Pay Yourself to be Motivated

I don’t know about everyone else, but I love marketing.  I love figuring out a theme and creating the copy and running a campaign.  What I have a lot more difficulty with is prospecting.  The daily grind of converting people who haven’t met me into people who want to elect me mayor.  I get all fired up some days, like when I was a stock broker: 200 calls a day and all the throat lozengers you can swallow.  Other days I’m speeding down the 2.0 path toward Social Media Marketing Mecca.  But at the end of the day (actually the beginning of the day for me), I still need to do the basics: phone calls, emails, letters and so on.  It’s a whole lot to do on an agent’s salary… Oh yeah, we’re not paid a salary.  We’ve got to keep all those balls in the air AND wait for the big pay days when an escrow finally does close.  Come on… admit it: sometimes a little daily motivation would help.

Lately, I’ve been monetizing my efforts.  Nothing ground breaking here; just some good old fashioned methods for spicing up the day.  If you’re looking for a little more excitement, give this a try.  (Warning: involves a little bit of math.  If you don’t DO math, or you’re already sufficiently motivated by the repo guy outside the door… skip this post now and save yourself the headache.)

One for the Money
Know your dollar figures.  There are two dollar figures I care about: What is my average Gross Commission Income (GCI) per transaction? and What monthly  income do I expect? (This can be found in the business plan you create and update each year… right?)  I work with lots of investors, so my expected GCI is $7500 per transaction.  I live in San Diego and pay a hefty “sun tax” so my income expectation is $75,000 per month.  (Go Big or Go Home!)

Two for the Show
Know your basic numbers.  What do I mean by that?  I mean, on average, how many clients lead to a transaction and what type of prospecting campaign is going to yield those numbers.  Personally, I subscribe to the basic numbers in Gary Keller’s tremendous book:  The Millionaire Real Estate Agent.  That means my data base is divided into two groups:

• the people I’ve met (called, surprisingly,  METs) are dripped on 33 times annually with an expectation of 1 repeat piece of business and 1 referral piece of business for every 12 METs in the database (#METs / 12 x 2)

• and those I am prospecting to blindly (often called a Farm), with 1 monthly contact each and an expectation of 1 transaction a year for every 50 people in the database (#Farm / 50 x 1)

Three to Get Ready
Know your average percentages.  Let’s make it easy on ourselves and say that your NET – meaning after your split, any splits you pay out, market expenses are covered and you’ve paid your business expenses – is 50%.  For every dollar of GCI, you put 2 quarters in your pocket.  Not bad.

Four to Go!  (look out… here comes the math)
I need 12 METs, each touched 33 times, to generate 2 transactions.  In other words: I must complete 396 activities (12 x 33) in order to gross $15,000 (2 x $7500).  If I divide my gross by my activities I find that each MET activity earns me roughly $38.

My Farm requires 50 people to be touched 12 times in order to gross 1 transaction of $7500.  In other words: I must complete 600 activities (50 x 12) in order to gross $7500.  If I divide my gross by my activities I find that each Farm activity earns me roughly $12.50.

Rock & Roll
First of all, it’s interesting to note that the METs return three times as much per activity; they also cost more in mailings and time.  You’ll have to check your own ROI and decide what mixture is best for you.  Once I have these numbers, I can use them to motivate myself financially; here’s how:

Go to whatever accounting software you are using right now.  Create a new account called Future Earnings.  At the end of each day total up all the activities you tracked (you do track all your activities… right?) and deposit $38 for every MET activity and $12.50 for every Farm activity.  Emailed 200 Mets?  That’s 200 x $38 which means you made $7600.  Not a bad day.  Watch your Future Earnings account grow.  Every time you get an actual commission check, deduct your average (in this case $7500) from the account.

