How I Made 100X My Money in Real Estate in Seven Years
Real estate values change due to the the economy, building improvements, and changes in rental revenue.
The economy is outside of a property owner’s control—it will affect property values, and there really is nothing an owner can do about it while he or she owns a building.
Building improvements (or deteriorations) are almost entirely in an owner’s control.
Changes in rental revenue are very much in an owner’s control, and can dramatically change the property value.
So although not everything is in an owner’s control, you can say that success is ultimately a 50/50 affair: 50% is due to skill, and the other 50% is due to factors that lie outside of your control.
I say this based on my long-term experience in real estate, observing both myself and other investors. Though I did not initially believe in chance, as time passed I could not deny the fact that it does indeed play a significant role.
Of course, contrary to chance is what is in your control—that is, the skill aspect of real estate investing, which involves activities such as finding the right deal, negotiating a deal, and adding value through making property improvements and increasing rental income.
From the onset of examining a potential property purchase, I do all my thinking, studying, and calculations beforehand. I first study the location. I then try to ascertain an accurate assessment of the property’s potential improvements to be made, rental revenue to be increased, and what it would take to achieve them. I also take into account the physical state of the building and its environment, as well as the historical data, such as operating statements, etc.
After familiarizing myself with all of this information, I prepare an assessment of the risk-reward ratio, and then I have a proper foundation of knowledge necessary to determine the offer I will make, if any. To me, this is the only way to buy real estate.
An ancient Chinese teaching says, “Before doing anything, be clear about why you are doing it.”
And so, any aspiring real estate investor should first ask himself, “Is real estate right for me?”
Like almost anything, it offers a host of advantages and disadvantages. And for some it is a great fit, while others, not so much.
So what are these advantages and disadvantages, and who is real estate investing good for?
Let’s first examine the issue from solely from the perspective of financial advantages.
The first thing to consider is that—to put it very bluntly—real estate is without a doubt among the best ways there is to make lots of money. There are very few businesses that offer such lucrative opportunities to invest almost any amount of money and achieve a high return on your investment.
What makes real estate such a superior investment?
Well, not only does it generally appreciate well over time, but it also offers the potential to borrow money and leverage an already high-returning investment.
Let me explain what I mean by this. First of all, looking at real estate from a very broad long-term point of view, it appreciates about 5% per year. Though this figure is not very impressive in and of itself, there are many other factors to consider.
For one thing, the long-term figure for real estate appreciation does not factor in gains made on income from the property—that is, on all revenues received minus all operating expenses paid. This operating income generally creates a return of about 6%.
So, your property value appreciates 5% per year, and the property also yields a 6% annual return from operations.
But I am still not done! Real estate allows you to leverage an already high return.
We have already established that real estate appreciates 5% per year, and also offers 6% income. Now, consider that these figures are based on an investment that is entirely your own money, without borrowing a single dime.
But what happens when you leverage this situation by borrowing money?
Let’s say you purchase a $1,000,000 property with $200,000 of your own money, and the other $800,000 borrowed from a financial institution, at an interest rate of 7%.
What does this do?
Well, to put it simply, you are paying 7% for the borrowed amount, but you benefit (from property appreciation and income) more than 7% from that money. So from that spread, you profit on money that is not even yours!
Or, looking at it entirely from the perspective of your own money, your $200,000 investment—with the power of leverage from the $800,000 loan—can now earn returns far greater than the 5% appreciation and 6% income previously mentioned. By leveraging your money, you have multiplied the effect of those gains.
But I am still not done!
Additional gains can also be made in real estate by finding buildings with particular types of potential for value enhancement, and taking advantage of this potential by making various changes and improvements that are to your financial advantage.
For example, if you purchase a $1,000,000 property that shows it has such potential for improvement, you might be able to increase the property value $300,000 by spending only $100,000 on improvements.
So through making judicious improvements, you can boost your property appreciation far above and beyond the aforementioned amounts.
But wait, there’s even more!
Real estate offers certain income tax advantages that very few other types of investments have. By deferring taxes and by taking advantage of various tax laws, you can allow your investment to accumulate gains more effectively than other traditional investments that do not offer such tax benefits.
So to sum it up in a sentence, from a financial point of view, real estate investing offers great potential for high long terms returns—returns that are hefty compared to low-yield low risk investments such as a Certificate of Deposit (CD) and Treasury Bills, or even common stocks.
Another advantage of real estate investing is that—unlike most other businesses—it allows for flexibility with your schedule.
For instance, if you run a retail store or an office with employees, you must open and close on time, every day, for five to seven days per week; whereas in real estate investing, you seldom are obligated to work at certain times of the day, week, or year, and you also might not need employees to run the business if you have a management company to manage them for you.
So now we have gone over some of the advantages of real estate investing. But of course, real estate investing also comes with several drawbacks, so let’s examine them as well.
For one thing, real estate is generally not a very liquid investment—that is, real estate is not easily converted into cash. And related to this are the significant fees and processes associated with real estate transactions, which cost money and take time.Compare this to an investment like common stocks, which generally is extremely liquid, has only small fees associated with transactions, and can be purchased and sold almost instantaneously.
However, it is also fair to add that the majority of non-real estate investments involve a significant amount of lack of liquidity and various transaction fees and processes—and while real estate is certainly not the most liquid, low fee, and quickly executable investments, it is comparable to most other investments in regards to these factors.
But now let’s move on to another financial drawback related to real estate investment: risk and unpredictability. Real estate is subject to income and property value fluctuations that, while generally are mild, can sometimes be quite the opposite—and these fluctuations are further intensified by having a leveraged position. Essentially, what it comes down to is this: while real estate in general has an established record of superior long term return, a real estate investor also has to be willing to stomach potential short term fluctuations—and in the case of negative fluctuations, they might cause serious financial problems, and in some severe cases, even require the infusion of funds to prevent a loss the property. Additionally, real estate is not all the same: there are different property types and areas that are subject to different factors, and while this offers a possibility of having your particular investment outperform the overall real estate market, it also offers the possibility of underperforming the market.
Of course, all these factors are by no means exclusive to real estate investment—virtually all investments that offer the potential for more than modest returns will be subject to these risks. But on the other hand, leveraged real estate investments do not rank high in terms of stability and predictability of appreciation, return, and cash flow.
So while leveraged real estate generally offers superior long-term returns, and thus the odds are in your favor, you also will have to be willing to “roll the dice.” Real estate involves risks, and it takes big risks to attain big rewards.
But, as this book will show you, the key to prudent real estate investing is taking calculated risks, and by making sound and diligent calculations and assessments of the potential for gain and loss, identifying and pursuing investments that are in your favor. And then you can continue by making further measures to deal with situations as they arise.
So while there certainly is an element of chance that is entirely outside of your control, what is really important is doing what is in your power to maximize the income and value of your property.
One other financial factor often associated with real estate is the necessity of making large investments. However, I personally feel that this is not entirely the case, and that there are plenty of possible ways to invest small sums in real estate—in fact, I myself made a very small initial investment in Part One of this book.
OK, now we have explored the advantages and disadvantages of real estate financially. But there are more factors to consider when assessing whether or not real estate investing is for you.
These have to do with the actual activity involved in real estate investment.
Some of these activities are acquiring, financing, improving, refinancing, and selling involve dealing with a variety of people, such as bankers, attorneys, brokers, contractors, engineers, managers, tenants, architects, city officials, and perhaps most importantly of all, buyers and sellers of properties—many of whom you have never dealt with before and must deal with. Of course, some of this necessary interpersonal interaction can be delegated to others—but in general, dealing with people is a major aspect of real estate investment.
For one thing, activities such as acquiring, financing, improving, refinancing, and selling involve dealing with a wide variety of people, such as bankers, attorneys, brokers, contractors, engineers, managers, tenants, architects, city officials, and perhaps most importantly of all, buyers and sellers of properties. Of course, some of this necessary interpersonal interaction can be delegated to others—but in general, dealing with others is a major part of real estate investment.
Another major component of real estate investing is making choices—choices on what and when to buy and sell, and choices in negotiating deals. Taking a comprehensive look at real estate, it is an arena that clearly involves numerous variables, distinctions, and options. And it helps to take a great deal of these into account when making buying and selling assessments—for example, the property type, property area, surrounding properties, location in general, trends in the area and population, zoning laws, city codes and ordinances, etc.
Real estate also involves direct firsthand experience in dealing with your investment, and strategizing. Real estate investment does not just end with buys and sells—you have hands-on control over your investment. You have options to improve the property, raise rents, refinance, etc. And you also have obligations to run the property in general day-to-day operations. Of course, you can hire people to handle most of this, but ultimately you will have to personally deal with some of the matters. So basically, real estate is one of several types of very proactive investments, as opposed to an investment like common stocks, where there is not much you can do outside of choosing what and when to buy and sell, and you respond mainly to derivative secondhand data.
Real estate is also a numbers and math intensive business. Now granted, it certainly is possible to get by without understanding the math and numbers behind what is going on—in fact, I for my part have seen plenty of investors who were, to put it bluntly, very ignorant in regards to the mathematical basis of their real estate investment. But on the other hand, I am a very firm believer that you can and should use math to get the most out of your investments. I personally have relied heavily on numbers to find the right opportunities and take advantage of them. Of course, there is more to real estate than just the numbers—but by disregarding numbers, you are neglecting information that can, when properly used, can be put to your advantage in numerous ways.
In commercial real estate, there is a broad variety of building types, but they generally fall under five main categories: apartments, office, retail, industrial, and hotel.[1]
All are indeed commercial real estate, but they differ in terms of pricing, operation, tenancy, marketing, etc.
Also realize that even within a property type, there are distinctions—for instance, a high-rise office building in downtown Chicago is vastly different from a three story medical office building in a suburban area of Chicago.
Let’s briefly explore each of these five main property types:
I tend to favor investments in apartment buildings. Their main advantages include:
A relatively stable and predictable cash flow, and less dependence on the economy than other types of real estate.
Less downside fluctuations compared to other property types. When real estate values drop, apartment values drop the least of all other types.
However, they do carry these disadvantages:
Increased management complexities, including factors such as health codes, fire and safety codes, and the necessity of making a variety of repairs and providing 24-hour hot water and heat
Rent control laws that apply to certain apartment buildings in certain areas. These laws make it difficult to raise rents, which can cause numerous drawbacks and limitations on your investment. *
Having to compete with the home market, particularly when there are low interest rates and good economic conditions. Note, however, that the home versus apartment factor depends heavily on the region. For instance, California has a strong apartment market due to high and increasing populations, whereas the South has a generally weak market for apartments due to low housing prices.
I disfavor office-building investments for these reasons:
The overall long term trend for the demand of office space has been on a steady decline due to modern technological advancements in communication, such as computers, the Internet, fax machines, and cell phones. Over the last two decades, the amount of office space companies have allocated per employee has decreased by 40%, and will likely continue decreasing.
It costs more to build a high rise than a shorter building, and it costs more to do tenant improvement in a high-rise than low rise office building. In return, the value as well as rent per square foot of a high rise building is higher than a building of one to four stories. *
They are sensitive to economic changes, and have volatile cash flow due to widely fluctuating revenue and capital expenditures. This makes it difficult to financially survive down markets.
Retail properties—that it, those with tenants in the business of selling goods, commodities, and services—are generally easy to manage, and are very tied to the quality and business performance of the tenants. For instance, one high quality retail tenant can have a very positive effect on the entire retail property.
One of the great challenges of large retail centers is to cope with changing tenants requirements. That is what makes large centers obsolete. For example, in the 1980s supermarkets required 20,000 square feet of low ceiling space. Today they require 50,000 square foot of very high ceilings. Example 2: In the past, malls made stores with 150 feet of depth—75 feet of frontage for the sale of their items and 75 feet in back for storage. Today due to changes in marketing strategies and the advent of just-in-time delivery, stores have almost eliminated storage of goods.
Shopping centers contain variety of commercial retail stores and other entities such as banks with a parking lot. If a major tenant such as a “name” supermarket or theatre occupies the largest portion of the center, it is called an anchored shopping center. Shopping centers range from 20,000 square feet and go up to mega malls as large as 500,000 square feet.
A strip center consists of small spaces ranging from 500 square feet to about 5,000 square feet up to total of 20,000 square feet.
One of the great challenges of large retail centers is to cope with changing tenants requirements. That is what makes large centers obsolete. For example, in the 1980s supermarkets required 20,000 square feet of low ceiling space. Today they require 50,000 square foot of very high ceilings. Example 2: In the past, malls made stores with 150 feet of depth—75 feet of frontage for the sale of their items and 75 feet in back for storage. Today due to changes in marketing strategies and the advent of just-in-time delivery, stores have almost eliminated storage of goods.
