An Interruption It's a cool Sunday evening. I am on my patio at our Colorado townhouse getting ready to grill a couple of steaks. Virtually out of nowhere a man appears and asks, "Are you Phillip Storms?" When I say yes, he hands me a document which I immediately recognize as a summons. I tell him thank you and he leaves. While this is somewhat of a surprise, it isn't totally unexpected. The homeowners association of a condominium I own has filed suit to collect $2,000 that they say I owe. Since I am a member of this association, in effect, I am suing myself. Without going into detail, there is little doubt in my mind that this suit is totally without merit. Since 2006, when I acquired this unit as as a foreclosure from a friend (or should I say a former friend) to whom I loaned money, I have been paying over $400 a month in HOA dues. This is an astronomical price for a 2-bedroom, 2-bath, 1025 sq foot unit and you might think that this is a luxury unit with many amenities. Not so. The units are run down, the clubhouse/pool is one that you wouldn't want your family to use and landscaping is barely maintained. The only saving grace is the location, a few blocks from light rail and in a relatively popular area of town.
How Did This Situation Occur? The short answer is mis-management by the homeowner association and, again, it is not necessary to go into detail. A major advantage of real estate investing is that you have a fair amount of control over the outcome of your investment. You can decide what improvements you might make to increase the rental income available from the property; you can decide the proper rent levels to maximize occupancy and increase cash flow; and you can decide; what steps you can take to increase the value. If you buy AT&T stock you can only hope and pray that CEO, Randall Stephenson earns his $7.3 million salary and makes the right decisions to maximize cash flow and share value. Not the case with real estate, you are not only an investor, you are CEO of your own company. If you own within a homeowner association, you give up most of this control to a group with many members who have no clue as to how to manage and maintain properties for maximum liveability and sustained property value. Your ability to control the destiny of your property stops when you walk out the front door.
How Could This Situation Have Been Prevented. I broke one of my existing rules when I made the loan on this property. That rule was to make loans only on properties I would buy at a price equal to the amount of the loan. When I made this loan, I really didn't want to own the property. Instead, I depended on the ability of the borrower to make the right decisions to maintain the value of the property and protect my investment. This has never been a good policy for me. The second rule is a new one. Do not make loans or acquire properties with homeowner associations who make most of the decisions affecting the value of your property.
Perhaps This Sounds A Bit Extreme. You may have notice that the title of this post is My Rules For Real Estate Investing. This doesn't mean that they should be your rules. In almost 5 years of publishing this blog, this is probably the first time I have described one of my investments that turned out to be a disaster. I am embarrassed to describe this folly to you but I think the ability to think about what could go wrong with an investment is often more important than the ability to think about what can go right. I recall one quote that I included in a previous post that said, "The ability to manage the unintended consequence of an unsuccessful investment is one of the most important abilities an investor can have." If you are thinking about making a real estate investment that has a homeowners association be sure to thoroughly investigate that association and decide what additional risks the HOA might impose. If you are like me, you will probably decline the investment.
Tuesday, September 28, 2010
Friday, September 24, 2010
MANAGING YOUR ASSETS IN A MARKET FULL OF RISK
"Forget the return ON my investment. What concerns me is the return OF my investment". Will Rogers (I think).
Return of vs Return on. This is probably one of the most misunderstood terms in investing and one of the biggest sources of argument between me and one of my very astute clients. It is best illustrated by an example. Suppose you make a loan of $100,000 to a friend with interest at 10% per year and the entire amount due in 10 years. If this is compounded annually he will owe you $259,374. If he comes to you at the end of 10 years and says I have managed to scrape up $100,000, its all I have and all I will ever get. I would say you got your money back. My client would say you have a big loss. I am not saying you made a good investment nor is your purchasing power preserved but you got your money back. Your return on investment was zero and your return of was 100%.
Let's recast this loan into one involving annual interest only payments at 10,000 per year. If we assume the friend comes to you at the end and says I have no money to pay your principal but at least you got your money back via the annual payments. Again, your return on investment was zero and your return of investment was 100%. These are relatively simplistic examples but they illustrate an important point. Remember I said your return on investment was zero and this was a poor investment but you put out 100,000 and you got back $100,000.
Let's Compare The Risk Levels. Which would you prefer? To go through 10 years and get your entire principal back or to receive $10,000 a year for 10 years and get no return at the end. From a total return standpoint, they are equal but if you think about it, the $10,000 a year scenario is far superior from a risk standpoint. This brings me to the key point of what I have been writing about for the past 5 years. The sooner you begin to get cash flow from your investment the lower your risk. Sitting on an investment for 10 years not knowing whether you will get what you have anticipated doesn't work. Especially for an investor in the later stages of life. Of course, I am aware that taking taxes into account, the conclusions are reversed but I still maintain that the lower risk of the cash flow scenario is worth a lower after-tax return.
