Real Estate 023: Real Estate Partnerships

You may be wondering if you should have a partner to help build your real estate portfolio. This is a valid question as some asset classes such as multifamily is well-known for being a team sport. But what about single family, note investing, or other asset classes? This is not an easy decision and it requires looking at your temperaments, the skills that you bring, and goals in forming the partnership.

I have met investors who formed partnerships from the beginning of their real estate careers through meetups, conferences, and even online. I have also met investors who began on their own and partnered up on specific deals where it made sense. Lets take a look into some of the pros and cons of using a partner or going solo in building your real estate portfolio:

Advantages

“If you want to go quickly, go alone. If you want to go far, go together" - African Proverb

Teamwork: Investing in real estate will require you to have resources, whether that be capital to purchase the home and make renovations, knowledge to structure/negotiate a deal, or time and hustle to underwrite the deal, communicate with your team members, and oversee the project. By having a partner, you are able to share the workload and also select tasks according to the strengths of each person. If you love to work with spreadsheets and look at the numbers, and your partner loves to network, build relationships, and find deals, there is a natural compatibility and chemistry between the deal finder and the analyzer. In another example, one person may have the money from a high paying W-2 job, but the demanding hours may not allow them to fly to the different markets, meet with the team, and underwrite/pursue leads. This person may benefit from teaming up with a person who may have low funds, but more time to perform the aforementioned tasks. This also works for people with poor credit, maximum Fannie Mae loans, and other commitments.

Shared Networking: You may have heard the idea Six degrees of separation, where all living things and everything else in the world are six or fewer steps away from each other so that a chain of "a friend of a friend" statements can be made to connect any two people in a maximum of six steps. By having a partner who is well connected, you instantly become two steps away from finding the next person who may be able to help you in your business, whether that be a realtor, contractor, property manager, private lender, or mentor connection. Real estate investing is very well a relationship business and having a strong network will certainly provide huge dividends down the road.

Increased Accountability: Assuming that you have found a partner who is equally motivated, capable, and willing to do the work, you will have won yourself an accountability partner for the long haul. Although you can find large profits in a relatively short period of time, real estate investing is generally not a "get rich quick" scheme. As such, there will be moments where you lose focus, motivation, and need someone to help you get back on track and keep your eyes on the prize. Further, as the saying goes, two heads are better than one, or 1+1 = 3 (synergy). When you encounter a roadblock, you and your partner will be able to put your heads together to come up with a better solution than just you alone. 

Disadvantages

"No deal is good enough, to take down with a bad partner"

Multiple Captains: When driving to a destination, it becomes difficult to stay on course when there are several people trying to take control of the steering wheel, each believing they know the best route. Compared to a solo investor, where each decision starts and stops with them, having a partner (assuming 50/50 equal general partners) means that you have to listen and respect the opinions of others. This may result in compromising even though you disagree with their strategy or decision in pursuing or passing on an opportunity.

Division of profits: While an advantage of a partnership is division of risk, the flip side means that any upside is also divided amongst the partners. Assuming all things equal, you may have found a home-run deal that brings a 100% return over 5 years ($100K --> $200K) through forced appreciation and improved management, but the overall returns are split in half with your partner. Contrarily, if you would have purchased this deal by yourself by utilizing debt for the other $50K seed money, you would have realized all $100K in gains (less debt service) which may be significantly higher than the partnership scenario. 

Partner problems: Whether you partner up with a stranger or your best friend from childhood, its very important to vet them and understand their finances, goals, and temperaments. I have seen people's situation change in the blink of an eye through death, divorce, health complication, gambling habits, etc. and these things can impact your partnership. There are numerous case studies online where partners sued each other alleging theft of assets, not fulfilling their part of the contract, and other types of fraud. Further, there may be cases where outside liability (e.g. car accident) of your partner results in the loss of your asset as they may be forced to liquidate the property to settle their debts. Make sure you protect yourself by engaging a real estate attorney to draft up the operating agreement or joint venture agreement that secure your interests.

To create a successful partnership, make sure that you and your partner have clearly written goals that align before you start to look for deals. For example, if you want to be a long term buy and hold investor and your potential partner only wants to do fix and flips for 2 years and get out of the game, there is clearly a conflict of interest. Next, remember that consistent communication is key. After identifying your goals and business plan on how to get there, make sure you communicate issues (without personal emotion) and offer solutions to the problem - no one likes a complainer. There may be times where one partner needs to concede to another, and other times where you stand firm. If partners learn to respect one another and compromise for the benefit of the group, then the relationship will become even stronger and you will be one step closer to your goal. 

