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Smart Leverage or Perpetual Leverage?

September 24, 2011 By Erion Shehaj Leave a Comment

There comes a point in the life of every long term real estate investor where he has to make a critical choice. He has been cruising along assembling this great portfolio of real estate investments when he reaches a fork in the road. The question is, do you go left or right? That decision can be the drastic difference between losing everything or retiring early. Do you know which way to turn?

Photo Credit: Frans Persoon via Compfight

Case and Point

Let me paint a picture for you to illustrate exactly what I mean. Let’s say that it has been a good year for your real estate investing aspirations and you have been able to purchase three solid investment properties with all the right qualities. Properties were rented out within weeks of hitting the market, they are cash flow positive and you are enjoying the sweet fruits of success. You purchased them with 20% down and took advantage of never-before-seen low interest rates to leverage your capital and increase the value of the assets you control. This is where you see the fork in the road that presents you with two choices. If you turn left, you purchase more properties, leverage your capital even further and pursue an increase in positive cash flow until you reach your desired income level. If instead you turn right, you use the positive cash flow from the properties along with additional capital of your own to pay off the mortgages on the properties in your portfolio. The answer is as much a question of math as it is a question of investing philosophy. To figure out the right answer you have to understand what leverage is and what it does to your portfolio.

What is Leverage?

Leverage is a tool that allows a real estate investor to acquire many times the asset value than they otherwise could if they paid cash. For instance, if an investor had $100k in capital they could purchase one $100K property if they paid cash or purchase $500k worth of property if they put 20% down on each. Why does this matter? It matters because in the event that each of the portfolios experiences 5% appreciation in value, that translates to $5,000 increase for the cash investor and $25,000 increase for the leverage portfolio. In other words, by increasing the asset value in the portfolio five fold, you increase the return on that portfolio five fold as well.

That’s the good aspect of leverage. Leverage also adds significant risk to your portfolio. The investor that owns one $100k property outright may not experience tremendous growth when things are going well. But on the flip side, if the market isn’t doing well, that investor could weather the storm better because they don’t have to make mortgage payments. Also, if property values are declining instead, leverage multiplies the value loss five fold as well. So leverage is definitely a double edged sword.

Two Options

Back to our fork in the road. If you decide to turn left, purchase more properties to increase your positive cash flow until you reach a point that your income exceeds your expenses, you are opting for perpetual leverage. In other words, you are constructing a portfolio with more cash flow, more debt and more risk. By opting for cash flow now, you are conceding that your portfolio will be encumbered by debt perpetually. And yes, I’m aware that it is a 30 year mortgage but let’s not kid ourselves, those properties will be traded for yet another debt encumbered property long before the 30 year mark. If instead you turn right, utilize the current cash flow to fuel and accelerate the debt payoff on your portfolio, you are using smart leverage. In other words, you are using leverage as a tool to get you from $500k in debt encumbered asset value to $500k in paid off properties in a short period of time therefore reducing the inherent risk that comes with it.

Answer

The ultimate answer depends on your investing philosophy. If you have a high tolerance for risk as long as it comes with higher returns then you opt for perpetual leverage. Instead, if you are conservative and like to take calculated risks for solid predictable returns you choose smart leverage. However, if you are building a real estate portfolio for retirement, there can only be one right answer: Smart Leverage. For two reasons. First, even the best “lever” can snap if used in perpetuity. And most importantly, can you imagine retiring using a portfolio with enough cash flow but millions of dollars in debt? There isn’t a sleeping pill strong enough.

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Even better, why wait until you get to that fork in the road? Let’s talk beforehand so we can lay out a Blueprint strategy on purpose so you know the path to follow. My cell is 713.922.2702. Have a great weekend!

Getting an early start

September 14, 2011 By Erion Shehaj Leave a Comment

Martin came to us referred from a personal friend and previous client of ours in the fall of 2009. He was in his late twenties, had graduated from college with an engineering degree about five years back and started working for a national consulting firm in the East Coast. He was a saver who had heard about the benefits of real estate investing in Texas, had a well defined set of goals, as most engineers do 🙂 but was looking for a pathway to achieve them. What follows is a case study of the Blueprint investing strategy I crafted for him, the execution of that strategy and most importantly the results it produced. If you identify some of yourself in these lines, it is my hope that this story can shed some light into what’s possible with a well structured, long term investment strategy and flawless execution.