Here is Another Scenario. Suppose in the last scenario, you have received $10,000 per year for 10 years and all you can collect at the end is $40,000. You have received a total of $140,000 and your return on investment calculates to be 5.30% compounded. So despite the fact that you only received 40% of your investment at the end, the interim cash flow more than makes up for this and your return is positive. Suppose this was a 20 year year loan and you received $10,000 per year for 20 years and $40,000 at the end. Your return is 8.80%. These bring me to two more conclusions. 1. When you receive interim cash flows from an investment, you really don't know whether they represent a return ON your investment or a return OF your investment until the investment is terminated. 2. The longer the investment continues and the more interim cash flows you receive, the less important the final payment becomes.
Do You Find This Boring? I wouldn't blame you if you did. That's part of the reason I seldom write about topics like this because, in my book, the biggest sin is boring. It's not boring to me. It's fascinating. The utility of these few points says a lot about planning your investment strategies. It's not just about getting the highest return possible on your investment, its about getting the type of return that meets your needs. If you are entering retirement, in a relatively low tax bracket, with an aversion to risk, it is far better to get the majority of your return in the form of interim cash flow (there are exceptions). If you are a high-tax bracket younger investor, you might want to have the majority of your investments in vehicles that allow you to build wealth with no interim tax consequences.
This Probably Leaves You With Questions. I would be happy to answer these via comments to this post or via e-mail or in person. Feel free to contact me at 303-902-3940. I will be in and out of town but should be back in Texas by mid October. I look forward to your comments.
Return of vs Return on. This is probably one of the most misunderstood terms in investing and one of the biggest sources of argument between me and one of my very astute clients. It is best illustrated by an example. Suppose you make a loan of $100,000 to a friend with interest at 10% per year and the entire amount due in 10 years. If this is compounded annually he will owe you $259,374. If he comes to you at the end of 10 years and says I have managed to scrape up $100,000, its all I have and all I will ever get. I would say you got your money back. My client would say you have a big loss. I am not saying you made a good investment nor is your purchasing power preserved but you got your money back. Your return on investment was zero and your return of was 100%.
Let's recast this loan into one involving annual interest only payments at 10,000 per year. If we assume the friend comes to you at the end and says I have no money to pay your principal but at least you got your money back via the annual payments. Again, your return on investment was zero and your return of investment was 100%. These are relatively simplistic examples but they illustrate an important point. Remember I said your return on investment was zero and this was a poor investment but you put out 100,000 and you got back $100,000.
Let's Compare The Risk Levels. Which would you prefer? To go through 10 years and get your entire principal back or to receive $10,000 a year for 10 years and get no return at the end. From a total return standpoint, they are equal but if you think about it, the $10,000 a year scenario is far superior from a risk standpoint. This brings me to the key point of what I have been writing about for the past 5 years. The sooner you begin to get cash flow from your investment the lower your risk. Sitting on an investment for 10 years not knowing whether you will get what you have anticipated doesn't work. Especially for an investor in the later stages of life. Of course, I am aware that taking taxes into account, the conclusions are reversed but I still maintain that the lower risk of the cash flow scenario is worth a lower after-tax return.
Here is Another Scenario. Suppose in the last scenario, you have received $10,000 per year for 10 years and all you can collect at the end is $40,000. You have received a total of $140,000 and your return on investment calculates to be 5.30% compounded. So despite the fact that you only received 40% of your investment at the end, the interim cash flow more than makes up for this and your return is positive. Suppose this was a 20 year year loan and you received $10,000 per year for 20 years and $40,000 at the end. Your return is 8.80%. These bring me to two more conclusions. 1. When you receive interim cash flows from an investment, you really don't know whether they represent a return ON your investment or a return OF your investment until the investment is terminated. 2. The longer the investment continues and the more interim cash flows you receive, the less important the final payment becomes.
Do You Find This Boring? I wouldn't blame you if you did. That's part of the reason I seldom write about topics like this because, in my book, the biggest sin is boring. It's not boring to me. It's fascinating. The utility of these few points says a lot about planning your investment strategies. It's not just about getting the highest return possible on your investment, its about getting the type of return that meets your needs. If you are entering retirement, in a relatively low tax bracket, with an aversion to risk, it is far better to get the majority of your return in the form of interim cash flow (there are exceptions). If you are a high-tax bracket younger investor, you might want to have the majority of your investments in vehicles that allow you to build wealth with no interim tax consequences.
