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Real Estate Investing Rules of Thumb are Dumb

April 23, 2018 By Erion Shehaj 1 Comment

You can’t escape it. Everywhere you look – in online forums, blog posts even books – you will run into real estate investing rules of thumb that promise you an escape from doing boring, old-fashioned analysis.

There’s the “world famous” 2% rule: The monthly rent on a good investment property should be at least 2% of the purchase price. As long as the rent is 2% of the purchase price, your analysis is done. You set out on your quest to find these unicorn properties that abide by this golden rule. Single-family properties that sell for $150,000 and rent for $3,000 a month? Got it. Small multifamily properties that sell for $380,000 and bring in $7,600 per month in rent? Sure. I have some good news and some bad news about the 2% rule. The good news is that should you find such a deal you should jump on it because it is an absolute steal! The bad news is that such deals are at best, fossilized remnants of decades past and at worst, pure fantasy.

Then we have the reformed 1% rule: The monthly rent on a property should be at least 1% of the purchase price. Not as radical to be sure but you keep looking for properties that fit into that box and you find yourself being pushed to lower and lower quality neighborhoods. Properties in these neighborhoods attract more problematic tenants that lead to evictions and turnover and expenses. In the end, you have a terrible investment experience and your actual returns aren’t that good when it’s time to face your accountant and year-end.

Last but not least, the 50% rule: You can safely assume that operating expenses on your property will be 50% of your gross rent. No need to figure out actual expenses or put boots on the ground. The magical 50% has you covered. Then you realize that it’s much more complicated than that. Are you managing the property yourself or do you have a property management company? Is it an older property that requires lots of capital expenditures or a newer property that needs very little? Is the owner responsible for any utilities or are they all covered by the Tenants?

Look, I get it. There’s an allure to the simplicity of these shortcut rules. They offer an escape from the boring analysis, the mind-numbing figures, and the time-consuming due diligence. Furthermore, they can provide a template lens through which to view potential investment opportunities.

But in the end, real estate investing rules of thumb are the realm of amateurs and they’re a poor replacement for solid analysis. There’s no shortcut to actually looking at operating expenses and estimating vacancy and repairs. There’s no getting around learning the market and figuring out what price to rent ratios it offers for each type of property at this point in time.

Even worse yet, rules of thumb can provide an arbitrary filter that can keep you out of the investing game when the opposite is the preferred course of action. Rules of thumb can establish rigid anchors in your thinking and ultimately prevent you from achieving your goals.

If you don’t know how to do due diligence on a prospective property that should be the first thing on your agenda to learn. Skip the analysis and due diligence at the peril of your investing results.

How to assemble a “judgment proof” asset protection strategy – A comprehensive guide

September 28, 2016 By Scott Smith 2 Comments

Note: Today I have the honor of welcoming Scott Smith as an expert guest contributor to Investing Architect. Scott is an Attorney that specializes in asset protection strategies for long-term real estate investors. He is a real estate investor himself and uses the same strategies he will share with us to protect himself and his portfolio. What I admire most about Scott’s writing is that it is all substance and no fluff. Enjoy!

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*** This information is not legal advice and I am not your attorney***

A proper asset protection strategy protects your net worth even if you are sued. Below, I will share with you the secrets that will have you sleeping easy at night and going about your business as usual even when you’re being threatened by a lawsuit. You won’t have to worry about what will have your friends aging overnight. After implementing a proper strategy, lawsuits will never even get filed and the problem is gone before it begins.

Asset Protection for real estate investors is premised on two parts:

Isolating the assets for liability purposes inside of a Holding Company and
Hiding the assets from being connected to you or the Holding Company

Additionally, this company structure is scalable at no additional costs or fees, streamlines your taxes, can be used in conjunction with traditional financing, and allows for the traditional recording keeping you are already using.

After it is set up, you won’t even notice it’s there in your normal course of business.

Which type of company should I use to hold my investment real estate?

