Tuesday, December 14, 2010

Investment Lesson #4 - Real Estate

Real Estate refers to land and buildings attached to the land though we could expand it to include mobile homes. In the past only royalty owned land and everyone else had to pay rent to the kings and queens either directly or through lords. These days it is common to either own your home or pay rent to a landlord. Of course real estate also includes office buildings, shopping malls and other structures intended for commercial purposes.

Compared to opening a savings account, buying bonds, mutual funds and stocks, real estate my seem like an advanced topic for a beginning investor but hang in there.

Let's begin with what I believe is the simplest way to invest in real estate. Buying shares of a Real Estate Investment Trust, REIT. The overall value of this type of investment tends to fluctuate just as much as stocks do. In fact I have owned REIT's and found them virtually indistinguishable from stock mutual funds. The investors' money is pooled together and the REIT invests in buildings that are leased and managed. REIT's are regulated to pay out at least 90% of their profit to the investors. Of course you may be wondering what's keeping the managers from keeping most of the profit for themselves. That's the "trust" part--OK, let's get into managing real estate by ourselves.

Much of my experience in real estate has to do with the homes that we have owned. Real estate agents talk about owning your own home as an investment but in my opinion your own home is an expense while a home you rent out or intend to immediately re-sell is an investment. You usually don't receive an income from the home you're living in so all the money that goes into the mortgage, taxes and maintenance are expenses. The only way to get money out of your home is to either rent it out or sell it. Real estate agents will tell you that you can get cash from the equity of your home but I hope you are reading "Debt is Slavery" and know by now why that is usually a bad idea.

Over the long term I have heard that bonds return on average about 6% per year, with stocks it is around 9%, but what about real estate? Property values barely out pace inflation, a measly 5%. So, why would anyone want to get into the complex world of real estate investment?

There are a lot of forces that go into real estate investment. One of the most important is called leverage. Let's say you want to buy an apartment building. You don't just plunk down a load of cash, you take out a loan, or as it is known in real estate terminology, a mortgage. You make a down payment of let's say 20% and mortgage the remaining 80%, you bought 100% of a building but only paid 20% of the purchase price. Your stake in the building, your equity, is less than the amount of the loan so technically, you're in debt--you owe more than you own. Now you've got a mortgage to pay but you are collecting rent and most of it goes to the monthly mortgage payments. If you made a good deal you're collecting enough in rent to pay the mortgage and other miscellaneous expenses like property tax and maintenance. Let's say the property value does go up an average of 5% per year. How much does your equity go up? Sure, you're paying off some of the principal of the mortgage every year but not much so let's not even factor that in.

Original purchase price --------------------------- $1,000,000
Mortgage 800,000
Down Payment (original equity) 200,000

5% property value increase after 1 year ------------$1,050,000
Mortgage 800,000
Equity 250,000

Note: Don't be alarmed by the size of these number, I'm trying to give you a realistic scenario and you could buy a small apartment building in Los Angeles for around a million dollars. Also, these are easy numbers to work with.

You're still making 5% on 100% of the building's value, but since you only put up 20% of the money you're actually making a 25% return on your investment. What about the bank? They're making whatever percentage rate that's on the mortgage, these days it would be around 4.5%. Why would they settle for such a small return while you're making the big bucks? You're taking all the risk and doing all the work, if you don't pay the bank they can take back full ownership of the building no matter what balance is left to pay off the mortgage.

You might wonder if you can increase your leverage by making a smaller down payment, say 10% or even 5%. The problem with this is that your monthly mortgage payment increases and the bank will add other charges like Private Mortgage Insurance (PMI) making it unlikely that the rental income will cover the mortgage, taxes and maintenance costs.

Of course this is an oversimplification. There's all sorts of charges and expenses that you have to deal with when owning rental property, but this is basically how leverage works in your favor. What if the property value drops? Hopefully you still have tenants paying the mortgage so you can wait it out until property values rise again--they usually do over the long term. One thing to take into consideration is that you haven't really made a profit or loss in this deal until you cash out by selling the property.

Something else to consider is if rentals go up during the time you own the property, you'll eventually have a decent cash flow. I had a friend who owned a few rental properties for many years and a large part of his personal income came from the rent he collected on those properties.

