Pearls of wisdom. Perhaps an expression overused on occasion, but certainly an appropriate characterization of the article that follows. Steve Layman has been selling, leasing, developing, re-developing, and investing in real estate for decades. He has the kind of domain expertise that many others do who have trod a similar path. But in his case, he found the voice to get that experience down on paper – succinctly. It’s a great retrospective for senior leaders in the industry, and a superior learning resource for those earlier in their real estate careers. For investors where real estate is peripheral to their primary professional focus, it is an essential guide.
Guideline #1: Do it.
"I found the road to wealth when I decided that a part of all I earned was mine to keep."So says Arkad, the hero of George Clason's classic book, The Richest Man In Babylon.
The idea is that out of any paycheck or income stream we must first set aside a percentage for savings and investing, then we can spend what is left. If we do it the other way and spend first, there will never be any money left for savings and investing. Something about human nature. Something about discipline.
Most of our economic troubles in this country would soon disappear if reading and understanding the principles of The Richest Man in Babylon was a requirement for high school graduation. Do yourself a favor – read this small tome once a year.
To summarize Guideline #1 for investing - just do it.
Guideline #2: Know why.
Know why you are investing.
Investing for cash flow looks different from investing for capital appreciation.
Guideline #3: The money is made when you buy.
You make your money when you buy. It takes hard work, discipline, and time to consistently earn money as an investor. If you overpay for an investment, it just makes it that much harder and takes way more time. Buying at cap rates below 8% is to be avoided at all costs.
Guideline #4: Value is derived from usage.
The value of real estate is derived from its use, or from its potential use. Over time, that often changes.
Guideline #5: Location, location, location.
Three very important words that everyone has heard make up Guideline #5.
Location, location, location.
An acre of commercially zoned land, on a busy commercial street, situated on the far corner of an intersection with a traffic light, may be worth twice as much as the acre adjacent to it that is not at the corner and ten times as much as an acre located a half mile away on a side street. All real estate is not created equal. See Guideline #4.
Guideline #6: Know what you are, and are not, buying.
There is a reason why purchase agreements have “due diligence” clauses.
Here is the "boiler plate" list of things to consider and inspect that we use before committing our clients, or ourselves, to buy.
"....environmental site assessment, appraisal, wood destroying insect inspection, well and septic inspections, gas line inspection, zoning and building code compliance, soil and wetlands study, soil compaction analysis, lot line location, inspection of the structural condition of the improvements, mechanical systems review, roof inspection, flood plain impact, utility availability and capacity, curb cut and access availability, lease and rental review, and economic viability analysis..."
Obviously the entire list does not apply to all investments, but using those that do apply and then adding the title insurance commitment (to locate easements and other potential restrictions) and perhaps a survey and your knowledge of the property now enables better decision making.
Use the due diligence time… As they say at Faber College, "Knowledge is Good".
Guideline #7: There is no bad real estate, only wrong owners.
There is no such thing as bad real estate, only wrong owners. If you can't feel good about a particular investment property, don't own it.
Guideline #8: Survive your first investment.
The trick to being a long term investor in real estate is surviving that first investment. Pay attention to both your comfort and your competency zones.
Guideline #9: If it is too good to be true, it probably isn't.
In 2009, the news media, both local and national, carried stories about investment gurus offering immediate returns on investment well above the norm. Those news stories ultimately included jail time.
See Guideline #26. Unless you are adding value to the process, real estate is an investment best suited for the long run. Be wary of "get rich quick" schemes and promises.
Guideline #10: These are business relationships, not friendships.
Landlords and Tenants have a relationship based on business, not friendship. Likewise, Lenders and Borrowers have a relationship based on business, not friendship.
Guideline #11: Good management makes good investments.
Properly screening tenants, maintaining the property, anticipating problems, communicating sooner rather than later, not letting issues fester. These are a few trademarks of good property management. It is not difficult, but it does take discipline. It is important.
Guideline #12: Budget for management.
Always. Successfully managing real estate investments takes time, discipline, and some acquired learning. If you are managing your own investments, pay yourself for your time. Not only are you earning it, but that way, once you get sick and tired of it, there will be money available to pay a professional.
Guideline #13: Budget for vacancy/credit loss.
Budget for vacancies and credit losses.