Some anchor national retail tenants pay a percentage of the store gross sale to determine the rent. This is called “percentage lease”. The lease for percentage lease tenants requires a minimum basic rent which is lower than the market rent.
[Revise and reorganize this entire section] Industrial property caters tenants who are in production, warehousing, and product distribution. Thus the spaces may be used by tenants who are in manufacturing or warehousing with some office and/or showroom space located within the space.
Provisions for the and maneuvering of trucks maneuvering and dock area for loading and unloading of goods are requirements of industrial buildings. The industrial property also needs ample electrical power for manufacturing purposes.
Properties which accommodate manufacturing businesses have been going through some downturn and demand for light manufacturing spaces has been dropping since new manufacturing companies are moving to Mexico, China and other parts of the world. As a result more industrial spaces are being used for warehousing only.
Location and management requirements make hotels completely distinct from other types of commercial properties. Hotels are occupied by travelers who use them for business, conventions, or leisure. Most hotels are close to airports to better accommodate business travelers.
The operation of hotel business is of paramount importance. Many good quality hotels are contracted with national hotel companies for management services.
Hotels are priced per room as well as per square foot.
Houses or single-family homes are not considered commercial real estate for the following reasons:
(a) Income plays virtually no role in a home’s valuation. A home is valued almost entirely on aesthetic or other intangible factors.
(b) Houses have a unique income tax structure.
If you do not reside in the house and you rent it out, then it can generate income and the property becomes a form of commercial property.
[Revise this entire section. Present things step by step.]
Real estate requires skill in analyzing and evaluating property based on numbers. From the time you purchase the property all the way to the time you decide to sell, you need to calculate and analyze and compare numbers for evaluation, financing, refinancing, operations, and selling. Thus, math is important in dealing with Real Estate.
The two major indexes used in the process of the purchase of real estate are Capitalization Rate and Return on Investment. Capitalization Rate or Cap Rate or “CAP” is used for evaluating a property. Return on Investment or “ROI” is the percentage rate of return on the money you are investing in purchasing the property.
Let us say there is a 12-unit apartment building which is for sale at $1.5 Million. Let us say you present the data sheet to a bank and the bank or the loan broker informs you that the bank is willing to finance the property in the amount of 75% ( you must put the other 25% or $375,000 as down payment) of the purchase price at 7% interest rate over 30 years. The “set up” sheet presented by the seller reflects the income and expense history of the property for sale. Thus you will create the following table to find out the Cap Rate and ROI associated with this building:
Income from rents (annual) 172,000
Other income __1,500
Total income 173,500
Operating expense ( 61,500)
Net Operating Income (NOI)112,000
Mortgage Payment ( 89,815)
Cash flow after financing 22,185
Cap Rate = NOI or $112,000/$1,500,000 = .0747 or 7.47% or 7.47
Price
Return on Investment = Cash Flow After Financing = $22,185/375,000 = 5.91%
Down Payment
Here is one more application of CAP and Return on Investment:
Let us say you already own a two story garden style office building in the Philadelphia suburbs and you want to find out its price (or value). You go about and find out that a similar building in the same area has been sold at 9 CAP.
Assume your office building annual Net Operating Income (NOI) is $ 152,500. If you plug in the numbers in the above equation, the value of your building would be:
Price or Value=NOI=$153,500/.09= $1,705,555 or $1,700,000.
CAP
If you think your building is better than the subject building in quality and location and is worth 8.5 CAP, then the value of your building should be:
Price or Value=NOI=$153,500/.085= $1,805,882 or $1,800,000.
CAP
The lower the cap rate, the higher the value of a property. High cap rate applies to a property of lower quality in less desirable area.
CAP rates for real estate properties generally range anywhere from 3 to 18. The main variables influencing a property’s CAP rate are the regional economy, the building’s condition, and its location and its projected growth and demand. The better these are, the lower the building’s CAP rate will be. Remember that CAP rate measure’s a property’s yield or net return (Net Operating Income divided by the Building Price)—and that the lower a particular building’s CAP rate is, the higher the multiple of its NOI it is selling for.
A property selling for a CAP rate of 3 is trading at an extraordinarily high valuation, and is likely a pristine conditioned building, located in a premier area, at a time when the local economy is flaming hot—think an immaculate Beverly Hills property during an economic peak. When a property exhibits these characteristics, buyers are willing to pay higher multiples of NOI, and accept a lower net return (in annual revenues minus expenses).
On the other hand, a property selling for a CAP rate of 18 is trading at a dirt cheap valuation, and likely has all the opposite attributes of the 3 CAP rate building—a poor condition building, located in a deteriorated and deteriorating area, during a local economic recession. Buyers are only willing to purchase these types of properties at low multiples of NOI.
The other method of valuation would be to compare the 2 properties by price per square footage, which is not as accurate as cap rate method, but is commonly used by real estate people and brokers.
In the case of an apartment building, not only may you evaluate it with the CAP method and square footage, you may also study its value by means of gross rent multiplier (GRM). To compute the GRM you divide the property price (value) by its total (gross) rent revenue. In the first example above, the GRM for the apartment building is:
$1,500,000/$173,500 = 8.65 GRM
GRM varies by neighborhood and the quality of the apartment building. The higher GRM represents the higher price.
Why do you have to know the numbers? You learn about the numbers to make a comparison between different properties. Between two similar buildings you will be able to compare CAP, rent collection, expenses ( and percentage of expense to income) and cash flow plus rent and improvement potentials, before you pick a building to purchase and to evaluate your own property at any time.
It is very useful to study the property by structuring a spreadsheet and plugging in all the numbers. Running different scenarios by plugging in different variables such as vacancies, income and mortgage one at a time to see how it affects your bottom line (such as CAP, return on investment, etc) is a good idea.
Rather than traveling at a steady and predictable pace, the economy moves in unpredictable short, medium, and long term cycles, with rises, peak, downs, bottoms, and flats.
Though the Federal Reserve Bank uses various measures (such as the regulation of interest rates the money supply) aimed at regulating the economy, minimizing fluctuations, and achieving a modest but steady gain in various economic measures, their efforts do not always produce the intended results—in fact, significant fluctuations in the economy have persisted in America, and will most likely continue.
In good times, jobs are abundant, wages rise, more money changes hands, and the volume of stock and real estate investment increases—and most people thereby have highly optimistic expectations of the economy’s future, sometimes to the point of believing the boom phenomenon will continue ceaselessly.
In bad times, all these figures go in the opposite direction, and there is also a far greater chance of increased taxes, riots, wars, and oil prices.
In considering the economy’s fluctuations, it is also important to realize that fluctuations frequently increase in intensity due to the investment activity of speculators. Speculators are characterized by their hasty investments aimed at riding a current trend in hopes of making quick gains.
For instance, during a time when prices are rising, many speculators will aggressively buy, and cause prices to go even higher—and this purchasing activity in turn attracts more speculators to purchase and drive prices even higher than that.
All these speculators are for the most part playing a game of chance and hype, buying based on price trends, while giving minimal consideration to fundamentals, and having no intention to hold an investment for a long-term period of time.
If prices begin to decrease, the speculators will likely begin hastily dumping their investment, and spark an opposite market reaction. Although many real estate speculators have made millions of dollars, just as many have gone bankrupt.
Real estate investors who employ a prudent investing method avoid focusing on speculative loops, and instead are concerned with making solid investments with the highest calculated chance of profit.
But getting back to the economic fluctuations, it is obvious that these fluctuations do exit, that they play a role in real estate market conditions, and that this will affect a real estate investor.
So what should a real estate investor do?
This is actually a more difficult question than it might appear.
Why? Mainly because no one can really forecast fluctuations in the macro economy, and trends in macro economic figures such as changes I interest rates or national real estate values. Generally speaking, it is impossible to know how these figures will fluctuate, and no one—including the most well informed and skilled economic experts—can consistently make accurate predictions of these figures and thereby beat the market.
This being so, fluctuations in major economic valuations are not what I consider an area where you can gain advantages to beat the market—you cannot forecast them, and you cannot change them.
A prudent real estate investor looks to gain advantages where he can, and not in how the macro economy will fluctuate.
The best a person can do in regards to the economy is have a general inkling when real estate values appear to be abnormally high or low—and in knowing this, adjusting his or her investing strategy accordingly, while still having much uncertainty where the economy is headed in the near future.
There is no better advice than you buy real estate when you feel the market is at its lowest or close to bottom out. Although savvy real estate investors ignore all the media discussing about depressed market, hard times, bubbles and peaks. They work on opportunities, potentials, good deals at al times no matter what the market condition is. No matter when you buy you should purchase a property when you believe it demonstrates in certain ways that it has a strong potential for achieving strong profits.
Your purchases must fulfill certain criteria. General speaking, you should purchase properties that fulfill having most of these criteria:
(a) A CAP rate of 8 or more.
(b) Potential for adding value to your property.
(c) Positive cash flow after paying all operating expenses and debt payments.
Replacement costs (cost of building the same property) to be greater than the purchase price.
Favorable location
Advantageous zoning and permit laws
In times when real estate is on an up trend and the economy is good, you can “fix and flip” for quick profits. During the good times that the value of your existing property has appreciated, you can refinance your existing loan and get the benefit of tax-free cash (which is explained in Chapter 23).
Real estate has demonstrated long-term value appreciation of about 5% per year. This is due to factors that you have no direct control over. What I mean by this is that you cannot change interest rates, the economy, etc. Of course, you can adapt to such factors, which I discuss in other parts of this book. But as far as direct changes in real estate values, they are something you cannot control.
A “mindless” real estate investor can expect to achieve the market rate appreciation of 5% a year over the long term.
But the savvy real estate investor does not settle for market rate appreciation. The savvy real estate investor accelerates the appreciation by adding value.
This is an element of human skill that you can utilize to increase value and returns.
When looking for real estate to purchase, you should, among other things, consider potential for adding value. There are hidden values in every property that the prudent investor recognizes, but others do not. Consider characteristics of a property that show potential to improve it and add value.
When any of the varying forms of potential are utilized, they all lead to property value increases. And they do this through rent increases and property improvements.
Rent increases increase a property’s revenue and cash flow, which thereby raise its market value.
Property improvements are related to rent increases. Property improvements give the owner the opportunity to increase the rents, which, like I just noted, cause an increase in market value. And, as an added bonus, property improvements also directly lower the property’s cap rate—i.e., they make the building trade at a greater multiple of its income.
When contemplating a purchase, the savvy real estate investor considers the most efficient and effective ways to increase the building’s value by utilizing potential, through measures such as remodeling, renovation, tenant changes, management quality, and so on. This involves creativity, imagination, seeing things in a new way, and seeing potential that others do not.
Now I will show some examples of ways an investor can use what is in his control in order to utilize potential. As you read these examples, please realize that with any property, you must first check with local city authorities to determine if making a certain improvements is allowable and meets all city codes. [How do you check?]
You see an industrial building for sale that may be changed into an office or retail building. By making expenditures to institute this transformation, you can double the price per square foot value. This example involves change of usage—and in this case is an upgrade of a property from a “lower” use to a “higher” use.
You buy a 2,000 square foot house for $600,000, or $300 per square foot. You add a bedroom and bathroom for 200 square foot at your cost of $125 per square foot. The new addition costs you 200 x $125 = $25,000, but the market value of this addition is 200 x $300 = $60,000. In this case and the example above, you must check with the local city whether you are allowed to do so.
Someone’s house is in foreclosure due to non-payment of a mortgage. The house is worth $300,000, and the owner owes $260,000, leaving $40,000 worth of equity. He does not want his credit to be ruined by going into foreclosure. You as an investor come into the picture and deal with the bank and the owner, negotiating with the owner to pay him $20,000 to transfer the ownership to you, and assume the loan amount. This way the owner is happy because he avoids foreclosure, and receives $20,000 to escape. And you win because you pay $20,000 for $40,000 worth of equity.
You purchase an older apartment building that has two vacancies, and is also under rent control and thereby has tenants renting units for well below market value. So you (a) renovate the two vacancies and rent them at market price, (b) evict any current tenants who have in any way breached the rental contract due to late payment, noise, overcrowding, etc., (c) make negotiations with other tenants and pay them to move out, and (d) renovate the vacated units and rent them at market price. By getting tenants to leave, you can change the rent to any amount you want, whereas while the tenant had occupied the unit, you could only raise the rent a small amount per year as allowed by city quotas. So by even getting one third of the units vacated, you have substantially increased the building’s market value.
