Key to economic recovery: Curbing rate of foreclosures
By Catherine Reagor - Jan. 24, 2010 12:00 AM
The Arizona Republic
Before renewing efforts to build a new economic model, Arizona needs to first fix the battered foundation of its devastated growth-reliant housing economy.
That means bringing down foreclosure rates, which continue to drive down home values. Unstable home values undercut the larger economy by discouraging potential new residents and businesses. And Arizona homeowners, builders and investors with money tied up in the housing market are virtually paralyzed until values stabilize.
There are concrete ways to help the housing market recover through combined efforts from government and business. A stable housing market could pave the way for future growth that is more sustainable. Immediate steps include more help for struggling homeowners, greater use of federal money for neighborhood stabilization, diversification of Arizona's mighty home-building machine with a focus on different kinds of residential development other than fringe suburbs.
Metropolitan Phoenix has been hit harder by the national housing crash than any other part of the country because of the area's dependence on real estate.
• Home prices plummeted more than 50 percent in two years. Foreclosures hit a record 55,000 last year.
• Home building is down 85 percent since 2005.
• More than 200,000 construction jobs have disappeared since the home-building peak; unemployment is now 9.1 percent.
• The area's population has fallen since 2007, the first such decline since the Great Depression.
Fallout from the housing-market crash has contributed to an anticipated state budget deficit of $3.2 billion for fiscal 2011. Phoenix's battered housing sector must be stabilized before the region's overall economy can be mended. And to prevent a repeat of Arizona's painful boom-and-bust scenario, the area's housing-dependent economic model must be overhauled.
Along with new tactics, this will require more cooperation between government and business.
Collaboration can increase the impact of federal housing money intended to shore up battered neighborhoods and retool development that values a range of new housing.
For example, Arizona's influential real-estate industry groups, including the homebuilders, could direct some of their resources and lobbying efforts to help consumers. Arizona's real-estate groups and businesses have the power, money and member expertise to do a lot to stem foreclosures, revitalize neighborhoods and help the housing industry evolve.
There will be pain felt by those reliant on the old growth model. But if the housing industry could work with government to pool resources, that would help more homeowners, save and create jobs, stabilize the economy and position Arizona for future growth.
"Arizona's problems are not just cyclical, like markets. They're structural," said John Graham, president of developer Sunbelt Holdings and the Urban Land Institute Arizona, a growth think tank. "Fast growth cycles are a thing of the past. We need to adjust and plan for slower and more sustainable growth."
Here are some immediate ways to stabilize the housing market.
Slow foreclosures
The first task is to curb foreclosures. Arizona continues to be one of the top three states in foreclosure rate.
Research shows that keeping more people in their homes stabilizes families, neighborhoods and the economy. National foreclosure-prevention programs hosted by big non-profits and lenders in the past year have not been as successful as many hoped. Government and business leaders, particularly those affiliated with lenders, have the power to push for more home-loan modifications backed by the federal government.
Arizona's budget deficit means the Arizona Housing Department is dealing with huge budget cuts and smaller staff when there is a need for more financial counseling for homeowners.
Housing non-profits receive federal funding for each homeowner they assist. Struggling homeowners are directed to these non-profits through Arizona's foreclosure hotline. However, the number of homeowners calling the help line isn't keeping pace with the rise in foreclosures, suggesting that many struggling homeowners don't know about the free help. Fewer calls mean Arizona won't receive all its federal funding. Housing counselors, real-estate agents and attorneys working on foreclosures say most struggling homeowners don't know about free help. Arizona's business community has the ability to spread the word.
Struggling homeowners also need more time. Other states have placed moratoriums on many foreclosures because government and housing advocates found that homeowners asking for help or in the process of receiving loan modifications were still foreclosed on.
Loan modifications for metropolitan Phoenix homeowners continue to lag and fail. A growing number of homeowners in the middle of negotiating with their lenders still lose homes to foreclosure because of problems with the process.
A foreclosure-moratorium program in Arizona, along with a private/public partnership group to review pending foreclosures, could substantially reduce foreclosures.
Better regulation
Weak regulation of Arizona's lending and real-estate industries led to poorly conceived mortgages that contribute to the state's foreclosure problem.
Not every industry that plays a big role in the sale of a home is even regulated. Confidence and stability in the system could improve if all segments of the real-estate industry were regulated equally.
During the boom, more than 10,000 Arizona loan officers operated with no regulations; they weren't even screened for criminal backgrounds. Bad mortgages, illegal mortgages and mortgage fraud perpetrated or assisted by unscrupulous loan officers became too common.
Even existing safeguards are weak. Arizona real-estate and lending regulators face huge budget cuts like other state agencies. The state Appraisal Board has no full-time inspectors. Budgets for investigations done by the Arizona Department of Financial Institutions and the Arizona Department of Real Estate have been slashed.
A bill to license loan originators passed in Arizona two years ago and is supposed to become effective this summer. However, the state agency charged with enforcing the law doesn't have the funds to administer the criminal-background checks.
Arizona's real-estate regulation could be improved if state agencies had investigators who were paid through increased licensing fees or fines collected for violations.
A group of Arizona appraisers are now pushing for new regulations in their profession. There is strong support from others in Arizona's real-estate industry for better regulation. However, if there is no money for more regulation and enforcement of current laws, industry leaders could help with more self-regulation.
Recently, a former Scottsdale real-estate executive was sentenced to six years in prison and ordered to pay $6 million in restitution to his firm. He was charged with embezzling $11 million through phony real-estate deals from his former employer. The executive's employer conducted its own internal investigation and handed the case over to the Arizona attorney general.
Empty homes
Phoenix's record number of empty homes presents other opportunities for stabilizing the housing economy.
Vacant properties often mean blight and crime for neighborhoods and drag down home values. Many empty homes today are foreclosure properties, abandoned by owners and neglected by lenders. Others are empty rentals. Some are unsold new homes.
Federal funds are available to rehabilitate, sell and utilize more than 80,000 empty homes across the Phoenix area. Doing so would create jobs and help stabilize neighborhoods and home values.
Arizona will soon receive $118 million in federal funding to help neighborhoods hit hard by foreclosures, which follows $121 million from last year. The money is aimed at people willing to take on foreclosure properties as their primary residences. But those prospective homeowners, often stretched for cash, are now in competition with investors.
Arizona could take steps to curb housing speculation and support more homeowners willing to help build neighborhoods. Lenders, especially government-owned Fannie Mae, could give such people preferential treatment.
Cities and non-profit housing groups also could convert abandoned homes into affordable rentals for people who have lost homes to foreclosure or into group homes for the elderly and handicapped. Such projects would allow local government, non-profits and builders to tap federal funding designed to provide different types of housing.
Industry overhaul
Metropolitan Phoenix needs more new residents to stabilize its housing industry.
A more diversified housing stock - including more apartments, affordable housing and mixed-use projects that reuse foreclosure homes in established areas - would offer alternatives to more acres of single-family homes in ever more distant suburbs. Again, federal money is there to help.
The building industry can reshape itself and metro Phoenix's growth pattern by shifting the long-standing focus on edge developments to include a greater variety of housing to attract and retain a greater variety of people.
Such a shift in focus could include, for example, reusing homes and vacant land in foreclosure and would provide construction jobs and help struggling neighborhoods and people by providing more affordable housing.
