Ten Commandments for Real Estate Investors: Commandment #9

Posted on May 13, 2012 by Frank Gallinelli

Commandment #9:  Thou shalt not expect something for nothing.

“There is no such thing as a free lunch.” “If it looks too good to be true…, etc.”

You have heard these truisms many times. I’ve reserved a place of honor for them in my upcoming “Encyclopedia of Clichés.” Just because something is a well-worn bromide, however, doesn’t mean it isn’t true, and sometimes we can look right past its importance because we assume it should be obvious.

Our rational selves all recognize that virtually everything has a cost, even things that are free.  “Call now for our free report about investing in gold! (or about mortgage modification or crabgrass prevention).” Translation: Give us your telephone number so we can hound you relentlessly until you buy something from us.

When a guy in a brightly colored checkered sport jacket tells you something is free or involves no obligation, you suspect immediately that you are being scammed. It is when the “great deal” is dressed up more subtly that you may miss what’s really at work.

I’ve seen such illusory great deals cloud the minds of investors, and I talk about this in my grad school classes in real estate investment analysis. One example that I use is the case of a seller who is providing extremely generous owner financing: very low rate with interest-only for an extended period. Should you assume that he’s doing this because he likes you? If not, then you ought to be looking for what element of self-interest is motivating him and whether or not you are paying for his generosity in some other way.

Perhaps the low initial debt service will improve your cash flow as a prospective new owner, and the seller expects that benefit to serve as a smoke screen of sorts, inducing you to look more kindly on what is actually an inflated purchase price. As a side benefit to him, maybe he is also thinking that he will shift some of his overall profit from what he would get by charging higher interest on the financing, taxed at ordinary income rates, to capital gain taxed (at least as I write this) at a lower rate.

In short, you need to look behind the “great deal” and work your way deeper into its implications for you as the investor. Will you really have an acceptable long-term return? If a life emergency forced you to re-sell this property soon, would a new buyer who requires financing on more conventional terms be willing to pay as much as you just did?

Or perhaps the deeper meaning in this example is simply that the owner is offering these terms because he really has to sell this building as quickly as possible. Can you use that insight to your advantage and negotiate to get the attractive financing as well as a lower price? Get the worm but not the hook?

Another example I use in my classes concerns a commercial property that has a vacancy in one of its six retail spaces. To offset your reluctance to buy, the seller makes this proposition: “I will guarantee the rent for that space for a full year at $x per square foot. Run your numbers and you will see that my asking price makes good sense and provides you with an excellent return.” (an aside: $x/sf is at the high end of reasonable rent for that space.)

It sounds good. Maybe too good, and that’s when your alarm bells need to clang. You pause for breath, think a bit harder, and then realize that another way of looking at this is that the seller has effectively offered you a price reduction equal to the amount of one year’s rent for that space. You need to ask yourself if that concession materially changes the risk associated with this deal.  Does this disguised price reduction compensate you adequately for the risk you’re assuming? Can you eventually rent the space for $x dollars?  Has there been a problem getting or keeping tenants in the past, either for this space or for the entire property? Is this proposition a creative solution to a temporary vacancy, or is the seller trying to kick the proverbial can down the road and leave you to figure out what to do about this property’s chronic vacancy?

The  could be a creative solution to a short-term problem, or it could be smoke and mirrors to hide a long-term difficulty. If this offer is nothing more than a price reduction, then perhaps you would choose to forget about rent guarantees and prefer instead to negotiate your own idea of an appropriate lower price, one that is more in concert with the actual degree of risk you see in this property.

So what is the takeaway from our ninth and penultimate commandment? In real estate dealmaking, there is seldom, if ever, anything offered that doesn’t have a cost of some sort, or a string attached. Your job is to identify that cost, follow that string. It’s not necessarily the case that anything underhanded is going on, although there may be a fine line at times between smart negotiating and subterfuge; but, in any case, you need to look beyond the outward appearance of what’s being offered and try to discover the motive behind it.

Ulterior, or otherwise.

A Postscript – (Can a post have a postscript?)

Before you conclude that I am a jaundiced, suspicious, disagreeable curmudgeon (and despite the fact that your conclusion strays not far from the truth), let me suggest that perhaps not every open hand portends a slap in the face. In an industry that is predominantly a zero-sum game, there are still those who are willing to be helpful without sending an invoice. I am of course not talking about the snake-oil salesmen and pay-to-play mentors I complained of in Commandment #6, but rather about those experienced investors and other real estate professionals who will actually – and willingly – share some of their expertise.

Several times in my posts and newsletters I’ve mentioned the forums at BiggerPockets.com as an example of this sort of knowledge exchange done right. (FYI, I have no financial or other inside interest in BP. Just a fan.) It works because it’s essentially a non-commercialized, pay-it-forward culture. I’ll answer your question, and someone else with a different specialization will answer mine.