To examine the magnitude of rent increase of a property and its effects on its value, let us say you increase one of your tenants monthly rent amount by only $1.00 per month. This increase transforms into extra income of $12.00 per year. Assuming your property is worth (or) sells at a cap of 10, then the additional increase in rent will bring in added value of $120.00 per the following equation:
Added Value = Added NOI = $12.00 = $120.00
CAP .010
As a result, for every one dollar increase in rent of your property, it appreciates in value by $120 (one hundred twenty times). That is a lot of value increase for a little rent increase.
Now let us examine how the rent increase of your property affects your total cash flow and total value.
Let’s review the same project from **Chapter 8, but with a 15% more rental income:
Case 1Case 2 +15%
Income from rents172,000 197,800
Other income 1,500 1,500
Total income173,500199,300
Operating expense (61,500) (61,500)
Net Operating Income $ 112,000 $ 137,800
Mortgage Payment ( 89,815) (89,815)
Cash flow after financing $ 22,185 $ 47,985
Case 1, rent as is
Cap Rate$112,000/$1,500,000 = 7.47
Return on Investment $22,185/375,000 = 5.91%
Case 2, increase rent by 15%
New value (using same cap) $137,800/7.47 = $1,844,000
New Return on Investment $ 47,985/375,000=12.80%
15% increase in annual rental income which is actually $2,150 per month rental increase (197,800-172,000/12=2,150) caused the following upsurge:
Value from $1,500,000 to $ $1,844,000 or $344,000 increase.
Return on your investment from 5.91% to 12.80% or 216% increase.
Set goals grounded in reality, and make thorough considerations beforehand. How much money do you have available to invest? How much money do you need for any required remodeling? Do you have the time and experience for remodeling? Who is going to manage operations of the building? Are you interested in and familiar with the property type?
The internet is an important tool for gaining valuable information pertaining to real estate investments.
Almost any property listed for sale may be found through listing broker’s web site. Thousands of websites list properties for sale. Cruise the internet for properties for sale and compare. You may find comparative statistics like recent sales of properties that are comparative to the subject property you are going to buy.
The internet offers information about demography, aerial photos, and topography. You can also use it to go through city records to find information about a specific property. You also may find lenders websites for loans, management companies and current interest rates.
It is important to be familiar with the neighborhood of the property you are considering investing in. Inspect all the properties in your area that are “for sale” and “for rent.” The best way to get to know an area is by driving around with local experienced brokers (one at a time) looking at properties.
In all kinds of real estate, it is of utmost importance to know the local market. This knowledge is beneficial before purchase and during ownership of a property.
There are two ways to make a real estate deal.
The direct method does not involve brokers. Many owners will simply put “For Sale By Owner” signs on their property, and/or advertise it in the classifieds section of their local newspapers. By not using a broker, the owner will reap savings of the 5-6% broker’s fee normally charged to a seller.
The broker method involves a seller signing an exclusive agreement with a broker who will list the property. The broker in this case is called the listing broker or seller’s broker. When dealing with a broker, a buyer has two choices:
A buyer can deal directly with the seller’s broker. This involves the seller’s broker representing both the seller and buyer, and then receiving the entire agreed brokerage fee if the deal is consummated.
A buyer can have his or her own buyer’s broker. In such a case, if the deal is consummated, the brokerage fee will be split between the buyer broker and seller broker.
In either case, it is customary for the seller to pay the entire brokerage fee. I personally recommend that you have your own buyer’s broker to look out for your interests.
If you are starting from scratch, the best way is getting in contact with a few brokers. You learn a lot from them. An experienced broker has good knowledge and is part of a network.
If the broker asks you what you are looking for, do not give them the all-too-common answer, “I am looking for anything that makes sense.” If you want the broker to continue working with you, be specific. I highly recommend that you decide and concentrate mainly on the type of property and the general area of location that is best suited for you (one that you are interested in, familiar with, is closer to your home, etc.) Also tell your broker the total amount of money you want to invest, including the down payment, closing costs, and possible remodeling costs.
Here are a few valuable tips for dealing with a broker:
1. Narrow the field by giving your broker specific criteria.
2. Do not let the broker negotiate on your behalf.
3. Do not discuss with the broker what is in your mind like disclosing in the early stages of negotiation the top dollar you want to pay and what you plan to do with the property.
4. If the broker tells you for example that there is 25% rent potential in the building or one commercial tenant in the subject property who is willing to sign a long lease with a higher rent, you must verify that.
Meanwhile, read the real estate classifieds. You will find properties for sale by owner and you will also find properties for sale by brokers. In the latter case you get to know many brokers. Classified ads also help you to compare property values.
Unlike the stock market, in real estate you can make money not just through owning (general building appreciation, rental income, creating value), but also through purchasing property at a price below market value.
Here is how to find bargains:
Find desperate sellers—those who are motivated to sell due to some kind of duress, particularly personal factors such as financial problems, accident or illness, or divorce. These types of problems often make people willing to sell a property at below market value in order to procure much-needed funds as soon as possible.
Find sellers who are in the midst of moving due to personal or work related reasons. Their urgency to sell creates potential for them to agree to below market prices. Merely going through brokers is not enough to learn the seller’s motivation for selling. You have to meet the property owner and investigate. Newspaper ads (both read the ads and/or place your own ad), the internet, and cold calls and networking will help you find motivated sellers and bargains and any deal that you find that has a good potential in rents and improvements.
Find sellers who need to raise money for another property that they are eager to invest in.
Find a vacant property. This is usually an indication that the owner is desperate, as well as the building having potential.
Probate. To buy a probate sale, you submit your bid to the broker or directly to the executor. A probate judge reviews all the bids. He may reject all or accept the highest. All the decisions are made at the judge’s discretion whose goal is the property to be sold at the highest price.
Look for foreclosure sale. One person’s misfortune is another’s good luck. Foreclosed properties are generally sold at prices much less than regular market sales. However the disadvantages with buying foreclosures are that you have to pay all cash. In addition to that, the foreclosed properties are often in poor condition and high vacancy, because the last owner abandons the property. Foreclosures will be explained further in the chapter that follows.
Foreclosure is a process by which a bank or lender takes back a property if the mortgage is not paid. Every state has different laws and procedures, but we describe here the method of foreclosure without referring to legal details of foreclosure.
If the borrower fails to pay three months mortgage, the lender sends the borrower a letter that if the mortgage does become current, a letter of default shall be sent. If the borrower ignores the lender’s letter, lender’s attorney sends another default letter to the borrower. At this stage, the lender orders a certified appraiser to appraise the property. This way the bank finds out where it stands in relation to what is owed to the bank and what the property is worth at the time.
If the borrower still takes no action to rectify the matter, the lender’s attorney shall start the foreclosure procedure. This will be done by a notice of foreclosure in which the borrower is given a few weeks to show up in court and respond to it. A judgment is issued on behalf of the lender at the request of the lender for the balance of the mortgage plus the back interest plus penalties and other related costs as provided in the mortgage documents.
While the foreclosure is in process, upon request of the lender’s attorney, the court assigns a receiver to the property. The receiver’s job is to collect the rents, pay the urgent expenses and pay the remainder to the lender.
Subsequently, the court sets a date to auction the property at a time and place and the bank will advertise the auction widely to get the maximum bid. If the highest bid brings in more than what is owed to the lender, any surplus money raised at an auction goes to the owner or borrower. In the event that the property does not bring in enough money at the auction—which is the case in most foreclosures—the bank will become the owner and the difference is called a shortfall or deficiency. If the borrower has personally guaranteed the loan, he/she is legally responsible for reimbursing the lender for the shortfall.
While the foreclosure proceeds take place (which generally take a few months), the borrower has few options:
Postpone the auction.
Correct the default or cure it.
Discuss it directly with the lender and try to settle with the lender. During the poor economic conditions when property values have dropped, banks are willing to defer-or even lower - the interest rate because banks are not interested to own the real estate especially in the bad economy.
The borrower or other owners, if any, or the entity that owns the property declare bankruptcy. This gives the borrower more time to reorganize.
Sometimes the borrower and lender may agree to waive the foreclosure process and not go through the auction by transferring the deed directly to the lender. This procedure expedites the bank’s taking over the property. Thus, it saves the bank legal and other costs. In return the bank may agree to waive any possible deficiency. This is called in lieu foreclosure and the borrower’s credit will not be affected.
Foreclosure is not to the benefit of the borrower and therefore you should plan your investment in such a way that you prepare yourself for the bad times. The disadvantages of foreclosures are:
You may lose your initial investment or equity
It takes considerable time to deal with the lender, courts and attorneys
The foreclosure will be negatively reflected in your credit
If you face a foreclosure, you must seek the advice of a competent attorney who has enough experience in foreclosures to handle your case.
Common real estate proverbial advice tells us the three keys to success are “location, location, location.”
I respond: This is only a half-truth, and taken the wrong way it is very misleading.
For one thing, the key measure of real estate success is not “location, location, location”—it is “profit, profit, profit.”
And where does “profit, profit, profit” come from? It comes from “value, value, value,” in the form of bargains and potential.
So what is location’s role, and what should be considered when assessing location?
Location is one of several factors that must be gauged in order to determine current and future value, and potential for creating value.
In the scope of this, some characteristics of good location include:
(a) A property in deteriorated condition that is surrounded by better quality condition properties. This indicates that significant value can be quickly added by bringing the building up to the standard of neighboring real estate.
(b) A surrounding area undergoing gentrification—that is, deteriorated urban property being improved by private sector or the government for higher income people and lower income people being displaced.
(c) An area undergoing job growth and other economic growth.
(d) Satisfactory access to the building.
(e) Satisfactory foot raffic count. This specifically applies to shopping centers. The higher the traffic count, the better the location.
(f) Area zoning and permitted use that are to your advantage.
Aside from location, I believe there are two other major factors such as allowed use and what you end up with at your local city as a final permit that affect the value of the property considerably. Of course, location plays an important role in this equation. But it certainly is not everything.
And as far as location goes, it is a multi-categorized component. And the mere selection of an affluent location like Beverly Hills, California by no means fulfills the criteria of selecting a location favorable for your investment. After all, consider how in Part one of this book, none of the properties I bought and sold was located in “prime” locations, yet I achieved phenomenal returns from them. The key for me was profit through value.
Let us say hypothetically that there are four exact equal vacant lots one at each corner of an intersection. All four lots are for sale and you want to choose one to buy for development. If we assume the traffic counts in all directions are the same and North, South, East, West directions do not play a role in our decisions, then you can pick any lot, or make it easier, toss a coin to choose one. Right? Wrong!
The actual value of a lot is decided by the zoning of that lot, allowed use and finally what would be permitted by the local city officials. All this may vary from lot to lot, because each lot may have different zoning ordinance and code restrictions.
What really matters is what type of property, what square footage and/or number of units is allowed. In essence, what will they let you put there? The use the city will allow for a specific property may differ from the use the zoning allows. This is because of all restrictions and codes and interpretation of the codes that will generally end up with less than what you expected.
If you plan to buy an existing building, the allowed use still plays a big role in your future returns on you investment for the following reasons:
If you plan to demolish the building in the future.
If you plan to add to the existing structure.
If you plan to change the use for higher income called conversion.
In general, the trend is for more restrictions on zoning and codes. The good news is the said changes or additional codes do not appear overnight. There is plenty of advance warning of a coming change.
So I conclude that it is not “Location, Location, Location” that makes the value. It is “Location, Allowed use, Final Permit” that affect the value of a property.
After locating a property for potential investment, you must evaluate it.
Study all the information provided by the owner or broker on the “data sheet” they provide you with. Examine the numbers and financial data such as the CAP, price per square foot, and return on investment. Determine whether they are sensible and meet your investment criteria.
If you feel the numbers fall within the bounds of what you are seeking, go see the property. Physically seeing a property is as important as examining the numbers.
Some people mistakenly believe that buying real estate is like buying art. You buy a piece of art on intuition, but I believe buying real estate is based on math, common sense, and intuition.
In doing your total examination, consider the investment from both your mental contemplations, and your feeling and inner impulse. Consider everything from multiple angles.
Is this a property you want to own?
What are its short-term and long-term prospects?
How do you feel about its location? Examine the nearby area and see what types of properties it contains. If the building you are examining is in worse condition than surrounding properties, this is a good indication that it has potential for making immediate improvements and a quick increase in value.
Diligently go out and look for similar properties in the area that are For Sale or For Rent. Call the brokers and ask questions. This will allow you to gain valuable information from brokers who are familiar with the local real estate market. Finally compare the asking prices and the rents with that of the subject property.
