Posts Tagged real estate investing
A friend of mine recently asked me about how he should start going about when finding a market to invest in. As I answered him on how to approach the market, I noticed his eyes started wandering when I continued to spew information out like a loose fire hydrant for the next fifteen minutes. My diplomatic friend suggested that I should write all my thoughts down instead. So here I am.
How Healthy is the City?
As I stressed in my podcast before, I’d look at where I invest based on how healthy the city is. I do not feel comfortable investing in a city with a declining population such as Detroit. A real estate investment can sometimes take as little as a year or as long as decades before you realize your profit. You never want to be investing in a city where you have no idea where it is going to go in the short to medium term.
Thus, when you pinpoint a market to invest in, make sure you drive around the entire city. Every city has its good neighborhoods and its bad ones. Even within the city there are areas where people are leaving and where people are clamoring for. One of the ways to look for a growing area is to see how the infrastructure is. Is there a Wholefoods? Are there parks? What about the library? Where is Target setting up shop? The more developed an area is, the more likely that the neighborhood will be staying for a long time. Obviously, do check out the houses as well. Good curb appeal typically means that the neighborhood has good homeownership pride. I tend to peek at what cars people are driving as well.
Know the Home Prices in Every Neighborhood
I would then go to Redfin or Trulia and start looking at the price ranges of the homes. For the most part, prices will be higher in premium neighborhoods. But having done the drive, you might start noticing certain neighborhoods which are good neighborhoods but prices haven’t caught up yet. Sometimes you can find bargains there. In any case, after all this you’d have a pretty good idea of whether the city would be worth investing and where you would want to invest in at.
Side note, certain investors enjoy chasing higher rental yields by investing in lower quality neighborhoods. This is a personal choice. I cannot say which one is better. Personally, I prefer to get a lower yield by investing in better neighborhoods. I do not have the time nor the patience to deal with lower quality tenants who tend to reside in those neighborhoods. Time is valuable to me and I believe in investing in good neighborhoods to avoid headaches.
Find the Right People
Then I would visit several property managers and explain to them that I am planning to invest in the city and is potentially looking for someone to work with. Again, depending on where you are and what you do, you may not need a property manager. Nevertheless, they are a good source of information as to which neighborhoods tend to have better tenants. This process is just sort of reaffirming what you have discovered so far.
Lastly, I will now find a real estate agent. I’d want a real estate agent who is willing to hustle and has an investor mindset. An easy question to ask is whether he or she invests in real estate. A real estate agent who does not invest in real estate is not one that you would want to have. Obviously, this depends on the market. But if the market is good, why isn’t the real estate agent investing? Since you will be working with the agent most of the time, you have to test the agent to see if he or she knows as much as you. On the flip side, you have to show the agent that you are a serious investor. If the agent senses that you are just here to play around, the agent is not going to spend a lot of time on you. You, too, have to impress the agent with your knowledge of the market. But do not be afraid to try sending out a bad offer and see if the agent is there to look out for your interest. If you try to “overpay” for a property and your agent is not there to stop you, it is time to look for a new agent.
With that being said, good luck in investigating your next market!
To many people, the slumlord — alias ghetto landlord and rent gouger — is proof that man can, while still alive, attain a satanic image. Recipient of vile curses, pincushion for needle-bearing tenants with a penchant for voodoo, perceived as exploiter of the downtrodden, the slumlord is surely one of the most hated figures of the day.
The indictment is manifold: he charges unconscionably high rents; he allows his buildings to fall into disrepair; his apartments are painted with cheap lead paint, which poisons babies; and he allows junkies, rapists, and drunks to harass the tenants. The falling plaster, the overflowing garbage, the omnipresent roaches, the leaky plumbing, the roof cave-ins and the fires, are all integral parts of the slumlord’s domain. And the only creatures who thrive in his premises are the rats.
The indictment, highly charged though it is, is spurious. The owner of ghetto housing differs little from any other purveyor of low-cost merchandise. In fact, he is no different from any purveyor of any kind of merchandise. They all charge as much as they can.
