• 28Apr

    I am going to discuss an interesting way to look at real estate investing that may be a bit unconventional to most property investors.

    A while ago, I watched a video by Charlie Munger, who is well-known as the business partner of Warren Buffet and his famous quote “Tell me where I’m gonna die and I’ll make sure I don’t go there.”

    In this video, Charlie who was 83 at the time, shared his life time of wisdom to make him a billionaire with a group of university graduates who are about to start their career.

    There is one particular statement that really interests me; he said “You are not entitled to an opinion unless you can state the arguments against your opinion better than your opponents can.”

    I find this statement quite profound but very difficult to apply in real life, I thought I would put it through some of the opinions widely circulated within real estate investment and see how it goes.

    Before I am entitled to an opinion of “how useful Charlie’s statement is”, the counter argument of “how useless it is” can be something like the following:

    We are all entitled to our own opinion about anything, regardless of whether it is right or wrong, it doesn’t really matter what other people say.
    Sometimes an opinion can be completely wrong, but still workable in life. “The earth is flat and still” is a good example of this, completely wrong, but workable! Wouldn’t it be more workable to think that you are walking on a still and flat surface than a rotating ball?

    So for the rest of the article, allow me to focus on how useful I think Charlie’s statement can help us as real estate investors.

    What I have done is, go back to look at some of the tenets of real estate investment that we have taken for granted without examining the opposite arguments, then see if we can learn something from it, and more importantly see if we can discover investment opportunities most people miss because they fail to see the other side of the story.

    I found the most common opinion about real estate investing is: Land goes up in value because of its limited supply so buy properties where land is of limited supply!

    If you look at the property performance in Australia since 1996, good quality established suburbs all share this land scarcity factor, they all perform very well according to this tenet. For example, while building cost is increasing 3-4% a year tracking CPI, the land value has increased as much as 12-14% a year, which averages out a 10% growth for a property over the last 15 years.

    It is very easy to not question the opposite side of this opinion when the facts are overwhelmingly supporting this argument.

    What if we follow Charlie’s suggestion, the counter argument can be something like: “Land goes down in value because of limited supply, don’t buy properties where land is of limited supply.”

    I must say when I first wrote this down, I thought to myself this must be considered crazy by anyone with any common sense in the investment industry, it is just utterly against anything we have been told about investing in property.

    The only reason I didn’t stop there was because of Charlie, he didn’t become a billionaire by being stupid, he must see tremendous value in this counter argument exercise to spot investment opportunities most people miss. So I ‘forced’ myself to see under what circumstances this counter argument could make sense.

    Interestingly enough, it didn’t take too long for me to see that this counter argument not only has its value, but it could also help us discover investment opportunities most experienced property investors miss in today’s market.

    Let me explain.

    It is obvious that land appreciation was the main driving force behind the property price growth in the last 15 years. But property prices are ultimately capped by how much income people have for qualifying for a mortgage, this is more so in today’s lending market where releasing equity without income support has become increasingly difficult.

    So you can almost say over the longer term, we should see something like:

    Income Growth = Property Price Growth (which can be broken down to Land & Building price growth)

    So if Income Growth is 3%, and Building Cost Growth is 3%, then Land Price Growth should also be 3% to make this formula work over the longer term. E.g.

    Income Growth (3%) = Property Price Growth (3%) [Land Price Growth (3%) & Building Cost Growth (3%)]

    However, in the last 15 years, our Income Growth is tracking along the Building Cost Growth, which is around CPI (3-4%), but the Land Price Growth has been 12-14% per year. So you have something like:

