Part I
Its soothing to believe there is always a silver lining no mater how dark the cloud may be. Those who not only see the bright side but take advantage of such an opportunity don’t just feel soothed, but prosperous. That’s what we’ve seen in the results of the most recent events of the 2008/2009 real estate crisis with those who were ready to strike the opportunities at their “hottest” point. Of course there was economic hardship for everyone in the lowest of the low times of 2008 but in an 2010 article from The HuffPost it is reported “After a 27 percent decline in the number of millionaire households in 2008, the ranks of U.S. millionaires swelled to 7.8 million [in 2009].
And it was an even better year to be an “Ultra High Net Worth Individual,” defined as someone with a net worth of $5 million or more. That population grew 17 percent in 2009 to 980,000”. That is no coincidence. The correlation of real estate to millionaire’s created is stronger than any other relation I can think of. So it is only fitting that in a time of economic crisis, specifically in real estate, out of the ashes rise a whole new generation of “the wealthy”. But let’s be honest. Yes, there are the “silver spoon fed” and trust fund kids we will always see running around becoming millionaires independently. However, real estate allows the everyday “average Joe” to put himself (or herself, right ladies?) in the position to increase net worth and cash flow.
Now of course we still need to give credit where it is due. The children born into the higher SES classes could easily squander their family wealth away instead of using it to their advantage. While most consider them lucky, there is a formula to that often thrown around excuse for prosperity. I was told many years ago “Luck is when opportunity and preparation meet” and that has really stuck with me. I am not at all the jealous type and have been raised to not covet others but growing up a majority of my youth as the daughter of a single mother I will not say I felt particularly lucky as a child. But as I’ve aged (and in theory grown wiser) I have realized how my childhood and early adult years have prepared me to be able to accomplish what I have in my career and more as opportunities arise.
Anyone and everyone will have opportunities cross their path usually multiple times throughout their life, myself included. My background established a persistent and sometimes stubborn mentality combined with a strong work ethic both of which prepared me to take advantage of opportunities when they show their face. At this point, I can think of a few people who specifically label me as “lucky”. Although I did not start with the ability to have significant financial preparation, I was frustrated by opportunities I could not or did not participate in due to my lack of financial strength.
That feeling of frustration has left a burning mark in my memory so that I know I never want to have to pass up on a deal like I’ve given up before. With that being said, I’ve had to get myself to a point to be able to be financially prepared as well as recognize an opportunity when it begins to arise. I’d like to save as many as I can from experiencing difficult lessons the way I had to and hopefully just give you some examples of what to do to be the luckiest SOB (son of-a brother) out there!
Market Volatility
“Market Volatility” is one of the most generic terms in the financial world. The word “market” can refer to any investable industry in any geographic location but generally refers to the stock market. Its also fair to say that “volatility” is incredibly subjective as well. A young, well informed & experienced investor probably feels significantly different during this phase of the U.S. stock market cycle than the inexperienced, elderly retiree who has relied on investment guidance from their 401k provider their entire career. Regardless of comfort or experience, market volatility can have a huge impact on your investment performance as well as your liquid ability to invest in deals that come your way.
Obviously, investment performance is usually on the front of most peoples’ minds but does the mass affluent really know how volatility impacts their overall plan? I’m going to assume the answer to that is no, mostly because personal experience supports the fact that the “funny math” Wall Street advertises to their customers has overcome true logic and relative statistics. Specifically speaking, the most prominent statistic affiliated with investing and performance is average rate of return. However, that calculation is almost a moot point and does not give true insight to an account’s actual balance in relation to market ups or downs. For example, let’s say your account balance starts with $500,000 in year 1.
That year, your advisor gets a 25% return in your investments. You’re feeling pretty good starting year 2, high fiving and sitting pretty at $625,000. Then year 2 comes and goes and “Uh-oh”, your advisor loses 25% in your investment. Now your account balance is $468,750. You may or may not be paying attention but at least quarterly you’ll receive statements regarding your investment account. At the end of year 2, you’ll have lost $156,250 but your statement could reasonably state an average rate of return of 0% (25% year 1 + -25% year 2= 0% average) since the inception of your investment. You can argue until you’re blue in the face that you’ve lost money, but your advisor and investment company can and will advertise that goose egg value.
The point is companies love to focus on the average rate of return for a couple reasons. First of all, its easy to calculate. Mrs. Young in third grade taught us to add up all the numbers in your sample and divide by the sample size. That’s it. The easy arithmetic mean is not a true indicator of the affect on your money. We need to look at the real rate of return. This is a geometric mean calculation which goes year by year to measure the impact of gains & losses to the account balance. So, if you start at $500,000 and end up at $468,750, that is a loss of $31,250 or -6.25% as the real rate of return. Obviously, you would never see that return advertised.
