For our 2013 Cabo San Lucas retreat with Modern Tribe (thats the software company I married in 2001), I gave a lightning talk to the team on the basic principles of real estate investing. Everyone on the team had to present on something they were passionate about while teaching us something new. Talks were amazingly varied from wine tasting to horse grooming, the art of clowning, how to run a marathon, lock picking and human memory hacking. While the business and software discussions were invaluable, and Mexico was gorgeous, these talks and the camaraderie that came out of them is what I’ll remember.
Why all the panda pictures you might ask? My daughter Sassy thinks they are cute and I had to entertain her while making this deck. She had a great time helping me hunt panda photos. ‘Nuf said.
Beyond awesome stories like Peter’s and my visit to Rochester to look at slum housing (now that is another adventure I should definitely write), I broke down why real estate makes such a powerful investment vehicle.
Check out the slides and click share if they made you smile!
Cashflow + Equity + Leverage
So where do the profits come from? One of the things I love about investing in properties are the many factors, when carefully managed, that work in my favor.
Profits come from positive cash flows.
Basically, I collect rents from some carefully chosen tenants. Then I pay expenses including PITI (principle and interest on my mortgage, property taxes, insurance) and a whole pile of other variable expenses such as maintenance, turnover, marketing and in some cases utilities and management. What is left in my pocket are cash flows. While the largest profits in real estate aren’t typically derived from cash flows, this is a key part of the trifecta. A healthy positive profit in coin buffers you from the tantrums of a market and a larger economy. That and some cash in your pocket is a nice way to supplement, and some day pay for, a pleasing lifestyle.
Profits come from Equity.
Most people get this. It is like a stock. The value of your property increases. So what drives an increase? Over the long term, inflation will create a steady pressure upon most, if not all, properties. While there are exceptions, over a long enough time horizon, you can pretty much count on it. Most properties though gain or loose true equity by local market forces driven by consumer demand. In short, good incomes, availability of lending and more people wanting houses than the availability of supply drives up prices. Think supply and demand. When I look at where to invest, Julie & I spend a lot of time looking at market research to identify locations which have opportunity for growth and stability for longevity. Every time I’m looking at a new neighborhood, I look for the key financial indicators (core industries, growth of rental base, unique features). In addition to buying in the right place, you can also force equity (see deal types) by doing remodels or repurposing a property.
Profits (can) come from leverage.
You can buy properties all cash. In fact, nearly 40% of property in the United States are owned free and clear with no debt. Used correctly, debt is your friend. This is called leverage. If you can acquire and control a cash-flow positive property, for the minimum of capitol possible, you gain in three ways.
First of all, it leaves more money in your pocket to go acquire other assets. The more you can effectively apply your capital, in a strategically diversified situation, the better a return you will see.
Second, as long as the property is legitimately cash positive and you didn’t do some absurd interest-only or highly variable loan, each and every month a small part of your mortgage payment goes towards your principal. Basically, my tenants are buying me a house, one month at a time.
Lastly, and perhaps most importantly, increases in equity get magnified. Lets say that your property goes up 10% in value this year. Its a good year and I think a lot of markets will see this kind go growth in 2013. If you own a 100k property out right, you get a 10% or 10k increase on your money. Not bad at all. On the other hand, you leverage the property using a loan and put have 20k equity (20% down). A 10% increase on the property is still 10k, but a 10k return on a 20k investment is a 50% return. That is a 5x magnification due to leverage. While this can work to your benefit, it can also work against you as many people have found out over the last 5 years, so leverage carefully.
There are so many possible deal types in real estate investing. For the purpose of addressing 1st time investors, there are a few very well paved paths.
Buy & Hold
The classic. The strategy with buy and hold is fairly simple. Find a solid property that you feel confident will rent well over the long haul and cashflow with the right loan. Rent it and collect a small check. Take good care of it, pick great tenants and let them pay down your principal while rents increase over time with demand. Watch your checks get bigger over time. The day your loan is paid off, your monthly check increases and provides a nice piece of your retirement. This is my plan. Julie and I have slowly and carefully acquired homes. We started by buying one for ourselves, building a new downpayment and then turning it into a rental. Eventually we got tired of moving, and switched to carefully choosing awesome rentals. My math says somewhere between 10-12 paid off three bedroom units in the santa cruz area is enough to offer our financial freedom.
There are number of creative ways to increase the value of a property.
Many great investors have found an underperforming property and based upon experience and some effort, increase the cash flow. That could come from better marketing, property management and more. After all, if you increase the monthly net operating income, you increase the value of the property to other investors.
In other cases the property is repositioned, such as changing an apartment building into a homeless shelter. Many times a dud in one situation, could be a major winner for another niche.
The most common, and the only place I have personal experience so far, is in the remodel. Julie and I have picked up a few houses with great bones, and some seriously worn down cosmetics. 30-40k later, they shine, and the property value has increased by quite a bit more.
Buy a junker, fix it up nice, sell it to someone who appreciates your hard work. Pocket the money and do it again.
A number of friends advised us to sell those remodeled properties, take the profit and buy more properties. We seriously considered it and finally decided that we believed in the long term value of these particular properties. That, and we already have very active companies. I’m buried in the software world as a partner at modern tribe, and Julie is hustling making BioScout, her science reciting agency, successful. Flipping is an amazing way to create short term revenue, which you can then put into a long-term investment. We weren’t looking for another highly-active income source.
The First Step
I’ve never been someone to move rashly or take uncalculated risks. I do a lot of research and I mix as many of the bets so as to hedge them. I deeply believe that a wise investor figures out how to weave their business and their strategy into their lifestyle. Julie and I love looking at homes. Its our hobby. We happen to like living in homes too (most of you probably relate). So we started carefully and when we sold our first townhouse, instead of upgrading to a big ‘ol home that max our budget, we bought a duplex. We lived in one half, rented the other. The plan was to stay for a few years until we could afford another. It gave us a chance to learn how to manage a rental up close and personally.
At the end of the day, I advise you to simple find someone who is living the life you want, look at what they are doing and then grab their coat tails. Santa Cruz, CA is full of baby boomers who bought a house every handful of years as they aged, and just took care of their renters. Today, they sit in the lineup on long boards at pleasure point in the middle of the day while many of their friends are working or worried about a retirement plan. I choose financial freedom.