There are lots of other ways to invest in real estate. If you can find a property that is close to defaulting on the mortgage you might be able to buy it for a substantial savings either from the unfortunate owner who is about to have his credit rating destroyed, from a foreclosure sale or from the bank (short sale), then fixing it up and flipping it. There are even ways you can buy property with no money down by taking control of a distressed property. This is what so many get rich quick in real estate schemes are all about. I have watched several infomercials by real estate gurus like Robert Alan, Carlton Sheets and Ron LeGrand. I've also read books on real estate investing, including "Real Estate Money Machine" by Wade Cook. It seemed simple enough but rather risky. How risky? In 1987 Wade Cook filed for personal bankruptcy and in 2007 he was sentenced to 88 months in Federal prison for tax fraud. Lots of wannabe millionaires who followed similar real estate investment schemes have either ended up bankrupt and/or in jail. Now don't get me wrong, there are legal ways to make a fortune in real estate. It isn't easy, in fact it takes a lot of work compared to other investments.

So much for what I haven't tried--let's get into some of my personal experience with real estate.

When I was helping out with my mother's finances I noticed that she was still paying off the house. My parents bought that house over 20 years ago but they still owed about half of the original purchase price of the house. How can that be? On a normal 30 year fixed loan the payments are fixed. In the early stages of the loan the principal amount is high so there is more interest due but as the principal is paid down there is less interest. As a result, the principal isn't halfway paid off in 15 years but in about 20 years.

I entered some nice round numbers into an online amortization calculator to illustrate how this works. Here's a $100,000 loan amortized for 30 years with a 5% interest starting in January 2000.
Amortization Schedule
Year Interest Principal Balance
2000 $4,966.49 $1,475.37 $98,524.63
2001 $4,891.01 $1,550.85 $96,973.79
2002 $4,811.67 $1,630.19 $95,343.59
2003 $4,728.26 $1,713.60 $93,630.00
2004 $4,640.59 $1,801.27 $91,828.73
2005 $4,548.44 $1,893.42 $89,935.31
2006 $4,451.57 $1,990.29 $87,945.02
2007 $4,349.74 $2,092.12 $85,852.89
2008 $4,242.70 $2,199.16 $83,653.74
2009 $4,130.19 $2,311.67 $81,342.06
2010 $4,011.92 $2,429.94 $78,912.12
2011 $3,887.60 $2,554.26 $76,357.86
2012 $3,756.92 $2,684.94 $73,672.92
2013 $3,619.55 $2,822.31 $70,850.61
2014 $3,475.16 $2,966.70 $67,883.91
2015 $3,323.37 $3,118.49 $64,765.42
2016 $3,163.83 $3,278.03 $61,487.39
2017 $2,996.12 $3,445.74 $58,041.65
2018 $2,819.83 $3,622.03 $54,419.61
2019 $2,634.51 $3,807.34 $50,612.27
2020 $2,439.72 $4,002.14 $46,610.13
2021 $2,234.97 $4,206.89 $42,403.24
2022 $2,019.73 $4,422.12 $37,981.11
2023 $1,793.49 $4,648.37 $33,332.75
2024 $1,555.67 $4,886.19 $28,446.56
2025 $1,305.68 $5,136.18 $23,310.38
2026 $1,042.91 $5,398.95 $17,911.43
2027 $766.69 $5,675.17 $12,236.26
2028 $476.33 $5,965.52 $6,270.73
2029 $171.13 $6,270.73 $0.00

If you add up the principal column it should add up to $100,000 but because of rounding errors on the calculator it only adds up to $99,999.98. Care to add up the interest column and add it to the principal? It's $93,255.79 in interest so $193,255.79 is what will be paid to the bank over the life of this loan, basically you will pay the bank double what you borrowed. Mind you 5% is a very low interest rate. Rates on 30 year fixed home loans were at about 10% when Rosie and I got married and have spiked even higher in history. Try plugging those numbers in an amortization calculator.

My mother was shocked to learn that after making mortgage payments for so many years she had so much more to go in order to pay off the house. I pointed out that by taking the money she had in a very low interest savings account and paying off the mortgage she would save several thousand dollars that she still had to pay in interest over the remaining life of the mortgage. She took my advice and asked me to take care of her finances for the rest of her life, which I did.