There are national grants and federal funding to help the building industry change its focus. The Arizona State University School of Construction and ASU's Stardust Center for affordable housing can both help find funding and provide training and design services to help the building industry evolve. Both entities are already working on innovative plans for different types of housing developments. They just need more builders and lenders willing to take them on.
Arizona cities can help by expediting building permits for these new types of projects. In the past, it's been easier to get plans approved for basic single-family homes built in expanding suburbs.
No quick fix
The housing industry can't rely on Arizona's old model for growth. No one in Arizona can rely on annual 50 percent home price run-ups again.
Many housing-industry leaders are working to overhaul their operations to meet current market reality.
The head of one prominent Arizona homebuilder has said his firm will never pay a high price for a huge chunk of land on Phoenix's fringes where there is no other development because it's no longer what the region needs, homebuyers want, or a money-making move.
Estimates now are that it will take more than five years for metro Phoenix's home values to climb back toward their highs of 2006. But recovery won't begin until more jobs are created, foreclosures slow and the building industry regroups.
Sunday, January 24, 2010
Sunday, January 10, 2010
How to Profit from the Biggest Housing Bust
Since the Great Depression
I remember when $7 trillion was a big number. That was the “wealth” Americans lost — peak to trough — in the dot.com bust in the early 2000s. Apparently, we were just warming up…
According to the Federal Reserve’s Flow of Funds, we just set a new record for wealth destruction as household net worth shrank by $12.7 trillion since 2007. That’s more than the annual economic output of any country in the world, except ours. And it comes close.
So what to make of another bust? Why, a bargain hunting extravaganza, of course!
“Buy at the point of maximum pessimism,” famous value investor Sir John Templeton once said. And he made quite a few hundred million for himself doing just that. I think the point of maximum pessimism would be about now and for the next year or two. Certainly, housing is priced for the end of the world. If they’re right, it’s a moot point. The world ends, and you don’t have to pay off the mortgage.
But if they’re wrong and this is just another chapter in our manic-depressive history, now is a good time to buy. But don’t just take my layman’s psychology for it. Take a good look at the numbers.
Almost Free Real Estate
Real estate is so cheap in some parts of the country right now, it’s almost free. Nationwide, prices for existing homes are down 20% since 2006. That’s according to the
National Association of Realtors, a massive, entirely biased and shameless lobbying group and the biggest bubble boosters since Alan Greenspan. So their numbers are probably padded. But even if you take them at face value, a 20% fall is HUGE in a country where they long bragged real estate had never fallen nationwide…not by a single percent.
Add to that the fact that most people in 2006, were buying with 10% down, 5% down, 3% or zero down and getting 3% back to buy the property (103% financing) you can see how many people from the peak years are automatically underwater. They owe more than the house is worth. And in the worst markets around the country it’s absolutely brutal.
From Bad to Best
Former boom markets now are the biggest busts and in many cases offer the best values. The time to buy these markets wasn’t when everyone and their aunt had a real estate license and the
shoe shine boy was talking “flips.” The time to buy is now, when no one wants to know nuthin’
about real estate.
That’s the case in South Florida, California, Nevada, and Arizona to name a few of the worst hit
— and best value — markets today.
In 2007, the median value of a house in Los Angeles was $593,600. Today it’s $311,100. That’s a
47% fall. In Las Vegas, the median has plunged 52%, from $297,700 to $141,800. And in Cape
Coral, Florida, from $252,100 to $84,000, a 69% crash! Here is a look at some of the hardest hit…
Busted: America’s Hardest Hit Housing Markets
Metropolitan Area 2007 2008.II 2009.II 1 Yr
Change Change from
07
U.S. 217.9 206.4 174.1 -16%
NE 288.1 272.3 246.0 -10%
MW 161.4 160.7 146.8 -9%
SO 178.8 176.9 158.6 -10%
WE 342.5 289.7 212.6 -27%
Akron, OH 119.3 106.5 88.0 -17% -26%
Cape Coral-Fort Myers, FL 252.1 178.1 84.0 -53% -67%
Chicago-Naperville-Joliet, IL 276.6 257.6 204.3 -21% -26%
Deltona-Daytona Beach- Ormond Beach, FL 192.3 173.4 127.2 -27% -34%
Grand Rapids, MI 129.4 112.5 86.5 -23% -33%
Lansing-E.Lansing, MI 126.8 108.4 81.2 -25% -36%
Las Vegas-Paradise, NV 297.7 235.3 141.8 -40% -52%
Los Angeles-Long Beach- Santa Ana, CA 593.6 418.9 311.1 -26% -48%
Miami-Fort Lauderdale-Miami
Beach, FL 365.5 310.2 207.4 -33% -43%
Ocala, FL 164.6 147.6 110.2 -25% -33%
Orlando, FL 261.3 223.5 149.2 -33% -43%
Palm Bay-Melbourne- Titusville, FL 183.6 148.0 104.1 -30% -43%
Phoenix-Mesa-Scottsdale, AZ 257.4 205.1 131.1 -36% -49%
Providence-New Bedford-Fall
River, RI-MA 286.5 269.2 215.7 -20% -25%
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eno-Sparks, NV 3 21.4 274.4 192.1 -30% -40%
Riverside-San Bernardino- Ontario, CA 379.5 265.2 161.5 -39% -57%
Sacramento--Arden-Arcade-- Roseville, CA 342.8 229.5 177.5 -23% -48%
Saginaw-Saginaw Township
North, MI 82.1 80.3 55.7 -31% -32%
San Diego-Carlsbad-San
Marcos, CA 588.7 434.9 347.1 -20% -41%
San Francisco-Oakland- Fremont, CA 804.8 684.9 472.9 -31% -41%
San Jose-Sunnyvale-Santa
Clara, CA 836.8 755.0 500.0 -34% -40%
Sarasota-Bradenton-Venice, FL 310.9 266.4 175.8 -34% -43%
Tampa-St.Petersburg- Clearwater, FL 214.9 180.8 140.9 -22% -34%
Tucson, AZ 244.8 215.9 174.1 -19% -29%
Washington-Arlington- Alexandria, DC-VA-MD-WV 430.8 371.1 319.2 -14% -26%
Worcester, MA 274.6 247.3 220.3 -11% -20%
Key Reasons for Taking a Hard Look at the Hardest Hit Residential Real
Estate Markets
It’s not just the fact that houses have fallen so hard so fast that makes them an excellent value in many areas. There are two other key reasons:
1. Many houses are selling below replacement value
2. Many houses are selling at unprecedented cash-flow prices
On top of that, you have a few compelling secondary reasons to buy now. These are…
• Interest rates are extremely low.
• The prospects for a resurgence of inflation over the next five to 10 years are good.
These are secondary reasons because even without them, the primary reasons make housing in many parts of the country an excellent investment right now. What’s more, the low interest rates may not last. And inflation may never take hold again with a vengeance. That’s unlikely but a possibility. Even without these boosters, however, houses in many parts of the country should
do well in coming years because of their phenomenal discount to replacement cost and the
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significant cash flow they offer.
Let’s look at replacement costs first.
Houses in Many Parts of the Country Are Selling for Less than Replacement Value
Many homes are selling at prices below replacement value. For instance, take an
1,100 square foot house in a working class neighborhood not far from where I live. This home sold for $150,000 at the peak and now the bank is ready to unload it for
$50,000. The mark-down from the former high is impressive. But the discount to replacement value is the key. That (and
the cash flow we’ll cover in a moment) is
what gives you a great margin of safety.
