Long Term Rental Properties

Paper tigers

August 28, 2012 By Erion Shehaj Leave a Comment

At some point or another, every real estate investor has experienced temptation. You could be the new real estate investor just getting started that gets his head turned by an obscene cash on cash return rate. Or you could be well on your way after purchasing several quality assets and questioning your direction when you see higher cap rates or lower prices elsewhere.

Analytical minds love simplicity. I know because I’m the proud owner of one. We hate ambiguity, it’s “maybes” and “it depend”s. Instead we seek factual benchmarks, hard statistics that show what’s what without a shadow of a doubt. It’s simpler that way: A cap rate of 9 is better than 6 or a cash on cash return of 20 is better than 13.

The problem is long term real estate investing is much more complex than that. When you try to reduce in depth analysis down to the myopic perspective of an indicator or two, it leads to wrong answers.

Ceteris paribus – all else equal – a higher cap rate and cash on cash return is better than a lower one. Thing is, all else is rarely equal. Higher returns on paper typically reflect a higher level of risk. Think about it this way. In order to acquire a property in a great location you will generally have to pay more than if you were to acquire the same in an inferior location. In addition, properties priced lower tend to have lower property taxes, insurance costs and HOA dues. When you pay less to acquire the same income stream, your rate of return on paper increases substantially. So it follows that to get off the chart returns you have to settle for lower asset quality. Since the property “picks” the tenant, that leads to lower quality tenants which leads to higher vacancies and turnover and lower actual returns. Defeats the purpose, doesn’t it?

So when you read that pro forma income and expense statement the question you should ask yourself is: Am I looking at a paper tiger? Because in the end, the only returns that matter are the ones you get to keep.

Essential real estate investing lesson learned from Starbucks

July 26, 2012 By Erion Shehaj 2 Comments

Do you ever wonder about the decision making process that a company like Starbucks goes through when deciding where to put their new store? Think about it for a second. Opening a new store involves tremendous costs: hundreds of thousands spent on building out the store, millions of dollars committed to a long term lease and thousands of man hours spent on hiring and training the new staff. Needless to say, it’s a pretty big decision that the company HAS to get right. But as any commercial real estate broker will tell you, every retail space owner wants to lease to Starbucks. So with all these options at their disposal, on what do they base their decision? Do they just wing it or “play it by the gut”? Not a chance.

In a much smaller scale, that’s a very similar problem that a real estate investor faces when trying to decide where to invest their hard earned capital. A real estate investor may not spend millions of dollars on a property like Starbucks does, but relative to the investor’s means, this decision is just as crucial if not more. Even within a single market, like Houston, there are hundreds of different ways to put that capital at work. Does the investor put their money into cheap properties that are riskier but cashflow well or is it better to invest into premium locations that have higher appreciation rates but lower cashflow? What about a middle ground solution? And that’s not even all of it. Do you buy older properties or new construction? Suburbs or Inner Loop? Decisions decisions. Problem is, unlike Starbucks, many investors do wing it. Either because they didn’t get the right advice or didn’t get any advice they end up squandering an opportunity that if utilized correctly would get them to retirement in a decade.

Back to Starbucks. So they have all these options – how do they make the right choice. They put the horse before the cart. Before deciding on the supply (store) they get to know their demand (customers). They know their customers’ demographics: Their age, their employment, their income, their family composition. But they also know their customers psycho-graphics: Their spending habits, their disposable income, their drive time to get coffee etc. Once they know their demand, they analyze potential sites to see how they fit their customer base. Will there be enough potential customers within a 5 minute drive time to meet sales goals for the store? If not, they move on to the next site until they find the right mix of demand for the supply they’re providing.

Most real estate investors do this backwards. They find a cheap enough property, buy it then try to figure out how to get their desired great tenants into that property. They never bother to figure our their demand. Sure, they want great tenants who will lease their property long term, pay rent on time and take care of their property like it were their own. However, unlike Starbucks, they don’t know their customers and what they’re looking for in a rental property. They don’t know their demographics or psychographics and they have no idea if there’s enough potential tenants that might be interested in that particular location. And if they got the location right by chance, they don’t know what level of upgrades and amenities these tenants expect in a rental property.

