Wednesday, July 9, 2008

Don't Wait to Buy Real Estate, Buy Real Estate and Wait

I have been unable to find the person to whom I can attribute the title of this post, but for people who have been tracking and investing in real estate it is a statement which rings true. I do not believe Real Estate is a way to get rich with nothing of your own to invest. However, you can start to build wealth with a small stake hold of $20,000 to $30,000. If you have liquid assets of $100,000 to $1,000,000 it is imperative you have a stake in Real Estate if you want to protect your money from inflation. This post is written for anyone who has $1,000,000 in liquid assets or anyone who wants to have this much money at some time in the future.

If you have any significant liquid assets you need to be proactive right now, placing your money in a location which will protect against the degradation of inflation. Remember, if you do nothing with your money it will be worth less next year (you can buy less with it) because of the impact of inflation. So what are your options? Here are some excellent ideas.....

Option 1) You can put the money in an interest bearing account and receive 1%-4% in income, but to benefit you must exceed the pace of inflation after you pay tax on the income. You need to ask yourself the question, do you think inflation will be more than what you receive in interest? If you believe inflation will be greater than the 1%-4% you receive in interest then you are betting you will lose money.

Option 2) You can invest in the stock market and pick stocks or index funds which will beat inflation, on average these types of investments have outperformed inflation. Stocks/equities are an important part of one's portfolio, but you suffer when we have situations like the 20% drop we have experienced in the past nine months.

Option 3) You can invest in precious metals and other natural resources like oil. Many experts says these are good bets because there is a finite supply of these items and these resources are being used at an increasing rate in the developing world, especially in Asia and Africa. Other experts say to be wary of these investments as they tend to be more volatile due to the impact of speculators.

Option 4) Go to Vegas! This is not a joke. Some people are wealthy enough that this is truly and option. You may win and you may lose, but you will have some good stories by the time you are through. Most people believe you only live once so you should go out with some good stories!

Option 5) Buying raw land. This is one of the most truly speculative forms of investing. The positive is that almost all land goes up in value over time (except the area around Chernobyl). There are some problems here including difficult or costly financing and the lack of income while you are waiting for appreciation until you sell for a profit. This is truly a "buy and wait" scenario.

Option 6) You can invest in Income Producing Real Estate. If you do this you need to be careful to match your investment with your need for quick access to the money. I strongly advise against real estate if you "need" to use this money in less than five years because the cost of sale may wipe out any profit. Real Estate has a significant advantage over interest bearing cash accounts, the leverage available through extended low rate financing. Real Estate has a significant advantage over stocks, it has intrinsic value that will extend beyond a business model or market. Real Estate has a significant advantage over precious metals and other natural resources in that it keeps producing income on an annual basis - it is not "consumed". About Las Vegas and buying raw land - you should only do these with money you can afford to lose. There are risks in Real Estate which you need to consider, primarily you need to understand the potential for prices to go down and the costs of divestiture. This can impact you if you may need quick access to the money.

What do I do with my money? In planning for my future I first take advantage of any matching funds my company may provide and any tax deferred plans available under current tax law. After that I set aside a portion my income as cash to invest. I invest portions of my portfolio in a cross section of these types of investments listed above. For cash I need in the next 12-18 months I invest in interest bearing cash accounts, getting my 1%-4% and accept the fact it may lose value due to inflation. The remainder I invest in stocks, natural resources (through index funds) and real estate. I spread my risk. In order to minimize risk in stocks I invest in index funds and avoid specific equities, in order to minimize risk in natural resources I keep my investment portion small and I also use professionally managed mutual funds to purchase these types of investments.

In real estate I buy single family homes and here are some of the strategies I use to minimize my risks and increase my opportunity for growth. I pick real estate markets where the investments can be easily purchased by the "average" household. I look to markets where the percentage of household income required to buy an average home is low. The National Association of Realtors uses a "Housing Affordability Index" to measure this. The Housing Affordability Index is the ratio of median family income to the income required to qualify for an 80 percent, fixed-rate mortgage to purchase the median-priced home. The National Association of Home Builders has a similar index called the Housing Opportunity Index or HOI, which is a calculation of how many homes sold in a particular quarter were affordable to the median household. Whichever ratio you use, the fact is that when fewer people can afford the average home you have an indication that homes are "overvalued" and priced high. By purchasing an investment property in an undervalued market I have three huge advantages, 1) there is a better chance the market is at low point so I minimize my risk for prices going down, 2) I increase the available pool of potential buyers when I want to sell because a higher portion of the public can afford a loan and 3) there is a greater opportunity for appreciation.