    Income Growth (3%) < Property Price Growth (10%) [Land Price Growth (12%) & Building Cost Growth (3%)] You can see the Land Price Growth has been much faster than Income Growth. When investors look at where to buy, they bought in areas where Land Price Growth has been 12%+ per annum, usually in established suburbs where land supply is very limited. And it has worked for them in the last 15 years (between 1996 till now). The question is "how long can the gap between Income Growth and Land Price Growth last without the Land Price Growth being forced to slow down?" Graphs of the Melbourne median house price between 1978 and 2009 show property prices have grown much faster than income for a long period of time till 1990 (reflected by the mortgage repayments of a median house taking up too larger a percentage of an average income), Property Price Growth then stopped for about 5 years to wait for the Income Growth to catch up. These graphs show a similar phenomenon is looming if you move your attention towards 2009. So I can see the counter argument "Land goes down in value because of limited supply, don't buy properties where land is of limited supply" makes sense when the Land Scarcity factor has been over sold for too long to the point that land value was severely over priced. In other words, Land Scarcity can be the main reason why investors can make good money, but it can also become the main reason why investors may make less money or even lose money. Before we all rush to abandon the traditional high growth areas, we all know that there is a shortage of supply of properties in comparison to demand, so property prices are likely to continue to go up for a while. The traditional strong growth areas didn't become high growth areas for no reason. After a period of flat performance (such as 1990-1996), they will always bounce back and accelerate the growth, so I personally think they will always be good areas to hold your properties for the longer term. The question is where you should be putting your money to work intelligently over the next 5-7 years to make the best return with the lowest risk? Right now, if you buy an old house in a traditional strong growth area within 20km of CBD in most major cities, you are expected to pay $700k+ with a gross rent of 2.5-4%. Some of these properties were worth only $200k-$300k less than 10 years ago. In contrast to these areas, you can still find property prices around $350k to $400k within 20km of CBD, whether they are houses in some transition areas (areas that are being re-zoned for residential housing) or lower price apartments in the more established areas, gross rent can still be around 4.5-6%, with the taxman helping the cash flow the first 5 years if the property is reasonably new. Let's look at an example. Let's say you have the capacity to buy up to $800k worth of investment properties, your wage is $100k pa, and you can borrow 100% plus stamp duty and costs at 7.5% interest rate, because you have equity from other properties. Let's compare the following two possible options using Melbourne data as an example: Option 1: If you buy 2 x $400k properties, two brand new houses, $200k building and $200k land, in a transition suburb 17km from Melbourne CBD. Achievable gross rent currently is 4.6%, we may assume a potential growth for the next 5 year is at 9.4% per year (Melbourne's average for the last few decades) due to its relatively lower price in comparison to Melbourne's median house price of $550k and its distance from the CBD. So 5 years later, each of these properties will be around $627k. Option 2: If you buy 1 x $800k property, an old house of 25 years, $200k building and $600k land, in an established & traditionally high growth suburb, also 17km from Melbourne CBD. Achievable gross rent currently is 3.5%, we may assume a slightly lower growth at 6.5% for the next 8 year due to its relatively inflated land value after a 15 year great run. So 5 years later, this property will be around $1.1m. (Please note that a $1.1m home in the same neighborhood at 7.5% interest rate, will attract a $83k mortgage repayment per annum, which is coming out of a family's after tax net income.) So let's look at the following diagrams to compare the Cash Flow of the above two options. Option 1 (2 x $400k):$75/week or $4k/year out-of-pocket the first year. A total $19k out-of-pocket for the first 5 years. (see below table) Now - Property Value $400,000 Year 1 - Property Value $437,600, Cost per week to hold $75 Year 2 - Property Value $478,734, Cost per week to hold $97 Year 3 - Property Value $523,735, Cost per week to hold $82 Year 4 - Property Value $572,967, Cost per week to hold $65 Year 5 - Property Value $626,825, Cost per week to hold $45 Option 2 (1 x $800k):$489/week or $25k/year out-of-pocket the first year. A total $113k out-of-pocket for the first 5 years. (see below table) Now - Property Value $800,000 Year 1 - Property Value $852,000, Cost per week to hold $489 Year 2 - Property Value $907,380, Cost per week to hold $465 Year 3 - Property Value $966,360, Cost per week to hold $436 Year 4 - Property Value $1.029m, Cost per week to hold $405 Year 5 - Property Value $1.096m, Cost per week to hold $375 Let's compare the total money made over a 5 year period by simply using: capital gain + cash flow. Option 1 (2 x $400k):Capital Gain ($627k x 2 -$400k x 2) + Cash Flow (-$19k x 2) = $416k. Option 2 (1 x $800k): Capital Gain ($1.1m - $800k) + Cash Flow (-$113k) = $187k. On top of that, the stamp duty difference was: $43k - $7k x 2 = $29k. So Option 1 is better off than Option 2 by: $416k + $29k - $187k = $258k. This doesn't include the following two major factors in favor of Option 1: Easier finance:it is much easier to get 95% finance for a $400k property, and almost impossible or too expensive to do the same for a $800k property. In other words, option 1 needs less money from you! Lower risk:the risk for a $400k property to lose $100k in value is a lot less than an $800k property in the current heated market condition. In other words, option 1 is lower risk for your money. Before I rush to claim "Option 1 is better than Option 2", I need to see under what circumstances Option 2 will be better than Option 1, if I were to follow Charlie's teaching "You are not entitled an opinion unless you can state the arguments against your opinion better than your opponents can." So the argument for buying a higher price old house in an established suburb for investment purpose in the current market condition is that good suburbs will always be in high demand, and rich people get richer quicker. One can never underestimate the long-term potential of those high growth suburbs even when they may experience some temporary slow down coming off a long period of strong growth. These suburbs may 'lose the battle' over the next 5-7 years against the up and coming transition suburbs, but they still have what it takes to 'win the war' over a much longer time frame. Can you see the power of applying Charlie's teaching on just one of the tenets of property investing? The benefit can be enormous when we apply this to other areas of our lives, such as relationship, work, values, moral standards and spiritual beliefs, it can teach us to avoid extreme ideology and be more accepting to people who are different from us.