Examine the physical visible conditions of the property. Walk into all vacant units. Look for potential. What improvements can you make on the property to cause the rents and property value to increase?
Can you make additions to the existing building? Check with the city if it allows for any addition. Have in mind that although parking spaces are a feature to a property, the city code requirements for parking for any additions may restrict your expansions and additions.
Before making real estate negotiations, find out what the seller’s motivation is for selling, and really know what he wants out of the deal.
Great negotiators get what they want by helping the other party get what they want.
Also, thoroughly familiarize yourself with the property, its numbers, and potential. With this knowledge, you can make a definite determination on exactly how much you are willing to pay.
Do not be concerned with how much a seller paid for the property. Be concerned with how much you should pay for it.
This brings up another important matter: Do not let your ego and petty vanities get in the way of a deal. Focus on making advantageous deals, not on personal issues and efforts to gain vain victory over brokers and owners.
Patience is also important. Granted, there are situations where you might need to be impatient. But in general, do not rush while you negotiate and do not make two offers in a row before you hear a response from the first offer.
When your offer is apart from the asking price, never offer to split the difference. If that is what you want, let the seller propose such a solution.
After you do your preliminary study and negotiate a price, you enter a "purchase-and sale" (P&S) agreement or a “purchase contract”. It formally binds both seller and the buyer to certain obligations. Once it is signed by buyer and seller, escrow will be opened. Among many things, the P&S states the sale price, amount of deposits, and date of the closing of escrow. In most cases, the buyer asks for longer escrow, but the seller insists on a shorter escrow period during the course of negotiation. In the end, escrow is usually somewhere around 60 days. At the end of the escrow period, the buyer delivers the entire purchase price less deposits and escrow and in return delivers the recorded deed of trust to the buyer.
On the seller side he takes the property off the market. The buyer then has to go through a "due diligence" process which is the most hectic of real estate experiences and explained in detail in this chapter.
In large deals, a document called letter of interest or letter of commitment is signed before P&S is prepared. Such letter is a short form of P&S and is not binding by either party.
Contingency is a clause in the Purchase and Sale Agreement that must be satisfied for the contract to be complete. Meaning that if the buyer’s expectations do not happen during the contingency period that is stipulated in the contract, he can back off the deal and get his deposit back.
There are many kinds of contingencies that the buyer may request to be included in the Purchase Contract, but the most common contingencies are inspection contingency and loan approval contingency.
Inspection contingency gives the buyer a certain amount of time to inspect the property and all the relevant documents provided by the owner or any other study he wishes to do such as checking city records regarding the property. Depending on size of the deal, the inspection contingency period may range from 15 days to a few months.
During the inspection, if the buyer finds defects with the property, he or she has can either (a) walk off the deal and get back the deposit, (b) ask seller to remedy the problem, or (c) buy the property in “as is” condition, but ask for a price reduction.
Loan approval contingency has a period for loan approval lasting from 60 to 120 days. During this time, the buyer applies for a loan from different lenders. The buyer must show good faith effort to obtain a loan with certain criteria stipulated in the contract.
Due Diligence is a process in which a variety of activities are performed by the buyer. It includes physical and environmental inspections, verification of the leases, examining all the documents related to the property and examining title to the property
In the due diligence process, the buyer gets a very close look at the property (which is called physical inspection) and check everything possible, with experts if needed, such as conditions of plumbing, electrical, heating and air conditioning and the structure. Also check the building and roof condition and number of parking spaces.
You should also make sure that no environmental hazards are attributed to the property. Lead paint, asbestos, mold, underground heating oil and radon are examples of hazardous materials that may be discovered in a property. In general, most of the above do not exist in newly built buildings. As an example, asbestos was discovered as health hazard in 1978. Thus any building across USA that was built after 1978 does not contain any asbestos.
As part of the due diligence process the buyer may talk to the tenants (with pre-approval of the seller), insurers, contractors, engineers, attorneys and banks.
At this time you may also study what is involved in the management of the subject property and who is going to manage it.
You or your broker should ask the owner to provide you with a copy of all pertinent information and documents related to the building such as latest rent roll, leases, estoppels certificates, operating statement for the last 3 years, any violations, certificate of occupancy, survey, building drawings, environmental report, contracts for services like trash removal, cable T.V., elevator, pest control, insurance agreement and the last 2 year bills from water department, gas company and electrical provider.
The owner may not have some of the above, but it is better to ask. In all commercial leases except apartment buildings, the owner must provide you stopple certificate. This document states that the attached lease is a true and accurate copy of the existing lease and that no other agreement or addendum to lease has been made between tenant and landlord. It also states if the rent is current and no outstanding rent is due.
You study the rent roll and other sources of income and expenses and any other document provided by the owner. I consider myself expert in managing “older” apartment buildings so that when I walk into an apartment building for the first time I can easily estimate how much my operating expenses would cost, if I owned it. Therefore I do my own calculations on operating expenses as well.
Rent roll is a list of the tenants in the property along with terms of the lease, area leased and the amount of rent being paid at the date the rent roll is prepared. Income and expense is prepared in a report called the operating statement that reflects income and breakdown of all the expenses during each month and for the year.
Make sure you check the leases, certificate of occupancy, square footage, title exceptions, zoning, review estoppels certificates, check who pays for the utilities (owner or tenants), study competitive properties rent and what was sold recently.
In the due diligence process I recommend that you go to the local city hall and study all the available data about the property. The City will also have in file of violations, if any. Check for all the code violations from the city and local fire department.
Depending on the negotiations, both parties may agree that the seller will make certain improvements or corrections before closing or the property may be sold in "as is" condition meaning that the seller is not obligated to do any work in the property.
If your P&S contract has an “as is” provision, it means you are buying the property as you see it. Thus do all your inspections and findings to be 100% satisfied, before you say “yes I want to go on”. As a buyer, the longer you have to do your due diligence, the better it is.
If there is any major problem you see there that is crucial and affects the property value significantly and that problem can not be cleaned up, or paid for, either renegotiate or walk from the deal and get your deposit back.
Title is a document that shows evidence of ownership. When you purchase a property you want to have a “clean” title for the property with no lien and defect. Title companies attempt to eliminate risks and losses caused by title problems that have been created in the past events. Title companies search public records and chain of title and check whether there are any adverse claims on the subject property.
Titles can be “clouded” in all kinds of ways. Liens, property tax liens, personal tax liens, zoning, easements and encroachment are some examples. But title problems do not usually kill a deal. An experienced real state attorney should be able to help you close a deal with some corrections by the seller and with some exceptions that will not adversely affect the property value.
You as a buyer require an owner’s title policy to be issued by the title company which insures that the title is free from defects or encumbrances, except those that are listed as exceptions in the policy. Your Purchase and Sale agreement will state the title guarantees and exceptions that are part of the transaction.
The title company insures you as the new owner against any monetary loss due to a title defect or lien created prior to the date of the policy that is not excluded as an exception to the policy.
Lien is an encumbrance against a property to insure a monetary obligation. There are two types of liens against a property.
Consensual. Includes deed of trust or mortgage
Non-Consensual. Includes:
Tax liens, imposed to secure payment of taxes. When the real estate owner fails to pay his property taxes, local government places a tax lien against the property.
Mechanic’s liens, imposed to secure payment for work done on the property. If the property owner does not pay for the labor work performed on his property, the worker may place a lien on that property.
Judgment liens, imposed to secure for payment of a judgment.
The outstanding liens must be removed by the seller from the title before closing of the deal.
Easement is a right that someone has to access, pass or use the property. Most of the easements are called utility easements which allow passage through the property for utility services such as water, electric (either aerial or underground), gas, telephone and cable, sewage and storm drainage.
If you are buying a vacant lot for development, watch out for all the utility easements because you may be not able to build over an easement area.
An encroachment is where something protrudes from adjacent property into your property. An encroachment may be visible at the property line or may be underground. A surveyor will show both easement and encroachment if surveys the property.
In general, all the liens, easements and encroachments, if any, are reflected in the title. Some “clouds” may appear in the title that are mostly errors, misfiled, or lien release that was not recorded. All that must be cleared by the title company and insured with the exceptions that are approved by the buyer.
Any time after signing the contract and before closing the deal, you may find things about the property that are not to your expectation and the problem affects the value considerably, but you are still interested in the deal. You bring this up to the owner’s attention through your broker and ask to fix the problem to certain specification that you spell out or renegotiate the deal to reduce the purchase price by a certain amount. If the seller does not meet your demand, you still have two choices 1) To close the deal in “as is” state with no reduction in purchase price 2) Walk away from the deal and get back your deposit.
To reap big profits, it is necessary to borrow money and make small enough (percentage wise) down payments in order to leverage investments, own more real estate, and magnify returns.
Let’s say someone buys a $100,000 rental property, and it yields an annual net operating income (NOI) of $9,000.
Now, I have calculated two down payment scenarios—the first at 25% of the purchase price, and the second at 10%. In both cases the interest rate is 6%, and the loan is a 30-year amortization.
[I said: Not a proper example]
[You said: LET US DISCUSS] Sarah liked it
Case 1 Case 2
Purchase Price100,000100,000
Down Payment 25,000 10,000
Loan75,00090,000
NOI 9,000 9,000
Annual mortgage 5,395 6,475
Net cash flow after
mortgage payment3,615 2,525
ROI 14.46%25.25%
(3615/25,000)(2525/10,000)
(net cash flow/down payment)
Generally, the more you borrow and the less cash you invest in a property, the higher your return on investment will be.
In other words as the cash flow grows, the lender who put in the larger part of the deal only collects the fix amount of mortgage and does not get any of the extra cash flow.
In the long run, fix rate loans and amortization comes into the picture in other facets as well. Let us say you are into the deal for 8 years now. If the value of the property above appreciates at an average of 4% a year, the value has grown to $132,000. According to case 2 above, your principle would be reduced to $77,211 after 8 years. The difference between $132,000 and & $77,211 is $54,789. At the end of the 8th year, not only you made $2,525 per year or 25.25% return on your initial investment, you have also had a tremendous growth on your equity (from $10,000 to $54,789 or about 5.5 times your initial investment). As your equity increases, you leverage is improved.
In the long run, the great majority of investors gain tremendously from leverage. With high leverage, all above benefits are attainable. They are also attainable if you are at the upside of the cycle during which you have a good opportunity to raise the rents and reduce the loan principal amount in the process of loan amortization.
Of course, borrowing money adds the risk of running into financial difficulties if your cash flow becomes negative. In the bad times, when vacancy rises and income drops, if you do not have cash reserve, the rent shortfalls and unbudgeted expenses may cause unprepared investors to miss their mortgage payments and suffer foreclosure. So when you are buying a property, run the spreadsheet for the next ten years with all the shortfalls predicted in your figures so that you make yourself prepared in advance.
But as I pointed out earlier, it is overall to your financial advantage to borrow money.
A real estate investor needs borrowing power, and consequently must pay attention to his or her credit score, and proactively ensure that it is good. A good credit score is conducive to getting approved for loans, having borrowing power, and getting larger loans at lower rates and with better terms.
Credit scores are based on an individual’s credit profile, borrowing habits, and payback habits.
Three companies calculate these scores: Trans Union, Equifax, and Experian. Each of these companies operates independently, and does not exchange data with the others.
Lenders usually get all three scores when checking credit.
Credit scores generally range from 300 to 900, with the majority of Americans falling somewhere between 600 and 800.
Lenders are most liberal giving loans to people with scores over 700.
Also note that young people with no credit records fall under a separate category altogether, and have no credit.
You can check your credit score for free at www.myfico.com or from certain mortgage companies.
If your credit score is above a certain figure, most lenders will accept you without examining its details.
If your credit is currently good, maintain its good standing.
If not, fix it.
If you have a dispute over a minor bill, it is generally best to just settle it and pay it, rather than letting vain disputes risk making the bill ultimately go to a collection agency, and then, if not paid, become reported and reflected on your credit record. Any blemish on your record will remain there for seven years.
Aside from credit scores, banks also pay attention to these items when assessing the reliability of someone who applies for a loan:
Occupation and income, including its reliability and constancy
Steadiness of place of residence
Your borrowing powers and your background, including real estate and management experience.
Lenders generally shun applicants who seem unreliable and unstable, and frown upon people who frequently change jobs or residence.
If you max out all your credit cards to the limit and use up the entire equity loan on your home and have eight credit cards, even if you pay them on time, still will count negative. Carrying abundance of open credit card accounts does not improve your credit score. The proper number of open credit card accounts acceptable to the credit company is about four.
