Real Estate 040: Why Invest In Real Estate?

If you have stumbled upon my blog, I am assuming you are looking for ways to start saving money, increase your income, or find ways to create additional streams of passive income (cash flow). I love to read business, self-help books, and the more I read these books, blogs, and success stories, the more I realized that over 90% of these people built their wealth through real estate (the other 10% were a mix of entrepreneurs, celebrities, athletes, and employees who struck gold w/ start-up company stocks). For me, real estate is great not only because it is a tangible, hard asset, but it provides a basic human need - a roof over your head. 

There are a couple additional reasons why I like real estate as investments (not your primary residence, which I will discuss this in another blog post):

1. Leverage
If you have read the book Rich Dad Poor Dad, by Robert Kiyosaki, you will be familiar with the term "other people's money" or OPM. This is a fundamental concept shared in Rich Dad Poor Dad where by using good debt, or OPM, you can significantly increase your return on investment (ROI). For example, most real estate conventional mortgages will allow you to put down as low as 5% cash (with good credit and income, of course) for the purchase of your home. That means 95% of the home is financed by the bank. Now, this is a very simple illustration, and there are many different things to consider when choosing the amount of downpayment (i.e. Private Mortgage Insurance (PMI), interest rate, mortgage payment, etc.). However, by using leverage, you are able to preserve your hard earned capital for other future investments. 

Example:
Purchase Price: $500,000
Downpayment: 20% ($100,000)
LTV: 80% ($400,000)

You cannot pay $20 dollars for an apple stock worth $100 and have the bank finance $80 (Not speaking about futures, options, margins, which is a whole different ball game). In a place like California where I live, real estate prices for a single family residence is so high (average $450,000) that without proper leverage, it would take me 10+ years to save enough money to buy a piece of real estate, let alone buy multiple. By using other people's money intelligently and analyzing the risk-reward, you can slowly build a portfolio that is leveraged and bring in cash flow for you every month.

Note: Other people's money can be anything from: Bank Financing, Private Lenders, Hard Money Lenders, Friends and Family, Home Equity Line of Credit (HELOC), and more.

2. Diversification
You may have heard the term, don't put all your eggs in one basket. This would have been good advice to the Enron employees who put their life savings, retirement funds, and other monies into the Company Stock which eventually plummeted to zero in the wake of the greatest accounting scandal that has rocked Corporate America. Although this is an extreme example, I personally am not comfortable having my retirement funds solely in the stock market. Although we have seen large gains (20%+ for my mutual funds during 2017 alone), I also know that these are all time highs, and this rise can't go on forever. I have diversified within my retirement account mutual funds to have a mix of cash, equity, bonds, U.S./International, REITs, however, if done carefully, tangible real estate properties will also be a great hedge against inflation as well as a means of diversification. Not only can you diversify in the type of properties: Single Family, Multi Family, Apartments, Commercial Buildings, but also in different markets like the West, Midwest, South, and Eastern states in the U.S.

3. Appreciation
Living in California, I have seen the tremendous appreciation that properties in my backyard have undergone in a short period of time. I was exposed to real estate during my parent's purchase of their primary residence back in 2012. Single Family homes with a typical 3 bed 2 bath around 1200-1600 sq ft were around $300-$350K in a decent B class neighborhood with an average school - places where you wouldn't mind raising a family. Looking at recent comps on Zillow or Redfin, I was shocked to see that these same homes that I walked through during 2012 are now selling for 500K or more, which equates to an annual return of 8.5% or total return of a whopping 56.3%!!! (Let me know if you find a mutual fund you can use leverage AND get those kind of returns!).

Now granted, I like to refer to the post Great Recession as the "golden years" roughly 2010-2014 where you can pretty much throw a dart in the U.S. housing market and come out ahead with massive appreciation (some markets more than others - coastal vs. linear). However, I personally don't rely on "appreciation" when I am analyzing real estate properties because it is like gambling. During the height of the housing boom in 2004-2006, people were drunk with appreciation until it all came crashing down, as such, I focus more on cash flow. That is, money in my pocket every month after all expenses (mortgage, insurance, tax, maintenance, vacancy, and property management have been paid).

4. Cash Flow
This is actually my top reason of why I invest in real estate, but naturally found itself here after appreciation. As mentioned previously, appreciation is "icing on the cake", but not my main focus. My main focus is to ensure that the property that I am investing in creates positive cash flow after all expenses are paid, and if it appreciates over time (hopefully outpacing inflation), then great! On the flip side, if there is another housing price correction and prices go down 15-20%, I am not that concerned, because although my rent may go down, I would have created enough cushion to make sure that the property is cash flowing and making money until housing prices go back in 6-10 years, just like it did in 2008-2016. In addition, if an investor was to take into account monthly cash flow + appreciation of rental properties, the total return on investment would be significantly higher than the average return of a S&P 500 mutual fund during the same period.

Cash flow will vary depending on the purchase price, down payment, interest rate, rental income, and other expenses/reserves. You want to be conservative during your analysis as there will always be unforeseen expenses, and being overly optimistic will set you up for a big disappointment.