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  • 28Apr

    Real estate investors instinctively pass on deals presented to them simply because the numbers don’t work. This is quite understandable, however sometimes a little more digging can uncover a simple reason for the property’s lack of cash flow. This issue often comes down to incompetent ownership which results in mismanaged properties.

    Mismanaged properties or properties which are “underperforming” can be a virtual goldmine if you know how identify and capitalize on the true potential another investor simply is not realizing.

    Owner incompetence typically comes down to six major issues. In most cases these issues can be remedied simply with a combination of good management practices, an understanding of fair market value pricing and rents in your neighbourhood and of course, injecting a little cash.

    The following examples generally pertain to smaller multi-families (2 -20 units) however the principles can be applied to larger multi-families.

    Below market value rents

    This common faux pas stems from a lack of knowledge of fair market value in the area, resulting in a cash flow issue. If a property is at +/- breakeven cash flow at 100% occupancy, any vacancy results in the property owner having to cover any shortfall.

    The solution is clear. Raising the rents even $100.00 per unit (depending on the number of units) can turn an apparent cash flow issue around. This can be more difficult process however, based on which province the property is in, and the Landlord/Tenant board guidelines of the particular province.

    As the new buyer of a property, you have the option of requesting vacant possession. This allows you to reset the rental amounts at whatever the market will bear. It is not until you have set the rental amount that you are bound by most provincial Landlord & Tenant guidelines as to how much of an annual rental increase you are allowed.

    It does need be said that by requesting vacant possession, you must abide by provincial laws which clearly state you must be either moving into the property yourself (or a family member) or you are intending to do significant renovations.

    Absence of good property management

    Lack of this skill is one of the biggest downfalls of any would be investor. This encompasses everything from improper screening during the tenant interview process to the daily aspects of running the property. Neglecting any of these areas will result in an underperforming property.

    Without a rigid system in place to screen the tenants, owners subject themselves to delinquent rents, frequent vacancies and potentially large repair bills. Lack of initial tenant qualification, absence of urgency in collecting rents and not having proper eviction procedures in place are common characteristics of a mismanaged property.

    Using property management or self – managing is another factor to consider. The novice investor often self manages to save money, however lack of efficiency is typically equated with the lack of time the investor has to dedicate to property management and ultimately the property suffers and becomes an underperformer.

    Hiring an incapable property management company can also create an underperforming property. Property managers have been known to have poor screening procedures because they only get paid when a unit is tenanted. This is more common than you may expect. The bottom line is low rents and high turnover.

    Often property managers also outsource repairs and “pad” the bills as extra income. If the owner was in control of the management, they would know exactly what the repair was, the cost of materials and labour necessary to fix the repair, not to mention the name and number of people in their database to do the repair.

    If the property you are looking at is part of a condo corporation or strata, there could also be mismanagement of reserve funds. This is common and results in excessive monthly fees. Being on the condo/strata board and having a hand in how money is being spent can potentially bring down the monthly fees, thus enhancing the bottom line.

    Ultimately by leaving the management to someone else or not managing the manager will often lead to underperformance. Negative results stemming from poor property management is also the main reason why many incompetent investors get out of property ownership.

    Lack of routine maintenance

    Lack of response to tenant requests of routine maintenance is the number one reason for turnover and vacancy. This obviously results in negative cash flow which contributes to underperformance.

    This issue is very easy and inexpensive to correct. Hiring a caretaker instead of a property manager who has handyman skills allows payment of an hourly wage instead of an overall percentage rate and “padded” repair costs.

    A caretaker can show units, perform tenant interviews, enforce leases, collect rents, deal with tenant issues and repairs as well as oversee more significant repairs to ensure they are done satisfactorily in terms of budget, schedule and quality workmanship, especially if you are an absentee owner.

    I also make sure my tenants get a repair request sheet which forces the tenant to document each repair and creates a paper trail. This helps avoid any hearsay if an issue arises and gives the landlord incentive to get the repairs done within a reasonable amount of time. This goes a long way in creating long-term tenants, which in turn creates an efficient property.