Its too complicated to calculate and not nearly as enticing as the arithmetic average. What I’m saying is, be aware of volatility and the fact that bad years do more bad than good years do good. A 10% loss requires 11% to be back at your initial value. Losing 25% takes just over 33% to get back to square one. If you lose 50%, you must earn 100% to be even again. This is a problem ladies & gentlemen, and not one being clearly communicated. I cannot even count the number of people I have met that are in their 50’s and 60’s who have all said the exact same thing.
They’ve tried to save, do the right thing, be responsible, invest in different asset classes, etc. But regardless of how many digits are in their account values, every single one of them has said (in reference to their finances) “I really thought at this point in my life I’d be farther along than I am”. Usually this is not any fault of their own. In life there are always events that blindside us and cause financial stress, but this realization I’m describing is primarily due to the lack of transparency and understanding of how volatility impacts our assets.
Let’s bring the conversation back to a relevant perspective. This article is targeted toward a group of people who do not primarily invest in the stock market, but instead utilize real estate to grow their wealth. However, there is a surprising amount of real estate investors who have their liquid assets and/or savings exposed to market volatility. This is seen in old 401k accounts, brokerage accounts and funds inside self-directed IRA’s. These accounts are all subject to fluctuations in value based on investment performance. The most important piece to remember in preparing yourself against market volatility is something I like to call “True Diversification”. We have to dissect this word to thoroughly understand the meaning. Diversification comes from the root word “diverse” which is defined as “showing a great deal of variety; very different”.
Basically, you want to be able to offset the losses of one side of your portfolio but still participate in gains. The traditional diversification method would be an allocation of stocks and bonds based on your risk tolerance. However, the basic principle is that when stocks go down, bonds go up. And when stocks go up, bonds go down. This is not diversified, this is intercorrelated. So if you’re trying to be diversified by partnering these particular assets together you are literally mitigating your losses while mitigating your gains. And if you’re too heavy towards one over the other you’re over exposed to losses which, as we’ve already discussed, are more difficult to overcome. Realistically, the relationship between stocks and bonds is not always this linear. In 2008 we saw a crash in the value of all market assets. Stocks, bonds, commercial and residential real estate, every one of them was in the red. Even in the most recent economic correction we’ve seen with the COVID-19 fears causing the stock market to tank, these assets aren’t always opposite. The market bottomed out and the Fed’s response is to lower interest rates in order to help incentivize loans and sway more people out of conservative assets and back into the market. So during a massive drop in market value, treasury interest rates were driven into the negative in March 2020.
Doesn’t sound very diversified does it? This is why Warren Buffet himself stated that “diversification is protection against ignorance”. So when the market crashes and real estate prices go down, how are we going to take advantage and buy more real estate if the value of our liquid funds is also down? It doesn’t make sense folks. If you want to get lucky, be prepared when opportunity strikes. Don’t allow all of your buying power to be sucked down the drain when you’re in the best buying environment of the decade. The counter idea would be to hold liquid assets in a stable bank account or money market fund.
This is another approach, but interest rates are at an all time low and show no signs of increasing to a profitable level any time soon. We’ll discuss in part II of this article the alternative issue of losing money due to inflation and the time value of money. Being able to earn a safe, consistent growth rate within a liquid account to outpace inflation and is uncorrelated to the market would be ideal. Like I mentioned, part II will go into more detail of how to never fall off the compound interest curve.
Investment Analysis
If you want to sound important and assert your intellectual dominance, just use “investment analysis” somewhere in your sentence and,…..mission accomplished! Really all investment analysis entails is understanding your investment asset and the factors that affect its value and cash flow. The process will vary depending on the category but there are truths that remain consistent and important. Getting lucky in real estate is impossible if the risk and operations of what you choose to put your money into is not carefully and diligently understood. I think most real estate investors, specifically those in multi-family, immediately think of underwriting so we’ll just start there. Single family investors have their own version of underwriting so consider the comparisons.
You do not have to be an underwriting guru to invest in real estate but every experienced investor I know (including limited partners) will say at least being able to process the basics of underwriting a deal is crucial. Probably the most consistent piece of advice I’ve been given is to get rid of assumptions. Another take away from my grade school years was when a teacher of mine (not Mrs. Young in third grade, I promise) taught us that when you “assume”, it makes an “ass” out of “u” and “me”. Wise words from a crazy English teacher but nonetheless they have maintained veracity in multiple areas of life but let’s get back to underwriting. There are so many ways to get accurate information regarding a property whether its multi or single family. We are in the information era people!! Use your resources and converse with people in the area of the asset you’re considering purchasing that are more familiar with activity you don’t see. This could be crime rate, structural problems, legal issues, management pitfalls, you name it. I know multiple syndicators who literally interview residents of the complex they’re looking to buy.
There is no more incriminating information you will get than from a tenant that wants to complain, am I right? I even heard one guy say he would call a nearby pizza place and place an order. If they would not deliver to that complex, he wouldn’t buy it. People way smarter and more experienced than me have emphasized the need to fact find with local, unbiased third parties who can tell you the back story of every neighbor on the block. You may have to go through a few cups of tea, but you’ll get the information you’re looking for and more.
