the property is held in an LLC?

Let’s address each of those questions individually.

From a purely asset protection standpoint, setting up dedicated LLC for each property is the optimal solution as it covers both bases. It creates a separation between your personal assets and real estate portfolio as well as insulates your real estate assets from each other.

But from a pragmatic or practical standpoint it may be a bit overkill. For instance, in investment blueprints that involve the acquisition of 9 or more properties, that means there are at least nine LLCs, nine tax ID numbers and nine bank accounts to setup, pay for and maintain.

On the opposite end, you could put everything into one LLC and it would be practical and easy to setup. But while you would create a wall of separation between your personal assets and real estate holdings, a liability issue with one property could take down your entire portfolio. And your retirement plans with it.

So a good middle of the road solution is to hold about two to three properties in a single LLC. That way you protect from liability contamination within your holdings and keep it practical.

What about tax returns? Will you need to file taxes for each LLC each year and won’t that get cumbersome and pricey?

Actually, no. When you setup your LLC you are given an option to make an election for “disregarded status”. That means, the LLC will be disregarded for tax purposes and will not be required to file annual tax returns. The gains or losses from the properties held in these LLCs will just flow through to your personal tax return. It’s important for you to make this election otherwise you will question the necessity of your asset protection plan come April 15. You will save yourself a lot of headache and dollars.

Finally, for those who are concerned about losing tax benefits by holding properties in an LLC – there’s no need to worry. Whether you hold a property in your own name or in an LLC, depreciation and mortgage interest expenses are used to offset the rental income the property produces in a given year. Then, the resulting gain or loss simply flows through to your personal tax return and there its treated in accordance with your personal tax bracket and particular situation. One item of concern is that LLC aren’t allowed to perform a tax deferred exchange by the IRS. So if you are holding the properties in a trust whose beneficiary is the LLC, you should transfer those beneficiary rights and close the sale under your personal name. Then perform the 1031 exchange in your own name and transfer the new property into a trust yet again.

tropicaLiving – Jessy Eykendorp via Compfight

Note: I am not nor do I pretend to be an attorney. Which is why I direct all my clients to an attorney that specializes in asset protection. You should always consult an attorney prior to executing any asset protection strategy.

April 11, 2013
The number one rule of investing

As the Sage of Omaha eloquently put it, the number one rule of investing is Don’t Lose Money. At first sight it is a blatantly obvious piece of advice although I suspect most investors don’t realize just how sophisticated it really is.

The Case Study

Allow me to share a hypothetical case study with you. Suppose you invested $100,000 in the S&P 500 on January 1, 2006. For the purposes of this example, there are no management fees or costs. During 2006, this index grew 13.62% so at the end your investment would be worth $113,650. The following year it was up 3.53% so your investment grew to $117,661. So far so good. But as we all know, 2008 was not a very good year. The market dropped 38.49% so now your investment value dropped to $72,385. However, during 2009 the market came back with purpose closing the year with a 23.45% gain and lifting your investment’s value to $89,359. And the rise continued in 2010 when the market was up 12.78% lifting your portfolio to $100,780. During 2011 the S&P 500 was flat so your value was unchanged.

In summary, during a six year spell, your investment had a flat 2011, four positive years with cumulative gains of 53% and one losing year where your investment lost 38%. So we should be up 15% right? Actually we’ve made a life changing $780 over 5 years. That ads up to two lattes a month! That’s before we consider the facts that over the same period, inflation “ate” over 15% of our investment’s purchasing power and stock market investments usually aren’t free of management costs.

The Explanation

How could this be? Because in all kinds of investing every step back is worth about two steps forward. Every loss of capital takes almost twice the gain to get back even. It took until January 2013 for the S&P 500 to get back to the 2007 high again! Six years to get your head back above water with the leaches of inflation at work the whole time.

I told you this was a hypothetical scenario but unfortunately this is the bitter reality that many people face all over this country. It’s how hard working folks come to consider pulling their hard saved money out of their Roth IRA after it sits idle for an entire decade as those same fund managers draw billions in fees.

How real estate investments are different

But wait a second, you might ask – real estate isn’t immune to capital losses. In many parts of the country real estate prices plunged at least as much as the S&P 500 in 2008. But there’s a huge difference between a stock portfolio that relies primarily on value increases (appreciation) and a long term real estate portfolio. Say you invested the same $100,000 in real estate in 2006 and it followed the same path as the stock portfolio. In other words, the value dropped substantially in 2008 then recovered back to the same amount by 2011. If you held on to the property through the whipsaw, your capital would be intact.

But the big difference is that throughout, your portfolio gave you a return of 12%/year independently of the value of the capital. So in this case, a real estate portfolio acted more like a dividend paying stock but with 3-4 times the return. Let’s face it – it’s much easier to ride out a bad market while making 12% a year in the interim. Not to mention that there were fundamentally stable markets all across the country that didn’t experience the value roller-coaster as much (or, at all).

Next

What’s Buffett’s rule number two of investing? Don’t forget rule number one.

Kevin Dooley via Compfight

April 9, 2013
Straight talk on investing in small multi family properties

“I know you are against investing in two to four unit properties – but that’s the direction I’m leaning in at the moment” – Theresa said somewhat tentatively.

The overwhelming majority of case studies or portfolio scenarios I’ve written about involve the acquisition of a portfolio of quality single family homes in great school districts. Therefore, it is not at all surprising that some of you might assume I discourage the purchase of other categories of investment real estate.

But the truth is I’m not against investing in any type of investment real estate. Nor do I have a bias to favor single family properties over all else.

So then, why am I advising clients to focus on single family homes when investing in the Houston market?