For any blemishes on your credit record, you must show alternative documentation to the lender explaining the circumstances in a convincing manner to bolster your reliability and credibility. Tell the lender your story, but one that makes sense.
The lender normally requires three credit runs, one from each credit company, and averages it up. I suggest you run them on your own and if you see any error and inconsistency and omissions in any report you must contact both the creditor and the credit company for correction.
If you are unable to get a loan due to your low credit scores, you can still increase your chances of getting a loan through these methods:
If you are married and your spouse has a good credit, let the spouse buy the property and sign for the loan.
Bring in another person with a strong credit to cosign.
Bring in a partner with good credit into the deal.
Find deals in which the property owner is willing to carry the loan. “OWC” which represents for Owner Will Carry” is often used in advertising a sale of a property. Individual owners are much more flexible for borrower loan qualification than institutional lenders.
Most banks today require a down payment of 20-30% of the purchase price of a commercial property.There are a variety of loan structures available in the market, but no matter what type you finance with, the interest rate is a key figure. Lenders base their interest rates on nationally published rates (e.g. the prime, 11 District, 12 MAT, Libor, and US Treasury Note)
The variety of loan structures fall under two main categories of interest rate terms:
A fixed-rate loan (or fix rate mortgage) has a constant interest rate and monthly payment for the life of the loan. Thus, the mortgage payment amount never changes.
An adjustable rate loan (or adjustable rate mortgage / ARM) has an interest rate that changes periodically according to changes in an interest-rate index selected when the loan is signed. Monthly payments increase or decrease according to rate changes.
It is difficult to determine which of these types of loans are superior for one’s needs.
However, a fixed rate loan is more suitable for conservative borrowers who wish to have a loan that is easier for predicting their investment’s cash flow.
Additionally, investors who want to speculate on interest rates should choose a fixed rate loan if they feel interest rates will increase over the next five years, and an adjustable rate loan if they feel interest rates will drop.
Local bank, savings and loan or credit unions are sources of financing a commercial loan. If you are buying a property and the owner of the property is willing to give you a loan, the owner in that case will also be regarded as the lender. Keep in mind that different banks have different loan plans and policies, and even if you do have a high credit score, you cannot dictate certain terms to a bank if they do not offer them. In such a case, you must go to another lender.
In general, the borrower wants to obtain the maximum loan possible (or put least down payment) from the bank or financial institution. This is called leverage. The idea is good for the buyer at the time of purchase. However, in a downturn, he may be much better off with a lower mortgage payment.
Back in late 1980s, lenders would advance as much as 95% of the purchase price. This left the banks greatly exposed at the time of a downturn that ended them with foreclosing and then selling properties at 30-40% of the replacement costs. The banks got into trouble in early 1990’s and lots of savings and loans went belly up because they had overloaded on too many properties with high loan to value.
In obtaining a loan you must have a good relationship with the bank loan officer, if not you may have a loan broker who would handle all the paperwork and help you with the loan. There are two stages during the process of purchasing of a property that you deal with the bank. Stage one is when you have some interest in the building and are doing your preliminary study at which time you get a feeling from the loan officer or broker as to what type of financing you can get so that you can plug in your numbers. Stage two is when you have tied up the deal and P&S is signed. At this time you get a bank commitment or letter of interest that requires you to pay starting fees for the bank to process the loan.
When dealing with a bank, personal liability is an important issue. During bad times when property income drops below the breaking level, either you must infuse cash every month to make up the shortage or you default on your mortgage. If you default you will be faced with foreclosure procedures. If you have guaranteed the loan, then the lender will not only look at the salvage value of the property, but also to all other assets that you have. That means that all or part of your personal assets are at risk and can be seized by the bank. However, there is also a non-recourse loan which is a loan in which there is no personal guarantee tied to the loan in the event of default.
Have in mind that the lender is your partner in the deal even though you own 100% of the deed. The lender is generally contributing more than 50% of the purchase price (depending on amount of down payment). Therefore while you do your due diligence, the lender will do its own due diligence for its own protection.
The lender will appraise the property at borrower’s cost to make sure the value is there, will check the title, will do an environmental study and check the net operating income (NOI) to cover the mortgage payment (debt service) and leave some margin of safety.
Another source of financing is the seller. Seller financing generally is provided with a shorter term than of other lenders, but many advantages such as, little money down, lower credit standard, no qualifying income, less paperwork and quicker sale are…
There are many people out there that own their home with no loan and want to sell their house and retire, but do not know what to do with the proceedings or do not want to pay a large capital gain tax and recapture depreciation at one time. They would realize this benefit of acting as a lender and carry a note only if you bring that up in your offer.
Homebuyers can get very attractive loans in purchasing a home for residence. VA and FHA loans are available for single family residences. Not only the interest rate of home buyer loans are lower than commercial loans, but the down payment for qualified borrower of a home loan is as low as 3%.
When you go to a bank to borrow money, you have to sign two sets of papers: a promissory note and a deed of trust (or mortgage).
The note states how much you owe, how much the monthly payments are, when the loan is due, and other conditions of the loan. The deed of trust is a security agreement. It states that if the borrower does not live up with conditions of the loan, the lender can force the sale of the property—in a process called foreclosure—to raise the money owed to the lender.
A borrower may decide to pay off the whole loan before the due date. There are three main reasons that would impel a borrower to pay off the loan:
The borrower decides to sell the property
The borrower decides to refinance the loan for the conditions that interest rates have declined.
The borrower can take a bigger loan amount or cash out.
The lenders usually impose a “prepayment penalty” as a condition of paying off the loan earlier than the due date. The amount of penalty is either in terms of a fixed percentage of the loan amount or in some cases the amount of penalty is variable and severe to the extent that may go as high as 30% of the loan amount.
The note also refers to amortization, which is distribution of the loan amount into many smaller installments for easier repayments. Each repayment installment consists of both principal and interest. The payments are of equal amounts, although a greater amount of the payment is applied to interest at the beginning, while during the latter portion, more money is applied to principle. The lender reports to borrower every year the status of the principal amount and amount interest paid for the borrower to be able to compute its tax consequences.
Lenders offer home loans up to 30 year amortization, but commercial loans are usually amortized for shorter term like 25 or 20 years.
With home loans, the loan term is offered up to 30 years term. It means that the borrower does not owe any principal amount in 30 years when the loan term expires. However commercial loans are offered earlier than 30 years, meaning that when the loan is due, there is still principal amount remaining that must be paid to the lender which is called the balloon payment.
If a loan broker tells you that, “I can get you a 25/10 loan”, it means that the loan is amortized for 25 years and is due in 10 years.
Some lenders offer loans that are assumable. This means that when you are selling the property, the existing loan does not have to be paid off (there is no due-on-sale clause in the note) and the new owner may take over the same loan with the same conditions. This is to the advantage of the buyer, because at time of sale the market interest rates may have increased considerably, thus, you have a commodity for sale with a financing at interest rate lower than the market.
All the terms of the loan documents are to be spelled out in the lender’s letter of interest and pre-approved by the borrower.
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If you are not familiar with the escrow implements the P&L plus other clauses that the buyer and seller may wish to add.
[Revise]
There are three reasons you may refinance your existing loan:
The loan term is due. You then look for the best loan available in the market.
The loan term is not due but you find a more favorable loan to replace the existing loan (with a lower interest rate).
You want to cash out some funds (whether your loan is due or not) and use them for improving the subject building or for other reasons. In this case, you take out a loan larger than your existing loan, then pay off the existing loan, and use the remaining funds.
If you refinance for extra cash, your loan payment or “debt service” rises. Therefore, do not pull out the cash until you do your math. Set up your spreadsheet and run it with different amount of loans and debt service and see the cash flow in each case. Have in mind that in a downturn, when the property income drops, you are much better off with lower debt payments. The main reason for foreclosures is low income and high debt service.
You have to meet two conditions when you want to cash out:
You must have enough equity in the property to be able to cash out.
The interest rate of the new loan must be lower than the rate you have with your existing loan unless you are so much in need of the extra cash that the interest rate is not a matter of concern.
In conclusion, do not put yourself in a situation that when the real estate market tumbles and income of your real estate drops, you are forced to infuse money into it each month to be able to pay your mortgage payment.
There are several forms of ownership for a given property or group of
properties in real estate. The type of ownership is a function of nature of investment, estimated length of investment ownership, investor requirements of individual or group owner, legal and tax ramification. You must confer with an attorney or accountant before you decide which one to form
Joint ownership is usually is for ownership by a couple to a single family house. In this case if one spouse dies, the survivor gets the whole property. For Joint ownership both owners are responsible for all the liabilities such as property taxes and mortgages.
Joint venture refers to two or more people or entities who engage in a project under a predetermined investing and profit sharing arrangement. Many large real estate projects are structured under a joint venture which will cease to exist at the end of the project.
Partnership is a form of Joint Venture with more government ruling and reporting. It is formed in two ways:
In a general partnership each partner, either
individuals or entity is liable for all the liabilities and debts of the
partnership.
Limited Partnership.
In a limited partnership there is at least one general partner and limited partners. The general partners are responsible for running the business as well as the debts. Limited partners are silent investors who have no authority in the partnership for any decision making and are entitled to the shares of the profit per agreement, but their risk
of losing money is limited to the amount they invested.
A partnership pays no federal tax, but the partnership must provide income and losses to Uncle Sam and provide K1 forms for each partner indicating the partner’s share of profit and loss.
A corporation is an entity that is formed by the state. A corporation can act as a person. Once formed by the state, the corporation issues and sells shares to investors called stockholders. The stock holders are like the limited partners in limited partnership with no authority or liability except that they vote to elect the board of directors annually.
A C corporation is a regular corporation that pays corporate taxes on its profits. On top of that each shareholder must also pay his/her own personal income tax on the dividend received from the corporation. This is called double taxation which is the major disadvantage of a C corporation. Subchapter S Corporation is the same as C cooperation except that Subchapter S Corporation profits are nontaxable and is directly transferred to the shareholder for paying taxes. So, double taxation is eliminated in this entity.
This form of entity is similar to limited partnership. It has the advantage of the legal protection of a corporation and the tax benefit of a partnership. LLC does not pay income taxes and each partner, called a member, has limited liability. LLC is a kind of new and a
popular form of ownership.
If you are buying a property and you intend to own it by any above entities, first you must form the entity before closing the deal.
Real estate investors can either manage their investment, or outsource the managerial duties to a management company.
No matter which way you choose, you should understand what is involved in real estate management, and know the benefits and disadvantages of dealing with a management company.
These are the duties of a management company:
Collect rents and other payments due to the landlord.
Pay all bills (utilities, insurance, real estate taxes, services performed, employees, repairs, supplies, etc.)
Maintain the property in good condition.
Enforce all the rules and regulations under the tenant lease.
Comply with all codes and regulations.
Lease vacant units directly or through hiring outside brokers to do so.
Pay the mortgage payment.
Prepare a monthly report of all the financial statements.
[For hired third party managers:] To meet the owner and discuss matters concerning the property, such as capital improvements, budgeting, etc.
The management company is responsible for all the repairs, maintenance of equipment, improvements and upgrading, pay for related expenses and bills. In some management agreements there is a certain clause that any expense costing over a certain dollar amount has to be authorized by the owner.
The advantages of using management companies are that they:
Have good knowledge of the rental market.
Have a good and firm set of policies, although some may not fit to your building.
Save you time
If one of the management company’s other clients wants to sell his/her building, the management will be the first one to know and can tell you the inside and outside of the building.
Large national management companies generally find you anchor and national tenants, negotiate for insurance and so on. Smaller local management companies are more appropriate for smaller projects.
If you decide to hire a management company to run your building, you must:
Interview with the person in the company who will do the actual work in your building.
Sign a management contract that you are able to cancel with a 30-day notice.
Also keep in mind that even with having a management company on board, you still have to supervise the management work, and make decisions such as approving the insurance carrier, capital improvements, cash flow, refinance, review vacancies and new leases and adapt policies to minimize your yearly taxes.
The advantages of managing your own investment are:
You will save money. Management companies with a large number of employees have big overheads. They charge about 6 percent of the rent collected, charge for leasing, charge for setting up their crew for repairs or contract for improvements. If you do your own management, I suggest you pay (not a rent reduction) one of your tenants to keep an eye on your building and do minor work for you. This way it saves you a lot of time.
You can learn about your specific rental market more than a management company will.
You can be a more active entity in renting vacant units, as compared to management companies that are responsible for filling vacancies in other buildings in addition to your own.
I personally recommend hiring a management company if your investment has many tenants, and if you do not have much experience dealing with real estate.
