Finding a Strategy
As a new real estate investor surveys all the possibilities within the general field of real estate investing, the view can become a little overwhelming. There are so many choices! Where to start first?
To make sense of the potential, you are wise to keep things simple. For example, residential real estate is much less complex than commercial real estate. The financing is easier, you don’t have to worry about the viability of the business that occupies your property, and there are more deals to be done in residential properties.
Planning ahead is always a good thing, and as you consider the direction you will travel as an investor, it will be important to formulate strategies, areas in which you can operate comfortably and profitably. This gives you a means of working without having to continually start from scratch.
A strategy implies a system, a program that can be done over and over again. The system provides you an overview of a geographic range to work in, types of properties to work with, the socio-economic levels of neighborhoods to work in, and the techniques you employ for making money. In short, a system means that a new investor doesn’t have to continually reinvent processes for every new deal.
To establish a strategy, you should first determine what it is you want to accomplish. The strategies you use hinge from a vision of what it is you want and need, taking into account where you stand now. For example, most people just starting out are short on capital. Properties held long term for rental require cash capital to cover overhead, but nothing in the owning of rental properties in-and-of-itself lends itself well to generating extra cash. On the other hand, a new investor with plenty of cash reserves will jump start the journey along the road to lasting wealth by using that cash to acquire properties to keep in the long run.
The Primary Strategies
We use three primary strategies available to the beginning investor within the residential property area:
Buy and Hold (Growth) – putting a portfolio of properties together that appreciates in value until someone else will pay you a high price for it, or until it supports you with residual income.
Quick Cash (Profit) – a quick start with $10,000 profit or more over the next 90 days.
Cash Flow (Income) – creating monthly income for the next 30 years without the need to hold onto a long-term ownership portfolio.
Buy and Hold
This is a well-known strategy that has been taught in seminars for years and practiced for millennia (going back to ancient Rome and before). Its primary appeal lies in its simplicity. You buy a good property, rent it out to offset its cost, and wait for the property to appreciate. It works!
The reason that people purchase and hold properties is for long term growth and wealth. The property owner collects rent first and foremost for the purpose of making it possible to hold on to the property. In the early years, any income realized beyond the costs of holding the property is a bonus.
Much of the complexity of a Buy and Hold strategy comes from the overhead involved in owning a property. You don’t just buy a house: beyond debt service on the mortgage, you also have ongoing costs like taxes, insurance, maintenance, repairs, upgrades, water and sewer costs and marketing expenses. People often underestimate the costs of holding on to a property; these can easily amount to 25-35% of the rent before debt service. This kind of overhead requires capital in the business. Without capital, the you have to come up with the costs of holding a property on your own. If you are so strapped for cash that you are unable to take care of the rental property, you are in over your head. On the other hand, with enough capital in your business, your business can take care of these needs for you.
With sufficient capital, over time, your equity in the property increases, and meanwhile the cash flow improves as you raise the price of rent year by year. But unless you can bring a lot of equity into the purchase, either by paying cash down or by buying at a deep discount, the up front cash flow will be merely enough to support ownership and not enough to produce a profit. That normally comes later.
We Only Buy Meat!
The essential rule of Buy and Hold is this: No negative cash flow allowed!
There are those who advocate buying a property to hold that lacks a positive cash flow, and then justify it by pointing to an internal rate of return with a particular yield on investment. They rationalize that future appreciation will make it all good. This is short-sighted and dangerous thinking.
A business cannot survive without cash. A new investor without a supply of available cash cannot afford a negative cash flow on a property. We use as an analogy of this the purchase of a hamburger.
Many people like to dress up a hamburger with ketchup and mustard. It makes the hamburger taste better. However, most people don’t just eat mustard straight out of the jar or drink ketchup straight. They are good in combination with the hamburger, not alone.
In our analogy, the hamburger is a Buy and Hold purchase with a positive cash flow. Given a positive cash flow, adding future appreciation and tax benefits is much like adding the ketchup and mustard to the hamburger. It’s important to remember, future appreciation is the name of the game with Buy and Hold, but it won’t work unless the owner can afford to keep the property. The tax benefits add a nice feature to positive cash flow, but only make things worse if the owner is already broke.