As mentioned above, there are both advantages and disadvantages for partnerships, and as an investor I have gone both solo and partnered up for deals on a case-by-case basis. Remember to carefully review how they apply to your situation, your personality, and the deal. There are many successful investors who have done it both ways and have reached their goal, so do not fear one or the other, and maintain an open mind. 

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 022: Using a Home Equity Line of Credit (HELOC) or Refinancing your Property

During the upswing of a market cycle, homeowners may be wondering if it is a good idea to tap into their home equity, or the difference between the market value of the property and remaining balance of the loan. There are three popular ways (other than selling) a homeowner extracts the equity portion of their property: refinance, home equity loan, and home equity line of credit. 

1. Refinancing your Home

We often hear it on the news, radio, or online advertisements, "take advantage of low rates, refinance and lower your monthly payment!" I know I have received dozens of mail from mortgage lenders offering me to take their deals. In short, refinancing means taking a new loan to replace your existing loan. This is usually done to either take advantage of lower interest rates, remove private mortgage insurance (PMI), or better terms (5, 15 vs 30 year amortization), to take cash-out, or both. People may benefit from taking the equity in their home which fluctuates with the market and putting that money to other use: consolidate debt, make necessary purchases, or even invest in real estate. In addition, without taking cash out of the property, you can use the lower interest rate to lower your monthly payments (assuming the gain is higher than the closing costs involved in the transaction). 

2. Home Equity Loan (HELOAN)

A home equity loan is another type of equity stripping used by homeowners to take advantage of a lower LTV (loan to value) which is experienced during times of appreciation. Equity loans are available in both fixed or adjustable rate mortgages where a financial institution (typically a bank or credit union) has 2nd lien position on the home. This means that in addition to your original mortgage which is in 1st lien position, or first in line to be paid out when there is a sale, refinance, or other action on the home, there is another mortgage that is on top of the 1st lien note. As 2nd lien position requires the 1st lien position holder to be paid in full before the 2nd lien holder sees a dime, this is seen as higher risk, as such there is more scrutiny during underwriting and may be more difficult to qualify. 

3. Home Equity Line of Credit (HELOC)

A HELOC, or home equity line of credit, is similar to the home equity loan in that it is a 2nd mortgage (home serves as collateral), but a HELOC is a form of revolving debt, like a credit card with simple interest (not amortized). This means that you are able to withdraw money up to an approved limit, using a bank transfer, card or check, repay it and draw it down again within the predefined terms of the loan. As a HELOC is a secured loan, you are able to obtain a lower interest rate than the average credit card (around 22-25%) or personal bank line of credit (typically 8-12%). 

A limitation to the HELOC is the draw schedule, typically 5-10 years, variable interest rate, and the loan to value requirements (e.g. 80-100% LTV). For example, if your house is worth $500,000 and you currently have a $300,000 mortgage balance, you are at a 60% LTV. If a lender decides to limit the LTV to 90%, that means the maximum amount your HELOC can be is $150,000 ( = $500,000 * 90% - $300,000). 

Depending on the usage of the HELOC it may be beneficial to consolidate debt or use the funds to purchase necessary items that otherwise may have carried a higher interest rate (e.g. 20% consumer credit rate vs 5.5% home equity line of credit rate). However, as this line of credit is secured by your home, you want to ensure you have a plan to pay off the debt so that you do not put your primary residence at risk of foreclosure.

In addition to purchases and debt consolidation, savvy investors use a HELOC to purchase a rental property all cash and refinance out their money to pay back the HELOC, or take enough funds for a 20% downpayment on a turnkey property. If the rental property is achieving double digit returns (i.e. 12% conservatively), against a HELOC rate of 5.5%, then you have created a 6.5% spread on the borrowing cost and increased passive income without using any of your own money (read: leverage/other people's money).

In conclusion, before you go out and apply for one of the three aforementioned products, please remember each bank and credit union have different rates and terms as well as conditions (draw schedule, etc.). Further, they will also have different programs that will incentivize a new customer such as paying for closing costs, appraisal, and introductory rates at 1.99% for 6 months. Make sure you watch out for any hidden fees such as annual maintenance fees and draw fees that may build up quickly. There are always risks involved when using other people's money and using debt to create income producing assets, however, if you know your numbers and have a solid plan of repayment, you will be able to scale up your property safely and quickly than other methods.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 021: Due Dilligence - Buy and Hold Rental Property Deal Breakers

Some of my readers have asked me, "what are some deal breakers when it comes to underwriting a real estate investment?" This is a great question and something we all should think about before starting to invest. The reality is, if we do not set standards, we can easily be blinded by the cash flow and satisfying feeling of the hunt, where we start to purchase mediocre deals that produce mediocre results and delay your path to financial freedom.