The moral of the story is that your real estate investing results will always outperform if you learn your demand first then supply it than vice versa. By the time we advise our clients on a particular location, we have already done rigorous research on the property and determined that the demand is there for the supply we’re trying to acquire. Case and point:

Above is a tapestry study of a property we recommended to one of our clients to purchase. This is a psychographic analysis of people that live within 0.5, 1 and 1.5 miles of the property (circles). In the immediate vicinity of the property there are three lifemode groups:

L7 High Hopes: Young households striving for the “American Dream”

L2 Upscale Avenues: Prosperous, married couple homeowners in different housing

L1 High Society: Affluent, well-educated, married-couple homeowners

So if I’m purchasing an asset located in this area, does the psychographic profile of the population match the type of tenant I’m looking to find? Take that one further:

The above demographic report provides even more information on the demand aspect of the equation. For instance, it tells me that over 70% of the population in the area makes between $50k and $150k. That info is very important when you compare it to the rent you are going to ask for the property. Do people that live in the area generally make enough to support the rent?

Last week I asked you a question: Who’s advising you about your real estate investments? The quality of the advice will determine the results you get. And the quality of the advice is dependent on the research your adviser does even before you take a look at the property to answer the questions you didn’t even think to ask.

On Cashflow – How to build real estate investment income the right way

July 24, 2012 By Erion Shehaj Leave a Comment

In the word of long term real estate investing, cashflow is the holy grail. Everyone wants it, searches for it and wants to know how to get it. And who can blame them? Build enough positive cashflow without undertaking excessive risk and you’ve made it. Free to do whatever you wish with your life without worrying about that monthly overhead “anchor” that keeps you tied down for decades. But most real estate investors have a mathematical understanding of what cashflow is but not a conceptual one. They see cashflow as the difference between incoming rent and expenses. That definition is correct – but it doesn’t explain what cashflow is at its very essence. And in the end, that essence makes the difference between a strategy that achieves your goal and one that falls short.

In a nutshell, positive cashflow is the yield on capital – similar to the interest you earn on your CD without the sorry rate. The more money you put in, the more interest you get out. Generally speaking, interest rates paid on CDs of the same term are about the same. So the only way for you to get more interest is to invest a higher amount of capital upfront. Paid off real estate tends to behave in much the same way. If you were to purchase a property in a suburb of Houston for $140k in cash, it would produce approximately $11,000 in positive cashflow – 0r about an 8% yield. Want to make 10 times more money? You better figure out a way to grow your capital – or equity ten fold.

It seems like I’m suggesting you need to have large sums of money to invest to be successful in long term real estate investing, but I’m not. What I’m suggesting here is that if you seek cashflow, your first and only priority going forward should be to grow your capital base. For example, say you have $100k to invest. Even by leveraging your capital, acquiring three properties with 20% down and creating a 12-13% return you’re looking at an annual income of $13,000. Better than a poke in the eye but certainly not retirement money. If your goal is to increase that to triple the size, you have to figure out how to turn that $100k into $400k between now and the time you retire. And you can do that by utilizing your cashflows and your job income. That’s the magic. The leveraged cashflow you create when you acquire your properties is just the tool you use (in conjunction with your income) to increase your capital base/net worth/wealth. So that when time comes to draw yield from that capital base, it’s big enough to provide sufficient income for you to retire. Subscribers to the perpetual leverage method will disagree with me on this but they’re wrong. Creating your cashflow by purchasing and accumulating 4x to 5x the number of assets involves increasing your risk ten fold. And having a portfolio with a boatload of homes leveraged up the nose for thirty years isn’t retirement – it’s an open invitation for Murphy to become your roommate.

The way to an annual investment income that sets your free goes through “Build your Wealth First” city. Any shortcut and you won’t reach a place worth going.

Eric Gjerde via Compfight

How is income from investment real estate taxed?