There is a cost – there is always a cost – but in this case I believe it’s simply the implied obligation to be helpful if you’ve been helped. Pretty low-impact in an industry otherwise infested with high-priced, low-value gurus. And maybe some meaningful business will percolate up from the bottom of all this socialization. Just don’t let Groucho Marx join. As he famously remarked, “I don’t care to belong to any club that will have me as a member.”

Come back soon for Commandment #10

Previously: Ten Commandments for Real Estate Investors: Commandment #8

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

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Ten Commandments for Real Estate Investors: Commandment #8

Posted on May 2, 2012 by Frank Gallinelli

Commandment #8: Honor Thy Broker and Lawyer.

“I can do it myself!”

These are the words that I would hear from my grandson when, as a toddler, he would try to pour juice from a large container into a cup. Grownups aren’t much different. It is a well-documented fact that no one of my gender will ever ask for directions. I’m not lost. I can find it myself.

Most of us (with the possible exception of investment bankers receiving TARP money) value our independence, self-sufficiency and self-reliance. Investors generally possess an independent and entrepreneurial spirit, so it is not surprising that they are at times reluctant to rely on brokers or lawyers to handle matters that they believe they can manage on their own – and at a lesser cost. Indeed, there are some situations you can take care of yourself, while others are best left to specialists.  The trick is recognizing the difference.

Your thinking may depend upon whether you invest in residential or non-residential (aka commercial) property. Let’s look at each separately.


Residential Property Investors

Using Brokers:

It is no secret that the Internet is changing the role of the residential real estate agent. Agents no longer have a near monopoly on information about single-family homes for sale. A survey by the National Association of Realtors® suggests that 88% of homebuyers search the Internet for properties. This kind of public access to information would have been unthinkable when I entered the real estate business in the 1970s. Then, the coveted multiple listing book was the only comprehensive source of information and was available only to agents.

So, if you’re a buyer of single-family properties, you should be able to accomplish most of your discovery on your own. Selling, however, is another matter. I won’t recite all of the justifications a well-trained agent will give you for using his or her services except to say that many of them are true. At the very least, selling a property is a labor-intensive undertaking, and after the dust settles you may not be much better off financially for having done the work yourself.

Using Lawyers:

Landlord-tenant relationships can be challenging for those who rent out residential property. It’s foolish not to have a written lease agreement to govern such a relationship – but do you need a lawyer to draft one? The short answer is yes. An off-the-shelf or do-it-yourself lease can prove dangerously inadequate. Every state has some type of landlord-tenant statute, and several cities have their own additional regulations. For example, some may require the lease to be in “plain language.” Speaking of language, most courts (if you have the misfortune to end up there) will interpret any ambiguous lease language in favor of the residential tenant. Their reasoning is that you, the landlord, produced the lease, so it was your responsibility to make it’s meaning clear.

How you handle funds can also have legal ramifications.  Most states have specific and detailed rules governing security deposits. What is the maximum amount you can take? Must you keep deposits in a separate escrow account? Do you have to pay interest, and if so, how much and when? How soon must you return a deposit after the end of the lease, and how must you document amounts withheld?

If your leases and security-deposit procedures are not in conformity with the rules of your jurisdiction you can end up with some nasty surprises, such as unenforceable lease terms and triple damages in the event of dispute.

Your best approach is to use an attorney who is familiar with landlord-tenant issues in your city and state to give you initial guidance and to draft a lease that is appropriate for your particular situation. You may need some provisions that are specific to a certain property type. For example, when renting single-family house, is the owner required to keep the water bill in his or her name? Who is responsible for exterior issues like snow removal or lawn cutting?

Once you have a suitable lease, then you can usually feel comfortable cloning that document for use with other tenants in the same or similar properties. Still, laws change so you should keep your ear to the legislative ground, or at least ask your lawyer to do so for you.

Commercial Property

Using Brokers:

The world of commercial property presents a challenge that is quite different from that of residential.  Yes, there are some national commercial databases like CoStar and LoopNet. (At this writing, the former has apparently just won U.S. antitrust approval to buy the latter.) In general, however, there is a great deal of information about commercial property that you cannot get by clicking a mouse, and so the role of the broker is often paramount.

Anyone who has tried to sell anything fully understands the need for exposure, but owners of commercial property also recognize the need for discretion. Most commercial properties house businesses – offices, retail stores, service establishments.  Putting a “For Sale” sign on a building, a “For Lease” sign in a store window, or an advertisement in a newspaper can have a serious negative impact on the businesses in that building. Even if all concerned agree that it is acceptable to make the availability of a building or a leasehold public, they may still be reluctant to reveal underlying financial data to anyone other than a bona fide prospective buyer or tenant. In short, commercial property is not an open book.