Obviously, there are more mathematical and practical pieces to consider other than street gossip. Key pieces such as taxes, insurance costs, capital expenditures, rent rolls, occupancy and more can all be pre-determined and with a decent amount of accuracy. Analyze the potential property taxes and compare them to like kind and quality in the area. Are they relatively close or is there a significant gap? There are so many tax breaks and discounts for certain demographics the current owner may be receiving but you’re ineligible for which can lead to unpleasant surprises later on down the road. Go down to the local tax/appraisal office and pull records for what the area tax rates have been over the last 10 years. There may be a trend of a consistent 3-5% increase every year that you need to be prepared for. The information is there if you are willing to look for it.
Insurance costs can vary depending on company’s and their specialty. All insurance companies are not created equal! I worked in a property & casualty insurance agency throughout college where I learned that there are certain homes and vehicles that different companies will not cover. Nationwide will not insure a $2.5 million Bugatti. The Hartford is typically more expensive for younger drivers than those over 50. Homes on the coast exposed to hurricanes are specially rated by insurance companies affiliated to the area. The point is, insurance is a transfer of risk so you need to be sure the one you choose knows how to actuarially calculate your property’s exposure. Keep in mind, you should not cut your nose off to spite your face. Trying to cut costs to a point that you lose important coverages can and will come back to haunt you. And the uncovered loss is usually exponentially more expensive than the meager amount that you saved. Anyway, most insurance providers are more than willing to give you a quote on the property in advance or even look at the current policy to see if it is relevant to what you would be paying.
Overall you’ll always be making an estimate, but you can utilize resources to be as prepared as possible. Rent rolls and occupancy provided by current PM’s are not always transparent so you can look online for geographical details to show population & job growth in the area, what other complexes have and are experiencing in occupancy as well as rent rates. Estimating Capex is a fun game to play too. I am personally invested in some single family developments at this point in time and just two days ago my builder advised me that thanks to the COVID-19 pandemic he is looking for a new lumber provider due to a 20% price increase from the original company. It is completely out of our control but an expense that is necessary to the property.
The same situation arises throughout all value-add real estate investments. Honestly, most syndicators and single family investors I know and have seen due a great job of leaving a buffer in their capex funds for situations that may come up, but a passive investor needs to be aware of circumstances such as poor planning that could lead to lower cash flow or worse, cash calls. This is a real concern in the multi-family world right now. Across the nation, millions are out of work and the government has prevented the ability of owners to evict. So, there is a very high possibility of going months below projected or even completely without rent.
A single-family landlord still having to pay the house mortgage is up a well-known creek that shall not be named. Syndications needing to cover expenses may be required by lenders to deplete their capex funds and then call to their passive investors for an influx of more cash to sustain the property. This environment we are in at this very moment is a prime example of how being prepared with proper estimations and heinous expenses so as not to lose the opportunity to hold onto your property and continue to receive benefits of investing.
This leads me to my last point on being prepared through investment analysis. I have had countless people ask about what real estate deal to look into or what category of real estate is better than others but I’ve found it always boils down to the same thing. Relationships. Know who you are investing with, what their values are, how they conduct themselves in life & business and what their experience is. Prime example, a successful multi-family investor decided to purchase a hotel in Amarillo, Tx. He underwrote the property and operated it the best way he knew how. Like a multi-family property. The problem is it isn’t a multi-family property. Apparently, hospitality is significantly different from apartments but this syndicator (and his passive investors) had to find out the hard way. The good news is an experienced hotel investor was able to come along to buy the property from him at a significant discount so at least he was able to get out from under the asset. So if you’re looking to invest passively, any experienced investor will tell you to get to know your lead(s).
If you are the lead, you have a responsibility to yourself and your investors to build a relationship built on trust and a positive experience. It is impossible for investors to trust you or feel that they had a positive experience if expectations are not met. Frustration flourishes in an environment that people feel they are getting less than expected. This dynamic proves that setting expectations is a key element in being successful in real estate. You can’t go around regularly promising cash on cash returns of 20% then deliver 9% and expect to build a network of passive investors. Of course, all investing has risk and real estate is no different.
We cannot expect anyone to be able to precisely predict the exact amount that will be generated, however if the syndicator has done their due diligence and has properly prepared their investment analysis the predictions for returns will typically meet the expectations that were set based on the same information. From there, relationships develop and a network of mutual trust and respect is prepared so that future opportunities in property can be taken when they’re available.
There are 3 more ways to include in your arsenal of becoming successful in this real estate environment. We will dive into those details in part II so I can hopefully continue to offer my own lessons that I have learned and am continuing to learn to you and prevent you having to learn the hard way. All of us are in uncharted waters but if you hope for the best and prepare for the worst you will put your self in a position of power. But regardless of the government, economic environment or personal background, being prepared to take advantage of opportunities when they are presented will make you the luckiest person alive.
