“Business, that’s easily defined – it’s other people’s money.” — Peter Drucker
“It’s tangible, it’s solid, it’s beautiful. It’s artistic, from my standpoint, and I just love real estate.” — Donald Trump
“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.” — Warren Buffett
Investing in real estate is about using other people’s money to increase one’s own personal wealth. It is not hard to hear a well-known business figure wax poetic about real estate. Robert Kiyosaki has said that he loves real estate because it is dumb as dirt. Meaning real estate is easy to understand and that anyone can master the fundamentals and build wealth using real estate.
The tax advantages alone make real estate a worthwhile addition to anyone’s wealth portfolio. Imagine having a property that pays you $6000 per year positive cashflow and imagine that that income is tax-free. What if you had 5 such properties? What about ten?
If these things are true, why do so many personal finance blogs steer clear of the topic of real estate investing while extolling the virtues of long-term investing in the stock market? And why have so many investors lost their investments through foreclosure because of this most recent real estate bust?
There are a myriad of ways to invest in real estate from mortgage-backed securities to REITs to tax liens. As a single investor, partner or part of a syndicate. Through properties bought for appreciation or cash flow. There are so many ways to interact with a property or group of properties for profit that the individual investor can get lost in the quagmire of information, courses and advice and end up going out with the tide, pushing up financial daisies or suffering any of the other terms used to describe financial catastrophes in today’s economy.
Because investing in real estate is a lot like specializing in a particular branch of medicine, this article is geared to the person who wants to own a tangible piece of property for investment purposes.
The Risks of Real Estate:
The risks of real estate are the same as any business and they are 1) liability 2) under capitalization 3) economies of scale 4) economic down turn 5) unknown exit strategy
Liability:
Unfortunately in America legal action is considered one of the acceptable ways for people to increase their wealth. If a property carries a mortgage, the bank will insist that the property owner carry liability insurance, but it doesn’t stop there. The savvy investor will explore the options of legal entities, LLCs and limited partnerships, before investing in even that first property.
Under Capitalization:
The most common reason that businesses fail is the lack of capital. Too many real estate investors are looking for the “no money down deal” which too many people take to mean free, free real estate. Whether or not an investor is able to acquire a property with no money down, that investor should have sufficient access to funds to cover taxes, insurance, 6 months of mortgage payments and repair costs.
Economies of scale:
Real estate investing can be and often is a capital intensive business and the costs are fixed. What this means is that a small investor must spread fixed costs over a few units and a large investor must spread fixed costs over a larger number of units. Vacancies, repairs, tenant damage that exceeds usual repair costs will affect a smaller investor to a much greater extent than a large investor. How do smaller investors become large? By systematically acquiring more properties, trading up and by partnering with other like-minded investors.
Economic down turn:
Factors precipitating an economic decline are outside of the control of an individual investor, yet an economic decline affects real estate exit strategies and affects the ROI of properties purchased for cashflow.
Unknown Exit Strategy:
The majority of people who purchase real estate buy with one strategy in mind: to resell the property quickly in an appreciating market. What if the market does not appreciate and you get stuck with a property? Is the cashflow sufficient to allow you to hold the property until the property turns around or will you have to let your property go in a fire sale at the same time others are doing the same?
The following are simple strategies that will allow you to break into real estate, keep your shirt and avoid the hoosegow.
1) Invest for cashflow
2) use legal entities to hold your properties
3) carry appropriate liability insurance
4) know when to buy
5) develop partners on the ground
Invest for Cashflow:
Cashflow will allow you to weather the storms of appreciation and devaluation. Additionally most of your cashflow will be tax-free. Simple rule of thumb for quickly analyzing properties:
a) Buy oven numbered plexes beginning with the number 4. Two units cover rents, one expenses and one goes in your pocket. With an 8 plex, 4 cover rents, two cover expenses and 2 goes in the pocket.
b) A property is worth roughly 100 times the monthly cashflow
Use legal entities:
Unfortunately America is the land of litigation and litigation is considered a socially acceptable way to make money. Proper use of legal entities can contain risk to one property and protect personal and private assets.
Carry appropriate liability insurance:
This one is self-explanatory.
Know when to buy:
Remember Buffett’s rule. It is time to sell when everyone is buying. When you buy for cashflow you won’t overpay for a property and when everyone is buying it is time to sell your underperforming properties. Keep your winners until you can trade your winners in for larger, performing properties.
Develop partners on the ground:
Developing your team is crucial to success. Property managers, mortgage brokers, and attorneys should be part of your team. If you are buying in a market you are unfamiliar with, ground partners become critical to your investment success. Don’t assume that because you live near a community you want to invest in, you are familiar with the dynamics of that community enough to safely invest. Develop your partners first.
Real estate is an essential part of any investment portfolio. Investing in a tangible piece of property is simple but team building, planning your exit strategy before you buy, and timing your purchases are part of the essential strategies for success. Forgetting the risks and ignoring the simple success strategies will wash many a would-be investor up on the shore or land him in the jail of failure.