Around 1988 I almost bought my first home. I was still making a living as a photographer but recently got out of a studio space that I was renting in order to concentrate solely on location jobs. One of the most important parts of the property that I was looking for was a garage where I could lock up my van and equipment. I found a very small house with a full sized garage near my parents. The structure was tiny, about 400 square feet, but it had a large backyard, enough for a pretty decent vegetable garden for now and room to expand the house when I needed the extra space. I called the agent who was handling the listing and put in an offer, along with a "good faith" check of about $1,000. The house was listed for around $92,000 and I started the transaction by offering $90,000, the seller accepted. One of the first things that happened was that the house was inspected by an expert and appraised. It was appraised at about $97,000 (I'm pulling these numbers from my memory so they aren't exact but well within the ballpark). I was planning on putting 10% down--in my earlier examples I used 20% because that's "normal" for rental or commercial property but this was a house that I was planning to live in and I didn't want to put my entire life's savings into it. One of my photography clients was a mortgage banker so I approached him with it and asked if I could qualify for an $81,000 loan ($90,000 minus the $9,000 down payment). "No problem," he said, but his company only accepts their own appraisers' valuations so he had it appraised again. This time it was appraised at $85,000. What this meant was that I could only get a loan for $76,500 and I would have to put up $13,500. I looked at other options including something called a VA loan which I qualified for because I was a veteran but nobody wanted to work with me on it because of the government bureaucracy involved. In addition, although I could technically buy a home with no down payment, I wouldn't be able to qualify because of the high mortgage payments and my very unstable freelance income--so much for serving your country! By this time I got to know the owners quite well. They were a cool, semi-hippie, unmarried couple who used to live in the house and leased it out when they moved to a nicer neighborhood. Their renters subleased the garage and they even had someone living in the garden shed! I actually started moving in and staying there a few nights just to see what it was like and discovered that it was a terrible neighborhood. The seller then suggested cutting out the real estate agent so he wouldn't have to pay her commission--she was representing both the buyer and seller so she would have gotten double commission, 6% for selling and 6% for buying and that 12% ($10,800) had to be paid by the seller. Of course the real estate agent could have sued both of us for breach of contract. It was all getting too weird so I backed out of the deal. I think I got back a little bit of the $1,000 I put in when I made the offer.

It was almost 10 years later that I finally did buy my first property. This time I was married, had a mostly steady income and enough money to put 20% on a $240,000 townhouse in West Hollywood. I actually had to qualify without including Rosie and her income because she was working on "The Mask of Zorro" and couldn't sign the loan papers during the escrow period. I was working in Northern California at Skywalker Ranch and flew down to Los Angeles every weekend to take care of things--other than that, the deal went through very easily. It was a bit scary having to pay $1,500 per month on the mortgage for the next 30 years, up until now the most I ever paid in rent was $850. As it turned out we didn't have any trouble making the $1,500 monthly payments and we were even able to put some money into an investment account. Interest rates were quite high at the time so when rates dropped I took the opportunity to refinance the loan, basically that means that we paid off the old loan with a new loan. I paid down the loan when we refinanced and lowered our payments to $1,300. This was a time when we were both working and the stock market was booming with the dot-com craziness. I was caught up in this irrational exuberance but it nagged me to owe money to the bank. I started to pay down the mortgage by paying more than $1,300 every month. At this point you might be thinking why would I do this? Only the interest on the loan is tax deductible, but only a small percentage of it--my feeling on the mortgage interest tax deduction is like having to pay a dollar in interest for every fifty cents saved in taxes--in reality it is probably even worse than that. Paying down the principal didn't lower our monthly mortgage obligation. If we were making more money we could have been able to afford to move into a larger house, but we liked our condominium just fine. What was I thinking? First of all, a mortgage is literally a contract to the death. Many people never live to see the day their house is paid off. I was doing quite well with my investments but I knew that I could lose it all with a few investment mistakes. The safest investment I could possibly make was to pay off the mortgage, the loan papers told me exactly how much I would be paying into the mortgage and it was much more than our home was worth. If we fell on hard times and missed a few payments the bank could repossess our home no matter how much we already paid into it. I cashed out most of my stock holdings and paid off our first house, two years after we first bought it, one year after we refinanced it. The bank had a clause that levied a $6,000 prepayment penalty, but they never charged it to us. I doubt they had much experience with borrowers paying off their loans that early.