5. Depreciation (Tax Savings) and Loan Pay Down
By using IRS rules, you can significantly reduce your tax liability through your investment properties. It should not be a surprise to you that some of the wealthiest people make more money but pay less taxes that the average middle or lower class using these methods. If you have an investment property, you can deduct all mortgage interest, property taxes, insurance, maintenance, repairs, and other fees (flying out to the Midwest to check on your rental property? expense it!). 

Depreciation is a powerful tool in which you can depreciate the value of your investment property over 27.5 years. Using the example above (Purchase Price: $500,000 - land value $100,000 = building $400,000), you can annually expense $14,545 each year. If you rental income was $3,000/month or $36,000/year, your taxable income would immediately be reduced by depreciation (We will later cover how depreciation will lower your tax basis, and how savvy investors use 1031 exchange to continually defer taxes and build wealth).

Loan Paydown is also another side benefit of owning rental properties. My strategy with real estate is buy and hold rentals. From running numbers and speaking with multiple investors, you will not be able to make money from real estate properties if you sell in less than 5 years simply because of transaction costs (i.e. agent commissions, escrow, title, etc.) unless you are buying 15-20% below market value, doing value add rehabs aiming for forced appreciation, or the market appreciates significantly during that period. With buy and hold rentals, if you do a careful analysis, you will make cash flow monthly, and benefit from the tenant paying down your mortgage debt every month that property is being leased. Please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!

Real Estate 023: Real Estate Partnerships

You may be wondering if you should have a partner to help build your real estate portfolio. This is a valid question as some asset classes such as multifamily is well-known for being a team sport. But what about single family, note investing, or other asset classes? This is not an easy decision and it requires looking at your temperaments, the skills that you bring, and goals in forming the partnership.

I have met investors who formed partnerships from the beginning of their real estate careers through meetups, conferences, and even online. I have also met investors who began on their own and partnered up on specific deals where it made sense. Lets take a look into some of the pros and cons of using a partner or going solo in building your real estate portfolio:

Advantages

“If you want to go quickly, go alone. If you want to go far, go together" - African Proverb

Teamwork: Investing in real estate will require you to have resources, whether that be capital to purchase the home and make renovations, knowledge to structure/negotiate a deal, or time and hustle to underwrite the deal, communicate with your team members, and oversee the project. By having a partner, you are able to share the workload and also select tasks according to the strengths of each person. If you love to work with spreadsheets and look at the numbers, and your partner loves to network, build relationships, and find deals, there is a natural compatibility and chemistry between the deal finder and the analyzer. In another example, one person may have the money from a high paying W-2 job, but the demanding hours may not allow them to fly to the different markets, meet with the team, and underwrite/pursue leads. This person may benefit from teaming up with a person who may have low funds, but more time to perform the aforementioned tasks. This also works for people with poor credit, maximum Fannie Mae loans, and other commitments.

Shared Networking: You may have heard the idea Six degrees of separation, where all living things and everything else in the world are six or fewer steps away from each other so that a chain of "a friend of a friend" statements can be made to connect any two people in a maximum of six steps. By having a partner who is well connected, you instantly become two steps away from finding the next person who may be able to help you in your business, whether that be a realtor, contractor, property manager, private lender, or mentor connection. Real estate investing is very well a relationship business and having a strong network will certainly provide huge dividends down the road.

Increased Accountability: Assuming that you have found a partner who is equally motivated, capable, and willing to do the work, you will have won yourself an accountability partner for the long haul. Although you can find large profits in a relatively short period of time, real estate investing is generally not a "get rich quick" scheme. As such, there will be moments where you lose focus, motivation, and need someone to help you get back on track and keep your eyes on the prize. Further, as the saying goes, two heads are better than one, or 1+1 = 3 (synergy). When you encounter a roadblock, you and your partner will be able to put your heads together to come up with a better solution than just you alone. 

Disadvantages

"No deal is good enough, to take down with a bad partner"

Multiple Captains: When driving to a destination, it becomes difficult to stay on course when there are several people trying to take control of the steering wheel, each believing they know the best route. Compared to a solo investor, where each decision starts and stops with them, having a partner (assuming 50/50 equal general partners) means that you have to listen and respect the opinions of others. This may result in compromising even though you disagree with their strategy or decision in pursuing or passing on an opportunity.

Division of profits: While an advantage of a partnership is division of risk, the flip side means that any upside is also divided amongst the partners. Assuming all things equal, you may have found a home-run deal that brings a 100% return over 5 years ($100K --> $200K) through forced appreciation and improved management, but the overall returns are split in half with your partner. Contrarily, if you would have purchased this deal by yourself by utilizing debt for the other $50K seed money, you would have realized all $100K in gains (less debt service) which may be significantly higher than the partnership scenario. 

Partner problems: Whether you partner up with a stranger or your best friend from childhood, its very important to vet them and understand their finances, goals, and temperaments. I have seen people's situation change in the blink of an eye through death, divorce, health complication, gambling habits, etc. and these things can impact your partnership. There are numerous case studies online where partners sued each other alleging theft of assets, not fulfilling their part of the contract, and other types of fraud. Further, there may be cases where outside liability (e.g. car accident) of your partner results in the loss of your asset as they may be forced to liquidate the property to settle their debts. Make sure you protect yourself by engaging a real estate attorney to draft up the operating agreement or joint venture agreement that secure your interests.