Careful with the Condos!
Condos have also suffered mightily. In Miami, Fort Myers and Las Vegas they’re down over
60% from their peaks. In Sacramento, over 55%. But we’re covering single family homes in this report. There are amazing opportunities in single condos, but you have to know how to research the condo association and make sure you’re not buying into a mostly vacant complex or one in serious financial trouble…so that you don’t end up buying a maintenance fee that is about to skyrocket! But that’s a house of a different color, as they say. So, for now, we are honing in on single-family homes because there is great value to be found in this segment and they have many advantages for first-time investors.
For instance, if we use a construction price of $125 a square foot, it would cost $137,500 to build the house brand new. Granted the current house is 50 years old, but the electric was recently updated and it’s solid CBS construction (concrete block and stucco) and sits on a nice fifth
of an acre corner lot. You could put a new roof on the house, install new windows and doors, completely renovate the kitchen and two baths, put in new floors, paint inside and out and put in new landscaping and fencing — all for less than $50,000.
Making an 1100 Square Foot House Like New*
Roof 1200 sf ($500/square*) $6,000
12 New windows $2,400
3 New exterior doors $1,200
500 sf of new wood floors $3,000
600 sf of new tile floors $1,800
New central AC $4,500
Exterior Painting $2,000
Interior Painting $1,500
Landscaping $1,500
Fencing $1,500
Lighting $2,000
Miscellaneous $5,000
Renovate two bathrooms $7,000
Renovate kitchen $10,000
Total $49,400
*In roofing a square is 100 square feet. So 1,100 square feet is equivalent to 11 squares. For this 1,100 square foot house we posit
1,200 square feet to accommodate for the overhang of eaves and some waste. The $500/square estimate is on the high side for a new shingle roof, including labor and materials. Depending on the condition of the roof and the kind of shingles you use, it’s possible you could do it for considerably less. 4
*All prices include labor and materials and are medium-high estimates.
The house would be like new once again for a total cost of about $50,000 less than it would cost to build it from scratch. And that doesn’t count the value of the land!
Now, that doesn’t mean you do all these repairs on every property you rehab. Nor would you necessarily spend this much. Even if you did all this work, you may spend considerably less if you’re experienced or a good shopper. It simply goes to show how houses are selling at prices
far below their intrinsic value when measured by their replacement cost. There is no limit to how high things can sell for in a bubble. But in a bust, there comes a point where you see you can
pick up assets for far less than what they’re likely to be worth in the long term. This is one of those times.
Houses Are Selling at Great Cash Flow Prices
One of the great things about real estate is that you can buy it with mostly borrowed money and then have your tenants pay off the loan. But only if you buy at a good cash flow price. If a house pulls in $1,500 in rent a month and you pay $450,000 for it, you will not cash flow no matter how high an occupancy rate you run or how low you keep your expenses. That’s because you paid too much as a multiple of rent.
The term is Gross Rent Multiplier (GRM). It’s the price you pay for the house divided by its gross annual potential rent. In the above example the gross annual rent was $18,000. Divide the price of the house by that rent and you get 25. That’s the GRM you paid.
And that’s way too high if you want a cash-flow property!
Instead, if you want to cash flow and are putting 20% down, you should pay no more than ten times rent. In markets with low to reasonable property taxes and insurance, you should cash flow a little at that ratio. But if you have higher levels of taxes and insurance (like in South Florida), with a GRM of 10, you may just break even. To be more comfortable, buy at a GRM of eight or better. From six and below, you’ll typically cash-flow like an ATM!
And these GRMs are available today in many markets. In some markets, even lower. To see the GRMs we’ll use HUD’s fair market rents for a three bedroom property in various markets and compare them against the average home price in that area. Today, these markets have also
experienced falling rents, but not nearly as quickly as property prices have fallen. So their GRMs have come down, often very sharply. And that means that many markets that didn’t come close to cash flowing a few years ago now cash-flow like rivers.
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Many Markets Are Turning into Cash Cows
Metropolitan Area Median Home Value Monthly
Rent* Annualized
Rent GRM**
Akron, OH $88,000 $969 $11,628 7.6
Cape Coral-Fort Myers, FL $84,000 $1,398 $16,776 5.0
Chicago-Naperville-Joliet, IL $204,300 $1,240 $14,880 13.7
Deltona-Daytona Beach-Ormond Beach, FL 127,200 $1,226 $14,712 8.6
Grand Rapids, MI $86,500 $956 $11,472 7.5
Lansing-E.Lansing, MI $81,200 $963 $11,556 7.0
Las Vegas-Paradise, NV $141,800 $1,478 $17,736 8.0
Los Angeles-Long Beach-Santa Ana, CA $311,100 $1,907 $22,884 13.6
Miami-Fort Lauderdale-Miami Beach, FL $207,400 $1,542 $18,504 11.2
Ocala, FL $110,200 $1,040 $12,480 8.8
Orlando, FL $149,200 $1,317 $15,804 9.4
Palm Bay-Melbourne-Titusville, FL $104,100 $1,234 $14,808 7.0
Phoenix-Mesa-Scottsdale, AZ $131,100 $1,338 $16,056 8.2
Providence-New Bedford-Fall River, RI-MA $215,700 $1,151 $13,812 15.6
Reno-Sparks, NV $192,100 $1,488 $17,856 10.8
Riverside-San Bernardino-Ontario, CA $161,500 $1,559 $18,708 8.6
Sacramento--Arden-Arcade--Roseville, CA $177,500 $1,499 $17,988 9.9
Saginaw-Saginaw Township North, MI $55,700 $815 $9,780 5.7
San Diego-Carlsbad-San Marcos, CA $347,100 $1,883 $22,596 15.4
San Francisco-Oakland-Fremont, CA $472,900 $2,350 $28,200 16.8
San Jose-Sunnyvale-Santa Clara, CA $500,000 $2,068 $24,816 20.1
Sarasota-Bradenton-Venice, FL $175,800 $1,465 $17,580 10.0
Tampa-St.Petersburg-Clearwater, FL $140,900 $1,215 $14,580 9.7
Tucson, AZ $174,100 $1,174 $14,088 12.4
Washington-Arlington-Alexandria, DC-VA-MD-WV $319,200 $1,745 $20,940 15.2
Worcester, MA $220,300 $1,185 $14,220 15.5
* Fair Market Rent per HUD 2010 tables for 3 bedroom rental properties
** Gross Rent Multiplier = Price/(Gross Annual Rents)
To get an idea of how dramatic the change is, consider this. In 2006, Los Angeles was trading at
a GRM of 30.5. That was impossible to cash flow. Now it’s just 13.6. And if you’re a sharp buyer
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in that market focusing on foreclosures or bank owned properties you can now begin to find
properties at 10 times rent or below.