First consider the purveyors of cheap, inferior, and secondhand merchandise as a class. One thing above all else stands out about merchandise they buy and sell: it is cheaply built, inferior in quality, or secondhand. A rational person would not expect high quality, exquisite workmanship, or superior new merchandise at bargain rate prices; he would not feel outraged and cheated if bargain rate merchandise proved to have only bargain rate qualities. Our expectations from margarine are not those of butter. We are satisfied with lesser qualities from a used car than from a new car. However, when it comes to housing, especially in the urban setting, people expect, even insist upon, quality housing at bargain prices.
But what of the claim that the slumlord overcharges for his decrepit housing? This is erroneous. Everyone tries to obtain the highest price possible for what he produces, and to pay the lowest price possible for what he buys. Landlords operate this way, as do workers, minority group members, socialists, babysitters, and communal farmers. Even widows and pensioners who save their money for an emergency try to get the highest interest rates possible for their savings.
According to the reasoning that finds slumlords contemptible, all these people must also be condemned. For they “exploit” the people to whom they sell or rent their services and capital in the same way when they try to obtain the highest return possible.
But, of course, they are not contemptible — at least not because of their desire to obtain as high a return as possible from their products and services. And neither are slumlords. Landlords of dilapidated houses are singled out for something that is almost a basic part of human nature — the desire to barter and trade and to get the best possible bargain.
The critics of the slumlord fail to distinguish between the desire to charge high prices, which everyone has, and the ability to do so, which not everyone has. Slumlords are distinct, not because they want to charge high prices, but because they can. The question that is therefore central to the issue — and that critics totally disregard — is why this is so.
What usually stops people from charging inordinately high prices is the competition that arises as soon as the price and profit margin of any given product or service begins to rise. If the price of Frisbees, for example, starts to rise, established manufacturers will expand production, new entrepreneurs will enter the industry, used Frisbees will perhaps be sold in secondhand markets, etc. All these activities tend to counter the original rise in price.
If the price of rental apartments suddenly began to rise because of a sudden housing shortage, similar forces would come into play. New housing would be built by established real estate owners and by new ones who would be drawn into the industry by the price rise. Old housing would tend to be renovated; basements and attics would be pressed into use. All these activities would tend to drive the price of housing down, and cure the housing shortage.
If landlords tried to raise the rents in the absence of a housing shortage, they would find it difficult to keep their apartments rented. For both old and new tenants would be tempted away by the relatively lower rents charged elsewhere.
Even if landlords banded together to raise rents, they would not be able to maintain the rise in the absence of a housing shortage. Such an attempt would be countered by new entrepreneurs, not party to the cartel agreement, who would rush in to meet the demand for lower priced housing. They would buy existing housing and build new housing.
Tenants would, of course, flock to the noncartel housing. Those who remained in the high-price buildings would tend to use less space, either by doubling up or by seeking less space than before. As this occurs it would become more difficult for the cartel landlords to keep their buildings fully rented.
Inevitably, the cartel would break up, as the landlords sought to find and keep tenants in the only way possible: by lowering rents. It is, therefore, specious to claim that landlords charge whatever they please. They charge whatever the market will bear, as does everyone else.
An additional reason for calling the claim unwarranted is that there is, at bottom, no really legitimate sense to the concept of overcharging. “Overcharging” can only mean “charging more than the buyer would like to pay.” But since we would all really like to pay nothing for our dwelling space (or perhaps minus infinity, which would be equivalent to the landlord paying the tenant an infinite amount of money for living in his building), landlords who charge anything at all can be said to be overcharging. Everyone who sells at any price greater than zero can be said to be overcharging, because we would all like to pay nothing (or minus infinity) for what we buy.
Disregarding as spurious the claim that the slumlord overcharges, what of the vision of rats, garbage, falling plaster, etc.? Is the slumlord responsible for these conditions?
Although it is fashionable in the extreme to say “yes,” this will not do. For the problem of slum housing is not really a problem of slums or of housing at all. It is a problem of poverty — a problem for which the landlord cannot be held responsible. And when it is not the result of poverty, it is not a social problem at all.
Slum housing with all its horrors is not a problem when the inhabitants are people who can afford higher quality housing, but prefer to live in slum housing because of the money they can save thereby.
Such a choice might not be a popular one, but other people’s freely made choices that affect only them cannot be classified as a social problem. If that could be done, we would all be in danger of having our most deliberate choices, our most cherished tastes and desires characterized as “social problems” by people whose taste differs from ours.