July 22, 2012 By Erion Shehaj 4 Comments

Investment real estate gets preferential tax treatment from the IRS -one that is not afforded to any other asset class. In a nutshell, if you hold real estate long term, you are allowed to deduct a “paper” expense called depreciation from an appreciating asset. It’s yet another way that real estate makes you money by letting you keep more of it after it goes through the government strainer. But in speaking with many investors (aspiring or active) there seems to be this gross misconception that due to the ability to deduct depreciation, cashflows from investment real estate are tax free. So, today I wanted to dispel this mistaken notion and give you a clear idea on how investment real estate income is taxed.

You’re pretty much allowed to keep two sets of books – legally. One is the actual cash inflow and outflow set. The other is the tax inflow and outflow set. So let’s look at some numbers as an example:

If these were the numbers on a different asset class and the investor was in the 30% tax bracket, they would owe $1327.65 in taxes making their after tax cashflow $3,097.85. But this is long term real estate, so here’s what the inflow and “outflow” look like for tax purposes:

As you can see, for tax purposes, you are allowed to deduct just the interest portion of your mortgage payments as well as the depreciation expense, leasing commissions and loan cost amortization. This results in a much lower taxable income which in turn results in 36% lower taxes or $854.25. The depreciation expense that the IRS allows real estate investors to deduct shelters a portion of your cashflow from taxes. Put a different way, instead of paying taxes at your bracket rate of 30%. you’re paying taxes at a 19.3% rate. I don’t know about you but any steps closer to zero (my favorite tax rate) are fine with me.

So back to the misconception. Investors tend to look at their cashflow figure then at the depreciation expense which leads them to believe that most (or all) of their income will be sheltered from taxes. However you aren’t allowed to deduct the portion of your debt service (mortgage payments) that goes towards principal and therein lies the rub. So it isn’t tax free but tax favorable. Something most other assets classes can’t claim.

John Morgan via Compfight

How to minimize turnover and maximize returns in your investment real estate

July 21, 2012 By Erion Shehaj Leave a Comment

Few things affect the results of a long term real estate investment strategy like turnover and vacancies. During the time a property is not leased it becomes an expense rather than an asset to the investor. Turnover has similar effects – every time an existing tenant leaves and a replacement is found, the investor incurs make ready and lease out expenses. If high turnover and vacancy cause investor returns to decrease, it follows that taking measures to minimize them as much as possible will increase and maximize investor returns. That sounds great – so how can we make it happen?

High turnover and vacancy have one common solution: Great tenants. So when you ask how do we reduce turnover and vacancies you are really asking, how do we find, screen and keep great tenants. The purpose of this post is to answer that question.

Finding great tenants requires three ingredients: Strong marketing, a great property and clearly defined standards. You need strong marketing to let great tenants know that you have a great property they should consider and to make them fall in love with it. We list our properties for lease on the MLS and syndicate to every online site that has rental real estate like Zillow, Trulia, Hotpads etc. We take great care in listing our lease properties – we take plenty of photographs with professional equipment, write descriptive copy and portray the property in the best light. In addition to that, we write an article (blog post) on our website to give it the exposure of 10k monthly visitors. Last but not least we run daily Craigslist ads to drive traffic to the property. But all the great marketing in the world couldn’t help you unless the property you acquired is up to snuff. Great tenants look for properties that have nice upgrades, good floor plans, neighborhood amenities and most importantly excellent schools. And the condition of the property has to be immaculate: professionally cleaned, freshly painted, carpets shampooed, air filters replaced etc etc. If your property doesn’t fit that profile, you made an acquisition mistake. Last but not least, you have to have a clear idea about what a great tenant is and you will have that idea when you have clearly defined criteria that the tenant must fulfill. From our lease listings as an example:

Looking for a good long term tenant with great rental history, good stable employment (2+ years) and income (Approx. $4700/month income to qualify salaried, not on commission) and no background check issues. Minimum two year lease. Credit score of at least 600 is required with rare exceptions

As you can see from that description, what defines a great tenant for us are rental history, employment stability, income sufficiency, clean background and long lease term. In that order. Credit is secondary for us and we would be willing to overlook it if the tenant fits all the other criteria. But do you see how well defined is the profile of the tenant we seek?