Hence, unless you have a substantial network of your own, you should not underestimate the benefit of using a  commercial broker and his or her network of investor and business contacts to get the word out to legitimate prospects. Likewise, buyers and tenants can use the broker as a primary source of information about available properties.

Commercial property brokerage is different from single-family home sales in yet another way. If you walk up to a house, knock on the door and say, “Sell me your house,” you generally won’t get an enthusiastic reception. Does the number “911″ spring to mind? If the homeowners weren’t already thinking about packing up their stuff, pulling their kids out of school and relocating to a different district, then your surprise visit probably won’t get them to do so. (Before you raise your hand to make a comment, I know what’s on your mind. Yes, in today’s hundred-year-storm market with so many homes underwater, you just might find someone anxious to take you up on this; but in general and certainly in more normal times, it’s a long shot.)

On the other hand, a good commercial broker should be aware of properties that are not currently listed for sale, but whose owners would let the broker “knock on their door,” i.e., give the broker an open listing in order to entertain a realistic proposal.   Information about such properties is part of the commercial broker’s stock in trade.

Using Lawyers:

Commercial leases typically differ from residential in a number of important ways:

  • They often involve greater dollar amounts, especially over the full term of the lease.
  • The lease term is usually longer and may contain interim increases in rent, as well as options to renew.
  • While there may be some standard covenants, commercial leases are more complex, seldom cookie-cutter, and often the product of paragraph-by-paragraph negotiation.

If the first two reasons don’t convince you to use an experienced attorney, then the last one certainly should. I always thought I was pretty good at doing this sort of thing on my own until I needed to negotiate a lease with a national tenant.  There was nothing at all simple or straightforward about the process, and the dollars involved were too great to risk making a mistake. Even though I had already negotiated the general terms of the agreement, the devil, so the saying goes, was in the details. So get an angel, or at least a good lawyer, to sit on your shoulder.

 

Come back soon for Commandment #9

Previously: Ten Commandments for Real Estate Investors: Commandment #7

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

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Ten Commandments for Real Estate Investors: Commandment #7

Posted on April 25, 2012 by Frank Gallinelli

Commandment #7: Thou shalt do the math.

Among the many famous quips of H. L. Mencken was this: “For every complex problem there is an answer that is clear, simple, and wrong.”

Novice real estate investors – indeed, probably novices in almost anything – long for simplicity.  A simple approach is fine if it leads to meaningful and reliable results; but most real estate investments involve serious money and so they deserve a more serious and detailed plan of attack.

Investing in real estate is all about the numbers. I rail about this in my books and articles, and in the classes I teach – from continuing ed through grad school finance.  The point I try to make in all of these is that you, as an investor, are not really buying a building, despite what your closing attorney says. You are buying an income stream, the present and future cash flows.

This is very different from the reasoning you use when buying or selling a single-family home. There you look at market data, so-called “comparable sales.”  If other houses similar to this one and in this same neighborhood sold recently for $400,000, then this house also should be worth about $400,000.  On the other hand, two office buildings, similar in size and style and in the same general location, could have very dissimilar leases and thus have very different income streams. Their physical similarities notwithstanding, they would then command different values and probably perform differently as investments.  The only way you would recognize the differences would be to do the math, i.e., run projections of their income streams.

Many potential investors I encounter, and some active investors as well, believe that they really don’t need to do any heavy mathematical lifting at all. Simple and familiar chestnuts are good enough: “As long as I can finance 100% of this deal, I’ll buy it.”  “Any apartment building that costs me less than $20k per unit will make money.” “I only want a property if I can get it for less then seven times the gross rent.”

To be sure, in a given market at a given moment, you might occasionally survive using guidelines like these. For example, if you have enough data on a particular market to identify an appropriate multiplier, then “x times the gross rent” might yield an approximate measure of value for a two- to four-family rental property. For most income-property investments, however, oversimplification seriously diminishes your understanding of a property’s financial dynamics and your chances of success.

What kind of financial work-up do you need to do in order to make an informed decision about buying, selling or financing a particular income property? A proper answer to that requires a good deal more depth than one can fit into a blog post, but the short answer is that you want to do a pro forma analysis going out at least seven to ten years and possibly more. It needs to deal with projections of revenue, vacancy, operating expenses, Net Operating Income, debt service, cash flows, resale value, sale proceeds, and Internal Rate of Return.