Slum housing is a problem when the inhabitants live there of necessity — not wishing to remain there, but unable to afford anything better. Their situation is certainly distressing, but the fault does not lie with the landlord. On the contrary, he is providing a necessary service, given the poverty of the tenants.
For proof, consider a law prohibiting the existence of slums, and therefore of slumlords, without making provisions for the slum dwellers in any other way, such as providing decent housing for the poor or an adequate income to buy or rent good housing. The argument is that if the slumlord truly harms the slum dweller, then his elimination, with everything else unchanged, ought to increase the net well-being of the slum tenant.
But the law would not accomplish this. It would greatly harm not only the slumlords but the slum dwellers as well. If anything, it would harm the slum dwellers even more, for the slumlords would lose only one of perhaps many sources of income; the slum dwellers would lose their very homes.
They would be forced to rent more expensive dwelling space, with consequent decreases in the amount of money available for food, medicines, and other necessities. No. The problem is not the slumlord — it is poverty. Only if the slumlord were the cause of poverty could he be legitimately blamed for the evils of slum housing.
Why is it then, if he is no more guilty of underhandedness than other merchants, that the slumlord has been singled out for vilification? After all, those who sell used clothes to Bowery bums are not reviled, even though their wares are inferior, the prices high, and the purchasers poor and helpless. Instead of blaming the merchants, however, we seem to know where the blame lies — in the poverty and hopeless condition of the Bowery bum.
In like manner, people do not blame the owners of junkyards for the poor condition of their wares or the dire straits of their customers. People do not blame the owners of “day-old bakeries” for the staleness of the bread. They realize, instead, that were it not for junkyards and these bakeries, poor people would be in an even worse condition than they are now in.
Although the answer can only be speculative, it would seem that there is a positive relationship between the amount of governmental interference in an economic arena, and the abuse and invective heaped upon the businessmen serving that arena. There have been few laws interfering with the “day-old bakeries” or junkyards, but many in the housing area. The link between government involvement in the housing market and the plight of the slumlord’s public image should, therefore, be pinpointed.
That there is strong and varied government involvement in the housing market cannot be denied. Scatter-site housing projects, “public” housing and urban renewal projects, and zoning ordinances and building codes, are just a few examples. Each of these has created more problems than it has solved. More housing has been destroyed than created, racial tensions have been exacerbated, and neighborhoods and community life have been shattered.
In each case, it seems that the spillover effects of bureaucratic red tape and bungling are visited upon the slumlord. He bears the blame for much of the overcrowding engendered by the urban renewal program. He is blamed for not keeping his buildings up to the standards set forth in unrealistic building codes that, if met, would radically worsen the situation of the slum dweller. Compelling “Cadillac housing” can only harm the inhabitants of “Volkswagen housing.” It puts all housing out of the financial reach of the poor.
Perhaps the most critical link between the government and the disrepute in which the slumlord is held is the rent control law. For rent control legislation changes the usual profit incentives, which put the entrepreneur in the service of his customers, to incentives that make him the direct enemy of his tenant-customers.
Ordinarily the landlord (or any other businessman) earns money by serving the needs of his tenants. If he fails to meet these needs, the tenants will tend to move out. Vacant apartments mean, of course, a loss of income. Advertising, rental agents, repairs, painting, and other conditions involved in re-renting an apartment mean extra expenditures.
In addition, the landlord who fails to meet the needs of the tenants may have to charge lower rents than he otherwise could. As in other businesses, the customer is “always right,” and the merchant ignores this dictum only at his own peril.
But with rent control, the incentive system is turned around. Here the landlord can earn the greatest return not by serving his tenants well, but by mistreating them, by malingering, by refusing to make repairs, by insulting them. When the rents are legally controlled at rates below their market value, the landlord earns the greatest return not by serving his tenants, but by getting rid of them. For then he can replace them with higher-paying non-rent-controlled tenants.
If the incentive system is turned around under rent control, it is the self-selection process through which entry to the landlord “industry” is determined. The types of people attracted to an occupation are influenced by the type of work that must be done in the industry.
If the occupation calls (financially) for service to consumers, one type of landlord will be attracted. If the occupation calls (financially) for harassment of consumers, then quite a different type of landlord will be attracted. In other words, in many cases the reputation of the slumlord as cunning, avaricious, etc., might be well-deserved, but it is the rent control program in the first place that encourages people of this type to become landlords.
