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Analyzing Real Estate; The Basics July 31, 2008

Posted by shaferfinancial in Uncategorized.
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Ok, so the mass media is pummeling real estate every day with more bad news.  All you need to know about real estate is that it is in trouble, right?  Well, no!  Today I will go over real estate as an investment.  Regular readers know that wealthy people have their largest chunk of their net worth in real estate.  They also know I love real estate as an investment for the middle class because of the leverage one can use.  Suffice it to say that the data is conclusive when it comes to investing in real estate.  It is a great investment as long as it is done correctly.

 

First let talk about types of real estate investment.

1. Your Primary Residence.  There is debate as to whether this should be considered, but I think since the data indicates that most people have significant savings in the form of home equity it should be included.  First let me say this, if your home is the only form of savings you have, you are in big trouble.  You should be considering equity management practices, which I have posted about before.  Now owning your primary residence is a good idea is most cases, although there are some exceptions.  My advice is buy close to your work, within walking distance if possible, buy small, use equity management strategies, and realize real estate is a long term investment.  The point is to minimize your cost of living so you have more money to invest.  If you spend all you have for housing, then you have created a situation where you are house poor and investment poor.  With the cost of gas, living  close to work can save you hundreds of dollars a month, which can be put to use acquiring assets.

2. Real Estate Investment Trusts.   There are three types of REIT’s.

     

  • Equity REITS, the most common type of REIT, invest in or own real estate and make money for investors from the rents they collect; 
  • Mortgage REITS lend money to owners and developers or invest in financial instruments secured by mortgages on real estate; and 
  • Hybrid REITS are a combination of equity and mortgage REITS.

Some REITS use leverage and some do not.  I only invest in leveraged REITS.  REITS are traded on various stock markets making them easy to buy and sell or liquid.  They have their own accounting regulations that require them to pay out the rent they collect.  Speak to an accountant for an in-depth discussion of REIT accounting.  You have dividends paid out each year, which can be reinvested.  The value of the underlying real estate backs up the investment and the rents along with the real estate value determine what the market prices their shares in the long run.  Because they are so liquid, they are subject to the whims of investors on a daily basis.  The REIT I own currently pays a dividend of 6%.  Over the last 10 years REITs have outperformed all other classes of stocks.  Positives include liquidity, someone else managing the properties, some leverage applied, access to larger properties than one would normally have, and potential for double digit returns.  Negatives include daily price fluctuations, limited leverage, and the passive nature of the investment.  Since I am a big believer in long term real estate investing, I keep a good percentage of my assets in REITs.

3. Owning investment real estate outright.  Perhaps the best way to take advantage of the various tax and leverage pluses of real estate is to buy real estate and rent it out.  This can range from single family homes to duplexes to apartment complexes to commercial property.  I can think of no better way to have a comfortable retirement than this strategy.  Beware, this is not the place for amateurs going it alone after attending some seminar.  You need an experienced hand to help you. I suggest talking to Bawld Guy first, if this is your intention.  Just click on the Brown & Brown link to the right!

The matrix for investment real estate is very different than the one for buying a personal residence. Here are some basic considerations:

CAP Rate: Net Operating Income/ Purchase Price.  This is a great tool for comparing properties.  Net Operating Income is the total of all rents received minus maintenance expenses, vacancy expense, taxes, insurance, repairs, management fees.  Cap rates are usually in the single digits.  The higher the better.  But this is only one metric to look at.

Cash Flow:  Add up the total of all expenses plus the mortgage cost for the year and divide by 12.  Compare this number to the total monthly rents collected X .8 to account for vacancies.  If this number is positive it is said to cash flow.  Never get in a situation where there is a negative cash flow.

Leverage:  How much money do you have to put down in order to have the property cash flow.  Generally the less you have to put down the better it is because you are using leverage.

Return on Investment:  Cash Flow + Appreciation/Down Payment.  If you put down $20,000 on a property that cash flows $2000/year and appreciated $4000 then you have a return on investment of 30%.

Market Demand:  First, what is the market demand for rental properties in the specific area you are thinking about buying?  Does this area of a net inflow of population?  Can they afford the rents you are asking?  How does the rent you are asking compare to other rental properties?  Are you trying to rent a one-bedroom apt. in an area dominated by families who are looking for multiple bedrooms?  What is your target renter? etc.    Now, how about appreciation in the area.  Is this an area where there was an extreme bubble.  Net inflow of population?  Area trends?  Affordability factor?  Jobs in the area? This is where an experienced hand really comes in handy!

Management:  Are you going to manage it yourself?  This is not recommended because it limits your investment to areas close to where you live now.  How much will it cost you?  6% seems to be a good number to aim for.

Location:  Can be anywhere the analysis leads you to.  Most likely not going to be in your backyard!

Once again don’t let this intimidate you, hire an experienced investment real estate person to guide you.  Remember, only a small minority of real estate folks specialize in investment RE!  Use only them.

Positives: Tax deductions, Leverage, Accessible to most of the middle class.  Negatives: not liquid, requires active participation, high learning curve (can be offset by using Bawld Guy!).

4.  Private placement investments.  Many groups form LLCs to invest in real estate.  Also land developers are always looking for capital.  If you can hook up with good experienced people, then you can get outsized returns.  Usually, this only happens after you have been an active investor for a while and meet people in the industry. This is not a place to start investing.  But to experienced real estate investors it is a place that can be very fruitful.  Positives: Outsized returns, limited time required (half way between active and passive investing), leverage.  Negative:  Higher risk, high level associations needed.

5. Second Homes.  Generally not a great investment, but if leveraged can get double digit returns if price appreciates 4%/year.  If you rent it out part of the year, you can get some cash flow, but generally they are cash flow negative.  Being totally dependent on price appreciation is not the best place to be, but can work out in the long run.  I put this under life style investing.  Instead of driving that Lexus, which will depreciate, own a Toyota and buy a second home.  You will get more pleasure out of it and will make money in the long run with it.

6. Raw Land.  Extremely speculative and long term.  Think in terms of your children and grandchildren.  Don’t expect to ever see the money in your life time.  If you do, then lucky you! 

Hope this helps folks.

****This is only the ramblings of the village idiot, who does not have a license to sell real estate or securities.  Go to a professional for real estate advice.  Go to an accountant for accounting advice with regards to real estate ownership.  Go to a stock broker/financial planner if you want to hear what Wall Street thinks about any individual security.  Once again this blog and this post are for amusement purposes only and does not represent any offer to sale or buy real estate or securities or offer any advice as to what the reader should do.  Do your own independent research as I have done before making any financial decisions.*****

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Comments»

1. Joshua - August 1, 2008

Very helpful. Nice to see many of the analysis items in one place!

2. shaferfinancial - August 1, 2008

Thank you Joshua

3. Another Investor - August 1, 2008

I think you mean return ON investment. If you realize $2000 net income and a net $4000 in appreciation over the first year on your $20,000 equity investment, then your return ON your investment is 30 percent.

Also, cap rates are not always in the single digits. When real estate is out of favor, rents are declining, and/or alternative investment yields are higher, cap rates will be in double digits. I distinctly remember looking at small, unanchored strip centers in Silicon Valley in the late 80’s or early 90’s that sold at 13 percent plus cap rates based on the NOI from occupied space (no value attributed to the vacant space).

We have been in a very positive real estate market with free-flowing capital and low yields on competing investments for a long time, long enough for most people to forget the last recession and the transfer of weath that resulted from the S&L crisis. Bad markets can and will happen again. There is risk in real estate, and the “secret” to wealth building with real estate is understanding and defending against the risks.

4. shaferfinancial - August 1, 2008

Yes, thank you, it is corrected! If you get double figures for a cap rate that is a wonderful thing. Real Estate doesn’t go up all the time, that is why you invest for the long term and make sure it cash flows. That enables you to float through the down times without issues. Bawld Guy also wrote about what he calls a Sominex account on this blog, which is a reserve account. Also an important factor. Thanks for your comments, it sounds like you have been there and done it successfully.

5. Another Investor - August 1, 2008

Cash flow and the size of your “Sominex” account go hand in hand. Leverage, which reduces your cash flow, is best maximized in the early part of the up cycle. Use leverage to accumulate assets when the market is on the upswing. Leverage should be stabilized and even decreased as you get to the top of the cycle and head down. Slow or stop acquisitions and protect what you have before the cycle tops out. Cash flow should increase as you decrease leverage, and that cash flow plus your “Sominex” account will carry you through those 20 percent vacancy and 30 percent decrease in rent times. Stronger cash flow equals a smaller botte of Sominex. If you have cash left over when the market bottoms out, you can be the bottom feeder.

And with all due respect to your hairless friend on the left coast, NEVER invest in a piece of real estate that does not cash flow. Not cash flows on paper with rosy assumptions, but cash flows with the actual income and anticipated realistic expenses. Hoping for appreciation to make an investment work when leverage is involved is even more dangerous than hoping the stock market will go up and salvage your 401(k). Long or short term, speculation can be very enticing, but it is risky and eventually you will get caught.

6. shaferfinancial - August 1, 2008

Words of wisdom, I’m sure!


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