Long Term Rental Properties

Equity and the myth of playing it safe

February 8, 2013 By Erion Shehaj 1 Comment

When I started Investing Architect a couple of years ago, I wrote a controversial post called Why Equity doesn’t matter that caused quite a stir. It was inevitable. A conservative, prudent, “low and slow” real estate investing guy (by his own admission) was advising his readers that built in equity was irrelevant. How could this be, considering what happened to real estate markets in 2008 with millions underwater on their mortgages? Wouldn’t it be more conservative and prudent to only purchase properties with built in equity – in case you have to sell the property due to another deteriorating market?!

There’s a powerful, fear-driven myth among long term real estate investors that says: Buying an investment property with built in equity is the best and only way of minimizing risk and playing it safe. In today’s post, I will dispel that myth.

1. Before we go any deeper, it’s very important that you have a clear understanding of equity’s true nature. Equity is a Snapshot that tells you what you would make if you were to sell the property today – and nothing more. This short term indicator provides zero information about what that property will do in the future. Don’t believe me? Most of those people underwater on their mortgages post recession had plenty of “equity” in their properties just a few short years prior. And sadly, the equity they thought they had, didn’t minimize their risk of being underwater in the future.

2. Next, the reason why investors feel that equity minimizes their risk is because it gives them an Exit. In the event that the stuff hits the fan, they have a better chance of cutting bait and getting out from under the property. There’s one major issue with that line of thinking: It doesn’t reflect the mentality of a long term investor. That is, when you assemble a long term real estate portfolio, that implies that during your hold period there will be some good markets and some not so good ones. As a matter of fact, that’s one of the few things you can count on. So if your first tendency during a trough in the market is to sell and get out, I have a much better strategy for minimizing risk to suggest to you. Don’t make the investment in the first place. If the risk that’s involved in holding an asset during a bad market is too much to handle, the best course of action is to not take that risk to begin with.

3. Further, let’s consider the reasons why a property might have built in equity. Typically, a property will sell below market value because it’s distressed. This could be because it’s a bank or government owned foreclosure, short sale, or simply a motivated seller in distress. In all those cases, you can count on the presence of deferred maintenance. And I’m not just referring to items that are in immediate need of repair but also to systems that will break faster because they have not been maintained well up until that point. This will lead to two things: Reduced returns due higher out of pocket investment and the evaporation of that built in equity you thought you had.
Since equity was the master criterion for selecting your investment property and not quality of location, neighborhood, floorplan and maintenance, you actually increased your risk and lowered your returns. And all that for “the equity” – most of which disappeared eventually anyway.

So, if equity won’t reduce risk, what will? That’s simple: Cashflow and Quality.

1. Here’s an illustration how positive cashflow minimizes the risk to the investor. Say you own an investment property worth $125,000 that while rented for $1325/mo produces $400/mo in positive cash flow after expenses and mortgage payments. Think about that for a second. Rents could plunge by 30% – and you’d still be breaking even. Talk about insulation against a seriously depressed market. Or look at it a different way – in a market with scarce tenants, you could drop your price by 30% and the property would still be paying for itself. But what if there’s no tenants? There’s no such thing as “no tenants” – just no tenants at a given price. People have to live somewhere regardless of the economical situation. But what if Armageddon strikes… In that case my friends, we have bigger problems than our real estate investing portfolio.

2. Quality is the ultimate risk minimizer. When you buy quality properties at a fair price – without overpaying – they stay rented to good long term tenants producing the kind of income stream that allows you to ride a bad market while making double digit returns and exiting the investment when it’s most beneficial for you. In short, when you buy quality, you buy patience. If you’ve got patience, you can invest on your own terms with lower risk.

Finally, there is one important idea with which I want to leave you. There’s nothing wrong with buying a property below market with built in equity – on the contrary, it can be quite nice. The problem arises when long term investors use equity as the primary reason to select (or avoid) an investment property. That’s where they go astray believing the myth of risk reduction through buying below market. Purchasing quality properties in great locations that have solid positive cash flow is the best way to minimize risk in your long term real estate investing portfolio. Equity is mainly a nice additional bonus if you can get it.