Leases are sources of income which in turn create value. Therefore lease negotiation is very crucial both for landlord and the tenant. There are numerous types of leases that are being used for each type of property.
Retail Leases. Leases for retail tenants are generally in the form of Triple Net Lease (NNN lease). In the NNN lease, on top of the base rent, the tenant pays pro rata share (based on square footage leased) for i) operating costs, ii) real estate taxes, iii) utilities. Some retail leases contain percentage rent. In the case of percentage rent, in addition to the base rent, if the tenant’s sales go over a predetermined figure, the tenant pays a certain percentage of the excess sales.
Office Leases. Gross lease is the typical lease used for offices whereby the landlord pays for operating costs, real estate taxes and in most cases the utilities. Office leases generally contain rentable area for which rent can be charged. This includes the tenant premises plus an allocation of the common area that directly benefits the tenant. Office lease also refers to usable area which is the area exclusively used by the tenant.
Another key word you must be familiar with in dealing with an office building is tenant improvement. Tenant Improvement (T.I.) is the amount of money that the owner will pay to the tenant for improving the tenant’s space by tenant’s own preference. The amount of T.I., measured per square footage , is subject to lease negotiation.
Industrial Leases. Industrial leases may be both in the form of NNN lease or gross lease.
Apartment Lease. Unlike retail, office and industrial leases that are for five years and longer with renewal options, apartment leases are usually for one year or in some cases for month to month. In some localities some certain apartment buildings are under rent control, meaning that even after the lease expiration the tenant may stay in the unit as long as he/she lives and the owner may only increase the rent by a percentage published by the local municipality. In some areas, even if the tenant moves out, you still cannot raise the rents. However, in others, you can. Research local laws to see what is allowed in the area you are planning to purchase.
No matter who manages your property, when it comes to getting new tenants, you as the owner must be in full command of selecting and approving the right tenant, negotiating with the tenant until the lease is prepared and signed by you.
I usually do not prepare my own lease form and I do not accept leases prepared by tenants. The best way is to use standard leases that are available to suite your needs.
Commercial real estate income directly impacts cash flow, return on your investment and the value of the property. The income does not come from anyone but the tenant. Thus getting the right tenant, treating a tenant right and fulfilling the needs of a tenant are very crucial.
For the new tenants, unless it is a “name” AAA credit tenant, you must fully screen your rental applicants. You need tenant financial documents and specifically you must run his/her credit report through a credit company (see section……..regarding credit score) to find out his/her credit history. Study the application carefully and make some calls to the individuals who are used as references. You must feel comfortable about the applicant’s character and financial history before you interview them in person.
My experience with tenants is that most tenants see the landlord as a big guy against the small guy. Because of that fear, from the beginning and during the term of the lease they see the landlord as an adversary and sometime, hostile. This unfounded impression sometimes takes them to a point that they may demand some things from the landlord that are beyond any reason or outside their contract rights.
You must establish a good relationship (not personal) with the tenant upon your first meeting in order to smooth the tension that frequently characterizes a landlord-tenant relationship. Be very cordial to the tenant and do not play authoritarian. Treat the tenant like you are treating a customer.
Further, as a show of good faith, do something extra for the tenant at the beginning and sometimes during the term of the lease, even though you are not obligated to do so (always remind the tenant that you did not have to do it per contract).
When you negotiate a lease, the term of the lease is very important. “Name” tenants ask for longer leases because they invest greater money in the premises for improvements. For small businesses, I suggest a shorter lease - up to 5 years is suitable. A shorter lease will give you the freedom to raise the rent sooner – if you feel the rental market is in upsurge- and if you plan to renovate the building in near future.
Landlord (or management) must do repairs within reasonable time, maintain the property in good condition and make the tenant a happy customer, within reason. In lieu of that you must enforce all the rules and regulations and collect rent on the due date with no exception.
Well known tenants that are considered anchor tenants in a shopping center generally dictate to the landlord certain lease requirements such as term, square footage and rent per square foot. You must give them the credit of creating traffic to the center that benefits the other businesses but their leases are still negotiable. Study what they pay in their other locations before you negotiate with them.
Regardless of the lease term, an annual rental increase is stated in the lease. This amount is usually decided by the Consumer Price Index (CPI) that is published for the whole year which is related to the rate of inflation. I persuade my tenants to go with a fixed percentage of rent increase and tabulate the pre-determined annual rents in the lease rather than every year wait for the CPI to be published.
When the lease is up, you want to raise the rent to what the market rent is for a comparable building. You must thoroughly study the market and gather supporting data before you notify your tenant of the new rent. If you have a good tenant and you do not want to lose him/her, I suggest that you raise him/her rent to a level slightly less than the market rent to avoid cost of vacancy and other related charges. You may also want to do something for them in return of that rent increase. Have in mind that a good and long stay tenant, even at a lower than market rent, is the backbone of your property’s financial structure.
For the unfit tenant who usually threatens and does not move out, I suggest that you make the utmost effort to negotiate a settlement rather than taking legal action and ending up in court.
If tenant complaints are out of the ordinary and tenant is irrational, that tenant should be removed if possible. However, whether you personally manage your property or someone else does, tenant complaints should be taken care of immediately.
As I mentioned before, real estate increases in value in the long run, even though it may dip in between, due to inflation and other economical external factors. But the human element is one, that if it played right, that can accelerate this appreciation much faster than market appreciation.*
Whether you or a management company manages the operation, I believe you as the owner is fully responsible for all the value increase items discussed in chapter….Since the value increase has the utmost importance in owning real estate we would like to discuss this matter further in this chapter. There are many ways to increase the value of your property such as:
Raising rents is an integral part of raising the cash flow and the value of your property. On average, for every $1 you increase a property’s monthly rent, it relates to a $12 increase in one year and the property’s total value increases about $90 to $150 depending on the property’s CAP rate. We discussed the impact of rent increase in Chapter 10.
To understand how to raise rents, it is necessary to understand how leases work. Leases can be signed for as little as one month (with month to month options of renewals), all the way to ten or more years. In general, apartment leases run from one to two years, office and industrial leases have a term of two to five years, and retail leases go for five to ten years. At the expiration of the term of the lease, the lease automatically converts to a month-to-month deal, optional for both the owner and the occupant, unless a new lease is negotiated and signed for a new term.
Leases have certain clauses for an annual rent increase—usually a fixed percentage of the rent amount (i.e. the rent increases 3% annually compounded), or a rate based on a certain index such as a cost-of-living index.
It is the owner’s responsibility to know and enforce contractual annual rent increases in a timely manner. Before the lease is expired, the owner should negotiate, preferably with the existing tenant, for a new lease at the market rent or slightly less than the market rent.
In order to maximize your rent increase, you must maintain your property in good condition during the term of the lease. Improvements in the property also allow for rent increases. You can improve on the common areas as well as inside the tenant’s unit.
The purpose of property improvements is to enhance a property’s income and value. Significant property improvements (renovation or remodeling) are performed on properties that are not newly built, and that the owner does not plan to demolish in the near future.
Making property improvements can often be a rather complex process, due to the numerous options there are, and the various budgets and economical efficiencies that must be met. There are two major factors to consider:
An owner must know how and where to spend his/her allocated property improvement funds in order to achieve a maximized increase in the property income and value. If, for instance, you own a small office building, and your cash flow situation provides you with a $5,000 budget for property improvement, you must determine whether it is better to spend the money on, say, landscaping to improve the property appearance, or on various improvements to the common bathrooms. In the end, you want to determine what will increase the value of your property.
When making property improvements, one thing also to consider is what the current and potential future tenants prefer—after all, property improvements are aimed at achieving highest rents and it is the tenant who pays the rent. If you own a twelve unit apartment building that is missing garbage disposals in the kitchens, and you have received several tenant complaints about this, then would it be better to install the new garbage disposals or to use your money to repaint the building exterior?
You must have some experience and know-how in construction and remodeling to minimize the costs of your improvements. For example, improvements can include the following:
New facades and/or storefronts
Painting or insulating the buildings
New roofing
The addition of elevators
Replacement of modern items such as new kitchen cabinets, appliances, bathroom fixtures, etc.
New plumbing and electrical
Additions to the property
In deal #4 in part 1 of this book, we bought a 36 unit apartment building on Sunset Boulevard with a large basement with no use. Since the property is zoned commercial, I brought the dead space into life by fixing it up and I built a stairway to get direct access to the new space from Sunset Boulevard. Then I leased it to an art studio business for $1475/month.
If the cap for that property is 8, we can figure our how much value I added to the property as a result of this improvement that costs about $8,000. Let us do it together:
Added Value=NOI=1475x12=$221,250
Cap .08
I created $221,250 value (equity) in a period of about six months at a cost of $8,000 and some of my time.
Not all improvements make such extraordinary results. Regardless, improvements must be done on a continual basis. Maintain the property in a constant upgrade mode. Raising rents can be done much easier if you keep up with the upgrading of your property. For what you are investing, you will see great returns in value.
Zoning is a process in which the city designates segments of the city into zones where only certain types of development could take place. This concept is implemented in most areas in the country so that, for example, a developer can not build a high rise office building next to your house. Houston, Texas is one of the cities that have no zoning restrictions.
Zoning and building codes that regulate what actually is allowed to be built on a given lot are very critical to commercial real estate. Each city has zoning maps of the real estate that is within that city and also has a building code book.
All the zoning and codes always go through changes continuously which may change the property value accordingly. An older building may have been built according to the zoning and building codes at the time the building was constructed. However, due to the change in zoning, zoning ordinances, and new building codes, it becomes a nonconforming use.
In the above situation, the building is grandfathered which means that you are still allowed to maintain the building as it is. That means that although the new codes have replaced the old codes, you are not obligated to bring an existing building up to the new code. However safety codes such as fire and health codes are not grandfathered. In these situations the city gives the owner ample time to bring it up to the new ire and safely codes code.
Every zoning classification has a list of possible uses that would normally be permitted within that zoning.
Zoning is an indication of what type and how dense you may build. For instance, in the city of Los Angeles R4 indicates that you may build 100 units of multifamily units per acre, whereas R3 signifies that you may build 50 units per acre of the land. What follows are the building codes that should be followed such as height, setback, and parking requirements etc. You may build less than allowed, but not more.
In Deal#3, Part 1, we bought a 36 unit 1920’s apartment building in a lot with an area of about 7,000 square feet with no parking, no handicap access to the building and no setbacks. Today it is zoned for R4 and the existing building does not meet any of today’s codes (because it was grandfathered). However, we provided heat and observed all the health codes and fire codes. The same building was also not up to today’s code of earthquake forces resistance, which was brought up to the new code for older buildings by the previous owner.
Zoning is always changing by the planning and zoning department in the city and can affect the value of your property. Some are down zoned, making them less dense and with more restrictions, and some vise versa. The owners may also make a request for zoning modifications or relief from a zoning ordinance under a zoning variance.
Real estate laws vary from city to city. What an R4 zoning allows you to build on a lot in one city may be different in another city with the same designation.
Allowed Use is one of the most important characteristics of a property. Whether you are buying a vacant land for development or a property with an improvement on it, the use and ultimately change of use of an existing building affects its value a great deal.
In the case of vacant land you should know: What they will let you put there. In the case of the existing structure, what will they let you add to the existing building or what other uses you are allowed to have other than the current use?
As the supply and demand plus property prices and rents for different categories of real estate change, the opportunity of change of use can yield huge profits. For example:
Converting office buildings into condominiums.
Converting office buildings into apartments/lofts.
Change a Victorian home into an office or medical offices.
Convert a storage space into a showroom.
Convert 1st floor of an office building into retail.
As I was writing this book, a friend of mine told me that he has a deal in escrow with the following descriptions. It is a huge building in south central Los Angeles which was once occupied by manufacturing businesses but now is vacant. He is buying it at $57 per square foot of the building and he is going to turn it into a swap meet which is very popular in that section of Los Angeles. He had already studied the market and the closest existing swap meet rents for $ 4.00 per square foot per month.
Assuming he loses 30% of the gross building area for common spaces such as aisles and corridors in turning the space into swap meet, that will bring cost of square footage by 30% more or to $76 per square foot. Let’s say it would cost him $20 per square feet construction cost of turning the space into swap meet, the total cost to him shall add up to $96 per square foot. Rents of $4.00 per square feet per month translates into $48 per year. Assuming $8 per square feet per year is total cost of operation, that leaves him $40 net income per square feet per year.
If he buys the property in cash, he would collect $40 per square foot vs. $96 investment. That is not a bad deal. It is a fantastic return on his money. If he borrows some of the purchase money, he would create a leverage, so that the return on his investment will be even higher.