Similarly, Cape Coral reached a GRM of 24 in 2006, Las Vegas was at 21, and Riverside, CA was at 30.5! None made sense on a cash flow basis. Now they’re all in cash-flow territory and Cape Coral is at an unbelievable level — trading at just five times rent! At those kinds of prices, you can get incredible yields. You can then put yourself in line for serious capital gains down the road. Take a look:
Cape Coral Cash Cows
Purchase Price (Median Price Q209)
$84,000
Repairs Reserves and Closing Costs $16,000
Total Investment $100,000
Cash $25,000
Loan $75,000
Monthly
Annual
Rent (FMR rent for 3BR House 2010) $1,398 $16,776
Vacancy and collection losses (10%) $140 $1,678
Net Rents $1,258 $15,098
Property Taxes (2%) $140 $1,680
Insurance $42 $500
Maintenance $125 $1,500
Lawn/snow removal $75 $900
Licenses/fees $15 $180
Miscellaneous $50 $600
Total Expenses $447 $5,360
Net Operating Income
$812
$9,738
Mortgage payment (7%, 30 years)
$508
$6,093
Cash flow
$304
$3,645
Cash Yield (annual net cash flow divided by $25,000 cash investment)
14.6%
That’s a killer yield. But when you add the appreciation you can see over the years, plus added equity you’ll gain in amortization (if you’re holding it for the long term), you can get some very nice total returns.
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Specifically, even if the market recovers in very moderate fashion over the next decade you could make three to four times your money.
As an example, we’ll look at a market not quite as cheap as Cape Coral. We’ll look at one trading at, say, seven times rent. And since you’re a diligent researcher and selective investor, you end up doing a bit better than the average. You buy at six times rent.
To put numbers to it, we’ll say the median priced home is now $105,000, and it rents for $1,250 a month (or $15,000 annualized for a GRM of 7). But you’re a sharp buyer and get a little better deal, and pick up a bank-owned property or foreclosure for $90,000.
You’re going to put down 20% ($18,000) and put aside $10,000 for closing costs, reserves and some light fix up. So your total cash investment is $28,000. The mortgage on your property is
$72,000 (80% of the purchase price). Let’s say you have good credit so you get an interest rate of
6% on a 30-year fixed rate loan. So your mortgage payment is going to be $432 a month.
(If you have lousy credit and no cash, you can still invest in real estate. Obviously, it takes more work but it is entirely doable. You just have to learn another skill: bringing investors together. That can mean equity investors or debt investors or both. We may cover that in other reports, but for now we’re running the numbers the simplest way.
If you put together your own financing through private parties, the same ideas apply. The one key difference is you may pay a couple of percent more in interest. But if you’re buying right, that’s OK. You can still do well.)
Here’s how the numbers might look…
An Example of Double Digit Yields
When Buying at Six Times Rent
Purchase Price $90,000
Down Payment $18,000
Loan $72,000
Gross Potential Rent
Monthly
$1,250
Annual
$15,000
Vacancy & Collection Losses (10%) $125 $1,500
Net Rents $1,125 $13,500
Expenses
Taxes (2%)
$150
$1,800
Insurance $38 $450
Lawn Maintenance/Snow Removal $75 $900
Repairs & Maintenance $150 $1,800
Licenses $10 $125
Advertising $10 $120
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iscellaneous $25 $300
Total Expenses $458 $5,495
Mortgage Payment
$432
$5,184
Net Cash Flow
$235
$2,821
Total Initial Cash Investment (Down Payment +
$10,000 for closing costs, reserves & initial repairs)
$28,000
Cash on Cash Yield (annual net cash flow divided by initial cash investment)
10.1%
We don’t have as quite a good yield as we had in Cape Coral, but it’s still very good. Even
after conservatively budgeting for reserves and initial repairs at the purchase and budgeting for vacancy and maintenance in the rental period, you end up with a 10% yield on your money!
A Strong Cash-flow Property Pays You a Strong Yield Now But Also Lets You
Hold It through a Recovery and Benefit from Leveraged Appreciation
Now let’s see what happens when you sell. Let’s say this is for retirement and you sell it in
10 years. We’ll also suppose real estate in the area appreciates by just 3% a year — about the long-term inflation rate. (With the government printing money like confetti, it’s very possible housing will appreciate at a much higher rate once the market bottoms. But we’ll stick with a 3% projection for this illustration.)
Since your house was worth $105,000 when you bought it (you got a discount, remember), we’ll start with that number and compound it at 3% a year for 10 years. (We’re going to round to the nearest thousand to keep things simple.) At the end of that time, your house is now worth
$141,000. The balance on your mortgage has fallen to $60,000. Let’s assume you pay $10,000 in commissions and closing costs when you sell. In that case you’ve turned an initial $28,000 into
$71,000 in net equity after 10 years! Plus you picked up over $28,000 in net rental income in that time. So you turned $28,000 into over $99,000 in 10 years.
$141,000 Sale Price minus $60,000 in mortgage balance minus $10,000 in commissions and closing costs = $71,000
$28,000 in net rental income + $71,000 in net equity = $99,000
That’s the power of leverage on a well managed income-producing investment.
Now imagine you happened to buy in an area that grows in popularity. It might be a formerly down-at-the-heels downtown that has been revitalized, or a neighborhood that becomes
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increasingly popular because of its schools. In that case, you might very realistically see 5%
annual appreciation because you had an eye for “location, location, location.”
Now your house would be worth $171,000. You net equity would be $101,000. Add in the net rents and you’ve turned $28,000 into $129,000 in 10 years. Now let’s say you do just three of these puppies and you’ve turned a portfolio of about $100,000 into $400,000 in 10 years.
That’s about a 16.5% compounded annual return — even if the stock market goes nowhere.
Investing in Houses Can Be Fairly Tax Efficient
Plus, you’d do pretty well on taxes. The cash flow would likely be tax-free or nearly tax-free. That’s because you get to use depreciation (a non-cash charge) to reduce your taxable income on the house. And when you sell the house, your gains are taxed at the lower long-term capital
gains rate. Also you can do things like a 1031 Exchange that could defer your capital gains taxes
indefinitely.
Last but not least, you could do all this in your Self-directed IRA for even greater tax savings and to put money “locked” in your IRA to better use than you may feel you’re getting with stocks currently.
But can you do even better? Absolutely.
Going from Individual Investor to General Partner
When you learn how to make money for yourself this way, you can begin to make money for others. Then you can bring private investors into your deal. Once you learn how to use good professional property management as well, there is no limit to the amount of deals you can do.
You can have investors bring most of the down payment and other investors furnish the debt financing. The equity investors get the benefit of leverage without personally being on the note themselves and without the work and expertise required to find and negotiate a good deal, close it, get the property “performing” (producing income near its capacity) and eventually liquidate the investment. All they do is write you a check. Their liability is limited to the amount on that check and their returns can be excellent.
Your debt investors meanwhile can get an interest rate much higher than from banks or investment- grade bonds or dividend yielding stocks. And they get it with the security of good collateral.
From Single Family Homes to Small Multi-Families, Large Apartment
Buildings, Office Parks, Public Storage Facilities and More
Real estate offers many different categories in which you can invest. And each category has sub categories. For instance, there is residential real estate. This includes single-family homes as well
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as small residential properties (from duplexes to four unit). These are all financed by the same
types of commercial banks. When a property has more than four units, it falls into the commercial category, involving different types of lenders, different requirements and terms for financing and different rules on disclosure, investor protection etc. Then, of course, you also have large apartment complexes as well as condos and co-ops. And that’s just a quick overview of residential.
You can also look into various types of retail: single store, strip mall, large mall, shopping center, or “anchored” shopping center (with a national name like Target or Home Depot drawing traffic for all the other tenants). Then you’ve got office buildings and office parks. You have warehouses and even warehouse condos. You have trailer parks (providing huge cash yields, often north of
20%) where residents own their trailers and others where they rent the land and the trailer from you. Then there’s industrial, specialty (like gas stations), public storage spaces (probably the greatest dollars per square foot property investment you’ll find when done right).