To be a bit more specific:

    • Start, as always, with your due diligence. Obtain an accurate current rent roll and a list of current operating expenses. Investigate what similar units are renting for in this location, and how much vacant space is on the market. Find out what the prevailing capitalization rate is for properties of this type.
    • Build an Annual Property Operating Data form (aka “APOD”), showing revenue, vacancy allowance, operating expenses, and Net Operating Income (revenue minus vacancy minus opex). Project these amounts as you think they might grow or decline over your investment timeline. Try a set of best-case, worst-case, and intermediate assumptions.  Here is an example of an extended APOD (this and the others below are screenshots from my company’s investment analysis software):

APOD

 

    • Estimate your annual debt service from all mortgages and subtract that from the property’s Net Operating Income to get your projected cash flow. Add or subtract any other items that might represent a cash inflow or outflow, such as money spent on capital improvements or leasing commissions. If the annual cash flows are minimal or negative, tear up your papers and go play a round of golf instead. Or maybe try to find a lower price at which the property will throw off a positive cash flow.  Here is an example of a detailed cash flow analysis:

Cash Flow Analysis

      • Estimate the resale value of the property by applying a capitalization rate to the projected Net Operating Income in future years. You can use the current market cap rate; or you can use one that is a bit lower or higher if you believe the market will improve or decline in the future.

 

    • Estimate your proceeds from sale of the property by taking its resale value and subtracting all mortgage balances and any expected costs of sale, such as a broker’s commission. Take back any cash you’re holding in reserve. These sale proceeds are really your final cash flow.  Here is an example of a resale analysis with IRR:

Resale and Rate of Return Analysis

There is nothing glamorous about doing the math, and for many people it is probably a chore; but as I’ve emphasized several times in this series of “commandments,” investing is a goal-driven enterprise where you need to identify your specific objectives and map a course to reach them. Whenever you invest, you expect a return on your invested capital. If you don’t run projections like these then you won’t really know what kind of income stream this property might produce, and whether or not that income stream can give you the return on your investment that you’re trying to achieve.  It can be an effort to do the math, but it’s a lot better than going off a cliff with a bad deal.

Come back soon for Commandment #8

Previously: Ten Commandments for Real Estate Investors: Commandment #6

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

 

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Ten Commandments for Real Estate Investors: Commandment #6

Posted on April 24, 2012 by Frank Gallinelli

Commandment #6: Thou shalt put no gurus ahead of your common sense and sound judgment.

No cash? No credit? No experience? No time?

All of us have hopes and dreams. It’s part of being human. It’s probably part of being anything that’s alive.  I’ll bet even plankton have hopes and dreams.

There is no shame in aspiring to a more rewarding life. The shame occurs when scam artists attempt to enrich themselves by preying on the hopes of others. These miscreants don’t typically try to dupe people of means; they target those who may be underemployed or in debt or just finding it difficult to make ends meet. They try to capitalize on desperation, probing to find those whose otherwise good sense has been clouded by financial difficulty.

They’re not educators. They’re not financial geniuses. They’re salesmen, selling smoke and mirrors. “Pay me, and I’ll show you how to get rich quickly.”

I’m painting with a pretty broad brush here. To be sure, there are authors and speakers who provide useful and responsible advice.  Unfortunately, they seem to be in the minority. For whatever reason, the real estate industry appears to have become a petri dish for growing a money-devouring bacterium called the guru.

There are some telltale signs that characterize this type of guru.  If you watch out for these, you can defend your credit card from being levitated out of your wallet:

  • Their content is primarily motivational. You’ll hear a lot of “Believe in yourself,” “Have the courage to act,” and my personal favorite, “Anyone can do it.” If anyone could do it, everyone would.
  • They want to upsell you.  You’re attending a free presentation; then you get a hard sell for expensive DVDs (used to be tapes) or a multi-day “boot camp” for thousands of dollars.  There is generally a special price that ends when you leave the room.
  • No cash, no time, no worries.  They want you to think you can succeed while having no skin in the game. You’ll hear a lot about “no money down” and “work in your spare time.” Yes, investors do make deals with 100% financing but you need to understand how to evaluate those deals. They can turn bad quickly.
  • Rich as Croesus.  You’ll hear lots of talk about achieving extreme wealth and the good life. Some investors actually do, of course. And some people win the lottery.
  • Nothing ever goes wrong. It’s all sweetness and light, and we wouldn’t want to spoil the sugar high by suggesting that something might not work out. Guru presentations often spend little time discussing pitfalls. Ask any successful investor if he or she has ever had an unsuccessful investment. You need to learn from their mistakes as well as their successes. A good teacher will show you how to recognize potential problems when you analyze a property.
  • Have I got a deal for you.  Some gurus actually promise to find deals for you – for a fee, of course. Think about it. What successful investor would give away a promising investment opportunity for a few thousand dollars?
  • Words, words, words.  In addition to some of the terminology mentioned above, your antennae should start to quiver when you hear things like “make a killing,” “gold mine” and “risk free.” The more outrageous the vocabulary, the less likely it is to be true.

Are there better ways to learn about real estate investing?