The best holding company for real estate asset protection is the Series LLC. You can think about the Series LLC as a Parent – Child relationship. The Series LLC is the Parent, and it can have as many children as it wants. Each child is known as a ‘Series’.

Even though the Series LLC is technically one company with one filing with the state and one tax return, each child ‘Series’ is treated as if it were its own LLC for liability purposes.

Each Series is typically designated with its own letter, e.x. Series A (See the picture below). This means that if a lawsuit is filed against Series A, it cannot affect Series B, Series C, etc. A lawsuit against Series A can only affect the assets held in Series A.

In the diagram above, the REI Asset Holding LLC has three Series. Each Series has only one property held by it. REI Asset Holding LLC – Series A owns a single asset, a piece of Real Property located at 123 Main st. As such, since Series A only holds that single piece of real property, a lawsuit against Series A does not jeopardize the real property located at 456 Main st. or 789 Main st.

Moreover, if there was a lawsuit against the owner of the parent REI Asset Holding LLC, that lawsuit could only collect against the assets of the owner and not against the assets of REI Asset Holding LLC. In this way, a lawsuit against the owner of the LLC does not affect his or her assets. [1]

How to stop a lawsuit before it starts

The Series LLC limits our downside risk in the event of a lawsuit since it limits the maximum amount we can lose, the amount held in the Series. However, limiting the amount of the lawsuit is our last resort. What we want is a protection system is that stops the lawsuits before they are ever filed.

To stop a lawsuit before it is filed you have to take out one of the three essential pillars of a lawsuit – what you need as a litigator to make a case worthwhile:

The law
The facts
The recovery

The law and the facts are generally easy to fabricate, and any decent lawyer can find a basis for a lawsuit that will survive summary judgment. The asset protection system I put in my place for my clients attacks the third leg, the recovery. The recovery is the ability to seize assets and get paid after you win a judgment. A judgment is worthless on its own, it is only a piece of paper. It is only as good as the assets you can seize with it.

So, before a case is filed an attorney will always research whether there are assets which he can seize from the defendant in the case that he wins. If it appears that the defendant has very limited or no assets, then in all but the cases but personal self-righteous vindication will the lawsuit be foregone.

To show the opposing side that there will be no recovery from the lawsuit we hide the assets using Anonymous Trusts. These Anonymous Trusts can own the LLC itself as well as serve as Title Holding Trusts for the real estate asset.

The LLC typically must disclose the members of the LLC on the filing instruments called the Articles of Incorporation. However, the member listed on the filing can be an Anonymous Trust. Since the Anonymous Trust is a private document and it is not filed with the State, anybody researching the Owner or Beneficiary of the Trust will be unable to find that information in the public records.

Additionally, anyone researching the owner of the real estate asset by searching the County Clerk records will only find the name of the Anonymous Land Trust. Typically, the property owner’s name is listed on the County Clerk’s records, but in this case, the owner of the property would be listed as the 123 Main St. Trust. Since the Owner of Trust and the beneficiary is not registered with the state, they cannot find out that the Series LLC is the beneficiary of that Trust.

For the purposes of clarity, I refer to the Anonymous Trust used for the purposes of filing the LLC itself as the “Filing Agent Trust” and the Trust used for holding the real property as the “Anonymous Land Trust”. The Filing Agent Trust in the below example is the actual owner of the Series LLC.

What should I expect for tax planning

The taxation structure with the above entity is typically done in one of two ways depending on the number and type of owners. If the owner is a single individual or a married couple, then the entire structure is a pass-through entity and the investor owner(s) simply report the income on their personal income tax return under Schedule E. If the owner-investors are unmarried, then the LLC will need to file a partnership tax return.

Financing inside of a company structure should only be done once traditional personal financing is exhausted. Traditional financing is typical with better, cheaper terms than the commercial financing required if the property is purchased directly in the name of the LLC. Once the property is purchased in your personal name, the property will need to be deeded into the company structure. Deeding the property into the company structure will violate the Due On Sale clause located in the mortgage; however, we have not seen a bank foreclose based upon the Due On Sale clause since before 1960 as long as the payments are made. I hear of lots of threats, but I have not seen any banks actually do it.