This Probably Leaves You With Questions. I would be happy to answer these via comments to this post or via e-mail or in person. Feel free to contact me at 303-902-3940. I will be in and out of town but should be back in Texas by mid October. I look forward to your comments.
Monday, September 20, 2010
SHOULD YOU INVEST IN REAL ESTATE?
Some Things You Should Know. There are a lot of things you should know before you invest in real estate. Probably the first of these is that virtually every one should invest in this area and part of the puzzle is to pick the investment vehicle that is right for you. While I have discussed most of these at one time or another I will confine this discussion to direct ownership as opposed to more passive investment vehicles such as real estate investment trusts (REITs) or tenants in common (TICs). There are also several property types from single-family homes to office buildings. Take my word for it, unless you are an experienced, high net worth investor, now is not a good time to venture into commercial properties. While you might buy one of these at a bargain price, it may be difficult to find and retain tenants to provide rent to cover operating expenses and debt service. Unless you have adequate reserves it might be difficult to hold on to the property until a strong market cycle allows you to sell at a favorable price. In the final analysis, the single-family market seems to offer the best combination of return and safety. We will confine the rest of our discussion to single-family home investment.
Is This A Good Time? The financial press is filled with articles that tell you that housing prices still have a considerable distance to fall before the market stabilizes. Is this true? In reality no one, including me, knows. To make things even more difficult, there is a tremendous difference between various regions of the country. In addition, there is a difference between different regions of the state, and even between different regions of a given metropolitan area. If you read national publications, the most common theme is that housing suffers from two major difficulties. 1. Excessive inventory of houses for sale and 2. Negative equity. This places a burden on sellers. There is heavy competition from other sellers and it is impossible for even desperate sellers to offer their property at a bargain price if that price is significantly lower than the amount owed on the property. If you offer a seller $150,000 for a property in which he owes $200,000, chances are he doesn't have $50,000 to pay out of pocket in order to sell the property.
Where Are The Opportunities? Despite all the negative publicity about housing, there are some opportunities for those willing to seek them out. The main opportunity in the Metro-Denver area is strong tenant demand. Investors sometimes forget that it is tenants that drive the investment market. Five years ago, real estate prices were increasing rapidly, and my phone constantly rang with investors looking to diversify out of financial markets into real estate. I informed most of them that high vacancy rates made it too risky to invest in real estate at that time. Now the situation is reversed. In Denver, the vacancy rate for single-family housing is less than 4% and for apartments the vacancy is in the 6% range. Our experience tells us that such low vacancy rates provide pressure on rental rates making future rent increases more likely.
Interest Rates Are Low. Although credit requirements are strong and fewer buyers can qualify for loans, those who can qualify will find rates favorable. Lenders are motivated to make loans to buyers with good credit, stable income, and higher down payments. Although there are always seminars about buying real estate with none of your own money, it is only the more entrepreneurial buyers who should venture into these areas. One thing to remember is that low down-payment financing adds a lot to your risk. You have to make those mortgage payments even if your property is vacant and the value of your property is below your acquisition price.
Housing Starts are Low. In most areas of the country, builders are producing little in the way of new inventory. This makes it more likely that any excess inventory of properties for sale will eventually be absorbed. Further, since it takes awhile for builders to re-enter the market, it is unlikely that this situation can rapidly reverse itself. In the early 1990's when the supply-demand balance began to reverse it took over a year for building to pick up. In the meantime those who owned houses were able to take advantage of very high appreciation rates. Unless you are in an area that is chronically depressed, this situation is likely to recur.
Some Initial Steps. 1. Know your finances. If you have a portfolio of financial assets and ample liquidity to provide for emergencies, this market might be favorable for you. 2. Know your market. Evaluate the market you are considering. If there is a very large inventory of properties for sale and few recent sales, don't buy unless you know the rental market is strong. The quickest way to evaluate the market is to find out how many properties have sold within the past year. Divide that number by 12 to determine the average sales per month. Then divide the total number of properties for sale by that number. This will tell you how long the current inventory will last. If there are 12 sales during the past 12 months, that means during the average month, 1 property sold. If there are 36 properties for sale, the inventory would last for 3 years or if there are only 2 properties for sale that means a 2 month supply. Our experience shows that when the inventory is more than a year supply, the market is depressed and less likely to appreciate. When there are less than 6 months supply, market values should be increasing. 3. Study the rental market. How many properties are for rent? What is the asking price. Don't be afraid to call on some of the properties being offered to find out the asking price.