Recalibrating his aim

On our first phone call, all he could talk about was cash flow. “I want to buy four investment homes in the next two years, rent them out for positive cash flow. I want to build enough cash flow, so I can do whatever I want and live off the cash flow”. You get the gist. So, we had to have a come-to-Jesus meeting. We started focusing on the “Why and When” rather than the “How”. It was immediately evident that Martin wanted to put together a solid portfolio of real estate investments that would produce enough cash flow at some point in the future to make him financially free. Just like it became painfully obvious that he didn’t need the positive cash flow right now to subsidize his income or pay his bills. He was right to want cash flow. It was the timing that was misconstrued.

The Eureka! moment came when I proceeded to explain what his beloved cash flow truly was: the return on capital. For instance, if you have $100K in available capital (a.k.a cash) and you invest it in a real estate portfolio that has a return on investment of 15%, your cash flow will be $15,000/year. While it does give you the ability to thump your chest that you’re out earning your friends’ 401Ks and CDs, $15K isn’t exactly financial freedom. So how do we achieve retirement or financial independence through real estate investing? We have to grow the capital first, to increase the amount of cashflow we draw on it later. If we managed to grow our capital from $100K to $400K, that same portfolio would return $60K/year. Sounds like we’re getting closer, doesn’t it?

Laying out the Blueprint

How do you grow your investing capital from $100K to $400k in 10 years? You execute the Blueprint. Over the next 24 months, Martin was to acquire four investment properties strategically located in specific areas with excellent schools, location and access to attract a good tenants. Two of the properties closed in 2010, the other two in the first quarter of this year. They were all leased out within four weeks of being placed on the market. Average price of the properties was $100K. Below is the actual breakdown on one of the properties:

Looks pretty good, doesn’t it? Funny thing is, the true magic lies into what comes next. If you put together a portfolio of four properties that have more or less the same numbers as the above breakdown, you have created $1600/mo in positive cash flow. Since our goal is to grow the capital now so we can draw a greater return (cash flow) on it later, we will put the current positive cash flow stream to work. The goal is to accelerate the payoff of the debt on the portfolio by executing a laser focused domino strategy. That is, we apply the positive cash flow as additional principal payment to pay off the mortgages on the properties one at a time. To use the example above, an $82K mortgage would be paid off in 44 months (little over 3.5 years) if we paid an additional $1600/mo toward the principal. This is when the dominoes start falling even faster. Now that the mortgage is paid off on that property, your available cashflow to “attack” the second property increases to $2,038/mo. At that rate of principal payments, the second property is completely paid off in 35 months. And so forth.

When Martin is done executing this Blueprint, his entire portfolio is projected to be debt free in 11.2 years. If we don’t account for any property appreciation, his real estate investment portfolio would be worth 4 times what he started with at a cool $400k+. If rents don’t increase one penny in 11 years (highly unlikely), Martin would collect over $40K in annual cash flow. All of that before his 40th birthday.

Are you ready to get an early start on your real estate investing? Let’s talk. Call me at 713.922.2702

Photo Credit: RonanCantwell

Why foreign investors should flock to Houston real estate?

September 6, 2011 By Erion Shehaj Leave a Comment

Government efforts to shore up the U.S economy after the global recession of 2008 have brought about a unique economic climate that’s extremely favorable to well-capitalized foreign investors. The substantial fall of the U.S dollar along with an ample supply of great investment properties at bargain basement prices have been turning investors’ heads towards the US for a couple of years now. But a strong local economy that produces good paying jobs and healthy tenant demand, the ever falling U.S Dollar and superior affordability make Houston the place foreign real estate investors should look into first.