Real estate is generally inefficient, meaning every property has a price depending on the condition, timing of the market, location, asset class, etc. that could potentially make it a good deal. Sometimes, that number is a negative, meaning the seller would have to take a loss to let go of the property to stop the bleeding. Some people may argue that large CapEx items such as an entire HVAC system, or foundation issues are deal breakers, however, a savvy investor may understand the problem at hand and be able to significantly reduce the acquisition price and the risk involved in the transaction. Other factors, such as increased crime rate and high vacancy are things that are less tangible and will have to be reviewed case by case.

Lets take a look at my top 5 list of real estate deal breakers:

1. Large houses and lots

This was a painful lesson that I learned and relates to my first rental property purchase. This home sat on a huge lot the size of half a football field which I thought was an advantage at the time. I believed that the large lot would attract tenants who wanted privacy as well as room in the backyard for family gatherings. In my situation this resulted in multiple break-ins during vacancies as the house was well-covered by trees and vandals were able to get in undetected by surrounding neighbors. 

Large houses pose a similar dilemma as in my markets, a 3,000 sq foot home does not necessarily command 2x rents compared to a 1,500 sq foot home. However, a larger home means increased reserves as it costs more to replace a larger roof, paint more walls, and replace flooring. On the contrary, I also avoid homes that only have 1 bedroom 1 bath as they typically become rented by transient tenants who often do not renew their lease. As tenant turnover is one of the single biggest cash flow killers to a landlord, I avoid purchasing tiny homes altogether. I have realized that in the Midwest, a conforming 3 bedroom 2 bath home around 1,200-1,600 sq ft is ideal in attracting the type of tenants that stay long term and take care of my property. 

2. High crime/War Zones

As discussed previously, a real estate investor must first decide where they would like to invest - A class, B class, or C/D class neighborhoods. Although each investor may have their own definition of these classes, I incorporate multiple factors such as school ratings, crime rates, median income, and purchase point of the homes. While A class homes are generally in more expensive neighborhoods, have better schooling, and higher median income, it does not necessarily result in a perfect tenant. I have had B class tenants who leave after one year and leave a mess, but I have also had Section 8 tenants in rougher parts of town that renew and take great care of my property. I personally avoid high crime areas as they result in externally driven situations out of my control - such as gang violence, drug related thefts/break-ins, as well as high vacancy/lower comps.

3. Awkward layouts

This is a common deal breaker when speaking with real estate investors. If you have done hundreds of walkthroughs during your real estate careers, you will notice that some homes in one neighborhood all have the same layout and materials, and one street may have 10 different layouts from 10 different developers. This presents an interesting situation as if you come across a house with an awkward layout (e.g. limited access to the kitchen or bathroom, tiny bedrooms, no access to the garage from the inside), this can result in your property staying vacant as tenants will also realize this as a problem.

4. HOA fees & high taxes

I want to start by saying that there are hundreds of investors who have found success investing in condos, townhomes, and even single family residence with HOA fees. Without getting into details of the pros and cons of having HOA fees, I avoid homes with HOA fees as they are typically variable costs that is difficult to account for while calculating your cash flow. As an investor I see this variable as an increased risk that I do not need to take as there are many other types of investments available.  Further I avoid homes with significantly high taxes / tax assessed value as they may be very difficult to contend depending on the local government. Tax assessors may see the value of your home much higher than what you paid for market value, resulting in a negative impact on your cash flow. Do not assume you will be able to lower your taxes with an appraisal as each market is different and may take more time and money that is worth.

5. Shady sellers

As you continue throughout your real estate journey, you will encounter people who are less transparent than others, and people who try to take you for a ride. This last deal breaker is subtle than the others, and you will have to rely on red flags and your gut in determining whether this deal is worth the risk. Through simple google searches, you will find countless stories on real estate deals gone bad and the shady acts of the sellers. These sellers may attempt to pass off a property with a cloudy title in hopes you take the risk, may fail to disclose repairs that were not done to code, and other issues. This is a key reason why due diligence, not falling in love with a deal, is so important. Investors must trust, but verify the responses made by the sellers through an independent inspection, searching of title, and having multiple eyes on the deal. If you catch the seller trying to give you false information, it may be a huge red flag that there is an issue with the property that they are trying to pass onto you. Like the old age saying goes, where there is smoke, there is fire.

Remember that each deal may have its merit and you can potentially find a diamond in the rough. With a little bit of work and negotiation, the potential issue may result in massive equity and gains. However, other factors such as those mentioned above are not easily fixed, and need to be carefully considered before taking the dive and making the purchase.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!