Our process to identify target acquisitions is deeply rooted in the principles of our Blueprint real estate investing strategy . In a nutshell, we look for quality, recently built properties zoned to great school districts that would attract long term quality tenants and offer solid returns.

To understand why small multi-family properties don’t fit that general standard, one must understand the concept of “highest and best use”. Imagine for a second that you are a real estate developer and you need to make some decisions on what to build on a vacant plot of land. If the land is a corner lot at a busy intersection with lots of traffic near the Galleria, you probably don’t want to build a home on it. There’s a higher and better use for that land than residential property. You might build a commercial shopping center or a single tenant building to house a Starbucks or a bank branch. Instead, if the land is a single lot on a residential subdivision, the highest and best use for it would probably be a residence of some sort.

Since the 1980, the Greater Houston area has experienced the full effects of urban sprawl. By and large, Houston residents don’t mind 30, 45 or 60 minute commutes if that means they could live in a great home with lots of space, 2-3 car garage and a yard. This has been a boon for real estate developers who found themselves with lots of cheap land and good demand for suburban properties.

But they were faced with an important question. If you had 1000 acres of land in Katy to develop residential housing, what was the highest and best use for that land? Should they build a community of duplex properties? Fourplexes? Or single family homes? Really, it was a demand question for the future homeowners that would occupy the properties. If you had a choice Future Buyer, where would you rather live: Duplex, fourplex or a single family home?

For over three decades, the result has been a resounding leaning towards single family homes. In fact, since the 1980’s, there has been very little new development of small multi family properties in the Greater Houston area. The ones that have been developed have quickly turned into outdoors apartment complexes with the wide majority of occupants being renters as owners have transitioned into single family homes.

So the first problem real estate investors face when looking for small multi family properties in the Houston market is a lack of recently built properties zoned to great school districts. What multi family properties exist in these areas are usually built in the 1980’s and bring with them the typical maintenance, repair and capital expenditure problems of older properties.

To illustrate the second problem investors face with small multi family properties, let me tell you about an actual case study. A long term client of ours purchased a four unit property from a bank that had repossessed it. This property needed work but had a lot of positives going for it. The unit mix was great: Two of the units were 2/2 and the other two were 2/1. These were large apartments (over 900sf each) and the building was across the street from three good schools (elementary, middle and high). The price was affordable too – $700 a month for the 2/2 units and $675 for the 2/1 units. Finally, the price to rent ratio was a favorable 5.6 (monthly rent was 1.5% of price) so the positive cashflow on paper promised a great return.

The second problem real estate investors face with small multi family properties in Houston is that proforma numbers don’t match real life numbers.

In order to qualify for a $700/mo apartment, a tenant’s gross monthly income has to be 3-3.5 times rent. So we were renting to tenants that made $24,000-28,000 a year in income before taxes. As a result, there isn’t a whole lot of disposable income there to save and absorb any major expenses (see: unexpected car repairs). To use a common term, our tenants were living paycheck to paycheck. I say this not in a denigrating way whatsoever as we all have been there and know what it’s like. I’m just stating the facts about the situation they face month in and month out. So, when those unexpected expenses showed up (as they usually do) the rent was late or unpaid. That inevitably leads to a much higher eviction rates and turnover of tenants.

The second wake up call came during showings. Prospective tenants weren’t as much interested in the unit itself as they were in the incentives I didn’t know we had to offer. Free rent, no deposit, deposit split into payments are all foreign concepts to those who invest in quality single family properties. Concepts that add much risk to the equation and reduce those paper returns substantially. More importantly, tenants in these properties do not usually commit to long term leases (or in some cases, violate existing leases) because they know there’s always someone offering a juicy incentive around the corner.

Furthermore, when you own a small multi family property you are most likely competing against larger apartment complexes for the same pool of tenants. In most cases, these properties have a competitive advantage over your duplex or fourplex. They can offer tenants amenities that you cannot (i.e. pool, on site management, gated community etc). They have more units so they can offer better incentives. So in the contest for the best apartment tenants they get first pick. And you get what’s left. Many of the applicants you will get have been turned down at the big apartment complex around the corner because they have a broken lease/background check issues/unapproved pets/insufficient income etc. So you are having to lower your tenant standards and keep a blind eye towards these issues if you want a full building. Which brings us to the third problem with owning small multi family properties in Houston – they fail to attract the high quality tenants that our strategy calls for.

Last, tenants that lease apartments have very different expectations of the responsibilities of the Landlord than tenants that lease homes. They expect the Landlord to fix every little thing that ever goes wrong with the property. Therefore, you must have an property management company actively manage the property for you. And when you read “actively” you should imply plenty of repair calls on a regular basis.

So you see, it’s not that I’m against any category of investment real estate. Our strategy lays out very clear acquisition criteria and we take what the market gives us and what the investor’s capital will allow. In Houston, there is no supply of small multi family properties that are recently built which would attract quality long term tenants and produce solid returns. In Houston, at the moment the market is giving us single family properties that fit all criteria and are within reach of the capital our clients possess. Once the capital base of our clients grows to critical mass, the market may give us commercial property with great business tenants. And we will surely make that transition when it’s available.

Other markets may be very different in this respect and small multi families might be optimal there. In that case, I’ll be the first to say, go ahead and invest. But before you pull the trigger please make sure that the property is in a good location and not just in a good enough location. Moreover, make sure that your numbers reflect reality. If you’re using the same assumptions for single and multi family properties, your numbers are wrong. Plan for higher vacancy rates, management fees, lost rent through incentives etc. Finally, make sure that ou have a clear understanding of how much attention a multi family property requires. If you think you can be an armchair investor with a small multi family property, you will find yourself off that armchair shortly after closing.

Matthew Rutledge via Compfight

March 29, 2013