If the slumlord were prohibited from lording over slums, and if this prohibition were actively enforced, the welfare of the poor slum dweller would be immeasurably worsened, as we have seen. It is the prohibition of high rents by rent control and similar legislation that causes the deterioration of housing. It is the prohibition of low-quality housing by housing codes and the like that causes landlords to leave the field of housing.
The result is that tenants have fewer choices, and the choices they have are of low quality. If landlords cannot make as much profit in supplying housing to the poor as they can in other endeavors, they will leave the field. Attempts to lower rents and maintain high quality through prohibitions only lower profits and drive slumlords out of the field, leaving poor tenants immeasurably worse off.
It should be remembered that the basic cause of slums is not the slumlord, and that the worst “excesses” of the slumlord are due to governmental programs, especially rent control. The slumlord does make a positive contribution to society; without him, the economy would be worse off. That he continues in his thankless task, amidst all the abuse and vilification, can only be evidence of his basically heroic nature.
Due to my dedication to the mortgage industry for the past two decades I often get questions like “When will lending return to normal?” or “How long will it be until rates go up?” While I do not have a crystal ball I can only theorize based on my knowledge of macroeconomics and experience in the lending world. First I will address that what we had for the first part of the last decade was not a normal lending activity in the sense that “free money for all” was an extreme event. What we’re experiencing today – a credit freeze – is the other extreme. The problem is however on how the equilibrium can be re-established and when. To have a prosperous economy a nation must have a healthy – not excessive and not rigged – lending sector. But alas, our political leaders and Central Bank are still trying to figure it out.
To get you an idea of where lending may be heading I have to bring in the topic of inflation and deflation as they are very much connected. The “Inflation or Deflation?” is one of the most debated daily topics amongst economists and central bankers. Recently it’s been one of the most debated topics I’ve had with friends and colleagues that I highly respect so I decided to analyze the subject based on purely Austrian fundamental principles. Of course there are other factors that could throw off my theory and change the outcome of what I believe to be runaway price inflation. For example, we could be involved in another major war, possibly WWIII, where unemployment would decrease (based on the idea that many unemployed people would be needed to go and fight the war) and the U.S. production would increase dramatically due to the need for military devices. That would not be a natural recovery and I don’t endorse it due to tragedy and loss of lives that it involves.
So, what’s it going to be? Inflation or Deflation? To determine the potential outcome one should understand how the money supply is one of the biggest pieces of the puzzle. The monetary base represents roughly a small percentage (15% or so) of the true money supply TMS. The U.S. Central Bank directly controls only this portion of the money supply. I should emphasize the word directly because indirectly there are a lot of things that the Federal Reserve can and does control, yet that’s another topic of its own on which I won’t elaborate at this time. Many experts argue that the monetary base has remained relatively flat. But in looking at the chart below I see a steady increase from 1980 until 2008. Then in 2008 from $850B the base shot up to $2.8T (as of July 14, 2011) in response to the first few rounds of “Quantitative Easing.”
The monetary base comprises physical currency and bank reserves. When the Fed purchases securities through its open-market operations, the monetary base increases by a corresponding amount, but it is ultimately the banks and their customers who determine the amount of circulation credit built on top of the monetary base. Indeed the Fed cannot force banks to make loans to individuals and businesses but by continuing to buy securities from banks it helps them increase their reserves, and do remember that bank reserves are part of the monetary base. This monetary base increase to infinity should and will eventually react in a less than desirable form.
OK, so now we understand that Mr. Bernanke is not really “printing” all the money that many believe he does, and again he only directly affects about 15% of the total money supply but indirectly he does rely on banks to expand the remainder through the fractional reserve banking system. Mr. Bernanke feels confident that at least for a while banks will not make loans due to factors such as newly taken risk (in form of new loans at low rates) at a time when the banks are still trying to heal their balance sheets.
It is known that these reserves are sitting quietly at the Fed generating a yield to the banks of 25 basis points (.25%). This gives me a hint that inflation could be the possible threat but not until banks start lending at their full potential. Back in March 2011 the amount of reserves posted by St. Louis Federal Reserve Bank was $1.2T. My recent search showed it spiked to $1.6T in just four months (see chart below.) But eventually the banks balance sheets will heal and they will be ready to lend again. And this is the concern for those that believe inflation would be the cause of another economic crises. In simple terms the reserves that were idle for a while would start circulating in the global economy and would lead to more money chasing the same amount of goods raising their prices and known as inflation.