    Letting properties become rundown by neglecting routine maintenance

    The properties being referred to are neighbourhood eyesores. Common characteristics are unkempt landscaping, clearly visible overdue repairs to even a makeshift car (or appliance) repair/storage facility on the driveway (or front lawn).

    Not only does the incompetent investor have an undesirable looking property but probably thousands of dollars of renovations. These properties ultimately attract the type of tenant that nobody desires.

    The good news is they can often be purchased for great deals and turned around into highly functioning properties with good tenants and great cash flow. To understand if it is worthwhile to get involved in such a project, it is important to ask yourself the following questions:

    a) Is this an ugly property in a good area?

    b) Are the repairs required cosmetic?

    c) How much will the repairs cost?

    d) If I do repair the property, will I be able to raise the rents enough to offset the costs?

    e) At the proposed new rental amount, how long will it take to retrieve my capital expenditure?

    f) If I do the repairs and raise the rents accordingly, will this property attract the type of tenant who will want to live in the neighbourhood and afford the “new” rental amount?

    Not taking initiative in your eviction process

    An incompetent owner who allows delinquent rent to perpetuate for months or is not familiar with the landlord/ tenant guidelines can create an inefficient property producing negative cash flow and tenants who often take over the property.

    These owners can be very accommodating when it comes to negotiation for purchase as they are often looking to get out fast. Properties do not have to be in a bad area to get to this state, they simply have an inexperienced or neglectful landlord.

    By demanding vacant possession, doing the necessary repairs and creating a new tenant base, these properties can be turned into gems.

    Records mismanagement

    Poor record keeping of rental income, repairs, employee payments, property management documents and even lack of formal lease agreements can “catch up” are signs of an incompetent owner. It is surprising the number of owners who run their business with cash and little documentation. This type of owner eventually must “wake up and smell the taxman”. A business can only survive like this for so long before the owner must change their ways or sell.

    Repositioning Properties

    Repositioning means turning a property into its highest and best use, which is what we have been talking about this far, essentially ensuring the highest potential earning capacity of a property. Let’s touch on the repositioning process.

    A property that is very accessible to all amenities and transportation could be categorized as an “A” area, but the property could be older, run down and may have significant vacancy, therefore categorizing it as a “B” or even “C” property. A cash injection to improve the property to the standards of the “A” area may allow significant rental increase. Once the building is renovated and can justify higher rents with less vacancy, it is easier to refinance to get most or all of your renovation capital out, allowing you to repeat the process on another property.

    Unfortunately we can’t reposition all properties. There are many building where the cost of improvement is excessive compared to the increased income expected, or perhaps the area just doesn’t warrant the effort. Proper diligence is everything.

    When repositioning a property, implement a strategy for both the repairs and the management simultaneously. For the repair phase, make sure to:

    a) Get at least 3 repair quotes to formulate a budget

    b) Hire a project manager if the repairs are extensive; otherwise hire handymen who specialize in particular trades. Make sure they have referrals of past clients you can call, proper insurance and are willing to work within a schedule

    c) Schedule the maintenance with the contractor or handyman for the quickest turnaround time and put the expected timelines in the contract, including bonuses for being on or under budget and time or penalties for being over

    d) Base your contract on materials and labour separately

    e) Make cosmetic improvements to create a safe and pleasant environment maximizing curb appeal. This will attract better tenants to the property and command a higher resale profit

    For the management phase:

    a) Hire a reliable caretaker or property manager; making sure they have referrals (call the referrals!)

    b) Create a marketing plan to attract higher income tenants

    c) Create a screening system and a tenant retention program for your caretaker or property manager

    If you are keeping existing tenants, have your new manager:

    a) Notify each tenant of the new management and give them a schedule for the upcoming renovations to their unit and the grounds

    b) Give each tenant a repair request sheet(s)

    c) Give the tenants a copy of the new “house rules” outlining expected behavior of both tenants and guests

    d) Collect any rents which are in arrears and begin immediate eviction proceedings on those who refuse to comply

    e) Alert the tenants of new rental rates on all renovated units. You can get exceptions from some Landlord/tenant boards to raise your rents higher than the annual allotment based on significant renovations or additions

    f) Pay any non-compliant tenant a “moving” fee to leave

    g) Begin new leases with all compliant tenants if possible

    Repositioning properties is kind of like becoming the new coach of a losing sports team ¾’s through the season. (Sounds like the Leafs!) Use your skill and experience to inspire and help coordinate many non-functioning parts into an entity which has chemistry and gels.

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