This is one of the factors that make Buy and Hold especially difficult in certain fast-growth, high-priced parts of the country. As property values skyrocket, rents cannot keep pace. In those markets, the only way to work in the Buy and Hold strategy is to put some of your capital into them to buy equity. Buying at a deep discount is a real challenge when prices are going up rapidly and properties sell quickly.
With these potential problems, why are we even thinking about Buy and Hold as a strategy? Let us keep in mind that fixed assets appreciate more rapidly than liquid assets. In the long run, an investor should work to achieve balance between buy-and-sell and buy-and-hold techniques. Most people doing nothing but cash-out deals would spend the cash and end up with nothing in 30 years: their investing would have done nothing more for them than a job would have. Acquiring properties and holding on to them for the long term means that your net worth will continually grow as the property appreciates in value and you pay down your debt.
The key is, always have a positive cash flow on every deal you do. No amount of tax deductions or hope for future appreciation can justify a negative cash flow.
As with any strategy, there are certain benefits and challenges to Buy and Hold:
- Long-term appreciation – the most sure road to wealth available.
- Steady cash flow that increases year by year
- Great tax deduction
- Property management costs and/or responsibilities
- Cash intensive investing
- Long-term cycle
If you are ever tempted to take an extra risk on a deal that doesn’t give positive cash ask yourself this question: “would I want 20 of these today?” The point is, if you can’t afford 20, you can’t afford one. If anybody ever tries to persuade you that yield and internal return make up for negative cash flow, just laugh and walk away.
Quick Profit is just as it sounds – a way to make a profit as quickly as possible. In terms of immediate return, this concentrates profit at one time more than any other strategy. However, your total income is smaller in this strategy than in any other. That is because there is no compounding, either of time or of income.
The key to this strategy lies in the buying. You act as though you are a buyer for a retail store. Your objective is to buy inventory and then resell it for a profit. In this case, the inventory is real property. You work to acquire properties at a price that allows you to quickly resell for a higher price. In this case, you can be either the wholesaler or the retailer, depending upon the price you sell at and the needs of the people you sell to.
The primary exit strategies encompassed within this strategy involve:
- Contract assignment
- Simultaneous closing
- Buy and sell
These exit strategies allow you to get in and get out quickly. You realize your profit at once (at least within a short time period). Since this is the highest concentration of income, it is the best independent means of creating capital for building an investment business. The wisdom of this is that you reinvest this cash into properties. Now you can cover overhead, build equity, and by building equity enhance cash flow. Nothing has such an immediate and intensive impact on the capital situation of a new investing business as Quick Profit deals.
Here Are Some Keys to Success with Quick Profit Deals
- You get a profit at purchase – profit is the reason for this transaction; there is no cash flow, no growth, and no appreciation.
- You help yourself when you can arrange buyers in advance – time is of the essence here; you don’t have a lot of time to find someone to take the contract or the property once you have started the ball rolling.
- Work to move from cash to asset to cash as quickly as possible. Sam Walton was a master of this – move them in and move them out. The longer your inventory sits, the more it costs.
- Use financial leverage whenever possible – lenders, investors, friends, perfect strangers; the less of your own money you put in, the greater your return on investment.
- Know the property; don’t buy a pig in a poke – do your inspections, get help if you need it.
- Factor in expenses with high estimates: create a projected profit & loss in reverse, with the “cost of goods sold” on the bottom line, profit as an expense (after all, this is all about profit).
- Get a minimum 20% discount on the price versus market value; don’t forget you have expenses and costs of doing business before you can even think about a profit.
- Make sure the re-market potential is good; you have to be able to move it fast. Remember this: the faster prices have been going up, the faster they will go down.