Voila, you can now watch your “bank account” grow EVERY DAY.  More importantly, you can see at a glance how your business is doing.  What’s in the Future Earnings account this month?  You can be fairly sure that’s what will be in your real account in 60 – 90 days.  Did I make any money today?  Well let’s see: wrote two blog posts… don’t get paid for those, read lots of interesting stories about real estate marketing… don’t get paid for those, called 10 of my METs… Yes!  Made $380 today.  Hmmm, that’s a long way from $75,000 in a month.  Better get my arse in gear.

It’s not that all those other activities aren’t important.  It’s just that now we can prioritize our day a little better (e.g. no reading until I’ve made $2000 in deposits).  Plus, it keeps us focused on what’s important (you get paid for that which makes you money – everything else is secondary).  Best of all: you get “paid” daily to help keep you motivated!  (Now, if I could just find the checkbook that goes with my Future Earnings account…)

Filed under: LENDERS, MARKETING, REALTORS , Farm, future earnings account, METs

Bankrupt Ideas for Changing Bankruptcy

Two excerpts from a local article:  Bankruptcy reform could help hard-up homeowners

Overwhelmed by debt from credit cards, a $536-a-month truck payment, $8000 in overdue property taxes and two mortgages, the single homeowner is hoping (San Diego bankruptcy attorney) Colwell can remove the $84,000 second loan on his home, which is now worth about $100,000 less than what he originally paid.  (emphasis mine)

———————————

House Speaker Nancy Pelosi (says) Congress is prepared to act on the (bankruptcy) legislation so “responsible homeowners can stay in their homes.” (emphasis mine)

The obvious question here is: Does House Speaker Nancy Pelosi know she’s a caricature?

But let’s go beyond the obvious for a moment and take a rational, economically based look at President Obama and Congress’ plan to allow bankruptcy judges to modify mortgages.  Why?  Because the effect of this legislation will impact not only home buyers, real estate agents and lenders but pretty much anyone who plans on using a mortgage to purchase or refinance a home in the foreseeable future.

This is not the venue to bore you with arcane language and minutiae on how mortgage back securities work.  Suffice to say that, as with all investments, investors in mortgage backs (upon which all mortgage rates are based) are happiest when they feel safest.  The more comfortable they are in their expectation of future redemption rates, the less profit they expect in return for purchasing mortgage backs.  Translation: a safe & happy mortgage back investor equals a low mortgage rate.

But, when you give a bankruptcy court the power to modify a loan at their own prerogative, you introduce the unknown and unstable into the world of our happy little mortgage back investors – you introduce risk.  Confronted with an increase in risk, investors naturally want an increase in reward.  That means higher rates across the board. This is not rocket science.

Says Dustin Hobbs, spokesman for the California Mortgage Bankers Association,

“If there’s the fear that judges can at any time modify mortgages, it’s no long the safe investment it was, and investors will charge mortgage bankers more to buy the loans – costs that will be passed on to the borrower in the form of higher rates.”

But wait, what about all the good this new law would do?  Won’t the ends justify the means?  According to a recent Credit Suisse analysis, this legislation would reduce foreclosures by approximately 20%.  That’s 20% of the homes that actually go into foreclosure.  In other words, everyone in the nation – all those who were responsible, all those who haven’t yet purchased, all those expecting to obtain a mortgage in the future – will pay a higher rate thanks to a change in the  bankruptcy law to help ease the pain of less than 1%  of total homeowners.  Does that seem rational to you?  Would you call that sound, economic thinking or just another bankrupt idea from a group of people that spell “economics:”  e-l-e-c-t-i-o-n?

Filed under: INVESTORS, LENDERS, POLITICAL & ECONOMIC FOLLY, REALTORS , bankruptcy

Real Estate Investing: The Infinite Investment Strategy

In the Introduction to Investing in San Diego real estate, I mentioned the idea of an Infinite Investment Strategy.  The ideal investment is one which costs no money, takes no effort and provides a never-ending, safe return.  If you find such an investment, please let me know.  In the mean time, investing in distressed real estate can get you pretty close.  Done correctly, your left with only frictional costs, the money value of your time and somerisk.  Sound too good to be true?  It’s not.  It’s simply built on the #1 requirement for all successful investing: have better knowledge, quicker timing or more money than the competition.  In other words: Know the Arbitrage.