How to tell if your investing strategy is working

January 31, 2013 By Erion Shehaj 2 Comments

Most long term investing strategies have one element in common: They all require hope and faith. The basic premise goes something like this: You will feed your 401k/IRA/mutual fund account regularly for 40+ years and then hope and believe that at retirement your nest egg will be sufficient to avoid Walmart employment at 65.

Don’t get me wrong – you will periodically receive detailed statements about your account balances and positions throughout the four decades. But those balances and statements aren’t worth the soft paper they’re written on the moment a 2008 type recession ravages your portfolio by 40%! The fact remains that despite the informative statements, your retirement plan hinges in part on your hope that the timing of recessions and market corrections will be kind to you. The problem with that plan is that recessions happen with painful regularity! You can pretty much count on one affecting you right around the time you get ready to retire.

But what about the fact that the market always bounces back up within a few years? Merely bouncing back may not be enough – if your retirement accounts had $100 before going down by 40%, you’re left with $60 and now require a 67% bounce to get back to your $100.

But you don’t have to take my word for it – just look at the facts. The average 401(k) at the end of 2012 had $75,900 in it and that’s an all time high! Let’s not stop there but instead let’s assume you’re not an average investor and I’m off by 100% – can you retire with a nest egg of $150,000? Don’t answer that.

Now contrast that with what our Blueprint real estate investing strategy for retirement offers. You invest your hard earned, even harder saved capital and purchase several high quality properties in a well crafted portfolio. Depending on your investing timeframe, approximately four to five years later one of those properties is debt free. Three years and some change after that blessed news, the second mortgage is paid off. And so forth in a beautiful chain that builds the capital that will lead you to retirement. I call these events “performance benchmarks” because they provide you with solid irrefutable proof that your plan is working long before you reach retirement. You don’t have to rely on just hope anymore. You will have assets that you own free and clear to assure you that you’re headed in the right direction. I believe this is one of the most important advantages our Blueprint real estate investing strategy offers over other long term investing.

Diversification and real estate investing

January 29, 2013 By Erion Shehaj Leave a Comment

One of the first things people tell you about investing is that you must diversify. And by people, i mean your Uncle Ralf, who took a finance class once. Then comes the proverbial “Don’t put all your eggs in one basket” accompanied by the mandatory wag of the index finger. After you put some thought into it you realize that Ralph might be on to something here. It’s commonsense – when you put all your money in one thing, if that thing goes bust so do you. So spread your money around and while you might not make as much, you won’t lose as much either.

Aspiring real estate investors and experienced clients alike always bring up the diversification question during our conversations. So in this post I want to go over two main types of diversification. The first type is diversification between different asset classes. For instance, you can invest some of your money in real estate, another portion in stock market mutual funds and the rest in CDs. The second is diversification within the same asset class. As an example, if you invest in real estate you might spread your holdings in different locations. Or you can purchase a mix of multifamily and single family properties or commercial and residential assets.

But whether you diversify between or within asset classes, the principal at work is the same. Diversification at its very core is about hedging your bets by spreading the risk over assets that will counterbalance each other. If the value of an asset falls, a well diversified portfolio will have assets in it that will gain or hold steady therefore softening the blow. And of course when things are good you just aren’t making as much as you could for the same reason. But since fear of loss is a much stronger motivator than the desire for gain, that’s a trade most of us are willing to make. In many ways, it makes us feel prudent, measured and restrained.

So is diversification a good idea? Does it have to be a necessary part of every wise investment plan? The short answer is: It’s complicated.

Let’s start by tackling the extremes. First, no wise investor would subscribe to an investment strategy that’s categorically against any type of diversification. If someone is trying to persuade you to invest everything you got on this one thing, run away as fast as you can. I don’t care how much of a “sure thing” you think it is. You are two M&Ms away from losing all your money. Then there’s also such a thing as extreme diversification. That’s when you’re so terrified of risk that you diversify and complicate things to no end only to discover that you could have just kept your money under the mattress and achieved the same thing. Except that you paid a guy in a suit and tie lots of money to accomplish nothing.