How do I make sure my LLC is not “pierced”

There are several things you must do to keep an LLC from being pierced:

Filing franchise tax
Having an operating agreement
Managing the money correctly

Where I see most of my clients drop the ball is in money management and record keeping.

The recording keeping of the above structure is likely very similar to what you already do for your basic accounting of the investment. For any investment, you need to know the profitability of the particular asset purchased, so you need to have records which reflect the amount of capital invested in the asset, the amount earned by it, etc.

The Series LLC structure above will require you to maintain the records of each Series separately just as if they were separate companies. In many cases, all this requires is for you to “tag” the entries in your QuickBooks so that the entry is shown in correlation to the specific company. If you do not use QuickBooks and instead use an excel spreadsheet, then be sure to add a new entry any time you add or withdrawal money from the bank account for the company. If you forget to do this a few times it is not the end of the world. You can always go back after and “catch up” on the accounting. The Court will allow this as long as it is “reasonable”: nobody expects you to be perfect, but don’t abuse it.

***Note: This information is not legal advice and I am not your attorney***

[1] Please note that this is not true in all cases, but it is the case per the Business Organizations law for Texas companies.

Capital, Income and Net Worth are not the Goal

September 20, 2016 By Erion Shehaj 2 Comments

Have you ever had that experience where you set an important goal for yourself, get intense about achieving it, work hard and grit your teeth to push it over the finish line and when you arrive there’s absolutely no joy? Just a whimper.

I have – and it feels like you just ran a whole marathon only to find out that the actual marathon isn’t until next week. And you were wondering why participation seemed so low this year. You get the wind knocked out of you and all that’s left is a deep disappointment and lack of direction.

The reason why you feel no joy about the achievement of a goal that you thought you wanted is because your inherited someone else’s goal and tried to make it your own. But it never was because there was no alignment between that goal and what matters to you. Here’s how you can tell if you’ve set such a misaligned goal: The aim of the goal is the accumulation of resources not what those resources will do to better your life.

Think about it this way: Imagine you are a farmer and your family is the most important thing to you and your mission in life is to take care of them. In order to do so you need your fields plowed, planted and harvested and for that you need tools. So you set a goal to accumulate the tools you need to take care of those you value most. You work hard, take extra jobs, pinch every penny you can and get obsessed with getting those tools. So much so that you have forgotten why you were getting the tools in the first place. You are laser focused and hellbent on getting those tools – whatever it takes. Then finally one day you reach your goal and you find yourself sitting in a still unplowed, unplanted and unharvested field, surrounded by all these tools you worked so hard grappling with this deep sense of disappointment and wonder if it was worth it.

Capital, Income, Net Worth are just resources, essentially tools. They’re the means to an end not the end itself. If you want to set goals that are aligned with what matters, you must spend more time thinking about what you value and how the resources you accumulate will help you improve and take better care of those people and causes that are important than obsessing over the tools. If you set a goal to make a million dollars because that’s what you think a meaningful goal looks like I have news for you. There’s no joy at the end of that rainbow. No amount will make you happy on its own. Perhaps there will be a brief high and ego boost but once that’s gone, there’s nothing left but the residue of disappointment.

Instead think about what that million dollars will allow you to do and design in advance the life you could create with those resources. How will that million dollars help you take better care of your family or start that business or travel for an extended period of time or …

The best part is that you get to decide what’s important. The most important part is that you don’t lose sight of it.

Why property taxes rise on your investment properties (and what to do about it)

September 13, 2016 By Erion Shehaj 1 Comment

Sometime in March, county appraisal districts across Texas have an epic party. There’s loud music, dancing, cake, party hats and party horns. Oh and they send out the new property tax appraisals to property owners.

Coincidentally, around the same time of the year, I receive numerous calls and text messages from clients. “Ouch”, “Getting killed over here” and “This is out of control” are some sentences that may be uttered.