So, how does it work?  In a simplified manner, once repairs are finished and a cash out loan has been secured based on a 75% Loan-To-Value, it would look like this

It looks nice on paper, but there is a glaring roadblock ahead: the First and Second Laws of Thermodynamics.  The first law says you can’t get something for nothing and the second law says that in every exchange there is a loss.  It looks like we’ve created a perpetual motion machine with no losses - in direct contradiction of the first and second laws of thermodynamics.  Quick, someone notify MIT!

All kidding aside, those two laws apply in real estate the same as they do in every other aspect of the universe.  You cannot create something from nothing.  In this case, you’ve created something from the value of your knowledge, time, and or financial ability to improve the investment property.  Even with that, there are losses we haven’t calculated: real estate commissions, lending costs, lost use of funds and so on.  The point here is not a complete course on accounting (nor even a course on quantum mechanics) but rather to open your eyes to the idea that you can buy investment properties in such a way that, when all is said and done, you have no money at risk.

These investments are not lying around waiting for the average investor to be sure; but they are out there.  I have done them.  It is the ultimate real estate arbitrage.  The parameters are easy to search.  You are looking for a neighborhood where the fundamental values are roughly 75% of the utilitarian values.  Within that neighborhood, you’re looking for a distressed property whose repair costs, when added to the purchase price, will be equal to or less than the fundamental value.  Voila!  You have an investment paying for itself with none of your money at risk.  The cost to you has been time, knowledge, market risk and whatever frictional costs you incurred.

The concept of frictional costs is an important one.  Commissions are not cheap in real estate; this is one of the points argued most pointedly by those who stand by the stock market as a better investment than real estate.  No argument from me – the costs in real estate can be a great deal higher.  But, you can acquire a real estate license for relatively little cost and effort as the laws are currently structured.  Which means you will be paying yourselfthe commissions and effectively removing them from the ledger.  (You are still spending your time though.  Just because it doesn’t cost you money doesn’t mean you can ignore it altogether.  But for purposes of this model, your frictional costs were reduced.)

As good as the Infinite Investment Strategy sounds on paper, there are a couple of final issues I want to mention.  First, don’t belittle the market risk as one of the costs I mentioned.  The example I gave above can be done.  But, you only have to be wrong once to put a real dent in your ability to keep going.  As a matter of fact, the more of these deals you find the more likely you are to form a little contempt for the market risk: this greatlyincreases your likelihood of being wrong on the next one.  Treat every investment you review the way you treated your first one: cautiously and with a whole lot of respect.  Otherwise, you may drop your entire investment nest egg in a property and be unable to get it back out.  That’s the end of the Infinite Investment Strategy.  Speaking of “drop,” that is the subject of the next article.  Given a specific amount of money to begin with, there is a Drop Amount you should know and understand.  This will give you the freedom to modify the Infinite Investment Strategy into the much more common Limited Investment Strategy.

Filed under: BUYERS, INVESTORS, LENDERS, REALTORS

Listen for the Music

It has been over two years since the Washington Post decided to have a little fun with people going to work.  In January of 2007, they asked Joshua Bell, an internationally acclaimed virtuoso, to play his violin at an entrance to the D.C. metro during rush hour.  It was conceived as a social experiment regarding the appreciation of art.  You can read the full story here.  I bring this up, not as a lover of classical music (I am woefully ignorant), but as a lover of people.  What we do and how we do it – the way we interact with actual life – this I find incredably interesting.  I also find a great deal of practical use.  Take this story for instance:

Joshua Bell is considered one of the greatest musical artists living today.  His violin, hand made by Antonio Stradivari himself in 1713, is a musical masterpiece worth over $3 million.  For his “subway” performance he chose Bach’s Chaconne, said by those who should know to be one of the greatest pieces ever written: emotionally powerful and structurally perfect… it is also considered one of the most difficult pieces anyone can play.  So there’s Joshua Bell, who a few nights before had sold out Boston’s Symphony Hall (where tickets in the parking lot start at $100),  playing possibly the most difficult and most powerful piece of violin music ever written on one of the rarest and most perfect violins ever made.  What do you think happened?  He earned about $100 in tips, a few people slowed down to listen, one gentleman stopped for almost 3 full minutes and over a thousand people rushed by without a glance or a moment to listen.

Actually, that’s not entirely true.  Some listened… some listened intently.  But they could not stop.  They were pulled along against their will even as they craned their little necks.  Children “heard” the music.  Children “saw” the man.  Children “knew” they were in the presence of something.  They knew this because they themselves were present.  Watch the video (did I mention the whole “experiment” was videotaped?) and you’ll see lots of people caught up in their past worries and future fears hurrying along.  But then notice the children - happily living in the present - try and stop; try and go back; try and hear what the man in the Levi’s with the funny instrument is playing.  They recognized the awesome beauty of what they were hearing.  They may not have been able to express it, but they knew they were in the presence of something transcendent.

I share this, not because it is so unique, but because it isn’t.  Opportunities similar to the violin player in this story are more abundant than you might think.  They are magical and they are transforming and they surround us.  As you go through your busy, busy day try to be a little more present.  Not only does this lead to lower stress and greater enjoyment, but you’ll begin to appreciate the miracles that play all around you.  Just slow down… and listen for the music.

Filed under: LENDERS, LIFE THAT POPs, MARKETING, REALTORS , Joshua Bell, MARKETING, present

The Passing of an Icon: George “King” Stahlman

San Diego lost a local icon last Friday.  George “King” Stahlman was a bail bondsman known throughout the county and I suspect, thanks to this once being simply a “Navy town,” parts well beyond the county.  His passing, while important to many, is not really the stuff of a real estate investment blog.  But he was a master marketer.  I doubt you could  find a dozen people living in San Diego who can’t sing his latest commercial jingle:  “It’s better to know me and not need me, than to need me and not know me.”

Even in death, King Stahlman still has something to teach.  This, his motto, as reported in an article in the local paper announcing his death:  “Early to bed, early to rise, work like hell and advertise.”

Vaya con Dios “King” Stahlman…

Filed under: MARKETING

Real Estate Investing: Arbitrage

If you are investing in San Diego real estate, or any real estate for that matter, there is a single idea you should be using to evaluate every property of interest.  Outside of Wall Street, however, it’s rarely discussed and you may be missing out on this infinitely useful and fundamental concept in investing.  You see, real estate investing may be unique in a number of ways, but the ultimate objective differs little from most other forms of investing.  Whether your goal is cash flow, equity appreciation, tax relief or wealth protection: in the final analysis you are looking for an arbitrage.

The market, if it’s open and transparent, balances pricing between competing interests.  On one side there is a seller.  The seller believes there is an acceptable profit (or loss of future profit) for a reduction of risk.  On the other side there is a buyer.  The buyer believes there is an acceptable potential for profit (or future profit) relevant to an increase of risk.  These levels of acceptable risk and commensurate reward encompasses many variables and are generally beyond the scope of one article.  What’s important is this: the ratio of risk and reward varies from person to person!  It is this difference in opinion, as the saying goes, that makes a horse race.  It is also where we find opportunities to create a profitable investment.  (Notice I say “a profitable investment” rather than just profit.  That’s because I am referring here to an outcome matching your goals.  Flipping a house may create a literal profit, but so can taking a monthly loss against gains for tax purposes.  Profit is generally an increase in immediate cash, whereas a profitable investment may be rewarding in other ways.)  You do not have to understand all of the variables (although we do and it certainly makes a difference), the investor’s primary concern is a comparative knowledge of their sum total.  That is to say: a knowledge of when the risk and reward are out of balance.  This creates an arbitrage opportunity.