Almost always. Few are the tenants that you can count on being there forever. And, just because they are there, doesn't necessarily mean you will collect all the rent.
In normal times, factoring in a vacancy/credit loss factor of between 3% and 5% was considered appropriate. In our new normal times, the range between 5% and 10% should be considered.
Vacancy rates for apartments increased by several percentage points during the 2004-2006 home buying mania. They have now settled back. Good thing.
Vacancy rates for retail space have been skewed by long term vacancies in a number of "big boxes". Needless to say, these percentages are at historic highs. It’s hard to budget for those, so extreme caution is merited before investing in the retail market segment.
Guideline #14: Cash flow sometimes equals deferred maintenance.
Another word for "cash flow" is "deferred maintenance". It is fairly important to maintain your investment. Yes, it costs money in the short term. But, that discipline really makes you money in the long term.
Guideline #15: Roofs leak, just a matter of when.
All roofs leak. It is just a question of when. As with Guideline #14, setting up a reserve for replacement account is a necessary evil in owning real estate. Leaky roofs have a way of reducing a property's value. Roof replacements are expensive. Start at the beginning to put some of the cash flow aside to prepare for those large expenses that are in your future.
Guideline #16: Budget for taxes, income that is.
Since we do not believe in "investing" in things that are designed to lose money (see Guideline #25), profitable investments create an income tax obligation. Prepare for it.
One of our youthful mistakes in investing was to believe that all our investments should be paid off within ten years. It is important to know that we typically put as little as possible cash into the deal, financing as much as possible. This was not some grand strategy. It was just a reflection of the fact that we did not have a lot of cash. Most of our early investments were rehab projects. Back in the mid-1980's, we found a niche that had been mostly ignored; buying, fixing, and leasing older properties in the smaller "county seat" cities around Ohio. Ignored niches often offer significantly good returns on investment.
Anyway, back to the guideline. We financed several of these early deals with ten year amortization, trying to pay the debt off as soon as possible. We forgot, or more accurately did not realize, that principal reduction gets accomplished with taxable income. We put all of our cash flow into reducing the debt, then had to borrow money to pay the income tax obligation that the investment created.
This led us to Guideline #32 and to the decision to finance our investments over a longer period of time.
Guideline #17: What you do, or don't do, matters.
When you buy a stocks, bonds, shares in a REIT, mutual funds, rare coins, gold, art, or collectibles, you have invested your money, which is a very good thing. However, you have done so passively. If you have purchased wisely you can make significant gains. If the market appreciates you can make significant gains. But, once you have made a passive investment, there is not much you can do, except wait.
Real estate is different. It is true that if you have purchased wisely, or if the market appreciates, you can make significant gains. It is also true that by inaction, ignoring your tenants, not fixing things that need fixed, not cleaning things that need cleaned – you can make your property value go down. It is even more true that by action, taking care of your tenants, fixing things that need fixed, improving things that maybe do not need improved, upgrading your tenants – you can make your property value go up.
A regular periodic review of the property matters. Is the rent appropriate for market conditions? Are the expenses in line? Are both you and the tenant following the provisions of the lease? Is the property in sound condition? What are the repairs or improvements on the horizon? Is the neighborhood around the property holding its own? What can I do to improve this investment? These are among the questions you, as the active investor, need to think about and answer to your own satisfaction.
What you do, or don't do, matters.
Guideline #18: Have a professional team.
Have a TEAM.
A serious minded investor values the talents of a quality support team. Team members include an attorney, an accountant, an insurance agent, a maintenance/handy man, and, of course, a broker. Your support crew will help you avoid most troubles. For those troubles that cannot be avoided, you will be happy to have their support.
Guideline #19: Read the fine print.
Read the fine print before you get to closing. We once signed mortgage papers with a "yield maintenance" clause. Thinking it was just other pre-payment penalty clause, we did not pay close enough attention. Ooops. Think of "yield maintenance" as a prepayment penalty on steroids. Very stiff. Stiff enough that it kept us from being able to sell the property at the peak of the recent commercial real estate mania. Read the fine print before you get to closing.
Guideline #20: Leverage is a two-edged sword.
It is through the miracle of leverage that real estate becomes such a fabulous investment vehicle. Leverage is borrowed money, a mortgage.