In all cases above you must do a market study to find out if new use magnifies the rent substantially and justifies the extra cost of improvements for conversion and the time you spend to do the work. Thus you must tailor the features of your property to perfectly fit that target market. The other matter is that you must check with the local city and find out whether the local zoning allows making such change of use and whether you have enough parking spaces for the new use.
If you are renting a place for residence, I highly recommend that you own a home instead and if you are a starter in real estate, your first purchase should be your home. Advantages to home ownership are:
You benefit from the deduction of interest in your personal tax return.
You benefit from the deduction of real estate taxes (unlike commercial real estate).
The down payment on a home is less than commercial property. You can get loans up to 97% for homes up to $200,000 and up to 90% for homes over $200,000.
Your home appreciates in value in the long run.
The loan amount is reduced through amortization of the loan.
If you are first time buyer of real estate, you gain experience in real estate.
If you reside at your home for a minimum 2 years and you want to sell, unless you want to make a 1031 exchange (defer the capital gains tax) any profit under $500,000 for a couple, or $250,000 for a single, is not taxable.
What price of home can you afford? No more than 25% of your gross income should go toward mortgage, property taxes and insurance. I do not recommend that you refinance your home and pull out cash simply because that is your home and your family shelter. You do not want to create high debts on your residence and lose it at time of depressed economy when you are not able to pay your mortgage..
Your other choice of buying a place of residence is to purchase a condominium, duplex, triplex or quadruplet. All the above qualify as a residential home for getting a home loan. In the latter case, you can buy the multifamily project (up to four units), reside in one and rent out the others and manage it.
Real estate investing involves either buying an existing property, or buying a piece of vacant land to develop. I have covered the former topic throughout this book, and I will briefly cover development in this chapter.
Developing land is a far more intricate process than buying an existing property, due to factors such as:
Time and timing. There is generally a span of about three years between the time you search for land to buy and the time you complete the development process. Many changes can occur over this time and upset your calculations.
The Market. You are creating a new product in the market, and must make assumptions about the income and the value of the finished product. [How is this marketing?] I think it is marketing. You are guessing market price of a finished product.
Tasks and people. You will need to deal with many people in numerous fields such as architects, engineers, city clerks, and contractors.
Personal liability. In order to secure a loan for land development, you will need to make a personal guarantee on the loan, and expose your personal assets to your potential business losses.
Risks involved with time and budget constraints. Land development involves deadlines and budgets to meet, and if you fail to meet them, you will be exposed to major financial losses.
If you are a beginner in real estate investing, I strongly recommended you avoid land development. Land development requires extensive real estate experience. First purchase existing properties, and after you have familiarized yourself with the business, you will be better equipped to deal with all the new variables involved with developing new properties.
We mentioned in the financing section, the property owner obtains a loan from the lender and a note is drawn up by the lender with the property as collateral, signed by the owner (borrower). Many lenders (note holders), due to cash requirements or other government regulations, sell the note. By selling the note, all the rights of the lender shall be transferred to the note buyer. So the buyer (investor) of the note is the new note holder or the new lender who collects the monthly payments and enforces all the terms and conditions of the note.
The note may be sold at a price equal to, less, or even more than the principal amount of the note at time of sale, depending on different circumstances existing at the time of the sale of the note such as condition of the property, status of the payments, the note’s interest rate versus the current market rates of interest and so on. But in most cases the investor may be a large insurance companies or the like who are looking to buy good status, performing loans, at a discount.
One way of buying a note at a deep discount price is when a property is in foreclosure and you can purchase the note from the lender. The investor can then complete the foreclosure process and make a substantial amount of profit. The only disadvantage for the buyer is that he/she must buy the defaulted note at all cash.
The deal is also profitable for the seller of the note, generally a bank, does not go through the hassle of foreclosures, owning of the property, managing the property and selling. All of the above are extremely expensive for a large institution plus legal ramifications that they may cause, whereas the individual investor is more willing to take on all the hassles for a large profit.
Unless you are a real estate attorney, you need legal consultations in real estate matters. You must engage a competent real estate attorney (not general purpose attorney) to represent and protect you in all real estate transactions. This does not mean you have to get the most expensive lawyer in town. Just get the one that best suits you and what you are doing.
Confine the use of attorneys to legal aspects of a deal. Business decisions such as price are matters for the investor to assess, not his attorney. The attorney’s job is to examine all the paperwork and the title and report to you of his findings, but you are the one to make the final decision. I recommend that you do not involve your attorney in any part of negotiating the transaction.
Another thing about attorneys is that they generally see their job as offering conservative advice, like “do not do this” or “do not do the deal” at all. You should not necessarily follow his advice. You are evaluating the deal, you know what the deal potentials are and you are the one who knows what is in the deal for you and after all you must be prepared to take some risks. Thus do not let your attorney discourage you in making a deal.
In my few deals in Part 1 of this book, I did not make my attorney involved in any of my negotiations or conferred with my attorney about the risks I was taking in making any of the transactions. My attorney only studied the contract, the title and the escrow instructions. In deal #1 I took high risk of purchasing a note collateralized by a property with a few legal issues. I took the risk without conferring about its legal consequences, if any, with my attorney and ultimately I ended up with big rewards for the risk. If I asked him his opinion about legal issues of deal #1, he would have definitely discouraged me of getting close to the deal.
I have sometimes confronted attorneys who created more problems than they are worth. Recently I was going to sign a lease with a tenant whom I had made verbal agreements on all issues. I filled out all the blanks of a standard lease that is very common in the trade and handed to him. The prospect tenant’s attorney insisted that he must prepare his own lease from scratch.
Since the tenant brought in his attorney, I had to get my attorney involved. My attorney rejected the new proposal because he said it would cost me thousands of dollars for his time and may take close to a month before a new retail commercial lease is drawn that would be agreeable to the two attorneys and the two clients.
I lost the tenant and I lost 2 weeks of my time in negotiating with the tenant only because the tenant’s attorney was going to customize a new lease for his client for a lease of about $1,500 /month rather than using a standard lease.
Income tax laws for real estate property owners allow them to defer taxes on their gains. There are several methods of doing this:
1. A 1031 Exchange allows an owner to sell a property tax free by using the sale proceeds to purchase another property (under Section 1031 of IRS code) within a certain number of days after the sales date.
2. Depreciation is a “paper entry” deduction of the estimated decrease in building (not including land) value due to wear, tear, and obsolescence. Owners use this deduction in their calculation of annual income.
For instance, if you have a property with $25,000 annual cash flow (after operating expenses and mortgage payment), and your accountant calculates $6000 in building, you only pay the IRS taxes on $19,000. Or, if in this example you have $0 annual cash flow, you would have -$6,000 (loss) that you can use against any other current or future income you have.
You do not have to pay taxes on the depreciated amount, unless you sell the property at a profit that indicates the overall property value has not depreciated.
For instance, if you bought the property in the above example at $500,000, and depreciated it on paper for $30,000 over 5 years, and then sold the property, your tax basis cost is now $470,000 ($500,000 - $30,000 depreciation), and thus, you ultimately pay taxes on the $30,000 you depreciated on paper, plus any appreciation that has occurred over the $500,000 purchase price.
The depreciation period for a commercial property is 29 years and that of single family residence is 31.5 years. For example, if you buy a commercial property for $100,000 of which $80,000 assessed for the building and the remaining $20,000 is assessed for the land, you may depreciate the property at the rate of $80,000/29=$2,758 per month for 29 years
3. Retirement plans might allow you to defer all or part of what you have invested in real estate (through your retirement account) and thereby defer taxes.
Note that in the above cases, the tax payments are being deferred, and must ultimately be paid someday. Still, deferring taxes is financially advantageous. It is like getting an interest free loan on the deferred tax amount—and you can use the funds to earn a return.
In all cases above, talk to your accountant or tax consultant before taking any action.
People who own and sell their place of residence are exempt from taxes on gains under $500,000 for couples, or $250,000 for a single person.
You can even take advantage of this law by continuously purchasing fixer upper homes to live in, improve, and then ultimately selling them for gains of $500,000/$250,000 limits without paying any taxes.
Another tax benefit of your place of residence such as a house or condominium is that the mortgage interest may be deducted.
When should you sell a property?
The common advisory is a generalized “buy low and sell high,” or perhaps, “buy when the market is bad, and sell when the market is good.”
But in truth, it is difficult and often impossible to determine where the economy is in its cycles of low and high.
You might believe you are selling high after the general real estate market shoots up 30% over six months, and then watch it increase an additional 60% over the next year. And likewise, you might believe you are buying low after a steady long term decline in values, but then values continue to decline much further for much longer.
When it comes to selling a property, I believe that the main reasons to sell are:
Major problems such as disputes with partners, etc.
The numbers (return on equity, etc.) do not justify owning the property anymore
You have exhausted all of the property’s major opportunities / potential
In trying to determine whether you should sell, consider the disadvantages of selling:
Broker fees
Legal fees
Closing costs
Prepayment penalty built in your loan
Potential difficulty in finding another place to invest your money
Payment of any deferred taxes.
Payment of any capital gain taxes (unless you do a 1031 exchange).
Loss of any advantages from various states property tax laws that benefit real estate owners whose property values have increased. For example, in California, an owner’s annual property tax due increases only 2% (in dollars) per year beginning form the year he purchased the property—so if you own a property that appreciates faster than 2% per year, you benefit. You lose this benefit when you sell the property.
Time and effort required to sell a property
These are all significant disadvantages.
Make a broad examination before deciding to sell. I know many people who sold a property mainly because of the excitement generated from its value appreciation and / or a broker’s encouragement, without properly assessing the total advantages and disadvantages of selling.
Also realize that you can refinance a property that has appreciated in value, and thereby procure additional funds for purchasing real estate investments.
In this chapter, I am going to discuss different processes of real estate such as buying, selling, leverage, loans, form of ownership, economy, title, foreclosures, etc. involved in one single property. I am going to use as many real estate terms as possible so that the reader understands the practical use of each term. Although the examples and the deals are hypothetical, they all happen in real estate at all times.
Let us say there is a commercial property for sale and Owner #1 buys it for $100,000 cash. Since Owner #1 did not borrow any money to purchase the property, the leverage is none or zero.
Let us say Owner #1 sells the property at $100,000. In this case Owner#1 has no gain. Thus, he does not pay any capital gain tax simply because he made no profit. If he had sold it for $105,000 and he paid $5,000 brokerage fee and other closing costs, he still would not pay any capital gain taxes on sale of the property.
Owner #2 does some preliminary studies on the same property. According to the data sheet provided by Owner #1, the property is an apartment building that collects $10,000 rent per year and expenses are reported as $4,000 per year. The owner provides the preliminary data to a bank and finds out from the bank loan officer that the bank is willing to give him a 25/7 year fix loan at 10% interest (25 is the amortization and 7 is loan due date). From that, he refers to his computer and figures out his yearly mortgage payment:
Income$10,000.00
Operating Expense ( 4,000.00)
Net Operating Income$ 6,000.00
Mortgage Payment (5,412.12)
Cash Flow$ 587.88
Owner #2 uses his math ability to figure out the following:
CAP Rate = 6,000/100,000 = 0.06 or 6
Return on Investment = 587.88/30,000 = .0196 or 1.96%
GRM = 100,000/10,000 = 10
Owner #2 with the above figures in hand goes to the market and compares them with that of similar properties for sale or similar properties sold in the last 3-6 moths. He also does a preliminary inspection of the property including building conditions, its potentials and studies the surrounding area and concludes that the subject property is what he wants to buy.
Owner #2 goes into escrow (the escrow company is to be mutually agreed by buyer and seller, but many times the seller names his choice of escrow company as a condition of sale which I do not see as an issue for the buyer). Owner #2 will deposit 3% of the purchase price, or $3,000, in escrow. Both owners agree on a 60-day closing, 15 days contingency for inspection and 30 days loan contingency. All are reflected in escrow instructions which are signed by Owner #1 and Owner #2.
The escrow company orders a preliminary title report for Owner #2 to review. Owner #2 does physical inspection before the 15-day deadline and looks for a loan of his choice from banks and loan institutions.
Owner #2 finds a proper loan with a bank and fills out an application. One question asked in the application is “what name do you want the property to be vested in?” If he wants to buy it under his name he will put his own name, but if he wants to buy it under an entity, he must have already set up the entity and recorded it beforehand. If there is an entity, as opposed to an individual, the bank wants all related paperwork to see who they are dealing with. They want to know whether the person who is applying for the loan is authorized by the entity (or the entity owners) to borrow money for the entity and ultimately sign the loan documents.