4. Take a look at what's available. Look at a few properties, estimate the rental income and expense, figure out what your debt service will be and determine your potential cash flow. If it doesn't show at least 4-6%, look at alternative ways to finance or pass on the deal. If there appear to be some opportunities, check with a lender to make sure you are qualified for financing and proceed with caution.
This Is Scratching The Surface. I will go into more detail in a later post. In this very difficult investing environment, you can't afford to ignore opportunities to improve your situation. I think real estate may offer those opportunities.
Is This A Good Time? The financial press is filled with articles that tell you that housing prices still have a considerable distance to fall before the market stabilizes. Is this true? In reality no one, including me, knows. To make things even more difficult, there is a tremendous difference between various regions of the country. In addition, there is a difference between different regions of the state, and even between different regions of a given metropolitan area. If you read national publications, the most common theme is that housing suffers from two major difficulties. 1. Excessive inventory of houses for sale and 2. Negative equity. This places a burden on sellers. There is heavy competition from other sellers and it is impossible for even desperate sellers to offer their property at a bargain price if that price is significantly lower than the amount owed on the property. If you offer a seller $150,000 for a property in which he owes $200,000, chances are he doesn't have $50,000 to pay out of pocket in order to sell the property.
Where Are The Opportunities? Despite all the negative publicity about housing, there are some opportunities for those willing to seek them out. The main opportunity in the Metro-Denver area is strong tenant demand. Investors sometimes forget that it is tenants that drive the investment market. Five years ago, real estate prices were increasing rapidly, and my phone constantly rang with investors looking to diversify out of financial markets into real estate. I informed most of them that high vacancy rates made it too risky to invest in real estate at that time. Now the situation is reversed. In Denver, the vacancy rate for single-family housing is less than 4% and for apartments the vacancy is in the 6% range. Our experience tells us that such low vacancy rates provide pressure on rental rates making future rent increases more likely.
Interest Rates Are Low. Although credit requirements are strong and fewer buyers can qualify for loans, those who can qualify will find rates favorable. Lenders are motivated to make loans to buyers with good credit, stable income, and higher down payments. Although there are always seminars about buying real estate with none of your own money, it is only the more entrepreneurial buyers who should venture into these areas. One thing to remember is that low down-payment financing adds a lot to your risk. You have to make those mortgage payments even if your property is vacant and the value of your property is below your acquisition price.
Housing Starts are Low. In most areas of the country, builders are producing little in the way of new inventory. This makes it more likely that any excess inventory of properties for sale will eventually be absorbed. Further, since it takes awhile for builders to re-enter the market, it is unlikely that this situation can rapidly reverse itself. In the early 1990's when the supply-demand balance began to reverse it took over a year for building to pick up. In the meantime those who owned houses were able to take advantage of very high appreciation rates. Unless you are in an area that is chronically depressed, this situation is likely to recur.
Some Initial Steps. 1. Know your finances. If you have a portfolio of financial assets and ample liquidity to provide for emergencies, this market might be favorable for you. 2. Know your market. Evaluate the market you are considering. If there is a very large inventory of properties for sale and few recent sales, don't buy unless you know the rental market is strong. The quickest way to evaluate the market is to find out how many properties have sold within the past year. Divide that number by 12 to determine the average sales per month. Then divide the total number of properties for sale by that number. This will tell you how long the current inventory will last. If there are 12 sales during the past 12 months, that means during the average month, 1 property sold. If there are 36 properties for sale, the inventory would last for 3 years or if there are only 2 properties for sale that means a 2 month supply. Our experience shows that when the inventory is more than a year supply, the market is depressed and less likely to appreciate. When there are less than 6 months supply, market values should be increasing. 3. Study the rental market. How many properties are for rent? What is the asking price. Don't be afraid to call on some of the properties being offered to find out the asking price.
4. Take a look at what's available. Look at a few properties, estimate the rental income and expense, figure out what your debt service will be and determine your potential cash flow. If it doesn't show at least 4-6%, look at alternative ways to finance or pass on the deal. If there appear to be some opportunities, check with a lender to make sure you are qualified for financing and proceed with caution.
This Is Scratching The Surface. I will go into more detail in a later post. In this very difficult investing environment, you can't afford to ignore opportunities to improve your situation. I think real estate may offer those opportunities.
Subscribe to:
Posts (Atom)