We might still be in that first home if it weren't for another situation that came up with my mother. At the time she was almost 80 years old and living alone. She wanted to live closer to her sons but still be independent. What she didn't want was to go to a retirement home, not yet. Rosie and I looked into several options, the most reasonable seemed to buy a duplex so we could have her right next to us. However, the duplexes we found were not as nice as our condo. We kept looking for something without stairs, nearby, nice neighborhood close to shopping and a hospital--just in case. Then one day after seeing yet another disappointing duplex I suggested looking at open houses in an area where we would like to move into, just a few blocks away from our condo. We saw a couple of very nice houses and Rosie almost cried telling me why were we looking at places that we couldn't afford, these houses were listed over $800,000. What we learned was that these homes had garages that were converted into guest houses. I did some calculations and if we sold my mom's house and rented out our condo, we could make this work. We made an offer on one of the houses, the owners counter offered and we finally settled on a price of $750,000. When we were going through the escrow period we found out that one of the condos in our building sold for a very high price so we changed our plans from renting it out to selling. I can't say that everything went smoothly but we were able to sell both our condo and my mother's house and buy the house that we now live in. Our condo sold for $420,000, nearly twice what we bought it for, and my mother's house, which my parents bought around 30 years ago for $22,000 sold for about $350,000. While our condo was in escrow we had to take out a mortgage which we easily qualified for in order to close the deal on the house, but our intention was to pay it off as soon as possible. We were able to pay off the mortgage in just two months. That seems to impress lots of people but I can tell you that those two months really hurt, $4,000 per month going mostly to the bank to pay interest on the loan. The funny thing was that the both times we bought homes I was between jobs and collecting unemployment benefits. Fortunately I didn't have to dip into our other investments because I kept an emergency cash account that easily covered these expenses.

Not having a mortgage allowed us to continue building up our savings and investments. At one point Rosie was becoming interested in owning an apartment building. She had some friends who owned rental property and they were doing quite well. She also wanted and investment that she could manage herself because she didn't understand the type of investing that I was doing. I agreed with most of her arguments except one--real estate always goes up, never down. We were very fortunate to have sold our condo at nearly double what we paid for it about 5 years earlier, and our house was rapidly appreciating in value but I have seen housing prices drop several times. When you have a loan on a property that is declining in value, leverage works against you. If the value drops to less than the amount of the loan, it is called an upside down mortgage, underwater loan or negative equity. However, at the time prices were going up and banks were coming up with all sorts of creative ways to package up loans in order to make it affordable to home buyers. One type of loan that has been around for several years ties the interest rate to an indicator of current interest rates, usually Treasury bills, this is known as an adjustable rate mortgage (ARM). These mortgages have lower starting interest rates than conventional fixed rate mortgages where the interest rate never varies, but there is a possibility that the interest rate could rise during the life of the loan to the point of becoming unaffordable. Other loans had low interest rates for a few years, usually 5 years, and would then either go way up in interest or would require a huge balloon payment. The way these loans were marketed the borrower would either move or refinance the loan before the balloon payment became due. Some loans required that the buyer pay the interest only for several years so none of the principal would be paid down and some were even negative amortization loans where the borrower wouldn't even pay the entire interest due so the loan kept growing with every payment. I didn't want to have anything to do with these loans and would only agree to taking out a 30 year fixed rate loan. By the way, eventually when housing prices did fall during the subprime mortgage crises these "creative" loans were termed toxic mortgages. In any case, one of Rosie's friends was a real estate agent and she found us a four unit apartment building a few miles away in an area known as "Melrose Hill." My requirements were that the rental income at least matches the mortgage payments, one thing I didn't want was an "investment" that we had to keep feeding in order to keep. We put down $150,000, mortgaged the rest of the $750,000 purchase price and became slumlords. For the most part Rosie enjoyed dealing with the tenants but every time something went wrong, stuck toilet, clogged drain, etc. I had to get involved. There was a community coin operated washing machine and dryer and we used to pay our smaller cash expenses with the quarters we collected. Technically we were supposed to report those quarters on our taxes but we didn't, in fact we in a rather gray area with some of the income and expenses we were reporting on the apartment building. That's actually quite typical with landlords. We would buy paint and use what was leftover on our house, you know, things like that. My friend with the rental property used to go to Home Depot and collect receipts off the floor to report extra expenses. Of course we had quite a bit of fully legitimate expenses too, during the time we owned the building we made several improvements including building a new enclosed patio on one of the units. When tax time did come, we had more deductions than we anticipated. You see the tax codes were written to heavily favor property owners. We could deduct all of the interest we were paying on the loan because it was a rental property. We could also depreciate the building which gave us even more deductions. For tax purposes we were loosing money but we were actually breaking even. After owning the building for just over a year I was noticing that real estate prices were rising very quickly. I suggested putting the building on the market for $1-million, after all if somebody buys it for that we would make a quick profit and it didn't really matter to us if it didn't sell right away because the renters were paying our mortgage. We got an offer for $950,000 and took it. Remember earlier in this lesson how leverage can work in your favor? We made a $200,000 profit on a $150,000 investment. Well, that's if you include the real estate agent and the bank under "we" because we had to pay commission, interest, loan fees and so on. However we did manage to double our money in just one and one-half years. This was the best return on investment in the shortest time that we have ever made. Though in a way I pitied the couple who bought the building, they had to take out two loans and there was just no way that the rents could cover the cost of their mortgage payments.