  • Books and book reviews.  There are academic texts on real estate investment and finance as well as trade books that don’t devolve into motivational hype. For the trade books, you can read the reviews on Amazon to seek out those books that readers describe as having useful content with no fluff. (I’m being coy here about my own books, which enjoy many such reviews by readers, but you’ll find other excellent books as well.)
  • Classes and courses.  You can eschew the guru extravaganzas and opt instead for classes that have credible sponsorship.  Most real estate boards give continuing education classes and many include topics related to real estate investment. The CCIM Institute, part of the National Association of Realtors®, has offered intensive courses in commercial and investment real estate for several decades. Local community colleges and adult education programs may also offer classes in real estate and finance.
  • Real Estate Special Interest Organizations. Social media has made it easier for investors to communicate and to help one another. Perhaps the best example for real estate investors is BiggerPockets.com. It is almost entirely education-oriented and has a rapidly growing membership – I believe 85,000 at last count. They have very active forums on a wide range of topics, where novice investors can feel free to ask questions and actually count on getting helpful replies with no sales pitch. As Yogi Berra once said, “You can observe a lot just by watching.” In this case, you can learn a lot just by reading the forums, blogs and member-posted articles.You’ll also find special interest groups on a variety of real estate specialties at LinkedIn.

Our takeaway from Commandment #5? The only person who is likely to make money from a get-rich-quick scheme is the person serving up the humbug.  Ignore the magic tricks and the shortcuts. The “secret” to success has always been the same: solid education and hard work.

Come back soon for Commandment #7

Previously: Ten Commandments for Real Estate Investors: Commandment #5

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

 

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Ten Commandments for Real Estate Investors: Commandment #5

Posted on April 22, 2012 by Frank Gallinelli

Commandment #5: Thou shalt treat your property as you would have your tenants treat it.

If property owners and managers could adopt one rule as golden, it should be this: “Treat your property as you would have your tenants treat it.” You really can’t expect your tenants to show greater concern about the welfare of your property than you yourself show. If you set high standards for yourself as the owner, then you set the tone for everyone and should be entitled to expect that your tenants will meet those same standards of care.

On the other hand, if you behave like a slumlord, then it’s a virtual certainty that you’ll get what you deserve – and it won’t be pretty.  After all, if you don’t care what happens to your property, why should anyone else?

You may argue that this principle is idealistic. There are, of course, no guarantees that by following this rule you will inspire every one of your tenants to behave responsibly. In real estate as in real life, there are always some people who will disappoint you.

Similarly, you will always encounter those tenants whose expectations are unrealistic, so I am not suggesting that you become obsessive about catering to frivolous complaints. When a tenant calls to say that one (and only one) outlet in a room no longer functions, I don’t rush to summon an electrician but at the same time I resist, with difficulty, the temptation to be dismissive. I first suggest that they take a working lamp from another room and plug it in as a test. The eventual response is usually something like, “Sorry, I guess what really happened is my stereo died.” But if the problem turns out to be real, then it’s not frivolous after all and deserves attention. Just don’t tell the tenant to string an extension cord across the room.

It’s unfortunate to see owners who view the landlord-tenant relationship as a blood sport, and who take pride in believing they will save money by deferring maintenance.  Such owners apparently see tenants as innately destructive and see money spent on maintenance as money wasted.

What to do? If I may be permitted to quote from one of my own books, “If something is broken, fix it. If something is dirty, clean it up. If something is dangerous, make it safe. You can be certain that very few tenants will put forward any special effort to take care of the property if your attitude is one of neglect.”

The words “ethical” and “responsible” should not seem out of place if they appear in the same sentence with the word “landlord.” Virtue, so goes the saying, is its own reward; but that doesn’t necessarily mean it has to be the only reward.  The moral high ground is a nice place from which to view the world, but the property owner can see some practical benefits from there as well.  Consider:

You have a competitive advantage and thus can ask for the top rents in a given market. You do not have to discount your rents because your building or grounds or individual units look shabby compared to others in that market. When you’re the best, you can ask the most.

You can minimize vacancy. Your reputation as someone who cares about his or her property and who keeps it in first-rate condition is better than any newspaper advertisement. You’ll gain new tenants as referrals from past and current tenants.

You can minimize turnover.  Dissatisfaction with a property’s condition and management is one of the chief reasons that tenants leave. Stable occupancy typically results in stable cash flow.

You can attract and retain good tenants.  If you and your property have a reputation as a first-class operation, you will attract and keep tenants who respect and appreciate that management style. You are also likely to discourage potential tenants who would prefer renting from an owner who is conspicuous by his absence. If you have tenants who appreciate your product for its quality, then you should encounter the fewest landlord-tenant conflicts.

To recycle an old cliché, you can do well by doing good.

