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Today’s post addresses a common misconception that costs inexperienced real estate investors thousands of dollars over the long term. When analyzing investment properties, investors have a compulsive need to oversimplify the decision-making process down to a single metric. If the cashflow on the property is X, then it’s a good property. Or if you get X amount of built in equity, you’ve gotten a deal. Because in the end, numbers never lie, right?

A tale of two properties

Let’s say you’re considering two potential investment properties for acquisition. The first property costs $105,000, has $4,100/year positive cashflow and $9,519 Net Operating Income. The second property costs $130,000, has $2,831/year positive cashflow and $9,526 Net Operating Income.  Which one is the best investment property to buy? When I pose this question to investors that are just getting started, they almost always pick the first. More cashflow, higher returns on investment, a numerical no brainer. There are several reasons why that’s the wrong decision to make. For starters, an analysis that considers only the “what” without regard for the “why” always yields flawed answers.

Einstein said that “if you judge a fish by its ability to climb a tree, it will live its whole life believing that it is stupid”. Put a different way, if you’re measuring the wrong statistics, you’ll get to the wrong conclusion. More than looking at the amount of cashflow, a smart investor looks at the reasons behind the difference in cashflow. Could it be that the property yielding less cashflow is in a better location/neighborhood than the other? More than comparing returns on investment head to head, a wise investor investigates why one opportunity yields more return. Remember, risk and return are best friends that go everywhere together. Could it be that the property yielding more return is a greater risk? Looking at the naked numbers alone is like picking cars based on the number of cup holders alone. A Hyundai and a Mercedes may have similar engine specs, but there’s a reason for that price difference.

When in doubt

If you’re doubtful about which investing opportunity makes the most sense, here’s a simple rule. Always pick Quality (APQ). Don’t skimp on the quality of your portfolio for a few hundred dollars extra per year. As long as the price to rent ratio makes sense, always select assets that are located in prime neighborhoods: They stay rented longer, attract the best tenants, benefit the most from value and rent appreciation. Look at it this way: If you consistently pick B properties with seemingly sweeter numbers or A+ properties, either way you will arrive to the finish line with a paid off real estate portfolio if you execute a Blueprint. The question is which type of asset would you rather own? Exactly.

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If our investing philosophy makes sense to you and you’d like to talk about putting it to work for you, my number is 713.922.2702. I could be talking with you about this stuff over coffee and coffee makes everything better 🙂

Photo Credit: David Villarreal Fernandez

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!

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