Screening great tenants is vital to insure that the applicant truly fits that well defined criteria we just discussed. As part of our standard screening we do the following:

Obtain and review rental history verification. Contact previous landlord, ask verifying questions and get an idea about what kind of tenants the applicants were.
Obtain income documentation (checkstubs and tax returns) and verify that it’s correct by requesting an employment verification.
Obtain and review credit report and background check.
Check references if any.
Run cross check verifications to make sure the information provided is correct – Is the landlord they’re listing on the application the owner of the property they were leasing or some family friend of the tenants?

Keeping great tenants is achieved by setting up the right expectations from the start, keeping communication lines open and showing care. Most disputes between Landlords and tenants stem from parties not being clear about what the other expects from them. We solve this issue by clearly defining expectations in the lease agreement and in the Rules and Regulations document and going over these expectations before the parties sign papers. Make it easy for the tenant to pay rent, submit a repair request and get repairs done in a timely fashion. Do what you said you were going to do. Keep lines of communication open at all times so wrinkles can be ironed out before they become problems. Finally, show that you care – about your property and the tenants. If a tenant sees that you don’t even care about your property, why should they? Schedule quarterly inspections of the property, provide air filters for replacement, make routine maintenance tune ups of your systems when they aren’t broken to extend their life and prevent unpleasant experiences for the tenants.

Finding, screening and keeping great tenants is the ultimate solution to the turnover and vacancy problem. Every time you manage to put a great tenant in one of your properties, you are actually putting money in your pocket and minimizing stress. So do it right, or hire pros who can.

Kevin Dooley via Compfight

Who is advising you about your real estate investments?

July 17, 2012 By Erion Shehaj 3 Comments

When you invest in real estate long term, what’s really at stake is your retirement. In the end, the path you take will either lead you to the retirement you want or it won’t. All the metrics us investment guys like to talk about so much – your returns on investment, equity positions or positive cashflows won’t matter at all if they don’t get you over the finish line. It’s a pretty brutal and unforgiving situation, if you think about it. Intentions, efforts and the such are completely irrelevant and worthless if they don’t lead you to the retirement you sought when you started investing.

So that brings up the question: Can you afford to get this wrong? The path you take today, the decisions you make on how, where and when to use your capital today will be the determinant of how far and fast you go. And in the end, the decisions you make are as good as the real estate investment advice you get – or don’t get. So, who’s advising you about your real estate investments?

If you were to ask any real estate agent if they work with investment properties, the answer will almost always be a resounding YES. After all, you’re just buying a house or two and they know how to sell you a house. They can send you a list of properties for you to look over and let them know when they should write up a contract for it. They might even use general and shallow investment terms like: “You will make a lot of money with this” or ” The ROI of this property will be off the charts”. The truth is they don’t know the first thing about real estate investing. And most importantly, they can’t offer you the most important necessary ingredient for success: A well-founded cohesive investment strategy. One that mitigates risk and maximizes long term returns. One that gets you over the retirement finish line. Remember this: Regardless of the vehicle you use – real estate, stocks, bonds, annuities etc – this is ultimately about protecting your principal and growing your capital to a point that the yield on that capital gives you enough after tax income to retire. If you’re just buying a couple of houses, you’re not investing – You’re just buying a couple of houses.

Another alternative for advice is to go to an investment club that offers “educational” seminars about how to invest well. There you could even network with seasoned investors that have a deal or ten you could buy today. These deals have tons of equity that these members are just passing on to you because they like you so much and they’d rather you make the profit off the deal than them. Next thing you know, you’ll be driving Hummers, wearing a lot of hair gel and dark shades. Sounds like a late night infomercial doesn’t it? Look I don’t mean to be cynical – there’s nothing wrong with folks wholesaling deals to each other. It’s a market that’s been around for a hundred years. But this is your retirement we’re talking about here. Do you think you should take advice from someone whose goal is to “flip” you a deal so they can make some profit that month?

When we start working with a new client, it’s usually the start of a lifelong business relationship that has one goal: Accomplishing the client’s retirement goals. Anything short of that, is utter failure and I don’t take that responsibility lightly. Whatever you do, make sure the quality of the advice you get is aligned with the goals you have. If you’re a long term investor, you owe it to yourself to work with a pro that will lead you down the path of success. Your retirement’s at stake.
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