Real Estate 026: The Real Estate Advantage

When comparing different asset classes for investing long term, the most talked about classes that I have found, were stocks, bonds and real estate. Real estate is often viewed as a middle ground between the high volatility of the stock market and the low returns of the bond market. Stocks definitely have their advantages and disadvantages when put head to head against tangible rental real estate (e.g. Not REITs, private lending, notes, etc).

In my opinion, rental real estate is a far better way for the average person to become wealthy and retire early through the various tax advantages and steady cash flow that rental properties provide the landlord. Lets take a look at some of the pros and cons as listed below an discuss the key features:

Stock Market

Advantages

• Liquidity: Stocks are a liquid asset, meaning that it is very easy for an investor to buy or sell parts of their portfolio, if not all, within a couple days (assuming its publicly trade).

• Less work: Investors who typically invest through their retirement account have the option of choosing from a pool of funds pre-selected by the brokerage. This equates to less work in researching the underlying shares within a fund and looking into individual financial statements, their projected earnings, and other metrics.

• Diversification: By investing in stocks, it is easy to pick and choose individual shares (slices of the pie) or purchase funds (whole pies) that have a mix of equity, large cap, small cap, international, and bonds (toppings and flavors) that provide diversification.

Disadvantages

• Short Term Flux: Stocks are known to have extreme fluctuations in a relatively short period of time, and this can negatively impact an investor who is trying to live off of their investments during retirement. Further, for the average investor with limited resources, it is even more difficult to understand the reasoning behind the fluctuations and the internal/external influences that impact the value of a portfolio.

• Market Value: Investments are typically made at market value or the trading price as the market is efficient, meaning that you cannot negotiate a discounted share or find a "distressed company." Although you can study the company and be a prudent investor in what you believe to be undervalued, there is also a chance it can plummet to zero.

• Less control: An investor has the ability to pick their fund or individual stock, but they do not generally have a say in the day to day operations of the company. Shareholders with a significant position can choose the Board of Directors who oversee operations, but for the average investor, they are merely a passive investor that does not have control of the decision-making process.

Real Estate

Advantages

• Tax Benefits: One of the largest benefits enjoyed by real estate owners is the numerous tax benefits currently in the IRS tax code. Write offs can relate to depreciation, maintenance and repairs, business travel & meals, mortgage interest, and many more. Further, you can defer the gains of the sale of one asset through a 1031 exchange into a new property.

• Inefficient Market: The real estate market is inefficient compared to the stock market, and investors will always be able to find distressed property and motivated sellers (e.g. death, divorce, inheritance, exit strategy, etc.). This gives real estate investors the ability to find discounted properties and create equity through hard work.

• Complete Control: With real estate, you are in complete control of the asset in terms of the purchase price, location, rent-to-value, choosing tenants, and exit strategy. You can choose to sell off your asset, 1031 exchange into a larger rental, or seller finance it to a tenant (lease option).

Disadvantages

• Illiquid Asset: Once you have purchased a rental property, it is much more difficult to sell or transfer than a typical stock. Even for an all cash transaction, a typical escrow may take 7-14 days to close due to inspections, and other contingencies.

• More Up-Front Work: Compared to purchasing stock through a fund, real estate requires you to do some research on the market, the team, and the property. With time, you can use your knowledge and streamline different processes or outsource the most of the work, however, getting to that point will require commitment from the investor.

• Tenant Risk: Rental properties have tenants living in the units, as such, comes with added risk unseen in the stock market. You have to be well versed in the local laws and regulations to ensure that you are not exposing yourself to necessary lawsuits and liability.
  

The simply way I view investing in stock vs real estate is by looking at my competitive advantage. For me, I know that there are hundreds of smart, capable people on Wall Street with deep pockets and resources to out perform the average investor. On the flip side, real estate markets are local, meaning what happens in Los Angeles, doesn't necessarily impact Texas the same way, and vice versa. This allows an investor to choose where they want to compete (e.g. single family vs multifamily, A class vs C class neighborhoods, primary markets vs secondary markets) and avoid stiff competition.