We looked for another apartment building near the beach so we could possibly keep one of the units for ourselves, but every time I tried running the numbers I couldn't get it to work. Somehow the real estate agent could get a positive cash flow out of the buildings she showed us but she was doing it with some loans that would charge just 1% interest for 5 years and then would come due. She too was convinced that the buildings would only appreciate in value but I wasn't that sure. I saw too much risk in her plans. Eventually I was proved right, the real estate bubble that burst in 2007 was triggered by bad loans on declining property values.

We still wanted to live by the beach so we looked for opportunities in Mexican properties. Once we made a trip to Mazatlan, Los Cabos, Todos Santos and La Paz searching for a beach home that we could live in part time and list it with a vacation rental management company for the rest of the year. We almost put an offer on a beautiful architect showpiece home in Cabo San Lucas but we didn't file the paperwork when we found out that access to the beach for that community of homes had been cut off. Good thing we checked, the real estate agent claimed he didn't know anything about it.

There are houses in our neighborhood that are selling for over $2 million, by some estimates our home is currently worth about $1.5 million but like I said, it isn't an investment unless you rent it or sell it. I have considered selling the house and moving to a more modest place away from the city, but we weren't quite ready to retire--or rather, Rosie didn't want me to retire just yet. I wanted to move to at least a semi-retired lifestyle so we came up with the idea of remodeling the garage, moving into it and renting out the house. People that I talked to about this either thought it was very smart or very desperate--how bad was work that I had to do this? We aren't really suffering at all. We were able to rent out the house for $4,000, the same as the mortgage I had to pay when we first bought it. Of course since we don't have a mortgage, the tenant is actually paying our living expenses. Sure, we have to deal with a tenant with a couple of kids living right next to us but so far it has been more than worth it--and actually kind of fun!

I can't claim to be an expert on real estate investing. By my definition we really made one investment in a single apartment building. Maybe not buying the properties we passed up were the best real estate investing decisions we made, maybe not. In any case, a part of the reason we can afford a comfortable semi-retired lifestyle is because of the deals we made in real estate.

In any case, for now our downsizing experiment is working and we're still thinking about selling the house and buying a small place by the beach, but not necessarily in that order. As I write this the real estate market is way down. Has it bottomed out? Who knows, all I know is that condos by the beach that used to sell for $1-million are now within our means. If we do buy a place we'll probably hold onto the house until the market recovers--at least we hope it recovers in a couple of years or so.

One last note about real estate investing. If you think being a landlord with a bunch of apartment buildings is a retirement, think again. It is a lot of work! In fact, you're running a business which is something we'll get into in the next lesson.


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