Objective Real Estate Investing
Objective Real Estate Investing
As an investor, what do you want? Pretty objects, green technology, socially conscious programs, or return on investment? How about safety, reliability, return on investment and a tax-advantaged upside exit strategy?
The real estate market
We have all been experiencing and hearing from the media all of the bad statistics and bad prognostications about the “real estate market.” It is true that at this time there are enough properties on the market listed for sale to take 12 months to sell at the current rate of sale. The “market” is as bad as it was in 1991, when so many banks went under and the FDIC took over and sold off the properties. The sub prime mortgage crisis has restricted many buyers from buying houses and has caused a flood of foreclosures.
It is true that the market is bad for sellers and banks; however, it is a good market for careful objective buyers with the cash and credit availability to capitalize on the market.
Gold, Google or Triple-deckers
It would be great if we had a time machine for making investment choices. We all would have bought Google after the IPO, gold at its lowest price, Apple before they re-hired Jobs or triple-deckers in the 90’s. This market allows us to buy triple-deckers at 90’s prices without a time machine.
Why invest in real estate? If you are reading this, you already have your own answer. If you were not predisposed to real estate, you would be logged onto e-Trade. Someone once said that the best investment would be owning a toilet paper factory because there would always be a demand for the product. Real estate is exactly the same: people need a place to live and every year, there are more people who need a place to live.
Then why don’t real estate prices just increase year after year? Good question. Economists have been trying to explain this for years. Apparently, there are a lot of factors involved and a new one comes along every five years to explain what happens. Real estate values have fluctuated in more or less regular cycles ever since people started keeping records. You just want to buy at the bottom of the sine wave and sell at the top of the curve, and make a very good rate of return on the way through.
Money is an emotional subject; but investing should not be based on emotion. The stock market can be analyzed in terms of two emotions: fear and greed. Objectively, these can be characterized as risk and reward. In order to take the other emotions out of the equation, we need to look at potential investments “on the numbers.”
Based on our experience, here are the criteria:
1. Three or four unit building.
For a safe investment, the house should have more than two units because if there are problems with one tenant, the property is still cash-flowing positively.
2. At least 8 bedrooms.
For Section 8 tenants, three-bedroom apartments are in strong demand; two bedroom units are harder to rent and one bedroom apartments are most difficult.
Families with young children cannot live in an apartment that contains lead paint.
4. No slate roofs.
Slate roofs are notoriously costly to fix or replace and there are no shortcuts to avoid the costs.
5. Vacant or easily vacant.
The properties we will be considering will all need repairs. It is infinitely more difficult to do these repairs with tenants in place and getting rid of tenants with code violations is a nightmare.
6. Construction costs.
Projected construction costs should not exceed 30% of the purchase price because it will kill the return on cash invested.
We should “red-line” certain neighborhoods based on history.
8. Due diligence.
Always check the “building jacket” and outstanding code violations as well as the difficulty for reconnecting utilities. Check out historical water usage and verify real estate taxes.
9. No underground oil tanks.
Removal cost is prohibitive and the potential for contamination is high.
10. No dirt basements.
Many older multi-families have this problem which is expensive to remediate.
11. Separate utilities.
The owner does not want to be paying the tenants’ heat, hot water and electric bills.
12. No major structural issues.
Although virtually anything can be repaired, major structural issues will eat up the construction budget and leave little for the cosmetic issues.
13. Investment goals.
The spreadsheet should show a return on cash of at least 40% and a cap rate no higher than 8.
Obviously, we may not be able to get every property to pass all of the above criteria; trade-offs may need to be made. However, if we go through the objective analysis and make the trade-off intelligently, keeping in mind the investment goal numbers, the investment should be safe and sound.
By spending cash up front to repair to a high standard, maintenance and inspection issues should be minimized or eliminated.
Houses passing these tests will be easier to resell at a profit in less time, when the time to resell arrives.
Holding and reselling.
The market will cycle up at some point. When? It's unpredictable, but houses have to be held for at least 12 months in any event because of “deed seasoning” issues with buyers’ financing and a realistic view of the existing market. Although there are no guarantees, houses meeting these tests, fixed up and fully-rented, should sell at a premium in any market.
You may have noticed that “comparable sales” or doing a CMA (Comparative Market Analysis) was not discussed. By basing the acquisition decision on the numbers and on the criteria, we have done most of the work of an appraisal. Comps are less dependable as a predictor of value in a falling market. The only relevance of comps is to justify the sale price to the lender and to justify the offering price made to the seller. The properties selected by our method should comp favorably.
- Last edited November 05 2008
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