So, where does that leave us? Will lending or can lending be frozen forever to avoid a potential massive inflation? For a while it may work considering the banks are still not ready due to lack of sufficient qualified borrowers. Eventually, down the road banks and borrowers will be ready but that event could trigger the massive inflation that most of us are not prepared for. To avoid it the Fed would have to use the strategy of banks reserves reversal. But it;s easier said than could be done because the Fed cannot simply take them away from the banks. From a banker’s standpoint this would be analogous to stealing. The option left would be for banks to buy back securities – that include toxic assets – and return some of these excess reserves back to the Fed while the Fed would remove them from their balance sheet. But again if banks buy back the assets they sold to the Fed – in exchange for the reserves they currently hold – their balance sheets would be no better than in 2008. This would lead to sky rocketing interest rates and a banking system failure worse than back in 2008. Either way a soft landing gets harder and harder to achieve.
Following is a brief reminder of how all of this had started during the early 2000 through the housing boom (that not coincidentally extinguished the potential harm caused by the dot.com bust.) The Fed’s expanded credit via banks – multiplied through the fractional reserve banking system – during the “roaring” 2000’s went primarily into hard assets and primarily into real estate. Through this credit expansion phenomenon the rates were kept at artificially low levels (when the money rate should have been allowed to rise in a free market scenario) and it distorted the value of assets by inflating them artificially. Then the defaults started to gain traction and what once used to be a good asset (for the bank and the borrower) it ended up being a toxic asset. Along with this the banks stopped making loans, the real estate activity suddenly dropped and the glut of foreclosed homes brought down the values of the rest of the homes.
To end with a more defined answer I will recap the options that appear to exist. One would be a moral one for the Federal Reserve and our leaders by allowing freedom of the markets to take its course. This would be expressed in form of very high interest rates, lack of lending capacity associated with a credit contraction, bankruptcy of many Wall Street institutions, and a deflationary depression that would be required for a fresh start. With this option the risk of Hyperinflation is considerably minimized. The other option, that appears more of where we’re heading is the one with government intervention in the markets. The Fed continues to expand the monetary base, keeps interest rates at the bottom, and when banks are ready to start lending at their full potential it may trigger a massive inflation or hyperinflation along with the destruction of the dollar.
If you’ve read any of my previous articles you most likely know by now that I am a big fan of hard assets. Precious metals are hard assets yet buying physical gold and silver is not an investment! It is simply a wise move to help you and your family maintain your purchasing power when the government devalues the currency (and there’s sure plenty of that going on today!) Keeping dollars in the bank (any bank) today is like putting your money under the mattress (some think it’s actually worse than that).
Real Estate is a hard asset however it may or may not represent a true investment. For years people who owned their own homes considered their residences an investment. Sure, it may have been the “cash cow” for the years prior to the economic Bust when real estate inflationary value was out of control. What most people called “property appreciation” the classic (not modern) economists were calling “a Boom in the making”. It makes me think of a client of mine, a formerly very successful builder, that was telling me how only a few years ago he was worth millions of dollars. Not anymore! His was simply an “artificial prosperity”. Artificial prosperity is created fast (usually during an economic boom) and lost as fast (usually during an economic bust).
Should you decide to invest in real estate take notice that your personal residence is not an investment. Your home is not generating an income for you…unless you own and live in a duplex, triplex, or any other kind of multi-family and you collect rents from your tenants. A real estate investment could be a house, an apartment complex, or a commercial property that provides a monthly cash flow for you. Nowadays I come across plenty of investors who prefer the small residential properties or apartment complexes. This type of investment satisfies one of the requirements for what I call “healthy investment” criteria. It’s a hard asset that provides housing to those who have no ability to own their personal home or have no desire to take on such a responsibility. In addition, there is a large influx of newly evicted homeowners which will most likely go up as more defaults are scheduled to occur in the next few years on the 5 and 7-year Option ARM loans (these loans are due to reset at higher monthly payments and had a negative amortization to start with.)