Strong Houston Economy

The ultimate foundation for long term real estate investing is a healthy supply of great tenants. But one can’t be a great tenant without well-paid stable employment. Texas leads the country in jobs creation with over 251,000 private sector jobs created just in the last year. About 1000 people move to Texas every day due to plentiful job opportunities, low cost of living and low taxes. Smart foreign investors can strategically invest their capital in properties that will satisfy the demand from this inward migration thus insuring great returns on capital and minimal vacancies.

Parachutist Dollar

Take as an example an Australian investor with 500K of Australian dollars in capital to invest. On January 1st 2006, that capital could have purchased $368K worth of real estate in the U.S. Today that same amount of capital can purchase $530K of real estate, or 30% more. Or put differently, this Australian investor could purchase the same asset for 30% less than a U.S investor using American dollars. Although, not as drastic, the same is true with Canadian (20%) or European investors (14%) The mighty fall of the U.S currency due to steroidal levels of stimulus is a beautiful thing to a foreign investor.

Unique Property Characteristics

Houston offers a unique blend of property characteristics to foreign investors that is hard to find in other parts of the country. Here, you can purchase a great investment property located in a superb community with excellent schools, shopping and access, recently built (after 2000) for anywhere between $90-$140K depending on location and condition. What’s amazing is that these properties are being sold at prices that are below their replacement cost. That means, it would cost you more to rebuild that same exact home today. That offers strong growth opportunities long term. By being able to purchase great properties for less, foreign investors can make their capital go further and increase the yield on their investment.

In the next post, I will cover a realistic scenario of what cashflow and returns a foreign real estate investor should expect when buying an investment property in Houston.

Photo credit: Christian Haugen

Why Equity Doesn’t Matter

July 4, 2011 By Erion Shehaj 4 Comments

If you were to ask a thousand aspiring real estate investors what is the key to a successful real estate investing strategy, I am certain that over 70% of them would say: Buy low, sell high. That answer reflects a very common misconception that the primary key to success in long term real estate investing is the amount of initial equity you get by buying the property below its current market value. Or put another way, “you make your money when you buy the house”. I am sure you’ve heard that one before. Well, in this post I will show you why (initial) equity doesn’t really matter when you are a long term investor. Not only that, but I will prove to you that chasing equity might lead you down the wrong path.

Using the wrong measuring stick

The first issue with using initial equity as a criteria to select investment properties is that it doesn’t align with your goals. Comparing the purchase price of the property to its current market value is only useful if you intend to flip the home two months from now. In other words, current equity is a short term indicator when your focus is long term. Your primary concern should be what that property will do in 5, 10 or 15 years not what it’s doing right this second. Quick arithmetic problem for you. Investor A purchases a property 20% below its current market value in a subpar neighborhood that over the next 10 years will only see 2% annual growth. Investor B purchases a property at market value in a fantastic neighborhood that over that same time period will see 4% annual growth. Who do you think will get to the “train station” faster? Exactly. Understanding this is crucial because your ability to maintain your focus aligned with your long term goals will make or break your strategy.

The opportunity cost of chasing equity

The second reason why equity doesn’t matter is that in chasing properties with “built in” equity, you miss out on other opportunities and your results will suffer from it every single time. When you make equity a prerequisite, you eliminate the majority of excellent properties from contention before you even get started. All under the justification that the deal just isn’t good enough, right now. My friend, you are missing the forest for the trees. When we devise long term strategies (Blueprints) for our clients, by the time everything is executed the client ends up with a million dollars (or two) in paid off assets and fantastic annual income. And you are willing to compromise that over how much? I rest my case. Fight the urge of one dimensional thinking and consider all factors that make a property a great investment. Smart investors pay a fair price for great properties in good condition and even better location. And their long term results thank them.