Come back soon for Commandment #6

Previously: Ten Commandments for Real Estate Investors: Commandment #4

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

 

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Ten Commandments for Real Estate Investors: Commandment #4

Posted on April 15, 2012 by Frank Gallinelli

Commandment #4: Thou shalt not lose sight of your investment objectives.

As you know, the shin bone’s connected to the knee bone, and the knee bone’s connected to the thigh bone.

You may find a similar taxonomy in the field of real estate, where your personal and financial circumstances are connected to your investment objectives, and those in turn are connected to your investment choices. Unfortunately, many investors fail to make or even to think about these connections; but, of course, they should. What might your options be?

It’s simplistic and not particularly helpful to say that your objective is to make money. That’s a bit like saying your personal objective today is to continue breathing. You need to bring greater clarity and specificity to the process. Let’s indulge in a thought experiment. Consider some possible objectives you might have, and the type of property those objectives might draw you toward:

  1. Your objective is to begin quickly to build substantial wealth; you recognize that great reward implies great risk and typically involves a significant commitment of time and personal effort.
  2. Your objective is to build wealth slowly, with a horizon of anywhere from ten to thirty years.
  3. Your objective is supplement your regular income with a steady and growing cash flow from your investment property.
  4. Your objective is to diversify your investment portfolio with real estate that provides a modest but stable cash flow, and requires minimal commitment of personal involvement.

I do not want to suggest trafficking in stereotypes, but let’s hypothesize on who these investors could be and what kinds of property they might seek out:

The person with objective #1 doesn’t consider herself an investor at all, but more of an entrepreneur. Her goal is to build a full-time business. This person might rehab or flip houses, or choose to develop a condo project or perhaps a commercial building in the central business district. She might buy a piece of land, slog through the process of subdividing, and sell off lots or spec houses.

The second person might be an income-property investor with a very specific goal in mind. He may have small children and wants to build up a nest egg to pay those gazillion-dollar tuition bills ten or fifteen years down the road. He may be thinking about his own retirement thirty or more years hence. If we’re guessing right so far, then he probably is not looking at real estate as a career; so he could choose to buy income property that has a good upside but requires just a part-time commitment in regard to his personal involvement. A few multi-family houses or an apartment building with decent cash flow might meet his objectives. Likewise, a strip shopping center in a good location could suit his needs.

Our third investor is looking for current cash flow, and that would seem to imply a willingness to devote a bit more hands-on effort to maximize revenue and to stay on top of expenses. Residential property typically has shorter leases than commercial, and so offers more opportunities to enhance the income stream. An apartment or mixed-use building might be the investment of choice for this person.

Our final investor seems willing to trade off maximum return in exchange for least volatility and lowest-impact management. This could be a good addition to anyone’s portfolio, but might have particular appeal to a person nearing retirement. A triple-net-leased property could be a good choice here. The lease is typically long term with the tenant responsible for most if not all expenses. (Some landlords will retain responsibility for some exterior aspects of the building.) Hence, the cash flow tends to be stable and the management responsibilities minimal.

You should recognize that the purpose of this exercise is not to “profile” investors or to provide a prescription for who should buy what type of property. If anything, it should provide a template for how to think about your investment choices: First, assess your personal and financial circumstances. Next, given those circumstances, decide what your objective is – what you’re trying to accomplish with your investing or with your entrepreneurial plunge into real estate. Then, identify the type of properties or real estate activity that’s most likely to square up with your objective.

Finally, keep in mind that change is the greatest constant. Your personal circumstances will certainly change at some point, and so will your investment objectives. The kids are out of college. Make a new plan.

There is a well-known paraphrase of a famous passage from Lewis Carroll’s Alice in Wonderland: “If you don’t know where you’re going, any road will get you there.” In real estate investing, as in Wonderland, it’s essential to keep your destination in mind.

Come back soon for Commandment #5

Previously: Ten Commandments for Real Estate Investors: Commandment #3

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

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Ten Commandments for Real Estate Investors: Commandment #3

Posted on April 7, 2012 by Frank Gallinelli

Commandment #3: Thou shalt invest for the long term.

I have no problem with the idea of getting rich quickly. If you can do it, ethically, legally and honorably, then please go right ahead.

However, there are a number of ways to make money in real estate, and I believe there is some value in differentiating among them.  The differences, you may say, are semantic, but that’s all right.  Words convey meaning, and meaning reveals purpose.

Rehabbing houses is one way to make money in real estate. Rehabbing is a business. You acquire inventory, add value, mark it up, and sell for a profit, all in a relatively short time.

Flipping houses is a speculative endeavor. You acquire inventory at what you believe is a significant discount below market, mark it up to what you believe is the true market value, and again expect to sell for a profit.  You can make a great amount quickly, but all speculation is risky because the market can go down as well as up. If it does you can be stuck with unsold inventory and high carrying costs. Remember that Ford Edsel franchise you bought in 1958?