The escrow company wants the ownership information as well to be able to record the deed.
Owner #2, as an individual, is approved by a bank (his credit score is 750, the building is appraised at $100,000 and no other problem exists) by a letter of interest in which all major loan conditions, such as the amount of loan is to be 70% of the appraised value or $70,000, are spelled out. The loan is a fixed loan bearing interest at 6% and is due in 10 years, but all are contingent upon the bank ordering an appraisal and doing other studies such as environmental reports (if needed) at Owner #2’s expense.
If Owner #2 is not satisfied with his inspection of the property or upon review of the paperwork and the title, before his 15 days are up, he will notify Owner #1 that he is not interested in the deal. He gets his $3000 deposit back and the deal is dropped from escrow. On the other hand, if the bank finds out that something is out of line, the bank will notify Owner #2 that they will not fund it unless some new conditions are met.
In that case, Owner #2 will send the bank’s letter to Owner #1 through escrow and if Owner #2 is not interested in the deal, on the face of that letter he can drop the escrow and get his $3000 deposit back. Now, what if he is still interested in the property?
The bank’s new conditions may be of two kinds. One is that the property is appraised for $90,000. Thus the bank is willing to give a loan of 70% of $90,000 or $63,000. The remaining $37,000 must be paid as down payment by Owner #2 rather than $30,000. The other may be that hazardous material or some structural material has been discovered in the property and the bank does not make the loan until it is corrected.
Both issues are problems of Owner #1. Owner #2 is not putting a $37,000 down payment on a $100,000 property that has been appraised for $90,000, unless he has found some potentials in the property that overweigh this deficiency. But this problem is generally negotiated between Owner #1 and #2 and the purchase price is reduced to a level that is satisfactory to both sides of the deal.
Environmental problems create many costs and take too long to be corrected and the bank’s loan conditions are good for only a short time. Therefore, in much of these cases the escrow is dropped.
Let us go back and assume Owner #2’s inspection went well, he did his diligence, he approved the title report and other documents and no major problems occurred with the loan. At some point the bank notifies the escrow company that it is ready to fund. The escrow company notifies both sides of the same and the only thing needed in escrow is $27,000 to be deposited by Owner #2 plus the fact that Owner #2 must show up in escrow to sign the note and trust deed prepared by the bank which reflects all items in the bank’s letter of interest.
Once the fund is placed in escrow and the deal is closed, the bank immediately places a lien on the property in the amount of $70,000 and records it with the recording office of the county where the property is located. The date and time of recording is of utmost importance. All of recordation shall be reflected in the property title immediately. We will call the bank “Lender #1” and the loan “Loan #1” and recordation date March 21, 2002 which is the same date of closing escrow.
Escrow gets about $1000 in processing the deal. This fee is split by Owner #1 and Owner #2. Upon closing the deal, the escrow company pays Owner #1 an amount of $100,000. $70,000 of which is paid by the bank and remaining $30,000 by Owner #2.
Owner #2 now owns an income property that was bought at leverage (he borrowed money to purchase the property). This property’s income covers the expenses and the mortgage (debt service).
The real estate market is in an upsurge and Owner #2 improves the building and raises rents. In February 2004, Owner #2 needs $25,000 cash for personal matters (he has another business that he wants to expand or is short of cash, or there is a federal tax lien on his assets including the subject property. The tax lien is due to non-payment of personal or business tax.)
The subject building value is now estimated at $130,000. He comes to this conclusion by looking at recent sales and making the following calculations:
Income$11,300.00
Operating Expense ( 4,200.00)
Net Operating Income$ 7,100.00
Value = NOI = 7,100/.055* = $129,090 or $130,000
* When the property was purchased in 2002, CAP rate at the time was 6. During the past two years, the real estate values of similar properties in the neighborhood have been moving upward. Owner #2 has also improved the property considerably. As a result, the CAP Rate for this building and similar buildings surrounding it has improved from 6 to 5.5.
His equity has been raised from $30,000 in March 2002 to $60,000 in February 2004. In order to raise money via his property, Owner #2 has a few choices 1) To sell the property 2) To refinance it 3) Get a second loan.
Owner #2 needs only $25,000. He decides not to sell, but refinance. However, he can not find a loan with less than a 7.5% interest rate, plus the fact that he has to wait 2 months to get refinancing done. Have in mind that in refinancing he has to pay back the existing loan, thus he will lose the existing 6% interest loan. In addition, he has to pay 2% of the loan principle amount (the existing loan is amortized for 25 years which is now at about $68,000) as pre-payment penalty and all other charges for applying for a new loan.
Due to numerous fees and the wait associated with refinancing, he decides instead to get a second loan for $25,000, which he will call Loan #2. He is referred to a mortgage company who is willing to provide him $25,000 hard money at a 9% interest rate in 10 days. Due to time constraints, he accepts the loan which was funded and recorded on October 15, 2004.
Borrowing more money increased the debt service to some extent, but higher rents due to a good economy created more revenue to balance the cash flow. However, at the start of 2004 the economy slowed down and income dropped due to vacancies. It got to a point in late 2006 that the income was not enough to pay all the expenses and the debt service. Owner #2’s income from his business also dropped so he is also not able to infuse money into the property.
The first thing he does is stop paying property taxes. Why, among so many expenses, did he pick property taxes? Because they are a low priority expense--he can put off paying them without suffering much negative consequences. He instead utilizes his available funds to pay off the most necessary expenses and accounts payable--those that will have much impact on him and that he benefits most from attending to.
As things get worse and his cash flow diminishes, and in order to stay afloat, Owner #2’s only choice is to hold payment to either of the lenders or both. If a mortgage is not paid, according to the trust deed clauses, the loan goes into default and the lender sets foreclosure procedures.
Let us say Owner #2 stops paying Loan #1 and continues paying Loan #2. In this case Loan #1 will go into default and Lender #1 will immediately order an appraisal of the property to find out the value of the property and where the bank stands.
According to the foreclosure procedures, Lender #1 notifies Owner #2 and Lender #2 via direct letters and notifies the public via newspapers that Lender #1 intends to auction the property and the minimum bid is set at $67,000 principal amount plus back taxes, legal fees, etc. of $4,000 or a total of $71,000. The highest bidder shall pay cash and will own the property.
Once the foreclosure is concluded, all existing loans are wiped out and the winner becomes owner of the property clear of any loans. Out of the sale proceeds, Lender #1 shall be paid for the principal balance of the note, late fees and other charges noted in the trust deed plus all of Lender #1’s legal fees related to the foreclosure which is $71,000. The remaining money, if any, shall be paid to the owner of the 2nd trust deed and if any amount remains from the auction, it shall be paid to Owner #2.
If the value at the time of auction is such that the highest bid does not reach the total of what is owed to Lender #1, then Lender #1 shall become the Owner of the property and all the interest of the 2nd note holder shall be wiped out in the foreclosure process. This is only because the 2nd loan was acquired and recorded at a later time than the first loan, or rather, the 2nd loan was standing behind the 1st loan.
What if the first loan was current (meaning they are still paying the mortgage) and the second trust deed is not paid and the holder of 2nd trust deed decides to foreclose and become an owner? In that case the 1st trust deed will not be wiped out as the foreclosure is completed. In other words, based on the date of acquisition and thus recording date of the loan, the earlier acquired loan has a priority over the later acquired loan. In this case, after the foreclosure, Lender #2 informs Lender #1 of its ownership and assures Lender #1 that it will continue to make the first mortgage current.
Regarding the priorities of liens, property taxes automatically take precedence over any other monetary lien. In other words property taxes are always in a form of a lien against the property. Thus in any foreclosure, property tax liens have priority over other liens and in the case of this foreclosure procedure, property taxes including penalties and interest has to be paid by the new owner even before the 1st mortgage.
Let us follow up the above by using real numbers:
The subject property bought at $100,000 in 2002 increased in value to $130,000 in 2004 and it dropped to ½ of its highest value or $65,000 in 2006. Let us see what is on the property title and understand each party position at this stage in 2006.
LienProperty taxes for specific periods in the amount of $2,500
LienA Loan in original amount of $70,000 dated March 21, 2002
LienA loan in original amount of $25,000 dated October 15,2004
If the owner has a personal tax lien, that is also recorded in all the assets of the owner including this subject property. Now let’s see the conditions and positions of everyone involved in this scenario:
The Property. It is worth $65,000, but there are three monetary liens in the order of seniority on the property 1) tax lien of about $2,500 2) 1st trust deed of about $67,000 principal plus $4,000 back interest and legal fees 3) 2nd trust deed of $25,000 plus back interests, if any. The property has now negative cash flow.
Owner. The owner can not afford to infuse money to bring all the above to current or even if he can afford, he is not interested to bring in any further money into this when he knows that what is owed is more than what the value of the property is (value is $65,000 vs. total owed is $98,500; taxes due are $2,500, Lender #1 is due $71,000 and Lender #2 is owed $25,000) and he has no way to know when the economy is going to turn around. If he decides to let go of the property with the foreclosure, he has lost his initial investment of about $30,000 minus a few years of depreciation which he can write off in his future personal tax return.
Lender #1. If Lender #1 forecloses, after payment of property taxes of $2,500 it will end up owning the property worth $65,000 short of what was owed. The only way Lender #1 could recover the shortfall would be if Owner #2 had given a personal guarantee for the loan. Then they could go after him for the shortfall. Or they could keep the foreclosed property and wait for better days when the market picks up.
Banks in general are not interested in going into foreclosure and owning a real estate property due to 1) the huge overhead associated with default and foreclosure 2) managing real estate and 3) selling the property at a price less than what is owed to them. Many lenders in a bad market negotiate for a short pay-off meaning they are willing to negotiate with the owner and get paid somehow less than the amount due, but in cash, and call it quits rather than going through the foreclosure process. In this case if the owner has the money, he pays Lender #1 the negotiated price for the loan, continues to pay the monthly mortgage on Loan #2 and waits for the time that the market turns around and the property income and value bounce back.
Lender #1 also has the option to sell the note, calling it a non-performing loan, to another bank or entity for a cash price of considerably less than $70,000. If sold, the buyer of the note is the new lender which under the terms of the loan and trust deed has all the same interest and legal rights as Lender #1. In this case, the buyer of the note will initiate the foreclosure process.
Lender #2. If Lender #1 is in the foreclosure process, Lender #2 may take part in the auction rather than the bank or others becoming the owner through foreclosure. In this case Lender #2 has to pay at least $71,000 plus $2,500 property taxes in the auction to become owner. Lender #2’s only reason to become the owner is to protect its $25,000 investment, thus putting good money after bad money thinking that someday in the future the value of the property will go up and will recover the original $25,000 plus $71,000 paid in the auction plus $2,500 paid for the back taxes.
County Assessor. There is $2,500 in taxes due at this time, and growing, plus the interest of 18% on the amount due. But although the county lien is ahead of the 1st and 2nd trust deed, the county can not put it into auction until 5 years have passed since the tax default started.
Let’s say Owner #2 had the staying power that every savvy real estate man should have. As the market drops and income diminishes, the Owner infuses cash deficiencies into the operation every month with the knowledge that someday the market is going to bounce back.
The market starts to turn around in 2007 and by 2008 total expense balances out the income and Owner #2 stops putting money into operations.
In 2012, ten years after the property was purchased, the property is worth $160,000.
Loan #1 is due (the loan term was 10 years), but the loan principal balance is now $54,000. Loan #2 was an interest-only loan and therefore there is no principal reduction. The principal balance always remains the same during the term of the note. Owner #2 owes a total loan of $54,000 + $25,000=$79,000 at this time. If he had let the building go in 2004, he would have lost his initial investment of $30,000. But instead he infused additional funds in the amount of $6,500 from 2004 to 2008 during the slow years of the economy. In 2012 his equity is $81,000 ($160,000-$79,000) and the building revenues allow him to take out $4,000 cash from the operations each year.
He now has to refinance the building because the loan is due. He can refinance it for an amount equal to 70% of the value which will be 160,000 x 0.70 = $112,000. Out of the proceeds of refinancing, he pays off the existing loan of $54,000 plus the 2nd loan of $25,000 and he cashes out the difference which is $33,000.
After ten years, he not only recovered his initial investment of $30,000 but he also has $33,000 in his pocket and has equity of $48,000 ($160,000-$112,000)
CONCLUSION
We have been discussing real estate as something that pays off in the long run. There are ways to make a quick buck in real estate, but a savvy real estate person is always prepared for the bad days until things subside.