This is what allows the investor to own a $250,000 piece of real estate while only having $50,000 (give or take) of their own money invested. Imagine if, after three or four years of tending the investment, you sell your $250,000 property and net $300,000. You have just increased your $50,000 original cash investment by $50,000 (Before taxes! Please see guideline #33), or doubling your money. Leverage indeed.
Leverage, if not properly respected, may have a dark side. If, as was fairly common in the years 2004-2006, you buy a property for $250,000 with no down payment, you now owe the bank $250,000. All is well and the rate of return is fabulous if you can sell it for $300,000. But if the market falters, as all markets do from time to time, it can become a bit problematic. See Guideline #10.
Guideline #21: Pyramiding is not to be undertaken lightly.
Pyramids stand the test of time… only if they have a really strong foundation.
Pyramiding, or using the equity in one property to buy another property, is not to be undertaken lightly.
As with leverage (see Guideline #20), pyramiding can be your friend, or your enemy.
With a strong foundation (well maintained properties with strong tenants, ample cash flow with reserves on hand, and a respectable amount of equity), a pyramid will build solid wealth.
With a weak foundation (poorly maintained properties with transitional tenants, with little or no reserves), pyramiding resembles a house of cards – soon to be tumbling down.
Guideline #22: Don't borrow just because they will lend you the money.
Just because they will lend you the money doesn't mean you should borrow it.
I am bewildered by the underlying philosophy of the really smart people who run our country.
"Many commentators have noted the effect of home mortgage refinancing and equity extraction on economic growth, particularly consumer spending, over the period 2000-2006. For example, former Federal Reserve Chairman Alan Greenspan (2002) stated:
"Especially important in the United States have been the flexibility and the size of the secondary mortgage market. Since early 2000, this market has facilitated the large debt financed extraction of home equity that, in turn, has been critical in supporting consumer outlays in the United States throughout the recent period of economic stress."
Those interested in erudite sounding scholarship can read more
How "extracting" equity to pay for consumer spending can be considered "economic growth" is a mystery to me. What did they think was going to happen when the equity was all gone?
Of course, we should all remember Guideline #22. We did this to ourselves (this being the current economic mess) by buying into mass hysteria. Nothing, which includes real estate, goes up forever. Some independent thinking, with a little discipline, goes a long way.
Guideline #23: Pay attention to your financing.
In the late 1970's a group of local investors were buying small apartment complexes with the assistance of "owner financing". They would put some money down, borrow some from a bank, and borrow the rest from the owner on a five year note. They thought of five years as a "long time". Add five years to 1978 and you end up in 1983, when interest rates were 15% or so. Made for some interesting times and some real scrambling.
There has been much in the news lately about the coming HUGE problem with commercial real estate loans. During the 2000's, lots of money was chasing investment real estate. Previous posts have discussed how badly smart people were over paying. Many of those investments were financed with five or ten year balloons. Those notes are coming due in the next several years. Given the current state of the banking industry and fallen property values, refinancing those notes is getting very interesting.
It should be noted that over our 25 some years in doing this, financing has only been a problem in four or five of those years. The other 20 or 21 years, borrowing money varied between a reasonable business proposition and way too easy.
There are lenders still making loans today; think community banks, credit unions, savings and loans. It has reverted, though, to the old fashioned way of doing business. You will need a down payment, the property will need to appraise out, and you will have to show that you can re-pay the loan. These are hardly earth shaking standards; they were just out of fashion for a while.
Like all cycles, this one will pass.
If you invested with a plan similar these guidelines, this current cycle most likely is not an issue for you. You just weather the storm, and maybe even take advantage of it. A lot of money gets made when markets are in turmoil. This go round is no different. Once your investment property has significant equity and ample cash flow, refinancing may be an attractive option.
Guideline #24: There is a lot of land.
Some lessons are learned harder than others. Value is derived from use (guideline #4), location (guideline #5), and difficulty of replacement. Look at the aerial maps at the Licking County (Ohio) Engineer's web site or go to Google Earth some time. Vacant develop-able land is anything but scarce. If you invest in land, be prepared to be very patient.
Guideline #25: It is an investment, not a tax shelter.