To create a successful partnership, make sure that you and your partner have clearly written goals that align before you start to look for deals. For example, if you want to be a long term buy and hold investor and your potential partner only wants to do fix and flips for 2 years and get out of the game, there is clearly a conflict of interest. Next, remember that consistent communication is key. After identifying your goals and business plan on how to get there, make sure you communicate issues (without personal emotion) and offer solutions to the problem - no one likes a complainer. There may be times where one partner needs to concede to another, and other times where you stand firm. If partners learn to respect one another and compromise for the benefit of the group, then the relationship will become even stronger and you will be one step closer to your goal. 

As mentioned above, there are both advantages and disadvantages for partnerships, and as an investor I have gone both solo and partnered up for deals on a case-by-case basis. Remember to carefully review how they apply to your situation, your personality, and the deal. There are many successful investors who have done it both ways and have reached their goal, so do not fear one or the other, and maintain an open mind. 

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 022: Using a Home Equity Line of Credit (HELOC) or Refinancing your Property

During the upswing of a market cycle, homeowners may be wondering if it is a good idea to tap into their home equity, or the difference between the market value of the property and remaining balance of the loan. There are three popular ways (other than selling) a homeowner extracts the equity portion of their property: refinance, home equity loan, and home equity line of credit. 

1. Refinancing your Home

We often hear it on the news, radio, or online advertisements, "take advantage of low rates, refinance and lower your monthly payment!" I know I have received dozens of mail from mortgage lenders offering me to take their deals. In short, refinancing means taking a new loan to replace your existing loan. This is usually done to either take advantage of lower interest rates, remove private mortgage insurance (PMI), or better terms (5, 15 vs 30 year amortization), to take cash-out, or both. People may benefit from taking the equity in their home which fluctuates with the market and putting that money to other use: consolidate debt, make necessary purchases, or even invest in real estate. In addition, without taking cash out of the property, you can use the lower interest rate to lower your monthly payments (assuming the gain is higher than the closing costs involved in the transaction). 

2. Home Equity Loan (HELOAN)

A home equity loan is another type of equity stripping used by homeowners to take advantage of a lower LTV (loan to value) which is experienced during times of appreciation. Equity loans are available in both fixed or adjustable rate mortgages where a financial institution (typically a bank or credit union) has 2nd lien position on the home. This means that in addition to your original mortgage which is in 1st lien position, or first in line to be paid out when there is a sale, refinance, or other action on the home, there is another mortgage that is on top of the 1st lien note. As 2nd lien position requires the 1st lien position holder to be paid in full before the 2nd lien holder sees a dime, this is seen as higher risk, as such there is more scrutiny during underwriting and may be more difficult to qualify. 

3. Home Equity Line of Credit (HELOC)

A HELOC, or home equity line of credit, is similar to the home equity loan in that it is a 2nd mortgage (home serves as collateral), but a HELOC is a form of revolving debt, like a credit card with simple interest (not amortized). This means that you are able to withdraw money up to an approved limit, using a bank transfer, card or check, repay it and draw it down again within the predefined terms of the loan. As a HELOC is a secured loan, you are able to obtain a lower interest rate than the average credit card (around 22-25%) or personal bank line of credit (typically 8-12%). 

A limitation to the HELOC is the draw schedule, typically 5-10 years, variable interest rate, and the loan to value requirements (e.g. 80-100% LTV). For example, if your house is worth $500,000 and you currently have a $300,000 mortgage balance, you are at a 60% LTV. If a lender decides to limit the LTV to 90%, that means the maximum amount your HELOC can be is $150,000 ( = $500,000 * 90% - $300,000). 

Depending on the usage of the HELOC it may be beneficial to consolidate debt or use the funds to purchase necessary items that otherwise may have carried a higher interest rate (e.g. 20% consumer credit rate vs 5.5% home equity line of credit rate). However, as this line of credit is secured by your home, you want to ensure you have a plan to pay off the debt so that you do not put your primary residence at risk of foreclosure.

In addition to purchases and debt consolidation, savvy investors use a HELOC to purchase a rental property all cash and refinance out their money to pay back the HELOC, or take enough funds for a 20% downpayment on a turnkey property. If the rental property is achieving double digit returns (i.e. 12% conservatively), against a HELOC rate of 5.5%, then you have created a 6.5% spread on the borrowing cost and increased passive income without using any of your own money (read: leverage/other people's money).

In conclusion, before you go out and apply for one of the three aforementioned products, please remember each bank and credit union have different rates and terms as well as conditions (draw schedule, etc.). Further, they will also have different programs that will incentivize a new customer such as paying for closing costs, appraisal, and introductory rates at 1.99% for 6 months. Make sure you watch out for any hidden fees such as annual maintenance fees and draw fees that may build up quickly. There are always risks involved when using other people's money and using debt to create income producing assets, however, if you know your numbers and have a solid plan of repayment, you will be able to scale up your property safely and quickly than other methods.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!