Benefits of Quick Cash
One nice benefit of the Quick Cash strategy is that the investor gets immediate cash now. As mentioned already, this can be used to create capital and equity in the investing business. That builds a strong and lasting business, one that can grow in the future. Meanwhile, this is all done in a short-term time frame.
From a banker’s point of view, a short-term asset is one that will be liquidated within one year. Thus, quick cash properties are short-term or liquid assets. Obviously, they are not as liquid as cash, but as they appear in the investment portfolio, they are intended for quick liquidation.
Additionally, investing in these quick cash properties comes with low-cost start up. To a degree not possible with Buy and Hold properties, a novice investor can use other peoples’ money. In the worst case, you can always use hard money. Even better, you want to find investor money that doesn’t cost as much. But it all hinges on what kind of deal you get.
Here is a good time to emphasize a hugely important principle of buying a property:
You make your money when you acquire the property; you may collect it later, but you earn it when you buy.
You have to get the property at a cheap enough price so that you can get it financed without cash out of your pocket, also so that you have room to make a profit after all your expenses.
Challenges of Quick Cash
- It requires cash (but who says it has to be your cash?)
- A project can become labor intensive – there may be trash to haul away, cabinets to scrub, carpets to clean
- Costs of repair can be complex
- It puts you potentially into a high tax bracket.
The Income Stream strategy is a hybrid of the Buy and Hold and Quick Profit strategies. Just as Buy and Hold depends on cash flow, and Quick Profit provides a quick lump sum of cash, the Income Stream strategy has both together. You get a lump sum up front AND monthly cash flow, besides. Even better, the cash flow is always greater than you get with Buy and Hold, and the up-front cash is enough to contribute capital to the business.
Another way to view this strategy is to call it the “quit your job income” strategy, because once you have built up sufficient monthly income, you don’t need a job to live.
By whatever means you acquire the house, you then maintain control over the property. It is possible that you picked it up with a lease-option transaction, or you could have acquired it subject-to with a wrap. Of course, you could always just buy the house outright.
The first thing to do is get tenants into the house. Where this differs with Buy and Hold is that the tenants are actively buying the house from you. It is because of this purchase action that you get a lump sum at the beginning. Meanwhile, because of the purchase action, they pay a higher amount than normal rent: rent to live there, extra for the right to buy.
There are two fundamental ways to help someone get into their new home. They can rent it from you with an option to buy it from you at a later date, or they can buy it with an installment land contract subject to the terms and conditions of an underlying mortgage.
Keys to the Income Stream Strategy
- The investor is not just selling the house, but also financing the sale; even a lease option constitutes seller financing. This magnifies the return on investment, so that you are making an increased income on your profit.
- You look for regular houses, the kind that Jim and Suzie would buy – assuming Jim is a machinist, Suzie works for Wal-Mart – simple, basic, no-frills, blue-collar housing.
- The payments you receive are more important than the sales price of the house in determining the volume of your income stream.
- You make a profit on the spread between what you acquire the property for and what you sell it for.
- Properties only need to be livable, but don’t need to be perfect; ideally you don’t fix anything. A sample ad for such a deal: “Home for sale by owner, needs roof, no bank qualifying required.”
- Leverage is vitally important; if you own a $100,000 house free and clear and make $12,000 per year, that is a 12% return, but if you only have $12,000 into the house, your $12,000 income means a 100% return on investment (if you have none of your own money in it, your return on investment is infinity.
- Observe regional characteristics; this works great in a flat market, because the people need more time to cash you out, so you keep the income stream going – but also works well in hot markets because rent alone will never cover overhead.
Benefits of Income Stream:
- Instant equity build-up in your property when you receive up-front cash on the deal
- Immediate contract profit
- Long-term cash flow
- No land lording – in their minds, the people are buying it from you!
- A nice auto-pilot system (how often do you call your lender about maintenance issues?)