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 025: Scaling your Real Estate Portfolio

After meeting with hundreds of real estate investors through BiggerPockets, Real Estate Meetups and Conferences, I have seldom met an investor who does only one deal. The goal is to find a formula that works for you and your goals, and repeat the process enough times to achieve the target passive income. The big question becomes, how does an investor scale from a handful of properties to tens or hundreds of units? I have highlighted four different ways that an investor can scale their portfolio below:

Spend less and invest the difference

This option may seem like a no brainer, but its sometimes easy to be overlooked. As a buy and hold investor, you are in it for the long haul, meaning that you have to be consistently earning more than you spend (I personally suggest you get to a place where you are able to comfortably stash away 40% of your earnings), invest the savings into cash flowing real estate, and repeat the process. Each time you go through this cycle, you should have additional funds from your new rental property to help enhance the velocity of this cycle. One mistake I see investors make, is they begin to inflate their lifestyle along with their newly built portfolio. For example, they may put $25,000 down to purchase a turnkey duplex property in the Midwest that generates $400/month in passive income after all expenses and debt service. They use this $400/month to pay for a new car lease that they wouldn't have bought otherwise. While rewarding yourself is important, this is a risky move as that $400/month cash flow is never 100% guaranteed. Meaning the tenant could stop paying, leading to an eviction and couple months loss of rent before that $400 starts coming in again. During this time, you are left paying the mortgage and expenses related to upkeep of the rental in addition to the new lease payment. You have effectively dug yourself a bigger hole to climb out of.

My advice is to continue living as if you have not creating the additional stream of income. Think of it almost as a 401K or IRA account that is restricted from use. By placing this phantom restrictions on this newly created income, you will be able to reinvest the earnings into your business again and again and exponentially assist in the growth of your portfolio. Lets say you were able to buy 2 rentals a year through this process. By year 5, you have  10 properties that generate $4000/month in passive income, which means that every 6 months, the cash flow from your portfolio alone is enough to purchase another rental so you can buy 4 properties a year instead of 2. This will shorten the growth from 5 to 2 years, and so forth. This is the snowball effect that myself, and many other investors have realized while building their portfolio. I have personally increased my W-2 income by 28% during the growth of my portfolio, reduced my expenses, and did not use the cash flow from my rentals to offset any of my personal living expenses. That way, I was able to allocate nearly 30-40% of my earnings straight into investing for my future.

Private lenders & BRRRR

Another way of building your rental portfolio is through using private lenders.  A private money lender is an investor who makes loans secured by real estate or promissory note, typically charging higher rates than banks but also sometimes making loans that banks would not make (rehab loans), funding more quickly than banks and/or requiring less documentation than banks.  Private money lenders exist because many real estate investors need a quick response and quick funding to secure a deal when looking for a real estate loan. Banks and other institutional lenders that offer the lowest interest rates don’t provide the same combination of speed and transparency in their decision making process, along with quick access to capital. By securing private lenders who will fund 80-90% of the purchase price and/or rehab, you have significantly reduced the amount of capital you need to acquire a new deal. As long as you can find a deal that is "all-in" near 70% of the ARV, then you are able to find a discounted property, renovate it, and force the appreciation (read: sweat equity), that will take place of a normal cash downpayment. You can repeat this property to scale your portfolio, otherwise known as the BRRRR (buy rehab rent refinance repeat) strategy.

HELOC

A HELOC, or home equity line of credit, 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%). Savvy investors will use the equity in their primary residence or rental property to withdraw capital at low interest rates (e.g. 5%) and re-invest the funds into another cash flow rental property (e.g. 15% cash on cash) and make money on the spread, or difference of the return (10%). As you are cash flow positive in this scenario, you can effectively continue this cycle until your HELOC is fully utilized. Be sure that you are investing into a deal has significant upside, as a HELOC typically has variable interest that may jump up and eat into your profits. I personally only use my HELOC on the BRRRR strategy as I have a exit strategy (re-finance) and pay off my HELOC balance in less than 6 months, reducing my overall risk to variable interest.

Partnerships

Whether your expertise is in finding good deals, underwriting potential leads, or bringing the capital to fund the deals, each investor that you meet may be a potential partner. If you find someone who has complimentary skills, you may consider bringing them on as an equity partner. I have personally bought 4 units together with an equity partner and there are multiple benefits such as pooling of resources, increased capital, and diversification of risk. Lets say that you are great at marketing, and can find distressed properties from motivated sellers for 20-40 cents on the dollar. This is a huge value add for an investor who has capital but does not have time to conduct direct mail campaigns or call motivated sellers for screening. By teaming up with each other, you are able to take down a property with significant upside and refinance once the rehab is complete to allow each of the partners to recoup their initial investment and/or create equity that would otherwise be unavailable had they chosen to work as separate individuals.

These are the four ways that have allowed me to purchase 12 units in about 1 year, and as you continue gaining experience, you will learn to add more tools to your tool belt such as seller financing, subject to, and other methods that allow you to scale by being a little creative. There is more than one way to invest in real estate, so find a way that works best to meet your goals. As mentioned above, it may feel as if $400/month is not life changing, however, the steps that you took and knowledge gained to increase your passive income IS. These small changes and building blocks will be the foundation that will eventually lead you to create thousands of dollars in passive cash flow a month and achieve financial freedom years.