Getting rich slowly, aka investing, is another approach. It doesn’t have to be to the exclusion of other ways of making money.  You can be a stock day-trader and still have a mutual fund account. You can be a rehabber or flipper, and also an investor.

Back to our semantics. I look at an investment this way:

An investment is the commitment of capital, time and effort in the expectation that it will throw off future income and grow in value. Issues accompanying most real estate investments include cash required, leverage, degree of risk, rate of return, liquidity and the ongoing commitment of time and effort (i.e., management).

When you acquire income-producing real estate as an investment, your mindset should be long term. By that I mean holding on to a property for at least several years and perhaps even many years. Your goal is to have an ongoing and growing cash flow from the property. As the income stream increases over time, the value of the property should increase along with it. If you can be proactive about enhancing that income stream, then you can literally create equity.

Leverage makes it possible for you to acquire an asset whose growth in value over time is disproportionate to the cash you invest. An income-property investment does not offer the liquidity of a stock investment, but that may counterintuitively work to your advantage. How many times have you seen a stock investor panic during a downturn, and sell at the bottom of a market? Your longer time horizon as a “buy and hold” investor means you are less vulnerable to market volativity. With a decent cash flow and a little discipline, you can ride out the economic cycles that invariably occur, and choose to sell when it is to your advantage.  Time, to paraphrase Mick Jagger, is on your side.

Come back soon for Commandment #4

Previously: Commandment #2: Thous Shalt Be Clear.

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

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Ten Commandments for Real Estate Investors: Commandment #2

Posted on April 5, 2012 by Frank Gallinelli

Commandment #2: Thou shalt be clear.

“I want to make something perfectly clear.”

How many times have you heard someone say that? Parents say it, trying to get a message past their kids’ MP3 players.  Politicians say it, signalling the impending arrival of a dense, rolling smoke screen.  Real estate investors ought to say it much more, and mean it.

And so our second commandment addresses an issue that is essential for all investors: Clarity.  The need for clarity is important not only in regard to your own personal objectives, but also in how you communicate with other parties in a transaction. I invite you to read a longer article that I’ve written on this subject, but for now, just some high points:

When you analyze an investment opportunity, you usually do so first to decide if you want to go forward and, if so, on what terms.  You need to be clear about your overall investment objectives (more about that in another “commandment”) so that you’ll have some rational basis for a decision.  Do you have a rate-of-return target, a required cash flow, a goal for growth in value?

Presumably, you’ll do some sort of financial analysis to get to that decision, and if you choose to go forward with the deal, your next task may very well be to “sell” your point of view to a third party. You need to be clear about your objective here as well so that you can tailor your presentation to be appropriate for your intended audience. Are you trying to convince the seller that your offer is reasonable? Trying to make your case with a lender to provide the financing? Looking to attract an equity partner to invest along with you?

Different parties will want to focus on different issues. For example, if your purpose is to get financing, you want to be sure that your presentation clearly shows items that a lender wants to see – for example, Debt Coverage Ratio and cash flow. If you’re soliciting an equity partner, it’s essential that you can demonstrate not only that the property makes economic sense in general, but also that your proposed allocation of partnership benefits – cash flow, preferred return, sales proceeds – holds out hope of a suitable return for the partner.

When you start to build your case, you need to be clear and precise in your use of terminology. I have often seen the misuse of terms that have very specific meaning to real estate professionals – “operating expense,” “NOI,” and “cap rate” to cite some of the more common examples of scrambled usage. Nothing can ruin your credibility and sink your deal faster than the improper use of terminology.

Finally, your actual presentation – pro forma or other financial workup – also requires clarity. You can’t expect other parties to a transaction to accept your analysis of a deal if you present them with a disorganized jumble of numbers.  Even if you have all the right calculations and all the right data, it’s of little value if your recipient has to go on a scavenger hunt, struggling to find the key information.

Your takeaway here should be this:  You must first be clear about your own personal objectives when you consider a potential investment property. Then, when you decide to move forward, you need to convey your analysis of the deal in terms that are accurate and unambiguous, and that will provide your target audience with exactly the information they need in a format they can understand.  Clarity trumps fog every time.

Come back soon for Commandment #3

Previously: Commandment #1: Thou Shalt Take Nothing for Granted.

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

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Ten Commandments for Real Estate Investors: Commandment #1

Posted on April 5, 2012 by Frank Gallinelli

Recently I had the honor of being asked to speak at the BiggerPockets Real Estate Investment Summit in Denver. Although I tried to warn them that I was a graduate of the Fidel Castro School of Public Speaking and could talk for four hours from a three-by-five note card, my time was limited. My plan was to conclude with “Ten Commandments for Real Estate Investors,” which I did, but briefly. Thanks to the wonders of modern blog posting, however, I can now share the unabridged version.