In my early days of commercial real estate, many of my compatriots were selling “tax shelters”. That was a fancy term for an investment that will likely lose money. Of course, back in 1980, the top marginal tax bracket was 70%, which meant that out of each dollar earned over $215,400, the IRS took 70 cents. (For reference sake, the current top bite is 35 cents out of every dollar over $372,950). A lot of smart, high income people figured that it was better to lose a little money on real estate, but maybe build some equity over time, than just give the money to Uncle Sam. I was never comfortable with that philosophy. To my young and naive eyes, it seemed unnatural that a certain property might be worth more to one investor just because his tax bracket was higher. The question I never got a satisfactory answer to was, why would you buy something that you knew was going to lose money on a regular basis? Seemed wasteful. As you might suspect, we did not sell a bunch of "investment property" back then.
When Congress passed the Economic Recovery Act of 1981, it amended the Tax Code to allow for really, really, really generous tax treatment for real estate. As a result, real estate development went into overdrive and the value of investment real estate was unnaturally inflated. In a successful attempt to curb tax shelters and to “simplify the Code,” Congress then passed the Tax Reform Act of 1986. The 1986 Act both eliminated special incentives, including accelerated depreciation (ACRS), that investment real estate enjoyed, and expanded the dreaded Alternative Minimum Tax (AMT). These simple changes instantly erased somewhere between 10% and 20% of the market value of commercial real estate. This fall in values, combined with some questionable lending practices, contributed to the savings and loan crisis of the late 1980’s.
The lesson I learned from all this was that when the government giveth, it soon finds a way to taketh. Basing investment decisions on the Tax Code is fraught with risk.
Today the Code appears to be neutral towards real estate investment. Depreciation is still available as a deduction against income. However, set for 39 years for commercial real estate and 27.5 years for residential, the current deduction for depreciation is just properly taking into consideration the fact that, even while the property value may be increasing, the components of the building, like the roof and the air conditioning system are wearing out. They have a useful life that gets shorter with each passing year and will need to be replaced. (It is possible to depreciate various components of investment property faster, but that is a question for you and your tax preparer/accountant to resolve.)
The Code still offers Investment Tax Credits (between 10% and 20% depending on what the project is) for rehabilitating commercial property put in service before 1936. The only problem is that if, as an individual tax payer, you try to use the Tax Credit, the Alternative Minimum Tax kicks in and removes most of the value of the Credit (it’s that giveth and taketh thing again).
Invest for value, not shelter.
Guideline #26: Hold it, or add value.
By its very nature, most real estate investing is profitable over significantly long time periods. For faster returns, there must be "value added".
"Value added" can mean, among other things, annexation, zoning change, sub-dividing, building roads, extending water and sewer lines, constructing a building, combining with an adjoining property, renovating existing improvements, or merely cleaning and painting.
Guideline #27: Flipping is speculating, not investing.
Profiting quickly by "flipping" is speculating, not investing. Flipping is buying a property with the intent of immediate re-sale for a significant profit. A flipper has no intention of either using the property or adding value to it. Two situations make flipping possible. The first is a bubbly hot real estate market.
The second is where the flipper knows something of significance that the person who sells to him does not know.
Guideline #28: Don't sell, exchange.
Unlike residential real estate, when you sell an investment property, you create an immediate tax consequence. Whether it is a capital gain or ordinary income depends on the time frame involved, come April 15th, you will be settling with the Internal Revenue Service. The fact that you intend to re-invest in another investment property is immaterial. The tax is due.
Unless... an IRC Section 1031 Tax Deferred Exchange comes to the rescue. The government recognized the necessity of equity preservation for the continuation of business, and so established a method for that to happen.
The rules are fairly simple: the seller intending to re-invest in property held for "trade or investment" cannot have "constructive receipt" of the sale proceeds (the money gets held by a "qualified intermediary"), must formally identify the property they will be re-investing in (the "replacement property") within a 45 day time period after the sale of the original, or "relinquished" property, and must take title to the new property(s) within 180 days after the sale of the relinquished property. If you follow the rules, the exchange will effectively defer any tax due until such time that the investor finally sells. This is generally considered a good thing.
It should be noted that using the 1031 Tax Deferred Exchange is not a do-it-yourself venture. You will need professional help.
Guideline #29: Don't eat your seed corn.
The first successful investment is a gratifying experience. All of a sudden there is this extra money, cash flow, sitting in your check book. It is very cool.
What you do next will go a long way towards determining your economic future.