On top of the types of property, there are dozens of major strategies: from straight out cash purchases to leveraged deals, from lease options to leasebacks, sale-backs, triple net investing, rehabbing, repositioning, land-banking, and conversions (from apartment to condos or vice versa), just to name a few.
All these property types and strategies can offer great opportunities. But they all have different challenges and require very specific knowledge. We’ve focused on single-family houses and renting them out for three to 10 years in this report. We’ve done that as an introduction to real estate but also because — even if you’re an experienced investor in commercial real estate — there are such compelling deals on single family houses today, that you may seriously want to consider picking up at least one or two even if you’re working full time on bigger property deals.
Also, if you haven’t done real estate before, single-family homes offer a pretty straightforward way to cut your teeth and make some money. When you buy in a bombed-out market, as we have today, with the intent of renting your houses out for three to 10 years, you can keep your risk
very low while profiting from net cash flow, amortization (the reduction of the loan balance) and
leveraged appreciation.
That’s the kind of real estate I did initially — from single-family homes to 4 unit properties.
Only after I had success with these and my shares of ups and downs, did I feel confident to invest
in value markets outside of my state. This helped me make money when Florida was a bubble and offered no more values. It also gave me a bit more confidence for when I finally made the move up to larger apartment buildings.
But for experienced and new investors alike, residential real estate offers some unique advantages:
• Residential real estate has fallen the farthest in many parts of the country, offering the best values.
• If you’re investing for the very long term, say 10 to 20 years, just three or four investments in single family homes could produce enough wealth for you to retire with a significant net worth…and a steady retirement income.
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• You can manage your own rental homes. If you have up to three or four houses, it
doesn’t have to be difficult or time-consuming. Plus, the skills you’ll learn with hands-on management of your initial modest portfolio can come in handy later if you expand to bigger properties. You may end up with 50 to 500 units one day and the principles you learned managing your first few houses will still apply to larger properties and make it easier for you to “manage your managers.”
• Tenants pay the utilities. With many multi-unit properties, even small ones, some of the utilities may be paid for by the landlord…especially water and heat. Granted, you charge a bit higher rent in those cases but the tenants aren’t going to be as cost-conscious when using electricity or water if they never see the bill and especially if they never pay the bill. With single-family homes, you usually won’t pay any utilities.
• Houses are relatively easy to rent. There is a large market of people for clean, safe and affordable rentals in the single-family home area. It’s not like you’re trying to rent out retail space during a recession. People gotta live somewhere. Of course, you have to be sensitive to local economic conditions and adjust your rents and deposit requirements to remain
competitive in the market, but as long as you do that, you should always be able to maintain a high occupancy.
• Houses are relatively easy to sell. Right now, nothing is easy to sell. But we’re buying during economic crisis to sell later, when the economy is growing again. And single-family homes are the largest segment of the real estate market. When the time comes to sell, you may find a lot more potential buyers than if you were unloading a trailer park or storage facility.
• Interest rates are very low today (if you know how to get the money). Interest rates right now are dirt-cheap. And even if you can’t qualify for a bank loan to buy an investment property… if banks in your area simply aren’t lending on investment properties…low interest rates also mean you can get good terms from private lenders. So where you might have paid a private lender 10% to 12% during the boom, today you may find one who is thrilled to finance your deal at 7.5% — especially when he’s getting less than one percent on his savings at the bank.
So if you’re just getting started in real estate or want to keep things simple, give some thought to single family-homes. When you learn how to buy right, adding just one, two or three of these to your portfolio can result in extraordinary profits down the road.
If you want to keep your risk low while pursuing those profits, here are a few good guidelines:
A Success Check List
• Focus on one or two target markets. (You’re more likely to find excellent deals when you thoroughly research one or two areas.)
• Buy cash flow only. (Run the numbers like we did and make sure you budget for vacancy and maintenance. Also have ample reserves on hand when making the investment.)
• Do your research so that you can buy at or below market value. (Go online to your local property tax assessor’s website or work with a real estate agent so you know comparable values very well in the market you’re buying.)
Since the Great Depression
I remember when $7 trillion was a big number. That was the “wealth” Americans lost — peak to trough — in the dot.com bust in the early 2000s. Apparently, we were just warming up…
According to the Federal Reserve’s Flow of Funds, we just set a new record for wealth destruction as household net worth shrank by $12.7 trillion since 2007. That’s more than the annual economic output of any country in the world, except ours. And it comes close.
So what to make of another bust? Why, a bargain hunting extravaganza, of course!
“Buy at the point of maximum pessimism,” famous value investor Sir John Templeton once said. And he made quite a few hundred million for himself doing just that. I think the point of maximum pessimism would be about now and for the next year or two. Certainly, housing is priced for the end of the world. If they’re right, it’s a moot point. The world ends, and you don’t have to pay off the mortgage.
But if they’re wrong and this is just another chapter in our manic-depressive history, now is a good time to buy. But don’t just take my layman’s psychology for it. Take a good look at the numbers.
Almost Free Real Estate
Real estate is so cheap in some parts of the country right now, it’s almost free. Nationwide, prices for existing homes are down 20% since 2006. That’s according to the
National Association of Realtors, a massive, entirely biased and shameless lobbying group and the biggest bubble boosters since Alan Greenspan. So their numbers are probably padded. But even if you take them at face value, a 20% fall is HUGE in a country where they long bragged real estate had never fallen nationwide…not by a single percent.
Add to that the fact that most people in 2006, were buying with 10% down, 5% down, 3% or zero down and getting 3% back to buy the property (103% financing) you can see how many people from the peak years are automatically underwater. They owe more than the house is worth. And in the worst markets around the country it’s absolutely brutal.
From Bad to Best
Former boom markets now are the biggest busts and in many cases offer the best values. The time to buy these markets wasn’t when everyone and their aunt had a real estate license and the
shoe shine boy was talking “flips.” The time to buy is now, when no one wants to know nuthin’
about real estate.
That’s the case in South Florida, California, Nevada, and Arizona to name a few of the worst hit
— and best value — markets today.