But what about the middle of that spectrum. Before I tell you how I really feel about it, I’d like to share some wisdom with you:

Diversification is protection against ignorance. Wide diversification is only required when investors do not understand what they are doing – Warren Buffett

Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results. – Charlie Munger

Deworsification – Peter Lunch

An investor should never have anything to do with that which he does not understand. Tell me what sense does it make to invest in several other businesses or assets you don’t understand to alleviate the risk from the original asset you invested in without understanding it? My thesis is that there are much more efficient ways to mitigate investment risk than diversification.

First, get educated to the point that you understand the risk-return dynamics of the investment. I’m not talking about being sold by advertorials that only shed positive light on whatever they’re selling that week. I’m referring to real education that will show you how that investment will make money, what’s the worse that could happen and what you can do to minimize that risk. That could come from the Institute for Hard Knocks and Past Failures or from a trusted advisor/mentor who can offer you their 10,000 feet view. It’s crucial that you get to know the real risks because once you do you can choose to either walk away or move forward after you do something to minimize it. The alternative is to eliminate this vague idea of “risk” by putting some money over there in case I get cleaned out here. That’s not risk mitigation. That’s reaction to fear and no way to invest successfully.

The biggest problem with diversification is dilution. In real estate investing as in most areas of life we achieve important things by executing well defined plans with focused intensity. In the wide majority of cases, our capital, our income and our time are limited. Most of us don’t have enough capital or income to try every investing strategy ever created. So when we take our limited resources and we spread them out to a number of different investments, we dilute it to the point of making it ineffective. So we end up with what Charlie Munger called “ordinary results”. And let’s be clear about it: When it comes to investing for retirement, ordinary results usually means working till you can’t to make ends meet. Listen, I’m not suggesting that you pick an investment strategy for your retirement and put all your money into it to avoid dilution of your capital’s power to achieve great things. What I am suggesting is that there has to be a primary strategy that you adhere to and execute over long periods of time and that most your capital needs to go there. You must keep some of that capital in cash reserves so you can sleep at night. You should have some of your capital in other investments (i.e. index funds) . What you shouldn’t do is to take your capital and split it 100 ways. If your primary aim is to preserve your savings, the best strategy is to keep your money in your savings account.

The absolute best risk mitigator is Quality. This is especially true for real estate investing. When your primary focus is the selection of quality properties in great locations that leads to quality tenants that pay rent on time and treat your properties like their own. That in turn leads to lower turnover, less make ready and lower risk of default and evictions. By lowering turnover and reducing the risk and cost of property damage, defaults and evictions, you have reduced risk to its lowest level. And here’s the beautiful thing: At the same time, you’ve increased realized returns. Beats diversification like a red-headed stepchild, doesn’t it?

Diversification can be good when it brings an additional dimension to your investments while minimizing risk. For instance, by purchasing expensive properties in excellent areas rather than your standard assets, you accept a lower return for a lower risk profile. But most importantly, you give your portfolio another dimension by adding an asset that would perform better during an appreciating market. This way you add the potential of appreciation capture to your investments in addition to reducing risk. Diversification is useless and harmful when it’s done for its own sake. For example, a portfolio with some investment properties in good locations and others in bad locations would be diversified location-wise but it would hurt your chances of success tremendously.

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What happens after you decide to move forward with your Blueprint

January 25, 2013 By Erion Shehaj Leave a Comment

Based on conversations after the fact, many of our clients revealed that they had been reading Investing Architect for months (and in one case, over a year) before they decided to contact us to craft and execute their real estate investing Blueprint. This surprised me a little at first.