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 024: Rental Property Insurance

One of the most important things that I have learned as a Real Estate Investor is risk mitigation. One of the ways to mitigate risk, both tenant related vs external, is to maintain proper insurance. When you are financing a rental property, a conventional lender, if not all, will require that you maintain a certain level of insurance to protect their loan. However, even cash investors should consider purchasing adequate insurance as it will be an additional line of defense between you and the liability. 

According to my insurance broker,  owner occupied insurance is underwritten differently compared to non-owner occupied, or rental property insurance. Non-owner occupied properties have different types of exposures in regard to liability as a result of the tenant. Further, there may be break-ins to the property during rehabs or vacancies that require additional consideration when understanding coverage. There are two types of policies when it comes to insurance, actual cash value and replacement cost. Lets take a deeper dive into each of these topics further below:

Actual Cash Value

Also known as the "fair market value", is what an insurance company would consider the replacement cost of the property - depreciation. It represents the actual dollar amount you would expect to receive for the item if you were to sell it on the market. Actual cash value policies are typically cheaper than its counterpart, replacement costs, however you may be placed in a tricky situation when trying to rebuild from a covered peril, such as fire damage, as it may cost significantly more to reconstruct a home than what you would be receiving from the insurance company after depreciation. This type of insurance may be beneficial for investors who are purchasing homes at a significant discount (e.g. $32/sq ft) but replacement cost at current market rates to rebuild may be $80/sq ft. In these situations, it may behoove the investor to cut their losses and take a cheaper policy, knowing that they will not be able to rebuild in case of major damages.

Replacement Cost Value (RCV)

Replacement cost insurance means that you are insuring the property for the amount to rebuild the property like new. In a situation where you have a total loss (e.g. fire burned down your building), your insurance provider will cut you a check to repair or rebuild the property. It is considered to be superior to the ACV as it puts the owner back into the same position prior to the covered peril. Typically, the replacement cost coverage is based on a formula on the sq footage of your home, location, and type of home, and can be adjusted by the investor to increase coverage based on the condition of the property. However, note that some insurance policies include a cap to the amount of replacement cost coverage, so be sure to check with your insurance broker. Although the premiums may be slightly higher than ACV, RCV policies provide enhanced coverage for the average real estate investor.

Types of coverage

Once you have determined between Actual Cash Value and Replacement Cost Value, the next step is to determine your carrier will provide necessary coverage:

Dwelling Coverage

Similar to homeowners insurance, rental property insurance covers physical damage to your dwelling, meaning damage to the structure of the home or apartment itself. For example, it will cover damage to your your walls and your roof, but not personal items of your tenant. Coverage will only extend to damage caused by a covered peril, and you should make sure to understand what type of perils, such as fire or lightning damage, are covered by your particular policy.

Liability & Medical Coverage

Liability and medical coverage will protect you from the legal and medical costs associated with someone being injured on your rental property. If your tenant or a visitor is injured on your property, and you are deemed responsible for the injury, rental property insurance can cover these costs up to your policy limits. If you're someone for whom the limits of this coverage are not sufficient to cover potential liabilities and you wish to increase your coverage, you could also purchase umbrella insurance for your rental property.

Loss of Rent Coverage

Loss of rents coverage provides protection against lost rent payments if the property you rent is uninhabitable due to a covered peril. For example, If the tenant is forced to move out as a result of a covered peril, a fire burns down the kitchen and living room and the tenant physically can’t inhabit their property, the insurance company would pay the monthly rent until the home is reconstructed back to a habitable condition. Coverage will generally extend up to a defined period of time, such as 12 months. Loss of rental income does not always come standard with rental property insurance, so you should check your policy before purchasing it if this type of coverage is important to you.

Personal Property 

Personal Property coverage provides protection against the loss of damages or theft to your personal property inside the home and vehicle.

Perils (Examples):

Building Ordinance/Law, Loss of Rents, Fire & Lightning, Vandalism & Malicious Mischief, Falling Objects, Weight of Ice, Snow, or Sleet, Theft, Windstorm or Hail, Mold, Power Failure, Water Damage (Sewers/Drains), Earthquakes.

Whichever method you decide to pursue, make sure that you are getting adequate coverage to protect your interests in the property. Although we hope for the best, insurance is there to protect us when unforeseen damages or liability occur. 

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!