I’m trying to make light of it, but truth be told ever increasing tax appraisals are no fun. They take a bigger bite out of your incoming rent and reduce your positive cashflow. On average, operating expenses account for 40% of incoming rent and property taxes account for 65% of operating expenses. Therefore, they’re the principal driver of those expenses. So when you have years like 2013-2015 where average property appraisals went up by 10-15% per year to track a similar appreciation in property value, the impact will be felt.

I wish I had a magic strategy that you could put to work and reduce your property taxes right away but unfortunately my supply of fairy dust is depleted. But I would like to offer some thoughts and tips on the subject.

Property appreciation and tax appraisal appreciation go hand in hand

Some real estate investors are focused primarily on cashflow while viewing appreciation as a welcome bonus. However, cashflow and appreciation don’t exist in a vacuum, they are interrelated and they impact each other. For instance, when property values rise (a welcome outcome for any investor) property tax appraisals rise and positive cashflow drops. But in fact, what’s happening is a transfer of returns from cash on cash return to appreciation return. For instance, let’s say you own an investment property where you have invested $40,000 and it produces $3500 per year in positive cashflow (8% return) in a year during which property values remain flat. So your total return for that year is the sum of return from cashflow (8%) and return from appreciation (0%). Now in the following year, your taxes go up by $100 per month so now your cashflow is reduced to $2300 per year (6% return) but property values rose 10% that year. While your cash on cash return dropped by 2% your total return increased by a factor of 7 due to appreciation returns. How? A 10 percent appreciation on a property in which you’ve invested just 20% of the value in capital translates to a 50% return on that capital due to 4:1 leverage. Therefore your total return for the year is 56%. The counter argument to this point is that appreciation returns don’t materialize until you sell the property and it’s well noted. But that’s not exactly accurate. For a long term investor whose goal is to built up a portfolio with a certain asset value, appreciation helps them get there faster. The main negative impact of rising property taxes and shrinking cashflow is that it might require more surplus injections from an investors surplus income to pay off mortgage debt at the same pace. But once the mortgage is paid off, the higher asset value due to the same appreciation (that caused reduced cashflow) leads to higher income at retirement.

Protest your tax appraisal every year

Once the property tax appraisal is sent out the property owner typically has 30 days after the receipt of the notice to file a protest. This can be done in three different ways: 1) File a protest online with the county appraisal district website (i.e Harris County http://hcad.org, Fort Bend http://fbcad.org) 2) Local investors can file a protest in person at the appraisal district office (their address is also on the website) or 3) File a protest using a property tax consultant. I have used this last option personally and have advised clients to use as well. The property tax consultant gets paid based on a percentage of the tax savings they’re able to provide (usually 30-35%). So if they aren’t able to secure any savings you don’t have to pay anything. And you can select the perpetual engagement option which means they automatically protest your tax values each year and you don’t have to remember it.

Full Disclosure: In recent years, county authorities have been very stringent and property tax savings have been small. However, if you don’t protest, tax savings will be exactly ZERO. Something is better than nothing

In long term investing, you sign up for the whole ride

One thing you sign up for when investing long term is for the whole ride – the peaks, the valleys and everything in between. There will be times like 2008-2011 where cashflow might be plentiful but appreciation absent. And other times like 2012-present where cashflow is getting squeezed but values are rising. We all have our preferences – some investors really go after cashflow and could care less about appreciation. They’d prefer that for the decade or two that they’re investing, things should stay constant like 2008-2011. Then there are investors who feel that if you built up enough net worth, income takes care of itself and they’ve been grinning these last few years. But the reality is in long term investing the only thing you can count on is change as we move and navigate through the cycle. The sooner you get used to and embrace that idea, the better. This year property prices have not risen like in recent years in response to the oil market struggles so property tax appraisals will likely reflect that reality as well.

The Freedom Formula: How to turn $244,000 into $1.4M in 14 years

September 10, 2016 By Erion Shehaj 10 Comments

Today’s post is exciting for me to write primarily because of what it can do for investors that actually heed the advice.