Commandment #1: Thou shalt take nothing for granted.

There is a witticism attributed to American humorist Finley Peter Dunne, “You trust your mother but you cut the cards.” In real estate, of course, the parallel concept is due diligence. If you assume that things are as they appear and if you fail to vet your potential deals independently, you’re setting yourself up for unwelcome and expensive surprises.

The cast of characters you may encounter in a real estate deal is almost archetypal. First there is the liar. I still remember well the kindly grandmother who recited to me her property’s rent roll. When I uncovered her perfidy, she explained that she had been telling me how much her tenants should be paying.

Another character is one I call the alchemist. He wants you to look at lead paint and see gold leaf, so he tries to take uncomfortable information and give it a positive spin. “It’s not too small; it’s compact and requires less maintenance.”

Finally there is the person who simply doesn’t volunteer information. He’ll tell you the truth if you ask, but assumes – perhaps justifiably – that it’s not his responsibility to supply the right questions as well as the right answers.

If you have a plan for due diligence and stick to it then you won’t have to rely on information from parties whose interests may not be in concert with yours. That plan should involve both the property and the market in which it is located.

Start with a physical inspection of the property. Deferred maintenance can cut both ways. On the one hand, it represents an expense and may signal that tenants are unhappy.  On the other, it can be an opportunity to remedy a problem, increase revenue and create value. Also look for capital improvements, both completed and needed. Check for code and zoning compliance, and certainly don’t assume that the property’s current use is permitted.

Then consider the financial issues. Examine the leases and look for unusual provisions. Commercial leases in particular can harbor some exotic covenants.  If possible, require estoppel certificates where the tenants can tell you if the lease terms are true and accurate and if there are any outstanding issues or litigation with the landlord. Independently verify expenses like property taxes and assessments, insurance costs and utility expenses. Ask to see historical rent and expense data.

Many investors neglect to go to the next important step, which is to scrutinize the market. What are the prevailing lease rates for properties of this type in this area? How much space like this is vacant in this market? What are the local cap rates for this type of property? What’s going on with employment and municipal budgets? You should know everything possible about the economics and politics of the area where you are buying property – or as I’ve told many investors, you should know where the cracks in the sidewalk are.

And so our first commandment is to take nothing for granted. Rely on your own independent research about the local market and about the particular property. Ronald Reagan may have said it best when negotiating a nuclear treaty with the former Soviet Union: “Trust, but verify.”

Come back soon for Commandment #2

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

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New for 2012: Real Estate Investment Analysis, Version 16

Posted on January 10, 2012 by Frank Gallinelli

Thirty years of development time, and of listening carefully to what to our customers want.  All this comes together now in the latest version of our most popular and powerful software app for real estate investors: Real Estate Investment Analysis, Version 16

What’s New in Version 16?

    • The Decision Maker

      The centerpiece of v16 is a new module called “The Decision Maker.” Here is how it works: Enter data about the property — revenue, expenses, financing, etc. — as you normally would.  Then go to the new module. The top half of the page will display 12-18 of your key assumptions, like those shown here:

      snippet - input, Decision Maker
      snippet 1 from Decision Maker

      You can now toggle any or all of your assumptions up or down with the arrows, while watching the effect of each change as it displays instantly on the bottom half of the page.

      There you’ll see more than a dozen key metrics, such as cash flow and IRR. These will update in response to your clicking the arrows to raise or lower any of the basic assumptions; the data will display going out 20 years.

      snippet 2, Decision Maker
      snippet 2 from Decision Maker

      For example, toggle the purchase price or the cap rate up and down, and watch the effect on your IRR. Toggle the mortgage interest rate, watch the impact on your cash flow. What better way to decide how — or if — you can make this deal work. Hence the name: Decision Maker

    • Detailed Capital Improvements

      Many users have asked to be able to provide a detailed break-out of anticipated expenditures for capital improvements. Here it is. You can now choose to fill out a complete year-by-year schedule of improvements, or simply enter an annual total.

 

    • Detailed Closing Costs

      Likewise, the ability to itemize acquisition closing costs has been another common request. You now have two options: itemize or enter a single amount.

 

    • Improved Reports
      We really do pay attention when users call and say things like, “Why doesn’t the partnership presentation show cash-on-cash return?” We keep track of those requests, and you’ll find several now implemented in v16.

 

    • Import Data from Your Version 15 Analyses

      Here’s a big one: If you’re upgrading from v15 to v16 you can run a special function that will read all of the user entries from an analysis you did in v15 and transfer that information into the new version.  That’s no small trick, but our super-smart programmers did it.

 

Upgrade from Version 15

      If you’re currently a registered user of v15, keep your eye out for an email from us with an offer to upgrade at a nominal cost.
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