What else do I do to minimize my risk in real estate? There are many other things I look for, including but not limited to 1) good rent/value ratios 2) immigration/rising population 3) job growth 4) desirability (usually translated to mean low crime, good jobs and good schools) and 5) opportunity for better than average appreciation.

One of the other strategies I employ includes buying more, less costly properties. In our markets you can buy quality investment properties from $140,000 to $350,000. Once you pay more than $400,000 for a rental home the rent/value ratios drop to a point where the performance of your investment starts to degrade at a fairly fast pace. To take this further I would rather have 8 homes worth $150,000 each then 4 homes worth $300,000 each. With more, less costly homes I have more liquidity if I want to sell and the impact of a vacancy is less harsh. The $150,000 home will also a simpler infrastructure (one air conditioning unit instead of two or three) meaning the maintenance costs will be lower. There will also be a bigger market for renting and selling since more people's incomes will match the price point.

There is also a market trait where the higher priced homes will pull up the price of the less costly home. You will see a neighborhood with homes in a $200,000 - $300,000 price range, and when the higher priced homes go up $50,000 in value the lower priced homes go up the same amount. Since you put less money down on a lower priced home your actual return on your investment is much higher. My father always told me "buy the cheapest house in the neighborhood, but make sure it is in a good neighborhood" so I could take advantage of this trait.

What not to do? Do not take what I have written and create a hard/fast checklist. Life is a series of compromises. I don't think I have ever found an investment that totally matched all of my desired traits. If I wait to find the "perfect property" I will be worse off then if I make a decision which includes some compromise. In the end, I need the performance offered by real estate so I must to get into the business even if the situation is less then perfect.

What does this type of portfolio cost? It will cost about $250,000-$260,000 in cash to acquire eight $150,000 homes and your return from 3% appreciation will be $36,000/year of growth in value. The return should automatically adjust for inflation by growing each year as the start point for your valuation is higher each year. This is about 13%-14% return on your money from appreciation alone - now that's an investment which beats inflation!

This conservative strategy I just laid out will provide an excellent return. But if you buy now when the market is slow, then you have the opportunity to be holding onto these investments when a good market uptick will happen. If you are fortunate to see a year with a 10% appreciation on your homes, you will actually realize a 40%+ return on your investment in a single year. Remember, Real Estate appreciation is a lagging indicator so do not wait until signs are pointing up, it will already be too late. Buy now with an expectation of waiting for 10-15 years to cash in and you will be in a position to take advantage of any extraordinary upticks. If you don't get any uptick you will still do very well as compared to most other investments.


Anonymous said...

Excellent article! In addition to all the benefits you mention, there are also the significant tax benefits of investing in real estate (rentals that is - not as residences; between the AMT hitting more and more people and the possibility of loosing the 250/500k exemption on residences, benefits are going away little by little on holding principal residences). It seems the tax laws were written by folks owning a lot of real estate, for people owning real estate. For those buying stocks, currently the long-term cap gain tax is at 15%, not bad, pretty low historically, but that one will probably go up with the next administration, and as you mention in the article, no leverage on buying stocks, makes real estate attractive. Of course, when leverage goes the wrong way, it hurts, but if you are willing to hold a property for 7 years or so, until the next cycle, it shouldn't matter. Your market research criteria (job growth, population growth, etc) is great, I try to use the same although I don't always find the data easily. Census data is old and chambers of commerce always paint a bright picture. I've also been using OFHEO's data to find an attractive market (one that hasn't bubbled, a "boring" 3-4% appreciation per year market, well at least that's what i was looking for before 2007 hit.

keep up the good posts on your blog, I really enjoy reading them!


Anonymous said...

T. Harv Eker. thats the man that said it