Since the beginning of Investing Architect, I’ve argued that quality real estate purchased in the context of and according to a sound overarching long term strategy can alter an investor’s life in fundamental ways. Surely, it can have an impact in that investors financial life – namely her passive income and net worth. But that’s only part of the magic. Most importantly, through their financial impact they can offer what I believe most of us are truly after: The freedom and independence to craft a life well lived.

I have a Freedom Formula that I’d like to share with you:

(Quality real estate + Strategy+ Discipline + Execution)^ Time = Freedom

The case study I’ll go over with you today is the “proof” of the validity of this formula. Let’s dive in the numbers.

Case Study

Suppose you were presented with an opportunity to invest in brand new small multifamily (4 units) properties in a new development in an established Texas market with impressive population growth and solid tenant demand with strong median household incomes to support your rents.

Annual Income: $55,200 (4 units leased at $1,150 per month)

Total Operating Expenses: $22,563 (property taxes, insurance, management and repair reserves, vacancy provision)

Net Operating Income: $32,638 per year

Debt Service and Leasing Fees: $23,485 per year

Positive Cashflow: $9,152.64

Purchase price: $460,000

Cash to close: $122,000 (25% down payment plus closing costs)

Why Strategy matters

This is usually the point where first time readers get a puzzled look on their faces. “Wait a minute – how do we go from a potential investment property that throws off $9,200 a year in positive cashflow to turning $244,000 into 1.4 Million?”.

In one word: Strategy.

There’s a reason why strategy is the second ingredient of the formula. Quality real estate comes first because in it’s absence none of the remaining factors matter. You could have the most sophisticated strategy in the world, the discipline of a buddhist monk, and Jason Bourne’s execution skills and none of it matters. But once you’ve purchased quality real estate your strategy makes the difference between magic and meh. Every month I meet with investors that through sheer gut feel have acquired a couple of quality properties. But only minutes into our conversation it becomes abundantly clear that their investing efforts lack a general direction, an overarching strategy. Therefore, they do okay with their investment but they leave massive potential on the table.

Let’s get back to the numbers to illustrate the opportunity cost of a solid strategy. If you were to purchase this same exact property but lacked a long term strategy, what would happen? Well, you would be earning 7-8% on your money (conservatively) and would take advantage of leverage as the property appreciated over time. That’s not a bad investment but it doesn’t exactly change your life.

Here’s a better option. For the investor with available capital resources, I’d recommend the purchase of two fourplexes (8 rental units in total). The completion of these two transactions requires $244k in capital (+- 1%). Upon the completion of acquisition, I would have this investor utilize the positive cashflow from both properties to aggressively pay off the mortgage on the first property while making regular payments on the second. To add more “wood to the fire”, I would recommend that the investor contribute an additional $500 from her income to accelerate debt retirement even faster. Think of this as a 401(K) contribution that actually works.

What’s the effect of this strategy? The mortgage on the first property is completely paid off in 112 months (just over 9 years). After the first property is free and clear, the positive cashflow from that property is no longer $9200 but rather the entire Net Operating Income of $32.6k since there no more debt to service. Now I’d recommend that the investor continue the same process with the second property. The only difference is now we’re attacking that mortgage with a LOT more money every month. Therefore the mortgage on the second property is paid off in 57 months (just under 5 years.

Final Results

Let’s look at the only thing that ultimately matters: Results. If you heed my advice, you invest $244,000 of your hard earned capital and after applying a Domino Strategy you end up with two free and clear properties in 14 years that assuming an appreciation rate of 3% (inflation) would be worth $1.395M at that time. Also at that time, these two properties would produce $65,000/year in investment income. That’s the difference between just buying a couple of good properties and buying a couple of good properties according to a solid strategy mixed with discipline and laser focused execution raised to the power of time.

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Important Note: A project with 11 new construction 4plex and 4 new construction 6plex multi family properties in a growing Texas market is about to break ground in 2-3 weeks. We have partnered with the Developer to offer first shot on these properties to our clients during the construction phase. Over the next few weeks, we will be holding one-on-one conference calls with our clients to discuss the opportunity. Typically we sell out projects of this magnitude in 2-4 weeks.

If you are interested and would like to receive an information packet containing detailed cashflow analyses, location map, site map, demographic and psychographic data about the location, contact us or if you’re reading this from your email, just hit reply.

Forget the Nest Egg Approach: How to create retirement income, grow your net worth and leave a legacy

September 6, 2016 By Erion Shehaj Leave a Comment

Take a good hard look at the Net Worth Timeline Comparison graph below:

It’s a colorful, damning indictment of the Nest Egg approach to retirement that an overwhelming majority of investors in the developed world follow.

Let me set the scene for you so the meaning of the graph can come into better focus: A very disciplined high net worth individual (over $1MM) with a six figure job income maxes out contributions to tax advantaged retirement accounts (401k) and college savings accounts. Her family lives well below their means so even after those contributions there is surplus income that is invested regularly in a taxable stock/mutual fund account (dollar cost averaging).

The return assumptions are the same shade of conservative we use on real estate investment projections. We are assuming that all accounts will average a 6% linear return annually and that stock markets don’t shed 40-50% of their value every 8-10 years. In addition, we’re also assuming that the surplus is invested without fail (continued discipline) in brokerage accounts. Finally, on the real estate side, we assume that property values track inflation (3% per year) and base income and expense projections on actual figures.

The first graph at the top illustrates the investor’s net worth projection should she follow the current investing path (securities) projected out over the next 50 or so years.

The second graph at the bottom illustrates the investor’s net worth projection if she followed our Blueprint strategy. Under the Blueprint strategy, she would utilize current investable capital plus a portion of the income surplus (60%) over the years to acquire and pay off quality income-producing real estate assets. That leaves the remainder of the surplus to fund major purchases, travel etc. As she executes on her real estate investments she would continue to max out tax-advantaged accounts and invest those funds in securities for an all-of-the-above approach to investing.

Two critical junctures

Let’s take a look at two points in time – The first is the projected retirement date in 2033 (at the age of 55). On that date, the projected net worth under the Blueprint Plan is $1MM (22%) higher than under the current path ($6.2MM vs $5.1MM). But that’s where these paths only begin to go in two opposite directions.

During the retirement years until the end of the plan (life expectancy 90), under the current path the investor’s net worth drops by 60% (to $2MM) while on the Blueprint Plan the investor’s net worth increases by 70% (to $10.6MM).

What happened here? Why such vast difference in the two approaches in the years following retirement? The answer: The differences originate in the structure and basic concept of the two strategies.

The Nest Egg Approach

By definition, the Nest Egg approach retirement investing has two phases: Asset Accumulation and Asset Distribution. In other words, during your productive years you are to set aside and invest a portion of your disposable income so you can accumulate assets. Then following retirement, you will distribute (read: plunder) a sizable portion of those assets to fund your income needs during retirement. In fact, on tax advantaged accounts such distributions are mandatory.

Therefore it should come as no surprise that the investor’s net worth dropped by 60% during retirement years. That was the plan all along!

Now – you might ask – what’s wrong with a plan where you save for retirement, arrive there with $5MM in net worth and leave $2MM to your heirs when you are gone? It’s not that it’s wrong – it’s just that you could do so much better!

If the legacy you leave behind for your loved ones is important to you, why not explore a different path that leads to better income at retirement while allowing your net worth to rise instead of plummet?

The Blueprint Approach

The approach I’m suggesting is fundamentally different. I don’t believe that the optimal path to retirement is to accumulate assets so then you could live off of them in retirement. Instead, I would advise you to accumulate cash flowing real estate assets and pay them off over time so the income they create takes care of your retirement lifestyle while the principal (net worth) is untouched and rising. Live off the yield and don’t cannibalize the principal.

The results speak for themselves. If by using the same resources (capital, income, time) you can end up with a net worth that’s 20% higher at retirement and 5x higher at the end of your plan, why wouldn’t you?