Playing not to lose

A common rationalization investors use for exclusively going after properties with built in equity is that in the event they had to sell quickly, they could get out and make a profit. My question to those investors is: Are you playing to win or playing not to lose? Because there’s a tremendous difference between the two. By the time you hedge against all the “what if”s that your mind can conjure, you end up with a crippled strategy. Look, I understand that they are trying to be cautious and covering all bases. But being a long term investor requires the discipline to not sell when the market fluctuates intermittently and keep your eyes on your prize. Fact: Prices will go up and down in the short term. They always have and they always will. But over the long term, the track record for Houston real estate is clear. One of the great benefits of a solid long term strategy is that it allows the flexibility to exit the investment when conditions are most favorable. Once you decide you are in for the long haul, execute your strategy and watch it produce results unfazed by news chatter and temporary fluctuations.

There’s a reason why it’s below market

Last but not least, that cherished equity doesn’t come without a price. Ever considered the reasons why banks would sell a property so far below it’s fair market value? After all, they do get an opinion of property value (appraisal) from the agent they will use to list the property. The agent will compile a report with comparable sales of similar properties in the same neighborhood so banks know exactly what is the fair market value of the home. The answer is they strongly consider the condition of the property and the required repairs that are needed it to bring it back to par. By the time you are done calculating the cost of repairs and the value of the time spent getting quotes and rehabbing, that illusory equity has all but evaporated.

Moral of the tale: Don’t use a short term criterion to select long term investment properties. It’ll cause you to miss out on the Big Enchilada because of Small Potatoes. Instead, use a disciplined approach, keep your eyes on the prize and execute.

Happy 4rth of July and be safe.

Photo Credit: janGlass

Decidere

July 1, 2011 By Erion Shehaj 1 Comment

For the past week, I’ve been reading a terrific book by Tim Sanders called Today we are rich and I can’t seem to put it down. The book is a goldmine of brilliant ideas that mostly came from his Grandma’s sage advice. But what I want to focus on in this post is when he explains what it means to make a true decision:

It’s important that once you’ve made a decision, you don’t give it another thought. The word decision stems from the Latin word decidere, which means “to cut off.” Making a real decision “cuts off” all other options or alternatives. Once you’ve made your decision, there’s nothing left to do but execute (emphasis mine)

Sanders, Tim (2011). Today We Are Rich (pp. 83-84). Tyndale House Publishers, Inc.. Kindle Edition.00

Sanders seems to be channeling his inner Tony Robbins that in Awaken the Giant Within said:

Part of the problem is that for so long most of us have used the term “decision” so loosely that it’s come to describe something like a wish list. Instead of making decisions, we keep stating preferences… Making a true decision means committing to achieving a result, and then cutting yourself off from any other possibility.

Robbins, Anthony (2007). Awaken the Giant Within (pp. 38-39). Free Press. Kindle Edition.

People often fail to make a decision and act on it because they’re afraid of making a bad decision. Know this: Even worse than making a bad decision is making no decision. So, do your homework, ask all the questions, check all references. But once that’s done, make a decision and cut off any other possibility. The results you will achieve and experience will change your life.

Good night.

How to find a great investment property

June 30, 2011 By Erion Shehaj 7 Comments

Last week, I was having lunch at Houston’s in the Galleria with an old friend that I hadn’t seen in a while. After some catching up, he revealed that after 15 years of two steps forward three steps back, his retirement had grown by just $10K. Not good. So, he was strongly considering investing in real estate long term (good call!) but just didn’t know where or how to start. That’s all the invitation I needed – The notepad was out and over the next two hours (that felt like 15 minutes) I laid out what I thought was the right strategy for his goals. I could see the “gears” in his mind spinning faster than the RPMs on a Maserati. It all made sense to him. Then he asked THE question: How do you find a great investment property? It’s a great question I get every single time with an investor that’s just starting out. The following is my response to that question.

At the heart of it, the answer is based on supply and demand. Essentially, you are trying to purchase an asset (supply) that will generate rental income based on how desirable it is to prospective tenants (demand). So the answer will depend on the answers to the following questions:

What are tenants looking for in a property to lease?

Try putting yourself in a tenant’s shoes for a moment. Why are the reasons you are making the move from an apartment (or living with family) to a home?