But after giving it some thought it all started to make a lot of sense. Before you take the step to contact someone like me, you have to come to two important conclusions. First, you have to decide that investing in real estate offers the most efficient path between where you are right now and where you aim to be at retirement compared to any other asset class. Then, after considering the plethora of options in the real estate investing spectrum, you have to decide that the Blueprint method we advocate is the one that best aligns with your goals, risk profile and personality. As tall an order as that might be, the “glue” that brings it all together is trust. After you decide that you will start investing in real estate and our strategy speaks to you unlike any other, you must be able to trust that with our help you will be able to execute a plan and bring the strategy to life.

So, just in case there are some of you who might be wondering what happens after you decide to move forward with our Blueprint real estate investing strategy, I thought I’d just tell you.

The Blueprint comes first

Everyone’s combination of financial goals, capital, income and time is unique so the very first thing we do is craft your Blueprint. For this you will need to provide some answers to our questions and then we can answer your most important questions in return. Namely, we need to know:

What is the main goal? (i.e retirement),
What income would accomplish it? (i.e. $75,000/year)
How long do we have to get there? (i.e 10-12 years)
How much capital do you have saved at this moment?
Based on your job income, what’s your savings rate? ( i.e $25,000/year)

If you don’t quite know the answers to those questions, let this be an invitation to start thinking about them. Once we have those answers, here are the major questions we can answer for you:

How many properties you will need to acquire during your asset accumulation stage?
How much liquid capital it will take to acquire those properties?
How long will it take you to complete the acquisitions based on your current level of capital and your savings rate?
How long your capital growth stage will take using just the positive cashflow from the properties?
If that will take too long, how much you will need to contribute from your job income to pay off the properties in the time we have till retirement?
How to allocate your porfolio between standard and premium assets based on your investment timeframe?

Financing and commitment

Now that we have our “roadmap”, we have to get ready for the trip. Before we go about the business of acquiring investment properties we connect you with our investment property specialist Lender. You aren’t obligated to use them after the pre-approval is done but after you speak with this pro you will understand why nearly 100% of our clients opt to finance their investment properties with this Lender. Once the preapproval letter has been issued, we are almost ready to start looking. Also at this stage, paperwork is drafted, reviewed and signed that establishes the client-agent relationship. We commit to help you achieve your goals and you commit to working exclusively with us.

Potential properties and acquisition

Now the fun part begins. We research hundreds of potential investment properties daily then distill that list down to about thirty contenders. At this point we run a market analysis on each property to find out what the incoming rent would be if we were to acquire it and what is the current market value for sale. What follows is an in depth cash flow analysis that projects the positive cashflow, capitalization rate and cash on cash return at Year 1. Then, it tells us how the property will perform throughout the investment timeframe and what your internal rate of return is during that time. When a property satisfies our high minimum standards and it’s a good fit for your portfolio, we will forward our research to you along with general property information and lots of photographs. After this, if you are a local investor, we would schedule a time to tour the property. Photoshop is a hell of a software so boots on the ground on every property our clients buy are mandatory. If instead you’re one of our out of state investors, we could shoot a video walkthrough of the property and send it to you. This process may take some time and will require some patience because Houston is the hottest real estate market for investors after all. But when that right property comes along, we pull the trigger and start negotiations right away. We go into those negotiations a strong pre-approved Buyer and that enhances our chances of success.

Hope that gives you an idea of what’s around the bend when you decide to move forward with your Blueprint real estate investing strategy. If there’s other questions or concerns you might have, ask away in the comments below, email me or call my cell at 713.922.2702.

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What catching monkeys can teach you about real estate investing

January 21, 2013 By Erion Shehaj Leave a Comment

The story goes that in ancient India, the natives used a clever technique to catch monkeys. Unable to catch them outright since the monkeys were much faster, they dug a hole in a tree trunk that was just big enough to fit the monkey’s open hand. Inside that hole, they placed some nuts to lure the monkey and hid. When the monkey would reach in and grab the food, he would make a fist that was bigger than the hole in the tree. The monkey was trapped and the natives would come out of hiding and catch him with ease. This technique worked because it would never occur to the monkey that if he just let go of the food, he could pull his hand out again and run away.

