It’s taken almost two centuries for bankers to pull the wool over Americans’ eyes, but today you and I are working for intrinsically worthless paper that can be created by bureaucrats — created without sweat, without creative ability, without work, without anything but a decision by the Federal Reserve. This is the disease at the base of today’s monetary system. And like a cancer, it will spread until the system ultimately falls apart. This is the tragedy of the great lie. The great lie is that fiat paper represents a store of value, money of lasting wealth.
The Constitution only gives people the right to pursue happiness. You have to catch it yourself.
Principles of Real Estate
Real estate confers to the holder several benefits. One, it gives him a place to hang his hat and call his own; real estate affords us independence from our neighbors, and is one of the principle tenets of a free society. Two, it allows him to benefit from the bounty that the land and his labor can bring. Three, it allows him the ability to rent the
land to others seeking those benefits but who do not have the ability to own the land.
It is the third part that we will concentrate on in this chapter- using land to generate income. However, without the first two benefits, the third would not exist. This is what separates real estate from many investments. While holding a paper asset, two peoples’ value of the asset may be different. Each player tries to outguess the other based on random data around the asset. The true value will be the sum of all the opinions on the worth of that paper asset. What is the ultimate value of that paper asset? Usually the best opinions come from the insiders, but we have laws governing the exposure of insider information. This transfers a lot of the risk of investing in paper assets to the public. I believe this makes investing in paper assets inherently riskier than other assets that confer value through the holding and the developing of that asset.
The real estate asset, however, has value through what it can provide to the holder. Much like gold, real estate is a store of value. But it is also a producer of value to the person whom can get the most out of it. One of the key concepts we will discuss is the highest and best use of land.
Highest and best use may be planting crops or raising animals on a pasture. It may be building an office space, condo, or single family home. It may be in changing the density of land through code changes, such as from residential to commercial to build an apartment complex. Part of profiting from real estate comes not only owning it, but in realizing, based upon several factors, what the ultimate use of the real estate will be and profiting from this development.
Note that many people invest in real estate through paper assets such as Real Estate Investment Trusts (REITs). These trusts are set up to collect money from public and private investors to fund the purchase and development of land. The holders of the actual land benefit most from these paper assets, and the return to the ultimate investors is often watered down. The risk to each party is the same- when a REIT loses value, the investors lose as well. And they do not have the upside of managing the land to create value from it.
Therefore, we will not discuss using REITs as a way to invest in real estate because it really isn’t. Investing in a REIT is primarily a way to invest in the manager of the real estate asset and their ability to manage the land to its highest and best use. It is not an investment in the real estate itself.
REITs are not unlike stocks, in which the purchasers hope that the company realizes the highest and best use of their resources. While the public theoretically can vote on the officers and major decisions, the managers really run the day-to-day operations of the company. In a REIT, the managers perform much like other managers runs a company. REITs are subject to the same inherent risk as investing in paper stock assets.
We prefer to actively invest in real estate. With active investment, there is more work, but there is also more reward. For the person that owns it, physical real estate can deliver returns much beyond that of investing in paper assets because the owner receives all of the benefits of the investment directly, not filtered through various levels of middle men taking profits off the table. Physical real estate is the ultimate real estate investment and is much sounder in times of economic uncertainty.
Single Family Homes
Details, Detail, Details
One of the very first things a new real estate investor will do is to rent a single family house. Houses are a relatively cheap way to get in on the active real estate market. They do not typically require huge sums of money to finance that a commercial project would require. And they are attainable by the average John Q. Public investor. This is why we love them!
When purchasing a home as an investment, the basic process is the same as purchasing the home you live in. In today’s credit society, this will involve the lending bank to put up most of the money, the down payment from the purchaser, and closing costs covering the various protective services required by lender and buyer. When you purchase an investment property, it is a good idea to hire an inspector to report on any potential structural problems. It is also good to hire a title company to ensure that any problems related to transfer of the title are taken care of ahead of time. This ensures that the buyer gains full claim to the home and that any existing liens or claims are cleared up prior to closing. The homeowner’s insurance policy will be partially pre-paid, along with any pro-rated property taxes that have accumulated during the year up until the purchase date.
All of this will be put on an HUD-1 statement by the title company. This statement is the ledger for both buyer and seller cash flows. All related costs associated with the purchase of the home will be listed here, along with the total net cash flows from buyer to seller listed at the bottom. This document can be confusing to read the first time through, so it is imperative during purchase that the buyer and seller receive this ahead of the closing. Because legal issues regarding the paperwork to close on a home has become much more extensive in the last few years, some title companies do not deliver the HUD-1 ahead of time. This should not be accepted by either buyer or seller as the net cash flows are needed ahead of time to confirm each party’s position on the sale. A good rule of thumb is to receive the HUD-1 from the title company forty-eight hours prior to closing. If this cannot be done, it should be encouraged to delay the closing date by a few days. If there is a discrepancy, it is much harder to cure at closing than it is if you have a couple days ahead of time to review the paperwork.
Scouting the Investment
It is often said by REI that your profits are made when you purchase the real estate, not when you sell it. This is known as buying at a discount. Discount can be accomplished for several reasons. One may be that the house needs physical work to bring it to rentable condition. The other may be an estate or other quick sale in which the seller needs to get out quick. These sellers are “motivated” because they are cash poor and house rich, and they wish to convert their equity into money. Looking out for motivated sellers is a good way to buy property at a sizeable discount. If seller is a bank, these types of properties are called Real Estate Owned (REO).
Banks generally do not like REOs because they have to pay for the maintenance and upkeep of them, they do not get the interest income from timely mortgage payments, they are liable for the property taxes, and they also are restricted on additional loans due to fractional reserve banking. When a bank owns the real estate, the funds it loaned on it are “tied up” and taking out of reserves that can be used for additional loans. This hurts their profit potential even more.
For this reason, the REO market has been a huge target of investors. I have met people whose entire businesses have been to purchase REOs, fix them up, and “flip” (sell within a short time frame) them to new homebuyers. It has been lucrative as banks are taking back more properties due to the mortgage crisis.
However, the double-edged sword aspect to this is that banks now own too many REOs. When this many bank-owned REOs exist on the market, several things happen. First, this means there are less overall qualified buyers. Therefore, if you play the REO game, it may take you longer to find a qualified buyer. Your holding costs (mortgage payment, utilities, etc.) on the property will increase over time, which means your profits fall. Secondly, too many REOs on the market dilutes the selling price, which hurts flipping of these homes even more. As more REOs show up on listings, appraisers have little choice but to use those low REO values in determining local real estate values.
I tend to agree with this practice, even though it hurt my own home values. Here is why. The real estate boom created a bubble in which people could not afford to keep up with prices and associated expenses, and subsequently the bubble burst. The house prices were inflated beyond what people could reasonably afford. In other words, those prices did not reflect the true value the homes conferred to their owners. REOs are a symptom of the fall in the real estate market. Just because homeowners don’t like the devaluing of real estate does not mean it is not going to happen anyway. Many investors fight the use of REOs in the calculation of their home value, but in the end, the REOs are going to win out. REO values are a legitimate claim on the reduction of the inflated value of real estate. The caveat is that they are a distorted value because we still do not have a true market in which actual real estate prices are known. But REOs most likely do bring values back closer to their REAL levels.
Therefore, even if you do not plan to invest in REO bank-owned properties as part of your approach, it is still very wise to understand them and research how many of these are found in your area. With this information, you will find a more true value of what your investments are ultimately worth.
That leads us to market price. What is a market price? It is the price that, in an open market, both buyer and seller can agree on. It is not the price the buyer wants, and it is not just the price that a seller wants to sell out. Often times, sellers have emotional value tied up in their homes and value them above the true market number. Often buyers have profit motive in mind and want to value them less than their true market value. But there are alternatives on the market, so buyer and seller and do not just negotiate this specific property. They negotiate against a backdrop of all like properties in the same area and what those buyers and sellers are willing to settle at.
Location is very important in real estate. Location can determine big swings in value. It is not just the sticks, mortar, and land that determine value. Better school districts inflate values upward, bad school districts downward. Crime rates also affect property values. The quality of nearby development projects and proximity to shopping and entertainment affects value as well.
Perhaps most of all, proximity to good job sources affects value. It is not unusual to see the closing of a major business affect the availability and price of real estate in that area. In one example, General Motors announced reduced production of a plant in Arlington, TX. The real estate in that area has already begun to devalue because there is less demand. People are moving to other areas to seek out good jobs. The buyers are getting a deal because the same real estate, with higher vacancies, has gone down in price relative to other options. What will eventually be the market value for homes in this area? It will be determine by what buyers and sellers decide it should be. If additional jobs move into the area to take up the lost ones, and these jobs are of relatively the same wage level or above, then those people that purchased at a down price may make a nice gain on their homes in the future as demand rises.
This is speculation, however, and not recommended for the real estate investor unless you have extremely strong knowledge of upcoming events in a given area. Speculation is for stock investors. Real estate investors like to work with knowns, not unknowns. Otherwise, why not just purchase Intel and Microsoft stocks and hope and pray for the best?
Tools For the Real Estate Investor
Real Estate agents are like the goose that laid the golden egg. Real estate agents have access to the proprietary listing network, called the Multiple Listing Service (MLS), which has the most homes for sale. This treasure trove of information can be searched very easily using basic search techniques to whittle down the list of investments to an investor’s specific set of needs. This proprietary network is very hard to access and serves as the basis for the value that real estate agents bring to the market. Therefore, it is a good idea to cultivate lots of contacts with real estate agents so that the investor is constantly getting a stream of property prospects delivered to his email inbox. Without this stream of prospects, the investor has less to choose from, which leads to much more prep work and potentially fewer profitable opportunities.
From experience, I would say that one out of ten real estate agents are good at working with investors. The others simply do not have the time required to find the good deals. Not every deal will meet the requirements an investor has, and not every real estate agent is willing to do the extra work that an investor requires before purchasing a home. Investors are searching for profits at the time of purchase, not for that perfect home in which to raise a family. Most of the homes on the MLS are sold at retail, or near retail, and so do not make good choices for profitable investments.
I want to repeat the following point one more time for emphasis. Buying any home and hoping for the value to rise is speculation because you cannot control all of the factors that will raise and lower the market value.
Real estate investors like to find bargains on the market and also add to value through their management of the property. Buying at retail substantially reduces the ability of the investor to take profits from real estate by limiting their profits to managing the property to higher returns.
It is not uncommon for an investor to search 100 potential deals to find the one deal that makes sense. Sometimes you can find one right away. I recently purchased a home that I thought was a fabulous deal. I offered only about 10% off of retail due to market conditions. It was the third home I had looked at. I broke most of the rules I just outlined above, but there was a strong reason why. I KNEW I could change the highest and best use of the property immediately upon seeing the home. And I knew that many bids were coming in for the home right off the bat due to the location. This is the exception, however; and a risky play in the real estate market which may see prices fall even further. It is not recommended except for experienced investors who see multiple opportunities in a property that others may not see. In most cases, I follow my own guidelines and look at scores of properties before making an investment decision. This is just wise practice.
Real estate agents must really be business partners. That is what it comes down to. How do they become your partners? You must emphasize to them the benefits of working with investors. First, you are likely to make multiple purchases over the years. Repeat buyers are great value for real estate agents who live off of commissions. Investors tend to buy more homes when times are hard, which can keep a real estate agent afloat during tough times.
Real estate agents spend inordinate amounts of time chasing potential leads, showing homes, and doing lots of legwork. They do this with the expectation that the work will pay off, and therefore don’t want to have their time wasted. The investors that respect their efforts and reward them by actually investing in good deals will earn a valuable ally in the business of real estate investing. Do not waste a real estate agent’s time because it makes it that much harder to find real estate agents willing to work with serious investors. We cannot survive without them, especially when you first start out and don’t know how to find your own deals. I get deals from agents all the time who I have worked with that are routinely better than what I will find on my own with minimal effort. This saves me hours of precious time sifting through thousands of listings.
I use the term “search engines” to describe any method used to find deals. This could be you as the ‘engine’. The possibilities are endless and are only limited by your creativity and aggressiveness. Real estate investing is a participator sport, not a spectator sport. If you want the opportunities, you have to get busy!
I routinely look through Craigslist.com because it is chock full of listings. Usually it is people that are selling their homes and cannot afford to pay realtor fees on top of what they owe. At first blush, this may not seem like a profitable venture. Sometimes, however, you will find a deal on a ‘for sale by owner’ that is pretty good. And hey, it’s an easy way to find deals.
When you have started building your business and have homes actively being rented, you will get calls from potential deals. I had a lady call me a couple of years ago on a rental listing I had online. She was looking for a place to rent. Our property was not in her criteria, but just out of curiosity I asked her where she was currently living. She told me that she was being foreclosed on and had no choice but to move. My first reaction was to feel bad for her. But I also knew that I could help her and possibly profit from the deal.
After a couple of conversations, I decided not to purchase her home from her. But, because she had called me early in the foreclosure process, I was able to refer her to resources that would help her market and sell her home, or rent it to stave off the credit destruction that a foreclosure would bring. If I had not asked her that one probing question, I would never have known she had a potential deal right there waiting on me. Sometimes, the best deals come from just talking to people you meet. You never know who could be the source of your next profitable investment.
As another example, I called a real estate agent looking for potential deals in a certain area of town. This was my FIRST contact with this agent. I had just decided to refresh my list of agents and see what I could find. The reason for using multiple agents, as you will see illustrated next, is that you sometimes get deals that you cannot find anywhere else.
This agent did not have anything in my criteria at the time, but she did have a deal for me. She had a friend of the family going through divorce and was therefore behind on their mortgage. She gave me their number and I called them.
The wife had left the home and the husband did not have the income to pay the mortgage. In addition, there was some deferred maintenance needed on the home. They had about forty-five days before losing the house. I took a look at it a couple of days later and negotiated a deal. I would pay off their loan and back fees, and they would give me their equity.
I saved their credit and got a great deal in the bargain. We closed the deal, and I rented that home for several years before selling it and earning a nice profit. While that home was for sale, I was the only one that had access to the couple directly that could help me negotiate the price at exactly what they wanted. I wouldn’t have found that deal on my own. I would have seen the MLS listing and, not knowing the discount they were willing to offer, passed right on by it. Being aggressive in calling a new agent also helped me find profits.
If you want to pay a fee, there are online services popping up that are designed and marketed to investors. One such site, www.investway.com, does this for real estate investors in Texas. Texas is a great market for several reasons. The state has the best job base in the US, one of the largest economies in the world, lower unemployment than most states, relatively high percentage of renters, and fairly priced real estate. In addition, the legislature makes sure that small business owners have tax advantages. Texas also has a net influx of people looking for jobs they cannot find in other areas, which supports strong rental demand. Those things add up to a prime rental market.
The Investway site I mentioned was started by a formal commercial broker turned real estate investor who was frustrated with not having the resources needed to effectively find and consummate deals. He set out on a mission to offer a product that would make finding investment properties easier. Not only does investway.com do this, it also has the ability to run comparative market analysis right from the website using MLS data, and it also offers a tool for making an offer on a property right off of the website. The owner also conducts local training sessions on single family and commercial real estate investing. Talk about easy!
The only thing an investor need do with Investway is pay the monthly fee, which for active real estate investors, is very reasonable. Even if you just want to run comps on one property, the cost of a month’s membership can easily be saved in correctly pricing out a house you are selling or thinking about buying. There isn’t any downside to this tool. I have used it quite a bit, and I am impressed with the quality.
How did I find investway.com? I attended a real estate investor conference and, just like that, I found the tool! This leads us to our next investor tool. Other investors!
Other investors are a great source of ideas on local values, deals, strategies, and just plain old information about everything real estate. I was recently a member of a real estate investing club in North Texas called Lifestyles (Website: http://www.lifestylesunlimited.com/). This real estate investor group offered tons of educational material, networking events, and even sorted and readied real estate listings for investors for the cost of a membership. I learned so much from this group that I immediately applied one technique to a set of properties I owned, and increased profitability by several hundred dollars per month. That increase has paid for my membership about twelve times over since joining.
I have joined other real estate investor clubs locally and as a benefit met a lot of vendors who specialize in products for real estate investors to make investing easier. These vendors can be lenders with special programs for investors, contractors who offer great rates and customized service, legal services, accounting services, and tax and estate planning services. I wasn’t aware of all of the estate planning options available, but just by joining this group, my family has benefited from the experts.
Other investors can also be your business partners. When two or more like-minded investors get together on a deal, their potential on the deal is exponential. First, you have just vastly increased the experience and knowledge available to your business. Second, you have increased your investible cash and therefore your profit potential. Third, you have decreased your learning curve which will yield increasingly positive results on each subsequent deal. One of the worst things about being a first time investor is fighting the herd mentality for investing in stocks and bonds, and doing all of the work on your own. It does not have to be that way. Many people are interested in real estate investing, and it helps to make contact with those who can give you ideas and resources to take your business to another level.
A lot of information in real estate investing is experiential. You don’t need a Master’s in Finance and Real Estate to succeed. I have seen examples of people with a high school education build very real wealth in relatively short periods of time. And most of the concepts you will learn as an investor will not be taught in school finance classes, which educate you on how to make someone else rich. Instead of working for others, why not take that same effort and make yourself and your family richer?
Why Real Estate Over Stocks and Bonds
Real estate has four core ways and two secondary ways of making money for you. They are:
-Discount you received, by doing your homework, when you purchased the property
-Equity payments credited against your loan principal every month
-Cash flow over your mortgage payments
The core ways are important because they are your bread and butter. When you buy a property, always buy at a discount. This means if you get it cheaper than whatever it costs you (purchase price, labor, and materials) to bring it up to rentable condition. That is an immediate profit resulting from your research.
The second core is the equity you receive when renters pay your mortgage for you. When you accept a loan, the payments are broken into principal and interest. The interest pays the bank for their money. The principal pays down your loan. This is a transfer to you, the owner, that is realized when the property is refinanced or sold. An important point to make about equity buy down is that it rises over time. Banks take their interest at a higher rate early in the loan. Over time, therefore, the part of the mortgage payment attributable to your equity rises, meaning your rate of return on the original investment will rise also.
The third core way is cash flow. When you find a good deal, your overall monthly payments are low. This means you can charge market rent, and the net of the rent minus your monthly mortgage and escrows payment is profit for you. As rents rise over time, this increases your cash flow, which in turn increases your annual rate of return on your initial investment.
- Note: As you will see from our upcoming discussion on renting, when you change your loan payment period, you can move this number up and down to suit your tastes. The longer the loan, the higher this monthly cash flow, in excess of your mortgage payment, is going to be. The downside is that your equity paid each month from the mortgage payment will fall. By manipulating your loan period, you are deciding whether you want to invest for cash flow or future equity gains.
The fourth core way is forced appreciation. Forced appreciation takes place when you increase the value of your home through improvements. Improvements can include new flooring, a covered patio in back, putting up a wall in a large room to make two smaller rooms, converting a half bath to a full bath, converting the garage to a room, upgrading fixtures, changing knobs on cabinetry to be more modern, and many other ways. You are forcing the value of the home to rise through investment of labor and materials.
If you pick the right upgrades, you will receive a higher return than your investment. Be aware, however, that you can only carry this so far. Spending too much money on a single family home will result in losses because there is always a market price cap that any buyer will pay for any home, regardless of what upgrades you make. Therefore, the simple upgrades often work the best. Finding inexpensive ways to add an extra room, fill out a half bathroom to a full bath, and making tangible improvements in the kitchen will yield the highest results.
-Depreciation against tax liability
-Appreciation of home value
The secondary ways of making money in real estate have conditions to them. For example, you gain income by taking a depreciation deduction on property against your taxable income. These are the conditions. The deduction can only be taken against business income, not income from a job. In addition, when you sell the home, you must ‘recapture’ all of the prior year’s depreciation gains you took for that property on this year’s tax return.
Why, then, is depreciation a benefit? Depreciation is a way to shield your profits from tax exposure. When you sell the home, you recapture the depreciation on your taxes, but you also get the cash value of your equity from the sale. These two things tend to balance out and help the investor manage cash flows on real estate projects.
The other secondary way of making money in real estate is through home appreciation. The prices of homes always tend to rise. This, however, is largely a result of the excess credit and money creation that leads to an inflation of the money supply, and therefore bids up the prices of everything, including real estate. This is why we don’t invest in real estate solely for appreciation, because eventually the home values could depreciate. But, if you sell your home in and do realize appreciation, then you have again profited from real estate.
This is an impressive list of ways to profit from residential real estate. When we compare these to stocks and bonds, it is really no contest. The only two ways to make money in stocks is price appreciation, which is speculative and like gambling, and dividends, which is the periodic return the company pays out when they are profitable. Some companies don’t even pay a dividend, so this narrows your choices down considerably. That’s it!
In bonds, you have the coupon and face value. When you buy the bond, you will receive, as part of the overall value of the bond, periodic coupon payments back. This bond coupon is the rate of interest for loaning your money to the bond issuer. The face value of new bonds often sells are the face value, called par. But, in the secondary bond markets, which involve many buyers and sellers, bonds can sell above face value, or premium, or below face value, called discount.
This is often determined by changing interest rates, general economic conditions, credit quality, and supply and demand. That is pretty much it for bonds. And don’t forget that bonds are debts to be repaid. When bond issues get issued at increasingly higher levels, as is the case with government bonds, their risk goes up exponentially. If the issuer defaults on their bond issues due to lack of assets, you are stuck holding worthless paper and have lost a portion of your original investment.
You cannot control the market for stocks and bonds. You can invest in what you think are good ones, but remember that you lack the advantage of insider information. This legislated risk in stock and bond investments is in effect a risk premium that buyers pay above what is calculated into the prices.
In real estate investing, YOU are the insider. You have much more managerial control of your property and its final value. You reap more rewards, in more ways, from active real estate investing than in paper assets. The bad news is that real estate investing returns are up to you. The GREAT news is that real estate investing returns are up to you!
When you use real estate to passively generate income, it takes very little additional work to generate money. As opposed to actively trading your time for money, real estate allows you to set up profit machines that run day and night, even when you are sleeping.
As with everything, taxes are the biggest drain on income. Taxes affect us at many levels. In real estate, however, there is a very powerful sneak attack to offset or delay tax exposure. By delaying our tax exposure, we get to take 100% of our profits and build our portfolio even faster. The way we do this is with an IRS tax code clause called the 1031 exchange.
This exchange involves selling a real estate property and, within a short time period, using those monies to purchase another similar type property. We can use this tool many times, effectively delaying the payment of taxes on our investments into some future date of our choosing. Not only a powerful estate planning tool, the 1031 exchange is a powerful wealth generating tool.
Here is an example. Let’s say you purchase a rental home which you hold on to for five years. At that time, you decide you have maximized your profit potential and that now is the time to sell and realize those profits. You do not, however, want to be assessed capital gains. Therefore, before you sell your existing house, you do your research and identify five to seven other potential exchange properties. These properties may be discounted due to mismanagement or because they need cosmetic work. You know that you can take your existing gains, roll them into a new property, and do the same process again.
At this point, you have identified several properties. This is important because 1031 exchange rules currently require you to identify your rollover properties within forty-five days of selling your existing house. You have 180 total days to complete the purchase of the new property. During that time, you must name a custodian to hold the proceeds of your current sale to distribute to the new purchase. When this is executed properly, you are not assessed any capital gains tax. The value of gain upon which you would have been taxed is rolled into the new property for later assessment.
It is possible to consistently use 1031 exchanges many times in a chain to avoid paying capital gains tax until some much later date. Each step in the chain may be a bigger property of same kind. The same kind means you exchange residential real estate for other residential real estate. At this time, when you pass your estate to your heirs, the value of the deferred capital gains taxes is less than what you would have to pay if you had sold your properties when you were alive.
So in other words, using 1031 exchanges with the current estate tax structure allows a deferment and overall reduction in tax liability in real estate assets. This is a tremendous planning tool for building wealth. Those who plan using 401K and IRA plans do not have this advantage. In fact, IRAs and 401Ks have two disadvantages to using real estate for tax deferment.
One, IRAs and 401Ks currently have forced withdrawals at a certain age. This means you cannot pass the value of these accounts to your heirs at reduced estate taxes. Secondly, given current economic conditions, it is VERY likely that taxes will have to rise in the future to pay for current spending and debt issuance. Therefore, 401K and IRA tax liability is much more likely to rise over time than that of real estate and capital gains. Why? Real estate investors typically own businesses and create jobs. It is less likely that tax rates on real estate gains will approach those of the general taxpayer as it would tax productivity providing assets of the nation.
This technique can also be used to transfer capital gains liability from commercial real estate projects to other commercial real estate projects. It is conceivable that one could start with a 30 unit property and turn it into a 3000 unit property while avoiding gains taxes that would slow the rate of growth down.
When you combine depreciation and 1031 exchange together, real estate has tax advantages that no other type of investment can offer.