So, if you are a novice at this kind of investing, how do you determine in a few minutes if a particular property is an opportunity worth further investigation? Following are some of the things that I look at when evaluating a real estate investment.
1. The local economy. First of all let me just say that it doesn’t have to be a big city. I say that because you can invest in a metropolitan area with a large percentage of its population that is unemployed. So what good does it do to you to buy real estate at a bargain price in an area where people can’t afford the rent? Familiarize yourself with the local economy by doing research on the city’s unemployment, major employers, recent news, and crime statistics.
2. Condition of the property. There are four kinds that I can think of: fully renovated, average, poor, and dilapidated. The first kind is self-explanatory and after an inspection you can probably be assured that for the next 3-5 years no major repairs should be required. The average condition is what a thorough inspection should disclose: the work and its estimated cost during the next 5 years. The poor condition is the type where you accurately need to estimate a full rehabilitation; and the dilapidated is the kind that you buy to bulldoze off and rebuild from ground up. This is the case where you ought to know the value is only in land and there may be a while until it can provide you with cash flowing revenues. It takes time, building permits, and lots of headaches. Beside that the prospect of financing the construction is extremely limited at this time.
3. Return on Investment. I saved this for last because this is very important and it needs to be elaborated in more detail. This formula is based on the total amount of money invested and it differs between an all-cash transaction and one where leverage is involved. An all cash transaction will show a lower ROI rate than when leveraged but there are benefits that may offset the lower rate. The two that come to mind are the peace of mind that you own the property free and clear, and eliminating the interest you’d pay on the mortgage.
The way to calculate the ROI is by first subtracting the annual Operating Expenses OE (current and/or projected) and the vacancy factor VAC (5 – 10%) from the total annual rental income (GSI for Gross Scheduled Income). This first calculation determines the Net Operating Income (NOI). Once you have this figure you divide it by the total Purchase Price(PP) and the result is the ROI also known as Capitalization Rate (CAP Rate) in the commercial sector.
GSI – OE = NOI
NOI / PP = ROI or CAP Rate
As an example let’s say you purchase a property for $100,000. The annual rental income is $15,000 and all expenses are $5,000.
$15,000 (GSI) – $5,000 (OE) = $10,000(NOI)
$10,000(NOI) / $100,000 (PP) = 10% ROI or CAP Rate
Since there is no mortgage in this case the property’s NOI represents the annual cash flow. In ten years, Ceteris Paribus, this investment would be fully recouped. In other words based on a $10,000 annual cash flow it would take 10 years to fully recoup your original $100,000 investment. ($100,000 / $10,000 = 10 years.)
If financing is involved things change because you don’t invest your entire $100,000 and you’ll make mortgage payments. In this case here are the formulas you want to use.
GIS – OE = NOI
NOI – DS = Cash Flow
NOI / Capital Invested = ROI
Remember these are all calculated on an annual basis. The Debt Service(DS) is the monthly P&I (Principal & Interest) on the loan multiplied by 12 months. The Capital Invested is the down payment plus all other costs that you invested from your own pocket (such as the cost to renovate). In our previous example if the property was already renovated and if the down payment was 30% of the purchase price here is how the figures would look like.
$15,000(GSI) – $5,000 (OE) = $10,000(NOI)
$10,000(NOI)- $5,700(DS) = $4,300(Cash Flow)
$4,300(Cash Flow) / $30,000(Capital Invested) = 14.3% ROI
The DS was calculated based on a loan starting balance of $70,000 amortized over 25 years at an annual rate of 6.5%. In this case it should take you about 7 years to recoup your investment ($30,000 / $4,300). However, by using financing the property won’t be free and clear until the loan is paid off. After seven years you’ll still have about 18 years of mortgage payments (if you make the minimum required payments.)
What I have just described is a quick way to determine if an investment is worth exploring. If a preliminary ROI is at 8, 10, 12 or higher percentage, and if the other two criteria look good in your eyes it is possible that such a real estate investment may be a good opportunity. Also, because the ROI is higher when financing is used many investors prefer to leverage their investment when they have the ability to do so. One reason is that the $100,000 used to acquire just one property in an all-cash scenario could be used to buy two or more properties when loans are secured. And because many real estate investors view their investments as long-term the end goal is what prevails, and that is the number of properties $100,000 can buy today.