In 2007, the median value of a house in Los Angeles was $593,600. Today it’s $311,100. That’s a
47% fall. In Las Vegas, the median has plunged 52%, from $297,700 to $141,800. And in Cape
Coral, Florida, from $252,100 to $84,000, a 69% crash! Here is a look at some of the hardest hit…
Busted: America’s Hardest Hit Housing Markets
Metropolitan Area 2007 2008.II 2009.II 1 Yr
Change Change from
07
U.S. 217.9 206.4 174.1 -16%
NE 288.1 272.3 246.0 -10%
MW 161.4 160.7 146.8 -9%
SO 178.8 176.9 158.6 -10%
WE 342.5 289.7 212.6 -27%
Akron, OH 119.3 106.5 88.0 -17% -26%
Cape Coral-Fort Myers, FL 252.1 178.1 84.0 -53% -67%
Chicago-Naperville-Joliet, IL 276.6 257.6 204.3 -21% -26%
Deltona-Daytona Beach- Ormond Beach, FL 192.3 173.4 127.2 -27% -34%
Grand Rapids, MI 129.4 112.5 86.5 -23% -33%
Lansing-E.Lansing, MI 126.8 108.4 81.2 -25% -36%
Las Vegas-Paradise, NV 297.7 235.3 141.8 -40% -52%
Los Angeles-Long Beach- Santa Ana, CA 593.6 418.9 311.1 -26% -48%
Miami-Fort Lauderdale-Miami
Beach, FL 365.5 310.2 207.4 -33% -43%
Ocala, FL 164.6 147.6 110.2 -25% -33%
Orlando, FL 261.3 223.5 149.2 -33% -43%
Palm Bay-Melbourne- Titusville, FL 183.6 148.0 104.1 -30% -43%
Phoenix-Mesa-Scottsdale, AZ 257.4 205.1 131.1 -36% -49%
Providence-New Bedford-Fall
River, RI-MA 286.5 269.2 215.7 -20% -25%
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eno-Sparks, NV 3 21.4 274.4 192.1 -30% -40%
Riverside-San Bernardino- Ontario, CA 379.5 265.2 161.5 -39% -57%
Sacramento--Arden-Arcade-- Roseville, CA 342.8 229.5 177.5 -23% -48%
Saginaw-Saginaw Township
North, MI 82.1 80.3 55.7 -31% -32%
San Diego-Carlsbad-San
Marcos, CA 588.7 434.9 347.1 -20% -41%
San Francisco-Oakland- Fremont, CA 804.8 684.9 472.9 -31% -41%
San Jose-Sunnyvale-Santa
Clara, CA 836.8 755.0 500.0 -34% -40%
Sarasota-Bradenton-Venice, FL 310.9 266.4 175.8 -34% -43%
Tampa-St.Petersburg- Clearwater, FL 214.9 180.8 140.9 -22% -34%
Tucson, AZ 244.8 215.9 174.1 -19% -29%
Washington-Arlington- Alexandria, DC-VA-MD-WV 430.8 371.1 319.2 -14% -26%
Worcester, MA 274.6 247.3 220.3 -11% -20%
Key Reasons for Taking a Hard Look at the Hardest Hit Residential Real
Estate Markets
It’s not just the fact that houses have fallen so hard so fast that makes them an excellent value in many areas. There are two other key reasons:
1. Many houses are selling below replacement value
2. Many houses are selling at unprecedented cash-flow prices
On top of that, you have a few compelling secondary reasons to buy now. These are…
• Interest rates are extremely low.
• The prospects for a resurgence of inflation over the next five to 10 years are good.
These are secondary reasons because even without them, the primary reasons make housing in many parts of the country an excellent investment right now. What’s more, the low interest rates may not last. And inflation may never take hold again with a vengeance. That’s unlikely but a possibility. Even without these boosters, however, houses in many parts of the country should
do well in coming years because of their phenomenal discount to replacement cost and the
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significant cash flow they offer.
Let’s look at replacement costs first.
Houses in Many Parts of the Country Are Selling for Less than Replacement Value
Many homes are selling at prices below replacement value. For instance, take an
1,100 square foot house in a working class neighborhood not far from where I live. This home sold for $150,000 at the peak and now the bank is ready to unload it for
$50,000. The mark-down from the former high is impressive. But the discount to replacement value is the key. That (and
the cash flow we’ll cover in a moment) is
what gives you a great margin of safety.
Careful with the Condos!
Condos have also suffered mightily. In Miami, Fort Myers and Las Vegas they’re down over
60% from their peaks. In Sacramento, over 55%. But we’re covering single family homes in this report. There are amazing opportunities in single condos, but you have to know how to research the condo association and make sure you’re not buying into a mostly vacant complex or one in serious financial trouble…so that you don’t end up buying a maintenance fee that is about to skyrocket! But that’s a house of a different color, as they say. So, for now, we are honing in on single-family homes because there is great value to be found in this segment and they have many advantages for first-time investors.
For instance, if we use a construction price of $125 a square foot, it would cost $137,500 to build the house brand new. Granted the current house is 50 years old, but the electric was recently updated and it’s solid CBS construction (concrete block and stucco) and sits on a nice fifth
of an acre corner lot. You could put a new roof on the house, install new windows and doors, completely renovate the kitchen and two baths, put in new floors, paint inside and out and put in new landscaping and fencing — all for less than $50,000.
Making an 1100 Square Foot House Like New*
Roof 1200 sf ($500/square*) $6,000
12 New windows $2,400
3 New exterior doors $1,200
500 sf of new wood floors $3,000
600 sf of new tile floors $1,800
New central AC $4,500
Exterior Painting $2,000
Interior Painting $1,500
Landscaping $1,500
Fencing $1,500
Lighting $2,000
Miscellaneous $5,000
Renovate two bathrooms $7,000
Renovate kitchen $10,000
Total $49,400
*In roofing a square is 100 square feet. So 1,100 square feet is equivalent to 11 squares. For this 1,100 square foot house we posit
1,200 square feet to accommodate for the overhang of eaves and some waste. The $500/square estimate is on the high side for a new shingle roof, including labor and materials. Depending on the condition of the roof and the kind of shingles you use, it’s possible you could do it for considerably less. 4
*All prices include labor and materials and are medium-high estimates.
The house would be like new once again for a total cost of about $50,000 less than it would cost to build it from scratch. And that doesn’t count the value of the land!
Now, that doesn’t mean you do all these repairs on every property you rehab. Nor would you necessarily spend this much. Even if you did all this work, you may spend considerably less if you’re experienced or a good shopper. It simply goes to show how houses are selling at prices
far below their intrinsic value when measured by their replacement cost. There is no limit to how high things can sell for in a bubble. But in a bust, there comes a point where you see you can
pick up assets for far less than what they’re likely to be worth in the long term. This is one of those times.
Houses Are Selling at Great Cash Flow Prices
One of the great things about real estate is that you can buy it with mostly borrowed money and then have your tenants pay off the loan. But only if you buy at a good cash flow price. If a house pulls in $1,500 in rent a month and you pay $450,000 for it, you will not cash flow no matter how high an occupancy rate you run or how low you keep your expenses. That’s because you paid too much as a multiple of rent.
The term is Gross Rent Multiplier (GRM). It’s the price you pay for the house divided by its gross annual potential rent. In the above example the gross annual rent was $18,000. Divide the price of the house by that rent and you get 25. That’s the GRM you paid.
And that’s way too high if you want a cash-flow property!
Instead, if you want to cash flow and are putting 20% down, you should pay no more than ten times rent. In markets with low to reasonable property taxes and insurance, you should cash flow a little at that ratio. But if you have higher levels of taxes and insurance (like in South Florida), with a GRM of 10, you may just break even. To be more comfortable, buy at a GRM of eight or better. From six and below, you’ll typically cash-flow like an ATM!
And these GRMs are available today in many markets. In some markets, even lower. To see the GRMs we’ll use HUD’s fair market rents for a three bedroom property in various markets and compare them against the average home price in that area. Today, these markets have also
experienced falling rents, but not nearly as quickly as property prices have fallen. So their GRMs have come down, often very sharply. And that means that many markets that didn’t come close to cash flowing a few years ago now cash-flow like rivers.