We can derive three essential real estate investing lessons from that story.

First, when you’re faced with an important real estate investing decision, there are almost always more options than what’s readily apparent at that moment. As an illustration, last week an investor asked me for my opinion on a dilemma he was facing: In the price range where he was looking, there were only two viable locations and neither of them would serve the investor well. But he kept insisting that he had thought this through backwards and forwards and there were no other options. He had painted himself into a corner then continuously went over those same two steps that corner allowed him to take. When I pointed out that he could purchase an excellent property in a high quality location at a slightly higher price while maintaining solid returns, there was a long pause on the line. His assumption that the property had to be restricted to a certain price range wasn’t based on data or reason – he just held it to be true and it negatively affected his decision making process. So next time you are faced with a similar situation don’t just accept the readily apparent options – there are always other alternatives. You aren’t restricted to either going hungry or being trapped – You can just pull out your hand with no food and live to eat another day.

Second, everything that shines isn’t necessarily gold. In the real estate investing world, we are constantly taught to “keep an open mind” and not turn down a deal that might not fit all our criteria exactly. “Sometimes you just have to be creative” – the advice usually goes. I’m certainly not against open minds or creativity. But sometimes when the only tool you have is a hammer, everything starts to look like a nail. When you have a solid investment plan that produces specific investment criteria, it inevitably eliminates some deals from your consideration. But in the end, that’s a good thing. Because it’s fine to be an open minded, creative investor as long as that flexibility does not lead you down a path that isn’t aligned with or (worse) goes against your goals. Next time you see that tree trunk full of goodies, it’s perfectly fine to whistle past it if your plan advises your to stay away from that type of tree.

Last, you can’t make money in this business if you don’t take risks but as Warren Buffet says: Don’t ever test the depth of the river with both feet. It’s not the end of the world if you pass on a deal that might have made you money if it ensures that you don’t go all in and get wiped out. In Wall St they have a saying: Bulls and bears make money but pigs get slaughtered. It’s a fine line between ambition or drive – both necessary ingredients to a successful investor- and greed. The stories of successful investors ending up in bankruptcy court due to greed are too numerous to mention. If you ask them, they will tell you that absent the greed, they could have taken a completely different path towards a prosperous retirement. But instead they kept chasing the next deal and the next one after that losing sight of risk in the process. Like the monkey found out, sometimes what might look like a “great meal”, may be the trap that seals our demise.

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Out of state investor’s guide to investing in Texas

January 15, 2013 By Erion Shehaj Leave a Comment

At this point, the idea that Texas is the best real estate market for long term investors is a well-established reality. And as it gains more national publicity and exposure, we are receiving daily calls from interested investors that reside out of state: New York, Massachusetts, Las Vegas, South Carolina, Washington DC – you name it. After they read articles about our Blueprint real estate investing strategy, they recognize the powerful impact that investing in high quality Houston real estate assets would have on their returns and retirement. Houston’s competitive advantage that springs from a strong job-producing local economy, affordable well located assets and attractive price to rent ratios has become hard to overlook.

However, from the viewpoint of an out of town real estate investor, it is one thing to recognize that the Texas market offers great investment opportunities. It is another to actually take that first step and acquire investment properties in that market. Inevitably, questions and challenges arise:

I don’t know the local market – How will I know which areas I should buy in?
How can I be sure that I will find a tenant soon after I purchase the property?
I don’t want to have to make a trip to Houston every time I buy a property – that will cost lots of time and money. How can I avoid that?
I don’t want the tenant to call me in the middle of the night with a leaking sink. How will I manage these properties from far away?

Although they arise out of fear, all these questions and challenges are legitimate and every out of town investor should have an answer and a plan to address them,before they buy their first investment property. So we’ll take them one by one and provide those answers right here.