School District – Tenants want their children to attend the best public schools that their budget will allow. So we start by looking a school district rankings, parent reviews etc. Note: The quality of the school district is not negotiable for a long term real estate investor. This is a mistake that investors without an overarching strategy make often by chasing cheap homes that come with lousy schools.
More Space – Imagine living in a 700 sf apartment with your spouse and a little one on the way. Or, picture your stuff bursting at the seams in that 400sf of rented space. Tenants often move because they want some more space to stretch out, maybe a backyard and a garage. So you look for properties that have at least 3 bedroom 2 bath 2 car garage and 1500Sf+ of living space with a reasonable yard.
Good Location – Proximity to workplace, access to major thoroughfares, availability of shopping, dining and entertainment are all factors that tenants take into account when leasing. So it would make sense to acquire properties in neighborhoods that are well appointed, close to highways and tollways with lots of grocery stores, restaurants, movie theaters and the like.
Neighborhood Amenities – In addition to leasing a home, the tenant is seeking the lifestyle that the home provides via neighborhood amenities. Community pools, playgrounds, walking trails, lakes etc. are what attracts good tenants and keeps them staying in your property longer.
Floor plan – Last, the functionality of the floor plan and the way it flows deeply affect the tenant’s immediate interest in their first visit to the property. You can get by with what I call a “unit”, basically a box, but that’s not smart in the long run. And remember, you can’t remodel floor plan unless you want to get into the construction industry

What are you looking for in an investment property?

All the criteria mentioned above is very important but in the end it’s got to make business sense

Growth Potential – You want to purchase a property that will not only preserve its value but appreciate in value over the long term. This is where most of what your prospective tenants want overlaps with what you need. If you purchasing a property with a nice floor plan within a great school district, well located within a neighborhood with great amenities will ensure that you capture the most appreciation over time. Don’t forget: Growing your capital is first priority within your Blueprint (long term strategy).
Cash flow– The final destination of your plan is about passive cash flow and lots of it. Whether you try to create intermittent cashflow to accelerate the growth of your capital now or income to live comfortably once the Blueprint is executed, you’ve got to manage two aspects:
1. Balanced Operating Costs – You could achieve everything a tenant wants in a great property by purchasing a $600K home in The Heights but it would make a horrible investment property for you. The operating costs: Taxes, Insurance, Vacancy etc. in that property are much too high. Most importantly they’re imbalanced vs. the rent you stand to get in those areas. In other words, it would take $6,000/mo rent to make that work and the chances of that are zip. Well balanced operating costs vary in the 40-50% range depending on the home. That will limit the home price to $100-$170K in the Houston area depending on location.
2. Low maintenance Costs – You want to keep your maintenance costs as low as possible and you achieve that by purchasing properties that are recently built. The reason is, you don’t have to replace major systems, roof, A/C, plumbing in a property that’s five years old. If I had a dime for every time I see an investor purchasing a cheap 70s home then complaining about excessive repairs …
Low (or No) Vacancy – Here again you can orchestrate a win win by purchasing a property in an area where there’s high tenant demand with great amenities. Also, setting a fair price and reasonable rent increases help maintain the vacancy low. Last but not least, being very selective with whom you decide to lease the property can make the difference between turnover and no vacancy for 3-5 years.

The identikit of a great investment property

Ben Stein said it best: In order to get what you want you first have to know what you want. In working with numerous clients, I’ve found that coming up with an identikit, that is, a rough sketch of the characteristics the property should have makes the process of identifying the property a lot easier. Great investment properties are found in the intersection between what tenants are looking for in a great property and what the investor needs for the property to make business sense. By blending some of the property characteristics that prospective tenants want with some of the business characteristics of what you need, you will select a winner every time.

I have the experience and know-how to show you and help you find a great investment property to start or expand your portfolio. Call me on my cell at 713.922.2702 and let’s talk.

In this series of posts so far, I’ve addressed how to prepare and position yourself for your first investment property purchase and how to find investment properties in Houston. Next, I’m planning to write a “meat and potatoes” post about how to properly analyze an investment property. Don’t touch that “dial” (whatever that means) 🙂

Photo Credit: HokutoSuisse