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Many Markets Are Turning into Cash Cows
Metropolitan Area Median Home Value Monthly
Rent* Annualized
Rent GRM**
Akron, OH $88,000 $969 $11,628 7.6
Cape Coral-Fort Myers, FL $84,000 $1,398 $16,776 5.0
Chicago-Naperville-Joliet, IL $204,300 $1,240 $14,880 13.7
Deltona-Daytona Beach-Ormond Beach, FL 127,200 $1,226 $14,712 8.6
Grand Rapids, MI $86,500 $956 $11,472 7.5
Lansing-E.Lansing, MI $81,200 $963 $11,556 7.0
Las Vegas-Paradise, NV $141,800 $1,478 $17,736 8.0
Los Angeles-Long Beach-Santa Ana, CA $311,100 $1,907 $22,884 13.6
Miami-Fort Lauderdale-Miami Beach, FL $207,400 $1,542 $18,504 11.2
Ocala, FL $110,200 $1,040 $12,480 8.8
Orlando, FL $149,200 $1,317 $15,804 9.4
Palm Bay-Melbourne-Titusville, FL $104,100 $1,234 $14,808 7.0
Phoenix-Mesa-Scottsdale, AZ $131,100 $1,338 $16,056 8.2
Providence-New Bedford-Fall River, RI-MA $215,700 $1,151 $13,812 15.6
Reno-Sparks, NV $192,100 $1,488 $17,856 10.8
Riverside-San Bernardino-Ontario, CA $161,500 $1,559 $18,708 8.6
Sacramento--Arden-Arcade--Roseville, CA $177,500 $1,499 $17,988 9.9
Saginaw-Saginaw Township North, MI $55,700 $815 $9,780 5.7
San Diego-Carlsbad-San Marcos, CA $347,100 $1,883 $22,596 15.4
San Francisco-Oakland-Fremont, CA $472,900 $2,350 $28,200 16.8
San Jose-Sunnyvale-Santa Clara, CA $500,000 $2,068 $24,816 20.1
Sarasota-Bradenton-Venice, FL $175,800 $1,465 $17,580 10.0
Tampa-St.Petersburg-Clearwater, FL $140,900 $1,215 $14,580 9.7
Tucson, AZ $174,100 $1,174 $14,088 12.4
Washington-Arlington-Alexandria, DC-VA-MD-WV $319,200 $1,745 $20,940 15.2
Worcester, MA $220,300 $1,185 $14,220 15.5
* Fair Market Rent per HUD 2010 tables for 3 bedroom rental properties
** Gross Rent Multiplier = Price/(Gross Annual Rents)
To get an idea of how dramatic the change is, consider this. In 2006, Los Angeles was trading at
a GRM of 30.5. That was impossible to cash flow. Now it’s just 13.6. And if you’re a sharp buyer
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in that market focusing on foreclosures or bank owned properties you can now begin to find
properties at 10 times rent or below.
Similarly, Cape Coral reached a GRM of 24 in 2006, Las Vegas was at 21, and Riverside, CA was at 30.5! None made sense on a cash flow basis. Now they’re all in cash-flow territory and Cape Coral is at an unbelievable level — trading at just five times rent! At those kinds of prices, you can get incredible yields. You can then put yourself in line for serious capital gains down the road. Take a look:
Cape Coral Cash Cows
Purchase Price (Median Price Q209)
$84,000
Repairs Reserves and Closing Costs $16,000
Total Investment $100,000
Cash $25,000
Loan $75,000
Monthly
Annual
Rent (FMR rent for 3BR House 2010) $1,398 $16,776
Vacancy and collection losses (10%) $140 $1,678
Net Rents $1,258 $15,098
Property Taxes (2%) $140 $1,680
Insurance $42 $500
Maintenance $125 $1,500
Lawn/snow removal $75 $900
Licenses/fees $15 $180
Miscellaneous $50 $600
Total Expenses $447 $5,360
Net Operating Income
$812
$9,738
Mortgage payment (7%, 30 years)
$508
$6,093
Cash flow
$304
$3,645
Cash Yield (annual net cash flow divided by $25,000 cash investment)
14.6%
That’s a killer yield. But when you add the appreciation you can see over the years, plus added equity you’ll gain in amortization (if you’re holding it for the long term), you can get some very nice total returns.
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Specifically, even if the market recovers in very moderate fashion over the next decade you could make three to four times your money.
As an example, we’ll look at a market not quite as cheap as Cape Coral. We’ll look at one trading at, say, seven times rent. And since you’re a diligent researcher and selective investor, you end up doing a bit better than the average. You buy at six times rent.
To put numbers to it, we’ll say the median priced home is now $105,000, and it rents for $1,250 a month (or $15,000 annualized for a GRM of 7). But you’re a sharp buyer and get a little better deal, and pick up a bank-owned property or foreclosure for $90,000.
You’re going to put down 20% ($18,000) and put aside $10,000 for closing costs, reserves and some light fix up. So your total cash investment is $28,000. The mortgage on your property is
$72,000 (80% of the purchase price). Let’s say you have good credit so you get an interest rate of
6% on a 30-year fixed rate loan. So your mortgage payment is going to be $432 a month.
(If you have lousy credit and no cash, you can still invest in real estate. Obviously, it takes more work but it is entirely doable. You just have to learn another skill: bringing investors together. That can mean equity investors or debt investors or both. We may cover that in other reports, but for now we’re running the numbers the simplest way.
If you put together your own financing through private parties, the same ideas apply. The one key difference is you may pay a couple of percent more in interest. But if you’re buying right, that’s OK. You can still do well.)
Here’s how the numbers might look…
An Example of Double Digit Yields
When Buying at Six Times Rent
Purchase Price $90,000
Down Payment $18,000
Loan $72,000
Gross Potential Rent
Monthly
$1,250
Annual
$15,000
Vacancy & Collection Losses (10%) $125 $1,500
Net Rents $1,125 $13,500
Expenses
Taxes (2%)
$150
$1,800
Insurance $38 $450
Lawn Maintenance/Snow Removal $75 $900
Repairs & Maintenance $150 $1,800
Licenses $10 $125
Advertising $10 $120
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iscellaneous $25 $300
Total Expenses $458 $5,495
Mortgage Payment
$432
$5,184
Net Cash Flow
$235
$2,821
Total Initial Cash Investment (Down Payment +
$10,000 for closing costs, reserves & initial repairs)
$28,000
Cash on Cash Yield (annual net cash flow divided by initial cash investment)
10.1%
We don’t have as quite a good yield as we had in Cape Coral, but it’s still very good. Even
after conservatively budgeting for reserves and initial repairs at the purchase and budgeting for vacancy and maintenance in the rental period, you end up with a 10% yield on your money!
A Strong Cash-flow Property Pays You a Strong Yield Now But Also Lets You
Hold It through a Recovery and Benefit from Leveraged Appreciation
Now let’s see what happens when you sell. Let’s say this is for retirement and you sell it in
10 years. We’ll also suppose real estate in the area appreciates by just 3% a year — about the long-term inflation rate. (With the government printing money like confetti, it’s very possible housing will appreciate at a much higher rate once the market bottoms. But we’ll stick with a 3% projection for this illustration.)
Since your house was worth $105,000 when you bought it (you got a discount, remember), we’ll start with that number and compound it at 3% a year for 10 years. (We’re going to round to the nearest thousand to keep things simple.) At the end of that time, your house is now worth
$141,000. The balance on your mortgage has fallen to $60,000. Let’s assume you pay $10,000 in commissions and closing costs when you sell. In that case you’ve turned an initial $28,000 into
$71,000 in net equity after 10 years! Plus you picked up over $28,000 in net rental income in that time. So you turned $28,000 into over $99,000 in 10 years.