Knowledge of the local market is the crucial puzzle piece that, when absent, can derail a real estate portfolio and condemn it to fail. The entire Blueprint investment strategy hinges on the investor accumulating quality assets in great locations that will rent to great long term tenants and stay rented. These properties must be located in excellent school districts, nice and safe neighborhoods and offer easy access to freeways, shopping etc. That’s what attracts great tenants that lease for long periods of time, take care of the place like it’s their own and pay rent on time. We can help you get this right: Not only do we have vast knowledge of the market but we also share our expertise with you during your feasibility period before you decide whether to move forward with the purchase. For every property we provide you with micro market statstailored specifically for that property, its neighborhood and the immediate vicinity. We show you what amount the property will command in rent (and why) as well as what the current market value of the property so you won’t overpay for the property. As part of a property proposal, we share with you all comparable rentals and sales for the neighborhood – so you can have the same data at your disposal as a professional appraiser. Last but not least, you will get a macro view of the overall market so you can see the trends of where the market is and where it’s headed during your investment time frame.

Every cash flow analysis starts with “Potential Rental Income” – for an important reason. Your ability to bring in rental income from a good tenant in a timely fashion is the foundation for the returns that follow. Falter here and the rest of the numbers are nothing but pro-forma, pie-in-the-sky projections that mean zip. So how can you be sure that once you close on your investment property there will be a tenant in place within 30 days or so? Those micro market stats I mentioned before will show you not only what’s the going rental rate for that area but also how long it takes an average property to get leased there. Before you buy, we make sure that those statistics show a market that has sufficient demand for the properties for rent in the area. And then, we pick great properties, make them move in ready and market them aggressively to bring in interested tenants. In 2012, we got 4-5 applications per property, leased out our properties in 21 days on the market (or less) and got two year lease terms on average.

When it comes to making trips to Houston, we recommend that each investor who isn’t familiar with the Houston area, at least fly down once while in the process to purchase their first property. Usually a 2-3 day weekend trip is sufficient to view the property itself, get a tour of the different areas and get a feel for the town. During such a tour I will show you actual examples of investment properties owned by other investors so you can have a benchmark to compare. After that orientation trip, it is up to you if you want to come down for every property. Most our clients, come down the first time then close on additional properties remotely. Usually we are able to arrange for the closing documents to be emailed to you so you can sign them from where you live. Therefore, additional visits are an option but not required.

Property management is usually the elephant in the room for out of town investors. You can feel it after just a few minutes of our phone call that the “big question” is coming: How do I manage a property from thousands of miles away? There are two possible solutions to the long distance property management problem: Implementing a property management system or hire us to manage the property for you. In a nutshell, the first option minimizes the need for “active” management through systems for rent collection and repairs, a trustworthy broker that will help you find and screen good tenants (I know a good one :-) , a handyman to handle miscellaneous items and an eviction service just in case. The second is self explanatory. The difference between the two is that investors who use our property management system save just over 30% of their cash flow before taxes that would have otherwise gone to management fees.

In closing, there seems to be a lingering stubborn idea that investors should avoid investing in markets that aren’t a short driving distance to their residence. While I understand the fear, I think it’s a recipe for disaster. If an investment is working the way it should, you shouldn’t have to drive by the property whether it’s located two miles or two thousand miles away. This illusion of control – that somehow the distance to the property determines it’s performance – leads investors to put their money in markets where it makes zero sense to invest. But at least, they get to drive by their money pit, right? You don’t apply this selection criteria with any other asset class. Do you only buy stock in companies where you can tour the facilities periodically? I rest my case. Take what the market gives you – don’t try to fit a square peg in a round hole and invest in way-past-their-prime markets just because they happen to be close to you. Pay attention to the fundamentals – economy, jobs, demand, supply, price. Work with a trustworthy adviser and implement systems to limit your risk. A decade from now you’ll be glad you did.

Are there any other concerns I forgot to address? Please let me know in the comments below or contact me. If you’ve been thinking about building a long term real estate investing portfolio we should at least talk. 713-922-2702 is my cell.