Sunday, June 22, 2008

What is a "Self Servicing Investment Property"?

I often hear people talk about cash flow from their investment properties. I want to introduce a different term, it is the "Self Servicing Point" for your investment. I will define this term a little later after I talk first about setting goals for an investment. When buying any investment you need to define what your goals are first and then decide if this investment is the proper vehicle for you to achieve your goals. This is a common decision process when working with an investment professional to decide if you want to buy stocks or bonds and what types of stocks and bonds you may want to buy. When buying investment real estate you have as many options as you do when buying stocks or bonds. Your broker or advisor always is asking about whether your goals are for growth or income and what is your risk tolerance. They try to educate you to understand your goals and to recognize that these goals will change over time. You have the same opportunity to tailor your real estate investments to meet your goals.

There is a huge difference when deciding to buy stocks and bonds versus when you buy real estate, and this difference impacts how you live with the investments on a day to day basis. When buying stocks and bonds all but very small percentage of individuals borrow money to buy stocks and bonds, whereas with real estate most investors borrow money for their investments. The fact that most real estate is purchased with borrowed money (leveraged) impacts how we have to live with an investment on a day to day basis because you may have to come up with money periodically if expenses exceed your revenue. If you pay cash in full for rental properties it would be very rare for your expenses to exceed the income in any single year. Most people want their real estate to operate without additional cash infusions, so achieving this goal is a big part of what I will later discuss.

Now let's talk about setting goals for an investment property. Some people need to receive monthly income from an investment property. Others could care less about the monthly return on an investment property (positive or negative), what they are most concerned about is the overall return at the time they sell the property. Most people are in the middle of these two extremes, they are looking for an investment where they get a good return at the time of sale, but they don't want to have to continuously contribute into the investment. This is why, for real estate, we want to understand the "Self Servicing Point".

Here is what I mean by the "Self Servicing Point". You want to understand how much money you must invest so the rental income covers all normal expenses. If you buy a house with zero money down payment and the rent received covered all mortgage, interest, taxes, management and maintenance expenses then you would have a self servicing point with zero money down. In this scenario, every dollar you receive when you sell the home, above what you owe in the mortgage, would be free money. Unfortunately these situations almost never exist, your role is to bring some money and a good credit history to the table and in return you can make a profit. Depending on the market and type of property you will need to bring anywhere from 5% to 50% down payment in order to reach the self servicing point. If, in a certain market you need to bring a 20% down payment for the product to be self servicing, you know what your true investment is. This point is where the investment is "break even" on an annual basis. You may receive positive cash flow in a given year but you may also receive a slight negative if you have a larger maintenance item, but over the first 3-5 years your net income after expenses will be break even. So in a certain market (the city) for a certain product (a single family 3/2/2 home) you may find it becomes self servicing at a 20% down payment. This is the first step to comparing investment properties.

Now that you have found the self servicing point, you need to make a decision on what you believe the appreciation will be. If you are looking at two products where a 20% down payment is the self servicing point but one is in a market with a tremendous upside potential for appreciation, the better investment should be the one with stronger upside, even though the numbers look the same at point of purchase. What if you have one market where the self service point is 20% versus a market where the self service point is 30%, then the one with the 20% self service point would be the better investment, right? Not necessarily -what if your goal is to purchase a home which will double in value over seven years. If this is your goal and the investment pegged at 30% doubles in value over 7 years, but the one with a 20% doubles in 15 years, then you would have been better off buying the home with the 30% self service point.

Let's put this into real situations. Prime Properties operates in three separate areas along Interstate 35. These areas are, from north to south, Oklahoma City, Dallas/Fort Worth and Austin. Most of the time, with a bit a research, you can locate an investment property in Oklahoma City with a self service point around 10-15% (on a 30 year fixed rate note). A similar home in the Dallas area has a 15-25% self service point. In Austin you are usually looking at a 25-30% self service point.

Why are there differences in the three areas and what is a good investment? In all three of these markets the average price of a home is well below what people can afford to pay based on average incomes, which is why experts and pundits say these markets are undervalued and a good place to buy. Austin is a less developmentally friendly area and I believe this accounts for part of the discrepancies, since this may drive up the base land costs. I believe part of this is also speculative. The speculation is based on a belief that Austin values will increase at a greater rate than Dallas or Oklahoma City. According to the US Census Bureau, over the next twenty years, Oklahoma City is supposed to grow by 25-30%, the Dallas area is supposed to grow by 45-50%, and Austin is supposed to grow by 90-100%. What does that do to housing appreciation? I don't know the impact but it may be causing some markets to get bid up higher than others. Part of the discrepancy is that people are willing to pay more to live in specific areas because it may have more of what they want. Just look at what people pay to live to in the San Francisco Bay area! (To better understand this I strongly recommend you read the book "Who's your City" by Richard Florida http://creativeclass.com/richard_florida/books/whos_your_city/ )

So how do you decide what to buy? It comes down to what do you believe will perform best over time. Just as you may decide to buy real estate over stocks and bonds you get to decide to buy a home in Oklahoma City over a home in Dallas. Think of it like this, if you are buying stock in a soft drink company you may be looking at Pepsico (PEP) and Coca-Cola Co. (KO). According to Yahoo Financial PEP closed on Friday at 65.08 with a P/E ratio of 18.78 and KO closed on Friday at $53.66 with a P/E ratio of 20.18. Pepsi costs more per share but based on it's P/E ratio it is a "lower priced". Why is it a lower priced? It is lower priced because the market believes Coke will perform better over the future. When you decide what to buy you need to decide what you believe will perform better. Maybe you drink Coke but your kids and all their friends drink Pepsi, then maybe you go with Pepsi. Or, if you want to hedge you bet, buy some of both! I look at the "self servicing point" like a P/E ratio. It gives you a good idea of what the market believes the long term value is of each product, but it does not really tell you which is the best investment for you.

If you have spoken with me or read any of my blog entries you know I believe single family real estate should be a strong component of an investment strategy and you know I believe that now is a good time to buy. So if you are wanting to buy maybe your answer is to buy two in Oklahoma City, two in Dallas and two in Austin. If you want to do research, click on the links at the right hand side of this page for each area where we do business, the links will take you to demographic information for each area as presented by wikipedia.

Once you decide where you want to buy and at what point a home is self servicing you can tailor your purchase to meet your goals simply by dialing up or down the amount of your down payment. If you do not care about any current cash flow, then determine the point of self servicing, put that amount down and go on about your business. At some point in the future, as rents rise, the investment should start producing increasing income on a regular basis. If you want to realize monthly income from the property right now then you need increase the amount of your down payment. If you want to have the highest return, and you can afford higher risk because you have other cash and income, you can go for the most leverage possible but you may have times when you are paying more in expenses each month then the property produces in income.

I am sorry if this is all seems too confusing or too many options. This is the good and bad of investing. I like investing in real estate as opposed to stocks because it is something more tangible to me. I can see, touch and feel the thing and I understand how it adds value. This makes it easier for me to make a decision. Add to this the tax benefits for real estate investments and the opportunity for leverage, and it makes it a no-brainer why real estate is where I put my money.

No comments: