His example, in my opinon, actually understates his case.  He compares a investor who puts $100k down (40%) on an expensive $250k property in a high value region to an investor who puts $100k (10%) down on $1 million worth of rental properties in a cheap region.  If the first market goes up by 10% then the investor makes $25k in appreciation.  But if the second market just goes up by 5%, on the other hand, then that investor makes $50k. 

The thing that jumps out at me here is that a one year 10% rise in property prices is huge.  Yeah, it's happened a lot in recent years in CA, FL, etc - but an investor who jumps in with the expectation that this will happen might as well take his down payemnt to Vegas and put it on red.  This isn't investing, it's speculating. 

Which is to say: I agree with Jeff's argument even more strongly than the example he puts out there. 

Look yourself up - you might find that there is more info on you out there on the web than you thought.  One drawback: search for a generic name (like, say, Chris Smith) and you'll get a whole boatload of info on all the other Chris Smith's out there.   [19 June] Ironic postscript:  As of today this page that you're reading right now comes up on page 1 of a Google search for "Chris Smith"

When you're screening tenants you'll still need to pay for a real background check, but I think this site might be useful for the quick preliminary screens I used to do on Google. 

It's not my custom to shill for realtors, but I've often written in the past about building business relationships and how this is a key to successful investing - so I figure it's time to give a some credit where credit is due.  Eurika is an agent that has helped me to maintain my sanity over the past few years. 

Unfortunately she works for a high-end firm with zero tolerance for reduced commissions - which means she doesn't represent me when I'm making a sale - but I do work with her when I'm on the buy-side of the transaction, and she does a great job of pre-screening tenants when I'm filling vacancies. 

If you're an investor in Houston (or just buying or selling a home) then give her a call.  Tell her I sent you. 

Related Link ::

• Eurika Coleman, REALTOR®

The tree, it turns out, was dead. Last time I’d driven past the property was early spring, and I noted that the tree seemed a little late in sprouting leaves. I made a mental note to follow up on this, but never got around to it. That was a mistake, and one that could have been costly had the tree fallen on the house, on someone’s car – or worse of all had hurt someone. As it turns out a gusty windstorm blew it over into the road where it caused a minor inconvenience but no real damage.

The neighbor has a chain saw and a truck so I paid him to haul it away. I don’t know what killed the tree – it was fine last year but for some reason didn’t bounce back this year. But I’m happy that I’m writing about a close call and minor annoyance instead of a major incident.

The premise of the company is that they identify investment possibilities for you, and for a $5,000 fee they’ll provide the investor with title and a bridge loan, then refinance at an 80% LTV. Their main pitch is that they’re offering you, the investor, “20% equity built-in as a head start.”

The details of how they propose to accomplish this are hazy. I’m a smart enough guy, but over the course of a couple of unsolicited phone calls and a few emails I haven’t really figured it out. Here’s their financing overview from their website:

There’s an interesting footnote to the right side of the diagram: “Depending on your loan structure, Blue Moon cannot guarantee no money down at refinance.”  Which to me means that it's likelly that you'll have to pony up 20% of the purchase price in order to get that 20% built-in equity.  Plus the $5k fee upfront.

Well I haven’t done exhaustive due diligence on this company, but I do know that chasing a something-for-nothing strategy is a sucker’s game – especially when the opportunity shows up via a cold call. Remember what your mom told you about deals that look too good to be true.

But I will say that being on the road non-stop (I’m writing this dispatch on a plane from North Carolina to Puerto Rico) has acquainted me with some of the finer points of being a long distance landlord – a good reminder of why I prefer to invest close to home where I can keep an eye on things. What’s saved me is the fact that I have developed a bullet-proof relationship with an excellent realtor that I trust and with a handyman/contractor that values me as a repeat customer and not an easy mark. So although I like to keep an eye on things I realize that the world isn’t going to come unglued while the cat’s away.Good investors who have developed reliable relationships realize that they’re not indispensable - their businesses continue to run in their absence.

I right now am looking at an article in the Economist that is reviewing the current foreclosure/subprime mess that we’re in. The article considers, among other things, the ratio of rents to property values as an indicator that many regions of the country have farther to fall. This is a metric that I’ve written about before, and one that, in my opinion, is not written about enough in real estate circles. Consider it a P/E ratio for real estate which assumes that the price of a property “reflects the discounted value of future ownership, ether as rental income or as rent saved by an owner who lives in the house.” According to the popular Case-Shiller index property values would have to fall an additional 10-15% over the next year and a half for the ratio to return to the historical average of between 5% and 5.5% (it reached 3.5% at the height of the boom.)

And yes – I do understand that all real estate is local. But this stuff is important – the credit market is a tide that lifts and lowers all boats, so I for one am keeping an eye on the broader market as I think about my next entry point.

But before you build that McMansion consider this: like aspirin and fine wine, more of a good thing will not necessarily lead to a superior outcome. Yes you should own your own home, but if you supersize it then you’ll be paying a cost.

Consider a buyer trying to decide between buying a $600k house and a $300k house (you can either double or halve these numbers depending on property values in your neighborhood). There are some that will argue that by splashing out on fancier digs that they’re investing in their future. But not so fast…buying an $600k pad is certainly better than renting a $600k pad (under most market conditions) but it doesn’t beat buying a $300k pad. Follow the numbers…

Assumptions:

• 6.5% fixed rate mortgage
• 0.75% property tax
• 4.5% property appreciation rate
• 9% stock market return. All excess cash (from tax deductions and lower mortgage payments) are reinvested at this rate.

The more expensive house generates a big gain through property appreciation – over $330k in ten years - assuming the market behaves roughly in line with the long term historical average of 4.5% per annum gains. Adding the pay-down of the loan balance and income tax deductions from interest and property taxes (which are continuously invested in the stock market), the $600k house creates around $500k in wealth over ten years.  Not too shabby.

Compare this to the option of buying the cheaper house.

The $300k house generates considerably less in terms of property appreciation over ten years vs. the more expensive home. But compare the two mortgage payments: around $46k per year for the larger house vs. $23k for the smaller one. This is an extra $23k that can be invested in other vehicles, plus savings in property taxes. When these funds are reinvested on a yearly basis then they can generate dramatic returns.

Result:

• $300k House: $506k of value created in ten years
• $600k House: $590k of value created in ten years

Extend the anaylsis out to fifteen years then the results are even wider.  And if you take that extra cash and put in into income generating real estate instead of the stock market - now you're really cookin' with gas.   

Is this an argument against the flahsier house? Well…maybe so, but maybe not. Perhaps ten years spent living in the nicer home is worth that $84k in foregone wealth. Fair enough.  Just don’t convince yourself that you’re making a strategic investment by going big. The house you’re living in doesn’t generate income – it only generates expenses. Living large is nice, but there’s a cost.

Vo won the election. But now it’s Vo who finds himself in the news. And this falls squarely into the “what was he thinking?” category. Vo, as it turns out, is a genuine card carrying slumlord.

Vo is a wealthy public figure. The four apartment complexes that he owns are public places. His ownership is a matter of public record. Real, live people live there; they raise families and hold jobs. But they’re living with broken and boarded-up windows, an algae-filled swimming pool, overflowing dumpsters, and other hazards – all documented in a recent article in the Houston Chronicle.

Remember, as landlords, we’re just behind oil company executives and sub-prime lenders as people that the media loves to hate. That’s too bad, because the vast majority of us are committed to providing safe, affordable housing to the public. That’s not because we’re altruists – it’s because providing safe, affordable housing is good business. And as State Representative Vo is now finding out, running an ugly, dangerous, violation-filled property is not a good way to make a profit.

For the third time in as many years I’m having to hire a guy in a bee suit to pull a hive out of an investment property. This is a pain. Bees aren’t like other garden variety insects. You can’t just throw some spray around and call it a day. You have to find the hive, get rid of the queen, and caulk the living daylights out of the opening so the next wandering swarm doesn’t take up residence a week later.

And as an added bonus: honey bees will freak out your tenants.

So when you get a call about bees, just accept the fact that you’ve drawn the short straw. You’ll save yourself some grief by being doing it right. Meaning:

• Call a professional. Don’t try to get rid of the colony yourself. DIY will NOT save you any money.  Suck it up and pull out your checkbook.  You've budgeted for this sort of thing, right?
• Bees can be ornery. If your tenant gets attacked by a swarm of bees that you’ve neglected then you’re gonna end up in court. Even if you show up wearing your sunday best suit you're still not going to cut a sympathetic figure.
• Make sure you get rid of the honeycomb itself, not just the bees. This is for three reasons. First: a rotting hive will attract the next swarm of bees. Second: a rotting hive stinks. Third: a rotting hive will attract other critters.
• Caulk up the scene of the crime. Bees have some sort of chemical, collective memory thing going. They’ll be back, so don’t make it easy for ‘em.

The conventional wisdom has it that foreclosed owners will be scurrying for somewhere to live, pushing up demand and, therefore, rental rates. In some areas this is exactly what has happened.  Landlords in these areas are sitting pretty.

In other areas, however, the situation is the reverse. Tightness in the financial markets has pushed many first-time buyers out of the market. Sellers, unable to find buyers, have converted low end houses into rental. Voila – supply goes up, and the glut of properties pushes rental rates down.

Some aggressive pricing and judicious screening will land a tenant for my vacancy. And as I get a good feel for where the rental market really is I’ll be looking for buying opportunities. Cycles, by definition, don’t last forever. Just when everyone is starting to feel squeezed is the time when you want to think about getting out your checkbook.

So how's the rental market in your region?

Here are five discrete thoughts that have emerged from experiences that I’ve written about recently.

• Honest investors are fearless investors: I have a lot of philosophical reasons for being honest, but I also have a practical one: I’m not clever enough to keep a web of deceptions straight in my head. That’s too much work. And as I tried to show in yesterday’s post, a deception which one commits doesn’t disappear. Ever. It sticks around; you can’t un-ring a bell. But honest men have no fear of such things.
• Ethics is good business: Honesty, truly, is its own reward. Honesty is the foundation of relationships, and relationships are the foundation of business. Honest business people can at times feel that they’re at a disadvantage (how can you break even if you never screw anyone but others screw?) but it’s my observation that the world doesn’t work like this. The short term gain that one may achieve through some slimy deception or half truth rarely translates into a long term gain.
• It’s ok to evangelize ethical behavior: And that means pointing out unethical businesses. When I run into a dishonest player I tell the world about it. I try to use the same respectful, measured terms that I use when I write – but I don’t pull punches when laying out the facts. Side note: a great key to persuasive communication is to lay off the adjectives. Write a review on Angie’s list. Send a letter to your local Better Business Bureau.
• Ethical investors avoid bad deals: A while ago I wrote about a fraud scam whereby investors were sucked into overpaying for rental properties. The consultant convinced them that tenants were lined up and ready to go, and all they had to do is sign on the dotted line for their zero down loans. Of course they got tricked – and most of them ended up being foreclosed. But the full story shows that the papers which these investors signed were full of fabrications and exaggerations regarding the investors’ financial situation. While it’s true that the consultant was the one who concocted the whole confusing scheme, the investors themselves surely knew that something fishy was going on. But the investors convinced themselves that it was the consultant’s dishonesty on those forms, not theirs, and they turned a blind eye. And it was the investors, in the end, that ended up getting hammered. Bottom line: if you smell something fishy then it’s probable that the entire deal stinks.  My grandmother used to say "if they'll crook with you then they'll crook on you."  Smart woman. 
• The benefits of unethical behavior are outweighed by the risks: We read a lot about lawsuits and malpractice costs running rampant in the healthcare field, but there’s a subtext that a lot of people aren’t aware of. Bad doctors aren’t the ones who get sued. Doctors who get sued are the ones who are rude, arrogant, and dishonest. Even with matters pertaining with one’s health most Americans understand that honest mistakes happen, which means that most patients aren’t on the hotline to the nearest ambulance chaser when something bad happens. But...if the doctor was a jerk...they’ll pick up that phone in a flash. There’s no reason to assume that real estate is any different. The goodwill that you generate by treating people in a transparent, respectful manner is good insurance against getting dragged into court if something goes wrong in the future.

We agreed on a $2,000 month-to-month retainer to do some marketing work. I paid him the first month’s two grand, he cashed my check and then disappeared. Vanished.

So here are some things I learned from this experience.

• Trust is crucial. I do business based on looking someone in the eye and shaking their hand. You can’t do business without taking risks. Trust is a big factor in my decision making process, and this experience won't change that fact.  But it does emphasize the importance of having a rock solid contract, and an organized file of every check that you’ve paid for services. A great convenience of today’s internet banking world is the fact that you can easily log on, click on a payment, and print out a front-and-back copy of the endorsed check. This guy took me for a ride, but I archived the paper trail and stayed prepared for round two.  This ain't over.   
• You can’t sue someone you can’t find. That was the big hangup in this case. I got all the prep work done to take my flaky business partner to court, but have never been able to serve him with papers.
• Don’t give up. The statute of limitations in Texas for civil cases is a leisurely four years. That’s an eternity. Take your paperwork and seal it in a file for safe keeping. And periodically take a look around – the creep might show up.  Even though you've written off the loss it doesn't cost you anything to stay on the trail. 
• Assume you’re going to court, prepare accordingly, and be ready to win. Once you track the guy down, hit him with a cool, well organized declaration explaining how you’re about to sue him back to the stone age. The other guy may be lazy and dishonest (which is why he stole from you in the first place) but chances are that he’s neither stupid nor insane. If you have your ducks in a row then nine times out of ten the guy will see the light and pay up before he suffers the indignity of being dragged into court.  The small claims court process isn’t difficult. If you’re savvy enough to buy and sell houses then you’re savvy enough to manage a small claims court case (up to $10,000 in Texas). Go get a brochure from your courthouse and follow the instructions.

Happy Ending

So here’s what happened in my case:  Every six months or so I’d take a look around for this guy online to see if he popped up somewhere. And last week – voila – there he was on www.linkedin.com, sort of a “facebook for professionals” (good website by the way, check it out.) No home address, of course, but he did list his current employer, and I was on the phone to his boss in a flash. Fear of professional embarrassment can work wonders, and now I have my two grand back – plus interest. Two years after the fact I closed the whole sorry mess in the course of a couple of days. It was like finding two thousand bucks in the back of my sock drawer.

Related Posts:

• How can contracts help me to build solid relationships?
• Real Estate Investing and the Psychology of Relationships
• You want to be a hippo, not a whale shark. 

The problem with the speech is that it will be blasted into a dozen Fox-news sized ten second snippets, and a truly honest discourse on race in America is not a topic that can be reduced into sound-bites. 

If you're a supporter of Senator Obama's then listen critically.  If you're not then listen with an open mind.  Either way - listen. 

Real estate investing is a long term play, and a few days ago I introduced five ideas that I feel are key to being successful as a buy-and-hold landlord.  I've already discussed the first two - here, as promised, are the final three...

Principle 3: Take care of your tenants

Nothing beats an investment that pays you every month – that’s why a prudently leveraged real estate portfolio beats the pants off the stock market in long term returns. But that rental property will only generate revenue if there is someone living in it. Vacancies are one of the greatest threats to achieving the financial performance that you expect out of your property, so once you’ve found the right tenant you’ll want them to stick around.

That means taking care of your tenants. But more importantly, perhaps, being responsive and respectful to your tenants will also increase the likelihood that they take care of your property. This will protect the unit’s value, and the end result is that happy tenants are likely to bother you less often.

This is what you want. Answer voicemails promptly and address needed repairs quickly – this is an investment that pays off. I recently had a tenant that would talk my ear off every time I came around. He was the first tenant to move into the property after I purchased it and made some upgrades, so I had to visit a few times after he moved it to get some problems ironed out. But building that goodwill paid dividends; they took great care of the house and I hardly ever got a call.

Principle 4: Don’t take shortcuts with repairs

Trying to save a few dollars on every repair is a short-sighted strategy. Your tenants will take note of how you treat the property and they’ll act accordingly; why should they respect your house when you don’t? A well cared for property is more likely to appreciate and in the end will cost you less to maintain and cause less trouble.

There’s no economic value in delaying a repair – you’re going to have to do it eventually, and if you wait not only will the problem have gotten worse (and, possibly, more expensive) but you will also have alienated your client: the tenant.

Principle 5: Know when to say “when”

The Peter Principle tells us that an individual tends to get promoted to his level of incompetence – essentially accumulating responsibility till he gets to the point where he can’t handle it, and that’s where he stays. Think Elliot Spitzer: great prosecutor, not such a great governor. So yeah, you’re trying to build your empire, but don’t overextend yourself with too many properties or projects. Most real estate investors have jobs to support their day-to-day lifestyle and invest in real-estate on the side as a long-term wealth building strategy. Assuming that you fit into this category (that you’re not a full time investor) it’s wise to make a deliberate decision as to how much you can take on in terms of workload and financial risk. Don’t cross that line.

You can do it

A well maintained property w/ a good tenant should not be a burden on your life. On an average month the only effort that is required of me is to take the rental checks out of my mailbox and deposit them into my bank account. But the key to maintaining this balance is being diligent in all of the steps along the way.

But the financial world is hearing the saber rattling of the politicians (broadcast through a megaphone as we plow though this politically charged season) and this is having a fortuitous side effect: the banks are preemptively starting to get their own houses in order. Note this week’s announcement by Freddie Mac and Fannie Mae mandating stricter standards for independent appraisals – a move which is likely to trickle through to other lenders.  Loose appraisal standards have been a major contributor to real estate fraud, so this is a step in the right direction.

The industry is out to save its skin – not only to slow the bleeding which was caused by their reckless practices, but also to put a positive public spin on their progress. To this end Hope Now, President Bush’s government-led alliance of lenders is now claiming to have helped 1 million home owners fend off foreclosure.  But don’t expect this to significantly alter the tone of the various presidential candidates for whom foreclosure is a big election issue.

Move over big oil – there’s a new bad guy in town, and it may be too little to late for the lenders.

But don’t underestimate the importance of the time part of the equation. In the past I’ve compared the performance of the real estate market with the stock market. For the disciplined investor, real estate performs favorably to the stock market over any reasonable period of time, but you’ll need a few years for the strategy to be effective. If you’re only going to stay in the game a year or two you might as well buy a mutual fund and call it a day. But investors with perseverance will see their wealth grow much faster by pursuing a prudent real estate strategy than they will betting on the stock market.  So to take advantage of time you’ll need a little endurance. Sticking with your real estate investing plan is a lot easier if you’re prudent about your decisions and keep your eye on some fundamental points.

Landlording and long-term investing go hand-in hand. Being a landlord isn’t for everyone, but if you have the right personality and decision making skills then it’s a snap.

Here are five tenants tenets that I’ve determined to be the most important. Ignore these at your peril…^*

• Principle #1: Look before you leap
• Principle 2: Select the right tenant
• Principle 3: Take care of your tenants
• Principle 4: Don’t take shortcuts with repairs
• Principle 5: Know when to say “when”

I'll talk about the first two in today's post:

Principle #1: Look before you leap

Many real estate investing courses are just personal motivation seminars with a thin veneer of real estate education . These courses may serve some use if they cause you to take charge of your financial future, but you don’t want to go charging into battle without the right tools.

A great source of real estate bargains is burned out investors who’ve jumped into a project without a realistic idea of what it would take to get it done. It’s easy to underestimate rehab costs when you’re bidding on a property. Don’t let your optimism lead you down the wrong path.

When a good deal pops up you’ll often have to act quickly, but even when under a deadline there is still time to conduct a basic economic evaluation. Compare the cash outflow (mortgage plus taxes and expenses) to the cash inflow (rental income) to get an idea whether or not you should expect the property to break even on a month-to-month basis. And things break, so don’t forget to include a reserve fund that should be around 1.5% of the property value per year. The best way to maintain your peace of mind is to invest in properties that offer an adequate return, and this will require you to do your homework.

Principle 2: Select the right tenant

Before I bought my first investment property my wife ran out and rented Pacific Heights on video and forced me to watch it. Perhaps you remember this movie: Michael Keaton plays a evil con-man who rents half of a San Francisco duplex from a naïve yuppie couple then turns their lives into a living hell. Bloodshed and drama ensue.

Well it’s not a great movie so I won’t recommend that you sit through it, but I will share with you the film’s primary insight: if you’re renting a high-end property do a credit check the applicant before signing the lease. Housing laws vary from state to state, but one trait that they have in common is that they’re designed to protect the tenant, not the landlord. If you end up renting to a family who destroys your house or refuses to pay the rent then you’ll surely spend a fortune and a lot of time and effort getting them out.

If you’re renting a lower-end property then doing a credit check on the applicant is less likely to yield any useful insights since applicants for inexpensive properties may not have established credit histories. You’ll have to rely on other methods of evaluating applicants, such as references from previous landlords and from employers. Call the references. Follow up.

And lastly, learn something about the applicants when you meet them (and yes, you should meet them – don’t leave this to your realtor). Do they arrive on time? Do they strike you as someone who will treat your property respectfully?

In the end you’ll have to trust your instincts. Having a vacancy is stressful, but it’s not nearly as stressful as having a unit occupied by a tenant who makes your life difficult. It’s not a good idea to indiscriminately accept the first applicant who waves some cash in your face, tempting though it may be. Remember – housing laws are first and foremost designed to protect the tenant; they’re not designed to protect your rights as a landlord. Renting your property to the wrong person is an expensive mistake.

I'll write about the other principles soon....stay tuned. 

* once you start writing tenets about tenants you're setting yourself up for this kind of typo.

The somewhat awkwardly named Emergency Home Ownership and Mortgage Equity Protection Act of 2007 and the Foreclosure Protection Act of 2008 are both being debated. Both are focused properties with nontraditional (neg am, interest only, etc) mortgages or subprime mortgages. Mortgage balances and monthly payments would be reduced based on how much a home’s value has decreased.

These won't impact investors directly, since they only applies to owner occupied properties. However, the measures are defiantly of interest to investors since it’s likely that it will impact the cost structure of the entire industry. The measure might decrease the number of underwater owners who walk away from mortgages, but essentially it forces the bank to eat the cost of the market downturn, instead of owners.

This is reform on the cheap, since short term the banks will be shouldering the cost. But the medium/long term effects won’t be good for consumers:

• Banks who are already reeling will be dealt an additional blow. This will lead to a real bail-out, paid for with real taxpayer dollars. The short term “reform on the cheap” won’t stay cheap for long.
• Banks are already recalibrating the way they quantify risk. But the current model assumes that a when a buyer purchases a home then said buyer will both enjoy the benefits of appreciation and the risk of a decrease in value. This assumption no longer holds, and the banks will be justified in charging accordingly. Home ownership will slip further out of reach of an increasingly large segment of the population.

Reform on the cheap doesn't work.  The banks will fix their own messes.  Some should fail - we should let them.  And if the government determines that citizens who are in trouble need help, we shouldn't fool ourselves that this can be accomplished without the government pulling out it's checkbook and spending some tax dollars.  Coercing the business sector to take an altruistic step will backfire in the end. 

Over on Money.com there’s an interesting piece on when is it ok to walk away from your mortgage, which reports on the deluge of homeowners who are upside down on their mortgages and are simply sending their housekeys back to the banks and walking away. "Jingle mail" they're calling it. 

Well the idea was enough to push me into a state of moral indignation, thinking about the great American blame game and the general lack of accountability in our society.

But, having though about it a bit, I’m not sure so sure...

But look at it a different way. The rules of the game are clear: you sign, you get the house, you pay. And just like in sports, the penalties for violating the rules are clear as well; in this case, if you walk away you get a nasty-gram in your credit file.

The banks know this when they sign up homeowners. That’s why they charge higher interest rates on riskier loans – rates which they themselves set.

So perhaps my moral indignation was...a bit misplaced.  And I think my opinion was changed a bit by reading some of the 1,000+ comments submitted by readers (and yes there are a lot of stupid comments in the mix as well – to be expected). Upside down borrowers who walk away stick it to the banks – and that in turn forces the banks to reevaluate their algorithms for evaluating risk. And that in turn forces them to get better at the game of offering competitive rates to creditworthy borrowers and also realize that peddling high-margin negative amortization loans isn’t good business in the long run.

So does a financially troubled homeowner have a moral obligation to keep paying the note on a property that suddenly has negative equity and a resetting ARM payment? What if the stress of making the payments threatens his marriage and/or pushes him towards bankruptcy?

So perhaps a homeowner who makes $50k per year and walks away from the $300k mortgage on a house now worth $250k that the bank financed for him using a zero down ARM is doing the system favor by sticking the bank with the loss and nudging it just a bit close to a sounder lending policy.

This isn't painless for the borrower, who sees his or her credit in tatters - but there is an argument that says that banks who make bad lending decisions deserve to get burned. 

Thoughts?

Towns like Akron, as it turns out, were a fertile feeding ground for illicit activity during the boom.  Even during the headiest days property values were appreciating too slowly to make a fortune quickly, so unfortunately there were some operators who combined greed and easy credit into a formula to bilk novice investors and, sometimes, the banks that financed the deals. 

Worth listening to.

Related stories:

• Real estate shell game :: Recognizing fraud
• Real estate shell game :: Part II
• Real estate shell game :: Part III

Most of us investors are part timers. And lots of us are somewhat handy and know something about houses (we live in houses ourselves, don’t we?) So those first three items are things we can generally get our collective heads around. We see roof jobs every day. We change the filters on our own AC system. Most of us have replaced a faucet or two in your time. So problems, both big and small, might not phase us when it comes to the roof, the AC system, or pipes.

But foundation problems? Woah Nellie. A sloping floor or suspicious cracks in the plaster will send most investors scurrying on to the next prospect. But this might be an opportunity. Less competition = fewer bids. Fewer bids = a lower price. And we like low prices when we’re buying, don’t we?

But not all foundation problems are created equal. Here in Texas (and perhaps where you live, as well) you’ll tend to find two types of foundation: slab, and pier & beam. If you tried to dig a basement in Houston you’d be playing table tennis underwater; Houston is essentially a paved over swamp with the water table a few feet below ground. In other parts of the country you’ll have other options – a crawl space foundation or a full basement. I don’t have any first hand experience with the structures I’ll I won’t say any more about them.

What I will say, however, is that pier and beam foundation problems scare me a lot less than slab foundation problems. Slab foundations mean buried pipes and no repair access. Fixing them is expensive. Last year I had a problem with some tree roots which grew about fifteen horizontal feet under a slab foundation and busted up the plumbing under a commode (lots of nutrients down there, I guess). Visualize jackhammers and annoyed tenants.

So I probably wouldn’t consider a property with major foundation issues if it had a slab foundation. A pier & beam foundation, however, is another matter. This is the preferred method for older homes, in which the home is constructed on beams which sit on piers which are driven into the ground for stability. I own a fourplex that was built in 1935: a hurricane-proof all-brick tank of a building. I wish I had ten more just like it. But it had some foundation problems a few years ago, but with a pier & beam foundation this was cheap to fix. So if you run into a prospect like this then you might want to give it a second thought before you put it in the “too hard” box and cross it off your list; you might be passing up a property you could snag at a bargain because it scares off all the newbies.

But make sure you get a structural engineer to take a look (not a foundation repair specialist, who will be trying to sell you something). The bottom line: a prospect w/ foundation problems might be worth another look if it’s a pier & beam structure. Go ahead and wave your arms and declare the house a disaster to the seller and to your Realtor, but know in the back of your head that this is a problem that most serious part-time investors can tackle.

Note: Graphic illustration includes diagrams taken from the Foundation Repair Network. 

Having a vision, taking a view, and running the numbers: the three pillars upon which you’ll build your ability to make sustainable decisions which will, over the long run, help you to achieve your financial goals. Well forming the vision is the fun part; we all enjoy thinking about where we want to end up in life. And you’ll have lots of help in taking a view; everyone and there dog is out there making predictions about what’s next for the real estate market – your task is separating the wheat from the chaff.

But what about running the numbers? How many of us get really excited about running economic models? Well in my view looking before you leap is the best way to keep your momentum as an investor, and that means having an idea about what to expect from an investment in terms of rate of return, cashflow and net present value.

But analysis is like aspirin, or fine wine, or just about anything, for that matter. A bit of it can make a big difference – but that doesn’t mean that a massive dose is a good idea. More isn’t necessarily better.

So how do you strike the right balance? Well watch out for two traps – 1) becoming infatuated with the analysis and forgetting about the underlying uncertainties (no analysis is perfect) and 2) becoming infatuated with perfecting the analysis to the extent that you never get a deal done. In other words: don't get paralyzed.

Both of these problems happen, probably more than you’d think.

So - how to avoid these issues? Again, it depends on your goals as an investor and your personality type, but I’d suggest a few rules of thumb:

• Remember: your analysis is based on your assumptions. Unless you have a working crystal ball you’re never going to get it all right. Your analysis will give you your base case. When you get your results ask yourself “is this target a good result? Does the potential reward justify the risks?” if the answer is “yes” then drive on and figure out how to make the deal work – don’t spend too much time fine tuning. 
• Analysis is a process: I worked for a while in strategic planning with a major corporation. We spit out huge, detailed plans. And we never followed them. Is this a bad result? Well, not necessarily, because the planning process in itself is hugely valuable. It forces executives to examine their assumptions, communicate their goals, and crystallize their thinking. The planning process helps organizations to articulate their vision and set their course, even if they don’t follow the resulting plans to the letter. Real estate analysis is similar: running the numbers will force you to consider the big questions around vacancies, rental rates, repairs, and other risks that you might not consider before jumping into the investment. 
• Evaluate the sensitivities: Don’t just look at the final “answer” – look at the sensitivities to understand how much risk you’re taking. Ok, you’re forecasting a 5% appreciation rate...but what if it’s -5%? Or 10%? Most investors who bought in 2006 didn't predict today's market - but there are a handfull who at least evaluated the risk of a downturn.  Investors who consider future risks are investors who are prepared to take action when things don't go right. 
• Be honest with yourself: There are two camps that you want to stay out of – the overly conservative camp that kills every deal that comes along by handicapping them with excess costs, and the rose-colored-glasses camp that tweaks all the variables up until they get the result they want. Nervous Nellies do no deals, and Pollyannas do bad ones. 
• Remember that once you’ve made your bed you’re going to have to lie in it: A single fortuitous event (a new rail line) or misfortune (a mold infestation or a disastrous tenant) will radically impact the performance of your investment. You’re still going to have a lot of uncertainty to manage once you make your investment; the purpose of the analysis is simply to ensure you’re pointed in the right direction before you pull the trigger.

You can expect a pretty heavy Realtor spin on things, but that's ok in my book; if you want a balanced worldview then it helps to hear both sides of the coin.  I'm a guy who gets his news from the Wall Street Journal (on the right) and the New York Times (on the left), so I believe that it's important to be open to different points of view.

You’ll see some of the boilerplate that you’ve read before, but pay attention to a reference to an influential paper written by Harvard economist Gregory Mankiw which back in 1989 predicted a precipitous decline in housing prices. The premise was that a shrinking body of first-time buyers along with a glut of downsizing baby boomers will collectively pull lots of demand out of the market, leading to an excess of supply and a sticky plunge in prices.

Regardless of whether or not you pay any attention to the experts’ predictions it’s important to have a view on what’s next; you can’t invest without having an opinion about the future. Personally, as prices slide and interest rates drop I’m actively pursuing multi-family opportunities. I don’t know that prices won’t continue to drop, but locally I’m also seeing strong demand for rentals and, in some cases, higher rental rates. According to the National Housing Council , rental rates are up 3.36% in Houston. Combine that with the fact that housing prices have slipped by 2.38% over the last year and you have a market in which an already competitive rent-to-value ratio has gotten even better. That, for me, is an acceptable risk.

Rental rates in some major markets are up even more: 8.87% in Dallas (accompanied by a big 6.18% slide in property values). Notably, some higher value markets like San Diego and Miami are showing strong double digit increases in market rents, but even with a little help you’re unlikely to find buying opportunities that will yield breakeven cashflow in those areas.

I’ll talk a bit more about the Center for Housing Policy’s recent press release on housing affordability in a post tomorrow.

There is an interesting article in today’s New York Times about a California woman who is suing her real estate agent because she feels she paid too much for her $1.2 million home.

The woman claims that her agent “ordered an appraisal of the house” for her and her husband but “...did not respond to the couple’s request to see it.” Shortly after moving in they got a flier from another realty agent showing a house just up the street sold for $105k less than theirs.

This reminds me of a hair-brained CNN story which was published recently about a woman who was debating the merits of suing her doctor for complications she suffered after a surgery.

Hmm...homebuyer purchases a home without ever laying eyes on an appraisal, then sues ‘cause she overpays. Patient suffers a complication during a major invasive surgery then sues her doctor for pain and suffering.

The who’s the blame phenomenon in American culture is one that I’ve written about before, but unfortunately I think we can look forward to reading a rash of stories in the real estate field in the coming months. Real estate is, in the best of cases, an inexact science. With prices falling these may be treacherous times for real estate agents in our litigious society.  So Realtors: when the guy down the street cuts a better deal than your client just inked, be ready to call your attorney. 

In discussing the concept of leverage, where an investor builds a profitable portfolio of investment properties over the year by occasionally executing a 1031 exchange, the Peter Principle might be relevant. As Max points out, you don’t want to get in over your head.

There’s something to this. There’s an implicit assumption that over the course of your investment career your ability to manage the complexities of larger properties and a greater number of tenants will increase. Additionally, you will also put yourself in a position to make judicious use of property management services. But at some point an investor needs to know how to say “enough”. Smart investors need to recognize when they’ve gotten to that point.

But often they don’t. And if you can find one who has gotten beyond his comfort level then you may be in a position to negotiate a great purchase. There’s a phenomenon I’ve noted which I call the “two-fer” sale – keep your eyes open for these. From time to time I’ll notice two similar properties which hit the market simultaneously. Sometimes they’re FSBO’s, and you’ll notice them if there are two identical FSBO signs on the same block. In my experience, this is a sure sign of an investor who paid for some expensive Rich Dad type motivational seminar, and in a wave of enthusiasm and empowerment hit the streets and bought the first two houses he could get a mortgage for. Essentially, this investor hit the Peter Principle very early in the game. He wants out.

Two-fer’s can be a great opportunity. If you can find a reluctant landlord who’s struggling with the negative cashflow drain of two vacant properties, you negotiate a great bargain by saying you’ll take both of the properties off his hands: I’ll take ‘em both for $XXX,XXX. And that should be a really low combined price. But the reason that this tactic works is that you’re making the seller’s problem disappear in its entirety. This can make the seller shift into “cut my losses” mode in one fell swoop.

This is a tactic that works. This is how I bought the two properties (FSBOs) a few years ago that I’ve recently vowed to sell as my New Year’s resolution. And on the buy side I’m looking at a couple of similar opportunities as we speak.

So the Peter Principle is a sword that cuts both ways – so make sure you’re on the right side of this trade.

There, of course, is no single right answer to this questions – it will depend you’re your risk appetite, your local market, your time horizon, and your view of what the market is going to do next. But from where I sit I see five basic paths forward for investors in 2008:

• 1: Rebalance in the same market. This is what I’ll be doing this year. Investors who have been in the market for a while are sitting on a pile of equity that probably won’t perform too well in 2008. That means it’s time to sell, re-leverage, and put it back into properties that will give you the right cap rate. I wrote about my specific example a couple of days ago. Although it’s no fun selling in a soft market, when you’re buying and selling at the same time it’s a wash. Price your property right and it’ll sell – and at the same time look to buy a property at the same sort of discount.
• 2: Lift and shift. If you’re in a market like San Francisco, Los Angeles, Florida or Las Vegas then you might be concluding that your market has done its thing and the future looks a bit less rosy. Some investors might be tempted to try to hold on until the market turns around and hits the peaks that it enjoyed during the acme of the roller coaster ride, but a better idea might be to sell now, grab that equity, and re-invest in a market that is less overvalued. Consultants like Jeff Brown in San Diego are advising this type of strategy, moving investors from California to Texas.
• 3: Bargain hunt (speculative version). Fifteen years from now they’ll be asking “what did you do during the market correction?” Well unless you have your crystal ball you don’t know now what the best answer to this question will be, but investors with a speculative bent are looking for the bounce. Again, this is a speculative view. Not that there’s anything wrong with that – as long as you're aware of the risks you're shouldering. There’s nothing so dangerous as someone who thinks they’re an investor but in reality they’re acting like a speculator.
• 4: Bargain hunt (value version). Regardless of your view of what’s going to happen next, in many markets the current correction is creating some great value deals – properties that you can pluck straight form MLS that will generate a positive month-to-month cashlfow with only a 10% down payment. You won’t be seeing many of these in, say, Las Vegas. But you will in Fort Worth, Tulsa, and Kansas City. You’re not looking for the dip with this strategy – you’re just poking around in a relatively favorable market for positive cashflow investments. If the market bounces then great. If it doesn’t then you’re in good shape to weather the storm.
• 5: Ride it out (do nothing). Good traders will acknowledge that sometimes their best trade of a given week was one that they didn’t do. Strategies 1 and 2 require you to have some underperforming equity to re-deploy. Strategy 3 is strictly for speculative high-rollers, and Strategy 4 only works if you’re living in the right kind of market. So what if you’re in the “none of the above” camp? Well patience can be a virtue in investing, and I’m not in the “now is always the best time to buy” camp of real estate investors.

Information wants to be free: Real estate investing certainly has an element of secrecy, as does any business endeavor that involves negotiations. For example, when you’re on the buy leg of a 1031 exchange you don’t want the seller and you’re running short on time you don’t want the seller to know that you’re under pressure to make a deal work. And when you’re selling a property that you just bought FSBO you don’t want the buyer to know that you purchased it for a song.

But that said, there is a great amount of general information that you can be generous with. This isn’t altruism; information truly wants to be free, and professionals who are open with sharing their expertise will in the end benefit in many ways.

This is a principle that I try to demonstrate myself – in this blog, for example. Everything here is free. And I frequently receive emails from readers who compare the things they read here (and on other free resources) with the stuff that they pay thousands of dollars for. The internet is a sleazy place when it comes to real estate. Want to find out “…closely guarded secrets for real estate investing” or ways to get “a whole new level of jaw-dropping wealth and financial independence” then all you have to do is whip out our credit card. (note: these are actual quotes from various websites). If you’re paying for a secret you’re getting scammed; there are no secrets out there.

But this “free information” principle applies directly to all of us as investors. I deal with a relatively small number of real estate professionals: contractors, real estate agents, lenders. And I share with them what I’m doing – how I make deals work, what’s been successful and what’s failed, and what my strategies are. And they reciprocate – which means I learn a lot more about, say, peer-and-beam foundation leveling and realtor commissions than I otherwise would. Information wants to be free, but it’s also very valuable. Give a little and you’ll get a lot.

I want the people around me to make money: I’m not a big fan of paying a 6% commission to sell a property. But that doesn’t mean that I mind when the people around me profit when I do a deal. Most successful corporations don’t get that way be paying their employees the bare minimum; this rarely is a sustainable strategy. Likewise, most successful investors don’t get that way by squeezing every cent out of every deal at the expense of the people who support them. When I call my contractor or my real estate agent I want them to be happy to see my name on their caller ID. I want to be known as a repeat customer who closes deals. I expect to be charged a repeat-customer rate, but they know they won’t have to twist my arm to get paid fairly.

Relationships aren’t just about dollars and cents: This is an area that I have to be vigilant about reminding myself. I generally show appreciation through repeat business – and since I’m generally a dollars-and-cents type I might tend to think this is enough. But it isn’t. Independent professionals get a great deal of satisfaction from the appreciation that their clients show them. Good businesspeople aren’t in it just for the money, and they won’t know you appreciate their expertise and hard work unless you tell them. Write a note. Post a recommendation on Angie’s List. Remember them at Christmas.

My fun resolution is tied to my interest in photography – create a history of 2008 in 52 photos by selecting a photograph each week that I think is good enough to show, and spend a few minutes writing about why I picked the picture and what the moment meant. If you look around you’ll see a lot of photo-a-week galleries on the internet, but this will be a private project for my family. So no downloads for me…

And my professional resolution this year is…drumroll…exactly the same as my resolution last year: to sell some properties that have accumulated some equity and flip them into a fourplex using a 1031 exchange.

The two properties I need to sell are a couple of nice townhomes in the West Memorial section of Houston. I bought both of them from an investor a couple of years ago and the market has treated the area pretty well.

The market in Houston is a bit soft in this price range, but since I’m buying and selling at the same time I’m not that concerned; my main goal is to ensure that my portfolio has the right amount of leverage and that I’m generating a good cap rate on my investment. These properties have appreciated, but rent rates in the neighborhood haven’t kept up.

Last year, publically declaring my resolution seemed to have some psychological effect in making sure I got it done. Worked last year….we’ll see if it does this year too.

We're so accustomed to having our intelligence insulted by politicians that we rarely complain about the dumbed down worldview that we’re spoon-fed by both sides of the political aisle. The partisan mudslinging that we’re subjected to these days makes it hard to imagine a world in which candidates might campaign by voicing nuanced, well articulated views on the complex issues facing our country. That’s too much to ask for, but at least we get to watch the primaries, which offer up the entertaining spectacle of Democrats savaging fellow Democrats and Republicans bashing Republicans as they fight for their respective nominations.

But there are a couple of issues that I think we should all hold our candidates to a higher standard. One of these is immigration reform.

Even the language of immigration reform is fraught with semantic landmines. Do you talk about “illegal aliens” or “undocumented workers”? Do you open the discussion with allusions to Ellis Island or by invoking 9-11. Is this about security or fairness.   Economics or the American way?

But it's safe to say that we're all interested in the state of our economy and national security – these are two tides that lift all boats. And as real estate investors – we’re more interested than most in how the housing market weathers the current storm, not to mention how we operate as landlords and as consumers of labor intensive services like roofing, landscaping and construction.

More specifically – as politicians target employment, benefits, and housing as keys to the illegal immigration question, some municipalities have proposed legislation which would hold landlords accountable for policing the residency status of their tenants. These are bad laws.

The reality of the situation is that it is difficult to take a complex issue like immigration reform and turn it into an effective sound bite, so it’s rare that we see a candidate discuss immigration with any subtlety or insight. But when I hear anyone address immigration I’m listening for a couple of key things…

Does the candidate acknowledge the complexity of the issue, and our society’s complicity in creating it? George W. Bush has lately become fond of invoking our society’s dependence on foreign oil. This is a step in the right direction (although the solutions proposed are all wrong – that’s another post) but as a society we’ve yet to confront the fact that we’re also addicted to imported labor – especially when it comes to difficult, physically intensive, cheap, dangerous work. When I walk into a construction site, a rehab project, a house that’s being cleaned for showing, or a landscaping job I without fail see a group of workers made up almost exclusively of immigrants. Always. Granted, this fact is exacerbated by the fact that I’m in Houston, but many readers will find this to be a familiar observation.

I live in a suburb where the residents, generally speaking, are more inclined to lean towards the Tom Tancredo school of immigration reform than the Hillary Clinton view. But if you walk this neighborhood on any weekday you’ll see the streets dotted with landscaping and housekeeping crews made up of employees who are in the country illegally.  It's interesting that the "Assault on America" philosophy of immigration reform is so successfully sold to those socially conservative families who every week enjoy a beautifully manicured lawn for $35 a pop - courtesy of the invaders. 

Does the candidate appeal primarily to fear? In recent years folks who live in my neighborhood here in Houston have been subjected to some of the foulest, ugliest campaigning I can remember as Hubert Vo (D) and Talmadge Heflin (R) squared off for a seat in the Texas State House of Representatives. They both took the low road on numerous occasions on various issues; one of them was immigration. This ad to the right (actual scan of a flier which landed in my mailbox) won the prize for the crassest.  According to Heflin, his opponent was so uninterested in the general public safety that if he won then Osama himself would eventually stroll into a local Texas Department of Motor Vehicles and get a drivers’ license.

Heflin lost the election in a very tight race, and I like to think that there were at least a few voters, like me, who were pushed into the opponent’s camp because they were angry about having their intelligence insulted.

Does the candidate talk about people?  Immigration is a human issue.  Immigration is about people. I think most of us would agree on how we should treat an illegal alien who slips into the country to sell drugs. But how do we treat an undocumented worker who has spent the past twenty years toiling in a Tyson chicken processing plant, paying social security, contributing to his community, and raising his kids who were born here and are now in high school?

If we were to wave a magic wand and magically deport all 12 million people residing in our country illegally, every restaurant in Houston, San Antonio, Los Angeles, Las Vegas, Miami, and San Diego would immediately close. Our crops would rot on the vine. Poultry and meat would disappear from our supermarkets. Hotels would shut down. Residential level construction work will grind to a halt.

Some of these industries would eventally recover – but at a great increase in cost to the consumer.

So ask youself: is the candidate presenting the issue to me in all its complexity?

Postscript:  The squeaky wheel gets the grease, and there's no area where this principle applies more strongly than in politics.  This blog post got picked up today by topix.net.  Take a look at the comments.  The bottom line is that if the general public is apathic towards important issues then thoughtful voices will be shouted down by the lunatics on the fringes.  Is this the America that you want to live in?

The Global Insight uses a number of factors in determining the theoretical price equilibrium level for each market, to include tax rates, population density, income levels, plus a somewhat nebulous “desirability factor”. So, as with all economic studies there is some art mixed in with the science, but nonetheless I find this study to be an useful data point when thinking about the relative valuation of markets.

The fact that Houston is ranked as the most undervalued market is interesting in light of the underlying economic factors and the disparity between the market’s current reactions with how it behaved in the past. Nowadays when we think about real estate bubbles we immediately think of California, Las Vegas, Florida, and other regional markets that have grabbed headlines with their flying property values over the past several years. But we forget that the poster child for real estate market collapses was Houston in the mid-to-late eighties.

Texans were knee deep in irrational exuberance long before Alan Greenspan coined the term. When the Gulf States kicked off the Arab oil embargo in response to Western support for Israel in the Yom Kippur War, the resulting spike in oil prices fueled investments in the oil industry. This, in turn, pushed property values to unsustainable heights.  Everyone wanted their own Southfork Ranch. 

Fast forward to the early years of the 21st century. Two rounds of armed conflict in the Gulf, rising demand and tightening supply have again sent oil prices into the stratosphere; and I’d argue that this time around the increases have more fundamental sustainability than in years past. Money is flowing into operational oil centers like Texas and Louisiana. But, the real estate market hasn’t responded. Yet.

The graph below shows the Department of Energy refiner acquisition cost of imported oil. 

Will property values in Houston and other economic centers for energy go up? In the short term, perhaps not. Economic malaise and a jittery credit market will help to continue to keep a lid on the prices, but I love the fact that the downside risk in undervalued markets is relatively low. Currently, investors in some markets need to plop down a 40% down payment in order to get into an property that generates breakeven month-to-month cashflow. Getting into an undervalued one where 5% does the trick feels pretty prudent.

I wrote in a recent column that when an investment starts “getting good” – when it starts kicking off some cashflow and putting some dollars in your pocket on a month-to-month basis – then that’s the time to sell. This might sound counter-intuitive, but I’ll give a couple of examples that show why it is true.

Judged on the basis of simple price appreciation, the stock market beats the pants off of the real estate market. Over the past twenty years the S&P 500 has appreciated at an average rate of almost 10 percent per annum, and the NASDAQ has averaged over 11 percent. Over the same period the average home price in America has increased at around 5.6 percent. So why do we get excited about the real estate market? Because it allows the investor to prudently use leverage to increase her returns. So why should we consider selling when the investment starts kicking off cashflow? It’s because this is a good sign that your leverage is running out of steam.

Let’s look at a simple example. An investor puts 20% down on a $100,000 property. The investor starts out with $20,000 equity on a $100,000 house, giving him 5-to-1 leverage. Meaning: if the market goes up by 5% then the value of the house goes up by $5,000, a 25% return on the initial $20,000 investment. This is a basic concept you’re probably familiar with.

As time passes by two things are likely to happen: a) the property will appreciate in value (good) and b) your loan balance will go down (also good). But there’s an unintended by-product of these two factors: a decrease in your leverage.

The graph above assumes a fixed rate mortgage at 8% and a property appreciation rate of 4.5% per annum. Now this isn’t a bad investment – in fifteen years that initial $20,000 grows to over $120,000 in equity. That’s an annualized rate of return of around 14%, better than you'd expect out of the stock market. But look what happens to leverage. By year five you can expect to have paid off around $4,000 of the loan. And assuming a 4.5% rate of appreciation, the property will have gone up in value by around $24,000. That adds a total of $28,000 to your equity – so now you have $48,000 tied up in the property. So here’s the results:

• Initial leverage: $100,000 property ÷ $20,000 equity = 5 to 1 leverage
• Five years later: $124,000 property ÷ $48,000 equity = 2.6 to 1 leverage

I don’t day trade stocks and I don’t flip houses – but that doesn’t mean I’m a completely passive investor, either. Smart investors know when it’s time to rebalance – and when your leverage starts falling it’s time to think about re-balancing.

The chart above shows an investor who rolls up his sleeves every five years, sells his properties and reinvests the equity. In the example above, the investor’s $100,000 property had grown to $124,000 – that’s good. But the $48,000 in equity now translates into a 20% down payment on a $240,000 duplex.

Summary:  Sell the property for $124,000, extracting $48,000 in equity.  Use the $48k to put 20% down on a $240,000 property via a 1031 tax deferred exchange.  Five years later: repeat.

Adopting this philosophy can have a dramatic impact on the long term performance of your real estate portfolio. Let’s look at the equity from the two figures above. In the first case, as mentioned above, the initial $20,000 investment grows into just over $120,000 of equity over the fifteen year period. Not too shabby. But the re-leveraged case is far more lucrative, growing to over $250,000 in the same period.

I’m a buy-and-hold investor, but that doesn’t mean holding forever. By executing a 1031 exchange every five years a real estate investor is able to maintain the desired level of leverage and risk and ensures that his real estate portfolio maintains momentum over time.

Related links

• Why is cashflow important?
• 1031 Exchange :: build your portfolio tax free
• If you invested one dollar :: Real Estate vs. Stocks

I talk a lot about cashflow in this column, but cashflow isn't really my game when it comes to investing in real estate.  The cashflow question, to me, really isn't about "how much cash is this property going to put into my pocket on a month to month basis."  The cashflow question, to me, is really about "are the fundamentals of this property strong enough that it will support itself?"

In other words: will it reliably generate enough income to cover principal, interest, expenses and taxes, with a little left over to cover vacancies and incidental expenses. When I run the numbers this is the primary thing that I’m looking for.

This is a strategy for long term wealth building; it’s not one that will finance a short term increase in your quality of life.

Compared with other investing opportunities – the stock market in particular – there is a compelling case for real estate. Consider the following two opportunities to invest $20,000:

• Put $20,000 in the stock market (assume a return of 8% - around the historical average)
• Put a $20,000 down payment on a $100,000 single family house (assume a rate of appreciation of 4.5% - also around the historical average)

The stock market’s 8% trumps the real estate market’s 4.5% rate of appreciation, but take into consideration leveraged backed by casfhlow an it paints a new picture entirely.

Instead of making an 8% return on a $20,000 asset, you’re making a 4.5% return on a $100,000 asset. That’s a great trade-off. And if you’ve done your homework on estimating the property’s cashflow potential then you’ve increased your confidence that the rent the property generates covers all of the associated expenses.

So that property isn’t going to finance your new Porsche anytime in the next 12 months, but when you cash out in ten years you can expect to put almost $80,000 in your pocket. And that beats the pants off the $43,000 that the same investment would have generated in the stock market.

Want a bit more risk? Take that $20,000 and put 10% down on two $100,000 properties - in ten years your investment will have grown to almost $140,000.

There is a catch, however. It’s going to be tougher to make your cashflow proposition work on that 10% down case. Assuming an 8% interest rate your annual payments (principal plus interest) will go from around $7,000 per year to over $15,000. Taxes and expenses will also be higher - so you’re going to have to search more diligently and negotiate harder to make the numbers work.

And here’s the ironic part; eventually an investment will turn into a really “good” one – one that starts churning out cash. Your rents should go up over time and your mortgage payments should remain relatively flat (assuming you’re not in some toxic waste exotic, which is harder to get these days). And when the investment starts getting lucrative on a month-to-month basis, that’s exactly the time to sell…your leverage is running out on steam. More on that in a future post….

I’m usually leaving some money on the table when I return 100% of a tenant’s deposit, but for me that’s ok. If a tenant leaves the house clean and the landscaping looking nice then I won’t charge him just because he left a few coat hangers in the hall closet.

But unfortunately I’ve had a couple of cases recently where I had to keep 100%. In my experience these tend to fall into one of three categories:

• The tenant slinks into the night. This will happen when the tenant knows he’s trashed the place and doesn’t bother to contest the fact that you’re not returning the deposit. Note that if you do owe the tenant the deposit back you’re not relieved of this obligation simply because he doesn’t leave a forwarding address – so make sure your documentation is in order in case he decides to come back for the money.
• A negotiated deal where you retain the deposit in lieu of legal action. I had a recent case of a tenant who broke their lease and abandoned the property with unpaid rent due. It’s always advisable to have a strongly worded clause cautioning the applicant that the deposit cannot be considered security for unpaid rent. In most states the property code provides the protection to landlords (in Texas it does). Having this language helps you to negotiate from a position of strength. After a series of threatening pay-or-quit letters we signed an amendment via which I agreed to forego legal action in return for retaining the tenant’s pre-paid last month’s rent and the deposit plus a pro-rated charge for the last month that they stayed.
• The tenant howls. This is the one you need to be prepared for. Take photos. Keep itemized receipts. And within the 30 day window (check your state’s property code) present the ex-tenant with a neat statement detailing your charges. The best defense, in these cases, is simply to act as if you expect to be taken to court. Take this philosophy and you’ll end up clear, transparent, solid statement of charges that will probably take the wind out of your complaining ex-tenant’s sails.

Related Links

• Dealing with Deadbeat Tenants

Our current all-volunteer armed forces is the most effective that our nation has ever seen, but compared to the eras of WWII, Korea and Vietnam, today’s military is further removed from society at large than ever. During conscript days most citizens had a father, brother, uncle or cousin in uniform - whereas today's ubiquitous motto “support our troops” has become an abstract theme for many.

And it’s a theme which is used at every turn by our politicians as they attempt to promote/defeat whatever partisan bill congress happens to be debating at the time. I understand that most Americans who have a “support our troops” ribbon stuck on their bumper do so through genuine solidarity with our military, but it is a slogan that I’ve personally grown to dislike. It is rarely spoken with sincerity by our representatives in Washington, and generally translates into a show of support for a particular position on the ongoing war, not (as it purports) for those who have to fight it.

I’m a veteran, but I’ve opted to keep the bumper of my car slogan-free. So in lieu of a magnetic ribbon, here are three faces and stories of soldiers who have made the ultimate sacrifice for our country. Real faces, names and stories.

• MAJ Bill Hecker: West Point obituary
• 2LT Emily Perez: West Point Mourns a Font of Energy Laid to Rest
• MAJ Guy Baratteiri: Ex Seattle Policeman and Green Beret Killed in Iraq

I choose these three simply because they’re three people who happened to be close to me – family or West Point company-mates. But their stories are no more important than those of the thousands of other soldiers, sailors, airmen and marines who have given their lives. Thinking about them today helps me remember how much I truly have to be thankful for.  Thank you.

Much has been written on the ongoing push for legislation to protect consumers in the wake of the unfolding sub-prime collapse.  The House of Representatives recently passed H.R. 3915, the Mortgage Reform and Anti-Predatory Lending Act of 2007.  Commentary on this legislation most often focuses on the restrictions that it would place on lenders seeking to make loans. 

But there is another important feature in this bill which will be of interest (concern) to investors.  In case of foreclosure, the entity reclaiming the property will have to honor all preexisting leases.   And you thought that banks used to be annoyed about that REO bouncing back onto their books - now they get the property and the tenant. 

This, potentially, is a two-edged sword for investors.  On the bright side, while a tenant-occupied property is a pain for a bank, it can be a good thing for an investor (assuming the tenant is one that you'd want to keep).  Furthermore, it restricts the bank's options for selling the property - your competition in bidding for the property is pretty much restricted to other investors. 

On the flip side, though, this will make the banks take a second look at their policies for lending money to investors.  This change represents an additional risk and cost for the banks, and they're gonna pass it right along to you and me. 

If you're interested you can read the press release and the bill itself, along with a related article from the New York Times. 

This week's Fortune magzine featured an interesting article that puts an interesting spin on the housing market that takes a page from the real estate investor's playbook. 

Followers of the equities market will be familiar with the P/E ratio, the most often quoted financial ratio calculates a company's share price as a multiple of its earnings.  A high P/E ratio is evidence of the market's collective assessment that earnings are poised to grow dramatically, whereas a low P/E ratio tend to stick to companies with poor growth potential. Sky-high P/E ratios are not sustainable.  Either the companies blow up (pick the dot.com of your choice as an example) or they mature, stabilize, and earnings "grow into" the stock price (Ebay, Microsoft, etc.)

So what's the P/E ratio for the property market?  It's the relationship between property values and rents. 

Again, for investors, this is pretty intuitive.  How much do you want for that starter house?  $500 thousand you say?  And it should rent out for $2,000 per month?  Hmmm....I don't even have to plug that one into my economic model to figure out that those numbers don't work.  The only way that investment will pan out is if the market races along for another couple of years at double digit rates of appreciation.  If that's your belief and you're willing to put your money where you mouth is then by all means go ahead and write that earnest money check. 

But, like P/E ratios in the stock market, sky high price-to-rent ratios are not sustainable (which is why, for the time being, Jeff Brown is sending his sunny San Diego investors hunting for deals in the Great State of Texas).  The article quotes Yale economist Robert Shiller: "Like P/Es, price-to-rent ratios are mean-reverting."

There is a little bit of good news hidden in this analysis, however.  Once the price-to-rent ratio gets out a whack there are two ways for it to drift back in line: a) property prices fall or b) rent rates go up. 

Fortune crunches the numbers for the major metropolitan areas and they stack up pretty much how you'd expect them to.  The article isn't online so you'll have to hit the newsstand and plop your $4.99 down if you want the details. 

At the top of the list is Nevada, with one fourclosure filing for every 61 households, up over 200% from this time last year.  California is in second place, with 1 filing for every 88 homes. 

Investors will keep a close eye on their local situation in making investment decisions, but there are some interesting national trends forming.  Notably, 45 out of 50 states experienced year-on-year increases in foreclosures.  This, along with tightening credit, increasing oil prices and declining consumer confidence have the potential to have a broad national impact.  This is "the tide that lifts/lowers all boats."  So even though we may view national headlines with a shrug, smart investors in Oklahoma and Virginia realize that what's going on in California and Nevada really does matter. 

The Fed is caught between a rock and a hard place these days.  On the one hand Bernanke is now making much more direct statements about his concerns for the housing market, however with oil prices inching steadily into the $90 range there are also persistent concerns about inflation.  But today when the Fed had to choose between stepping on the gas (easing rates) and putting on the brakes they chose the former, to the tune of a quarter point rate cut. 

The challenges facing the economy are complex, and to a large extent they're still looming in the shadows as opposed to impacting us directly.  But the pessimistic scenario has American's holding on to their spending dollars as they fret about decreasing equity in their homes, compounded by sub-prime losses trickling throughout the banking sector as blue-chip firms like Merrill Lynch who bellied up to the mortgage-backed securities trough back when times were good start to see the chickens come home to roost. 

We all have our crystal balls tuned to different frequencies, but mine is telling me that now is the time to take off your speculation hat and put on your investor hat.  Cashflow is king when you're confronted with a skittish market and an uncertain immediate future.  And that, ladies and gentlemen, is what we're facing right now.  But medium term I'm still optimistic (even though my Countrywide trade isn't doing all that well) and I'm firm in my belief that investors who make smart investments during the downturns will fare well over the long term. 

Related posts

• Investing vs. Speculating
• Countrywide cheap @ $20?

I occasionally write editorial pieces on real estate and real estate investing for the Business Journal Network. I recently provided a column on avoiding fraud scams that appeared in several markets. Here’s the article as it appeared in the Silicon Valley / San Jose Business Journal.

This column emphasizes points that I've emphasized recently in blog postings on fraud and scams. 

Related Posts

• Real estate shell game :: Recognizing fraud
• Real estate shell game :: Part II
• Real estate shell game :: Part III

________________________

Chris,

I was approached by an acquaintance, Phil, to invest into a get rich quick scheme. I was to be the buyer and mortgage holder for two houses, but all documents and paperwork would be mailed to Phil’s residence and Phil would be responsible for all mortgage payments and monthly maintenance fees. I was promised a gift of cash in exchange for using my good credit. All was good for several months, and then I started receiving calls from American Servicing Company for non-payment.

Unfortunately, being very trusting of Phil, I did not ask for copies of any documents that I originally signed. Phil kept everything. At this time, I don’t know what to do. Phil does not return any phone calls. As of today, the two residences are unoccupied. Please, any advice is welcome.

___________________________

First of all, I'm not a lawyer and laws/property codes vary from state to state. This shouldn't be considered legal advice. You need to contact a lawyer.

A couple of things that I would do were I in your situation.

1) Don't ignore the mortgage company. Regardless of what happened between you and Phil it appears you’re currently on the hook for these mortgages. Call the lender.

2) Get ready to go to trial. I understand that you don’t have the paperwork, but you must have some documentation that a deal was done...receipts for cash payment, etc. Get these together, along with a written narrative of what occurred, and discuss these with a lawyer.

Now I'm guessing that one of two things might have happened here....

• Non-evil Phil case: Phil got all fired up from attending one of those Rich Dad Poor Dad seminars or some other such motivational pep rally. Then, realizing he had no credit, talked you into backing one of his deals. Phil overpaid for the houses, realized he couldn't lease them out, ran out of money, and buried his head in the sand. Now your phone is ringing off the hook as the bankers are looking for their money, which you owe.  It's possible that Phil didn't set out to rip you off, but he abused your trust and, in the end, skipped town. 
• Evil Phil case: Then again there are lots of ways to rip someone off in a case like this. Example...Phil found a seller selling his house for $100k. Phil offered $110k on the condition that the seller kicked back $10k at closing. The seller got his price, Phil pocketed $10k, and you’re stuck with a $110k mortgage on a house that's only worth $100k. There are many, many other schemes.  It's possible that Phil is a genuine scumball. 

In hindsight (not helpful, perhaps) there are lots of problems that led to this. The most important are a) you got into a deal that you didn't really understand, and b) you can't rely on trust; you need a contract.

This probably isn't much help, but at this point the horse is out of the barn.  Call a lawyer, deal with the mortgage companies, and good luck.

Related Posts

• Why I don't like Rich Dad Poor Dad
• Real estate investing psychology
• How contracts help me to build solid relationships
• Real estate shell game :: Recognizing fraud
• Real estate shell game :: Part II
• Real estate shell game :: Part III

I was going to write an article about this not to long ago when, bam, I ran into a problem: tenants who stopped paying.

The tenants were a flaky young couple that I knew I might be taking a chance back when they signed the lease in May. But I decided to rent to them and mitigated my risk by signing a short lease (six months, with renewal contingent on timely payment), charged them first and last month’s rent upfront, plus one month’s rent as deposit. I won’t go through the boring details, but they ended up breaking the lease and abandoning the property while they owed me money. If you find yourself in a situation like this one here are some points to keep in mind.

• Property codes, generally speaking, exist to protect the tenant. However, most tenants who end up in situations like this have not followed the law. On the other hand, you have – assuming you’re a responsible landlord. The party who is on the right side of the law (you) negotiates from a position of considerable strength.
• Ensure that you use a current, legally compliant lease contract that includes specific references to the property codes. For example, all of my leases state that tenants are prohibited from withholding payment for any portion of any month’s rent on grounds that the security deposit is security for unpaid rent, and that bad faith violations may subject the tenant to liability up to three times the rent wrongfully withheld plus Landlord’s reasonable attorney fees.
• We all have our own style, but in tenant/landlord disputes you want to be more like Agent Friday (“just the facts, ma’am”) than, say, John Madden. Communicate clearly, calmly, and factually. Quote relevant state property codes, chapter and verse. Read the relevant clauses from the lease that the tenant signed. Use the facts, the contract, and the law as a blunt instrument.  Don't call or email when you're angry. 
• Back up phone calls with written communication – email or a leter. Tell ‘em on the phone, the follow up in writing to tell ‘em what you told ‘em. Keep copies of everything.
• Once you feel a problem brewing, keep a written log of everything. Capture dates and times of phone calls and what each party said.
• Follow the law with regards to notices. You can’t just put deadbeats out on the street; you need to serve them with a Pay or Quit notice with the proper lead times. Consult your local property codes and know what your obligations are.

The idea of all of this is that you’ll be following a rational, well planned strategy. If you end up in front of a judge, either in an effort to evict the tenant or suing for damages, your ducks will be in a row.

This reminds me of my brother. Greg isn’t always right about everything, but if he offers to bet me about something then there’s a 99.9% chance he is. Greg hates to lose, so when he puts his money where his mouth is and offers to shake on a bet then I tend to back down. If you end up in court you want to be like Greg; you should know you’re going to win. Smart, ethical landlords don’t lose these cases.

And if you follow these guidelines then, in the end, the tenant (if he has a rational bone in his body) will often back down. That’s what happened in my case; they paid and got out, and I didn’t have to drag them to court. They saw the handwriting in on the wall.  Sure I wasted some time hammering out threatening letters and trying to chase them on the phone, but all in all it wasn’t a bad outcome.

The first thing that I think when I see a bandit sign is "here's a guy who's willing to do something illegal to make a little money."  Not exactly a first impression that inspires me to pick up the phone and strike up a business relationship.

Laws vary from region to region, but in most areas the city comes around periodically to collect these things eyesores.  There's so much of it that I doubt that anyone gets prosecuted for breaking city ordinances.  That might be enough to make you think "hey these guys are getting some pretty good free advertising; I'm missing out."

Well there's another way - a better one.  When I'm looking to find a tenant for a home that doesn't have good exposure to traffic I'll simply knock on a few doors.  I'll pick a nearby house that does have good traffic, and then offer the owner $10 or $20 to plop a sign in their front yard.  You can get a sign from the FSBO center at Lowes or Home Depot for fifteen bucks or so, and some vinyl stick-on letters (recommended) for a few bucks more.  

Advantages:

1)  It's legal.  Ok, I know that not everyone out there is as uptight about the bandit sign thing as I am.  But some folks are - and bandit sign users turn off these potential applicants.  

2) It looks better and makes a better impression:   Bandit signs need to be cheap.  Why?  Because they're disposable; someone eventually will come along and toss them in the trash.  Therefore bandit signs tend to be cheap, flimsy and ugly.  But if your sign is legal then you're less likely to lose it, so you can spend a few bucks on a nice sign with stick-on letters. 

3)  It's an excuse to strike up a conversation with your neighbor.  Sometimes they might know someone who is interested in renting the property.

 Related Link:

• Citizens Against Ugly Street Spam