- Few hassles
- Preferential tax treatment (it’s spread out, possibly no capital gain)
- It allows you time and financial freedom – you can retire at any time
Challenges of Income Stream:
- Collections – you have to make sure the cash continues to flow
- Short term negative cash flow potential – in case of vacancies
- Take backs
The Essence of the Income Stream Strategy
It is within this strategy that you make money from real estate without owning it. You provide housing, but more importantly, you provide financing for that housing. By getting into the financing business, you get the money up front with the income while getting rid of the property. There is always plenty of business to be done in this strategy, because only 67% of American households own their home, meaning 33% don’t. At least 75% of those that don’t own desperately want to own, so 25% of everybody you see needs and wants to own a home.
Better yet, these people are relatively easy to work with. All they care about is:
- Do we like the place?
- Can we handle the down?
- Can we keep up with the monthlies?
In other words, they are not going to complain about the color of the carpet or the view out of the kitchen window. As a matter of fact, it is not uncommon for a Income Stream deal to happen in a case where there is no carpet at all, only the pad and the tack strip. Just to get into home ownership, the buyers are happy to take care of the carpet themselves. You can even provide them financing for that, then add that amount to the purchase price.
Additional points About Income Stream Transactions:
- Since the amount you receive monthly from your buyer is the most important number in the transaction, you should peg the buyer’s monthly payment at 25% over your own monthly expense.
- The worst thing that could happen is that your tenants stay in the house 30 years and pay it off – then you only make about 250% of the price you sold it for. However, this is unlikely, since they will either drop out or complete the purchase much sooner than that.
- The best thing that could happen is that they give you the required down payment, stay a few months and then leave; you will take it back, whereas the bank will not. Then you collect an additional down payment from new buyers (thereby doubling your immediate profit) and continue the cash flow, possibly at a higher amount.
- This is a strategy that provides the opportunity to develop a substantial monthly income without the burden of property management. Banks don’t manage properties, and here you are the bank.
As an example, here is possible deal done subject to the terms and conditions of the existing loan:
- House worth $100,000
- You buy it for $90,000, paying $12,000 down
- Sell the house for $115,000
- You collect $5000 down
- You pay $550 per month, and collect $950 per month; your monthly cash from is $400, or $4800 annually
- Since you got $5000 from the buyer, your net total outlay is $7000 (your $12,000 down payment, less what you receive up front) – thus $4800 is a 69% annual return on investment ($4800 is 68.5% of $7000).
Making Offers within these Strategies
Buy and Hold: This is all about having a positive cash flow. You don’t consider a profit here because you collect profit in the indeterminate future. Over the long term, the value of the property will increase in all states – some faster than others. You need to compute market value because the lenders will base their loan on market value. But it is most important that you do not have negative cash flow.
Quick Profit: Start with the market value (in this case, future market value in recognition that there may be some work to be done before it will be worth that much). Subtract costs and expenses from the FMV to solve for the amount of an offer. This parallels a banking profit and loss statement with a reversal of the profit and the cost of goods sold: profit is an expense and the bottom line is the cost of the house (the goods you will sell).
Income Stream: This is the easiest offer to make: just offer a little below market and sell it for a little more than market. Compute monthly payments that work for you and for the buyer, and you have a deal. You don’t fix it up, so rehab costs don’t matter. You will learn more how to do this as you study the various exit strategies that work with this market strategy.
The three strategies provide you a variety of ways to deal with the people who live in these houses.
- The Buy and Hold strategy allows you to take on tenants who have no thought of buying, for whatever reason. You can always give them hope of buying a house from you in the future, even promising a credit based on the fact that they rented from you for as long as they did.
- Quick Profit allows you to work either with buyers who have excellent credit and the financial means of closing a purchase, or with buyers with marginal credit and no available cash for a down payment. In the first instance, they can close without your help and you offer them the convenience of an acceptable home with the deal already negotiated, possibly at a small discount from the market value. In the latter case, you help them find a good loan situation and show them how to get the down payment. You will learn how to do this in a later module.
- Income Stream transactions work well with buyers who have horrible credit but enough cash to make a down payment. So you see, you can deal with whomever comes along.
Understanding the ins and outs of these market strategies provides you a solid platform for the various exit strategies you may want to use in the future