$141,000 Sale Price minus $60,000 in mortgage balance minus $10,000 in commissions and closing costs = $71,000
$28,000 in net rental income + $71,000 in net equity = $99,000
That’s the power of leverage on a well managed income-producing investment.
Now imagine you happened to buy in an area that grows in popularity. It might be a formerly down-at-the-heels downtown that has been revitalized, or a neighborhood that becomes
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increasingly popular because of its schools. In that case, you might very realistically see 5%
annual appreciation because you had an eye for “location, location, location.”
Now your house would be worth $171,000. You net equity would be $101,000. Add in the net rents and you’ve turned $28,000 into $129,000 in 10 years. Now let’s say you do just three of these puppies and you’ve turned a portfolio of about $100,000 into $400,000 in 10 years.
That’s about a 16.5% compounded annual return — even if the stock market goes nowhere.
Investing in Houses Can Be Fairly Tax Efficient
Plus, you’d do pretty well on taxes. The cash flow would likely be tax-free or nearly tax-free. That’s because you get to use depreciation (a non-cash charge) to reduce your taxable income on the house. And when you sell the house, your gains are taxed at the lower long-term capital
gains rate. Also you can do things like a 1031 Exchange that could defer your capital gains taxes
indefinitely.
Last but not least, you could do all this in your Self-directed IRA for even greater tax savings and to put money “locked” in your IRA to better use than you may feel you’re getting with stocks currently.
But can you do even better? Absolutely.
Going from Individual Investor to General Partner
When you learn how to make money for yourself this way, you can begin to make money for others. Then you can bring private investors into your deal. Once you learn how to use good professional property management as well, there is no limit to the amount of deals you can do.
You can have investors bring most of the down payment and other investors furnish the debt financing. The equity investors get the benefit of leverage without personally being on the note themselves and without the work and expertise required to find and negotiate a good deal, close it, get the property “performing” (producing income near its capacity) and eventually liquidate the investment. All they do is write you a check. Their liability is limited to the amount on that check and their returns can be excellent.
Your debt investors meanwhile can get an interest rate much higher than from banks or investment- grade bonds or dividend yielding stocks. And they get it with the security of good collateral.
From Single Family Homes to Small Multi-Families, Large Apartment
Buildings, Office Parks, Public Storage Facilities and More
Real estate offers many different categories in which you can invest. And each category has sub categories. For instance, there is residential real estate. This includes single-family homes as well
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as small residential properties (from duplexes to four unit). These are all financed by the same
types of commercial banks. When a property has more than four units, it falls into the commercial category, involving different types of lenders, different requirements and terms for financing and different rules on disclosure, investor protection etc. Then, of course, you also have large apartment complexes as well as condos and co-ops. And that’s just a quick overview of residential.
You can also look into various types of retail: single store, strip mall, large mall, shopping center, or “anchored” shopping center (with a national name like Target or Home Depot drawing traffic for all the other tenants). Then you’ve got office buildings and office parks. You have warehouses and even warehouse condos. You have trailer parks (providing huge cash yields, often north of
20%) where residents own their trailers and others where they rent the land and the trailer from you. Then there’s industrial, specialty (like gas stations), public storage spaces (probably the greatest dollars per square foot property investment you’ll find when done right).
On top of the types of property, there are dozens of major strategies: from straight out cash purchases to leveraged deals, from lease options to leasebacks, sale-backs, triple net investing, rehabbing, repositioning, land-banking, and conversions (from apartment to condos or vice versa), just to name a few.
All these property types and strategies can offer great opportunities. But they all have different challenges and require very specific knowledge. We’ve focused on single-family houses and renting them out for three to 10 years in this report. We’ve done that as an introduction to real estate but also because — even if you’re an experienced investor in commercial real estate — there are such compelling deals on single family houses today, that you may seriously want to consider picking up at least one or two even if you’re working full time on bigger property deals.
Also, if you haven’t done real estate before, single-family homes offer a pretty straightforward way to cut your teeth and make some money. When you buy in a bombed-out market, as we have today, with the intent of renting your houses out for three to 10 years, you can keep your risk
very low while profiting from net cash flow, amortization (the reduction of the loan balance) and
leveraged appreciation.
That’s the kind of real estate I did initially — from single-family homes to 4 unit properties.
Only after I had success with these and my shares of ups and downs, did I feel confident to invest
in value markets outside of my state. This helped me make money when Florida was a bubble and offered no more values. It also gave me a bit more confidence for when I finally made the move up to larger apartment buildings.
But for experienced and new investors alike, residential real estate offers some unique advantages:
• Residential real estate has fallen the farthest in many parts of the country, offering the best values.
• If you’re investing for the very long term, say 10 to 20 years, just three or four investments in single family homes could produce enough wealth for you to retire with a significant net worth…and a steady retirement income.
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• You can manage your own rental homes. If you have up to three or four houses, it
doesn’t have to be difficult or time-consuming. Plus, the skills you’ll learn with hands-on management of your initial modest portfolio can come in handy later if you expand to bigger properties. You may end up with 50 to 500 units one day and the principles you learned managing your first few houses will still apply to larger properties and make it easier for you to “manage your managers.”
• Tenants pay the utilities. With many multi-unit properties, even small ones, some of the utilities may be paid for by the landlord…especially water and heat. Granted, you charge a bit higher rent in those cases but the tenants aren’t going to be as cost-conscious when using electricity or water if they never see the bill and especially if they never pay the bill. With single-family homes, you usually won’t pay any utilities.
• Houses are relatively easy to rent. There is a large market of people for clean, safe and affordable rentals in the single-family home area. It’s not like you’re trying to rent out retail space during a recession. People gotta live somewhere. Of course, you have to be sensitive to local economic conditions and adjust your rents and deposit requirements to remain
competitive in the market, but as long as you do that, you should always be able to maintain a high occupancy.
• Houses are relatively easy to sell. Right now, nothing is easy to sell. But we’re buying during economic crisis to sell later, when the economy is growing again. And single-family homes are the largest segment of the real estate market. When the time comes to sell, you may find a lot more potential buyers than if you were unloading a trailer park or storage facility.
• Interest rates are very low today (if you know how to get the money). Interest rates right now are dirt-cheap. And even if you can’t qualify for a bank loan to buy an investment property… if banks in your area simply aren’t lending on investment properties…low interest rates also mean you can get good terms from private lenders. So where you might have paid a private lender 10% to 12% during the boom, today you may find one who is thrilled to finance your deal at 7.5% — especially when he’s getting less than one percent on his savings at the bank.
So if you’re just getting started in real estate or want to keep things simple, give some thought to single family-homes. When you learn how to buy right, adding just one, two or three of these to your portfolio can result in extraordinary profits down the road.
If you want to keep your risk low while pursuing those profits, here are a few good guidelines:
A Success Check List
• Focus on one or two target markets. (You’re more likely to find excellent deals when you thoroughly research one or two areas.)
• Buy cash flow only. (Run the numbers like we did and make sure you budget for vacancy and maintenance. Also have ample reserves on hand when making the investment.)
• Do your research so that you can buy at or below market value. (Go online to your local property tax assessor’s website or work with a real estate agent so you know comparable values very well in the market you’re buying.)
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