If you spend the cash flow, your current living status will get a bit better. Not a bad thing.
If you re-invest the cash flow with discipline and a plan, you can build an unshakable foundation of wealth. A much better thing.
One of the easiest ways to re-invest is to pre-pay the mortgage. Steady extra principal payments work magic in reducing both your debt and future interest payments.
Guideline #30: Don't sell the little piece before you sell the big piece.
Real estate often has various components. A five acre lot can easily be divided and sold from an 80 acre farm that has a decent amount of frontage. The fixtures, equipment, and licenses can easily be sold from a closed restaurant or bar. The timber can easily be sold off of a wooded tract of land. And so on.
Peoples' needs and motivations vary, so this is not a "never do", but it is a "really think hard about it" type of guideline. There are times when it may be best to sell a piece to protect the whole. But, more often than not, "cherry picking", or the selling of the first piece at a good price, seems to negatively impact the value of the remainder. Diminish the value of the remainder enough, and you have devalued the entire investment.
Guideline #31: Have a plan for the future in mind.
Don’t think of it as an exit strategy.
Friend Tony told me that the first or second rule in investing was to have an "exit strategy". When he first posited that, I nodded my head and said "of course". The more I thought about it though, the more doubts I had about it. As Teacher Furman often said about investing in the stock market, "its great advantage is its liquidity, you can take your losses at any time". Doesn't appear to me that Warren Buffet has an exit strategy. Then there are the examples of some extremely successful local real estate investors who haven't sold anything for thirty years, and have no plans to sell now. Their estates will handle the exit from their real estate holdings.
Exit strategies are surely tougher to execute in real estate, for Mr. Market will on occasion decide not to cooperate.
Friend Pat solved my problem by suggesting that an "exit strategy" was nothing more than a plan. A plan that elaborates on Guideline #2 (know why you are investing), assumes that you pass Guideline #8 (survive the first investment) and take Guideline #17 seriously (what you do matters), and then projects out five, ten, or fifteen years.
I like that approach. Our plan has evolved. We invest for both cash flow and capital appreciation. We like creating things that are not there now. I like fixing old buildings, my partner likes putting up new buildings. A time or two we have speculated. Mostly we look for opportunities that appeal to us. Truth be told, our best investment opportunity ever just came looking for us one day when we were busily working on something else. Economic circumstances have on several occasions called for adjustments to the plan. That is just part of the adventure. We have fun and feel good about what we are doing, and do not plan on stopping any time soon. I suspect our children will execute our exit strategy.
Guideline #32: Cash flow is king.
If you have a problem that has a financial solution, and your investments generate the cash flow to solve the problem, do you really have a problem?
Guideline #33: The IRS always bats last.
You never truly know how well your investment has performed until you have sold it and paid the tax. The IRS always bats last.
In Summary, All 33 Guidelines for Investing in Real Estate
- Do it.
- Know why.
- The money is made when you buy.
- Value is derived from usage.
- Location, location, location.
- Know what you are, and are not, buying.
- There is no bad real estate, only wrong owners.
- Survive your first investment.
- If it is too good to be true, it probably isn't.
- These are business relationships, not friendships.
- Good management makes good investments.
- Budget for management.
- Budget for vacancy/credit loss.
- Cash flow sometimes equals deferred maintenance.
- Roofs leak, just a matter of when.
- Budget for taxes, income that is.
- What you do, or don't do, matters.
- Have a professional team.
- Read the fine print.
- Leverage is a two-edged sword.
- Pyramiding is not to be undertaken lightly.
- Don't borrow just because they will lend you the money.
- Pay attention to your financing.
- There is a lot of land.
- It is an investment, not a tax shelter.
- Hold it, or add value.
- Flipping is speculating, not investing.
- Don't sell, exchange.
- Don't eat your seed corn.
- Don't sell the little piece before you sell the big piece.
- Have a plan for the future.
- Cash flow is king.
- The IRS always bats last.
This is my list. Yours may be different. It has been fun thinking about it.
About the author
Stephen T. Layman is a Commercial Real Estate Broker with NAI Ohio Equities in Columbus, Ohio. He is a CCIM and has over 30 years of experience in land development, site acquisition, real estate investing, commercial sales and leasing. Steve can be contacted by email or by phone at 740.349.7844.