(Note: this is not an arbitrage in the true sense of the word.  A true arbitrage takes place almost simultaneously and involves no market exposure.  This is done in electronic markets that are extremely liquid… neither of which applies to real estate investing.  Going forward, I am using arbitrage in a simpler context: the opportunity to create a profitable investment by recognizing a discrepenacy in the marketplace.)

When pricing gets out of balance, the very act of arbitrage will right it again.  Our job then, is to find  – or create – these opportunities.  There are three areas you can arbitrage in real estate: knowledge, timing and finances.  If any one of these creates an advantage in pricing that the market hasn’t (or can’t) balance, you have found a profitable investment.  Let’s take a look at an example for each of these and see how they interact.

Example 1 – Knowledge Arbitrage

There is a home for sale and it has a cracked slab.  This has sent most buyers running in the opposite direction and for good reason: if you don’t know how to properly fix a cracked slab your expense risk is completely unacceptable.  Plus, this lack of knowledge prevents you from properly pricing the property which means you cannot write an informed Offer to Purchase.  You should pass.  The seller, Sliding-Away Sally, knows all of this is happening because she has been advised by her very informed and helpful listing agent.  She has therefore priced the home according to her belief in an acceptable gain (or loss of future profit) against a reduction of the risk and potential for future loss associated with a cracked slab house.  Now, along come our hero: Arbitrage Andy, and he knows quite a bit about cracked slabs.  He knows roughly what it will cost to fix based on his own inspection and he has access to people who will do the work.  Arbitrage Andy looks at the work involved on Sliding-Away Sally’s place and sees that there isn’t nearly the work everyone thinks there is.  Due to his superior knowledge, Arbitrage Andy is able to buy this house for much less than it’s worth, perform the work and reap the reward of a knowledge arbitrage.

Example 2 – Timing Arbitrage

A home owned by Sloppy Sam is not for sale… yet.  The listing agent doesn’t want to put it on the market in its current condition.  It is such a mess that neither Sloppy Sam nor the listing agent have a good idea what it might sell for once it is on the market, but they’ve priced it according to their belief in an acceptable gain (or loss of future profit) against a reduction in the risk that comes with owning this mess.  Along comes Arbitrage Annie and she sees the agent leaving the house (his car is plastered with advertising) so she stops him and asks if the place is going to be for sale.  She discovers that it’s for sale now, but no one  knows about it yet.  Arbitrage Annie asks to go inside, sees that the “mess” is purely cosmetic asks what they want for the “dump.”  A little embarrassed, the listing agent throws out the low number he has previously discussed with Sloppy Sam.  Arbitrage Annie looks around disappointed, takes another 5% off and says that’s the best she can do.  The seller takes the offer and Arbitrage Annie, thanks to being ahead of the competition and quick to act, will enjoy a very nice profit for her timing arbitrage.

Example 3 – Financial Arbitrage

Here’s a relatively simple example: the Not-so-Nice Niece and Nephew of Dead Donald want his house sold so they can pay off bills with their share of the profits.  They have two offers in already when Arbitrage Alex talks to the listing agent and discovers the seller’s needs.  He offers less than the other offers and gets accepted because he can pay all cash and close in seven days.  The estate of Dead Donald believe the reduction in profit is balanced by the short escrow and the lack of exposure to the lending world created by the all cash offer.  Arbitrage Alex gets a great deal on an investment because he had liquid cash and could act quickly on a financial arbitrage.

There are many ways these three opportunities may interact.  I have personally done deals involving all three of the scenarios presented.  In the end, you will find your profitable investments are those in which you were able to leverage your ability to recognize and act on a knowledge, timing and/or financial arbitrage.

Filed under: INVESTORS , Arbitrage, finance, knowledge, profitable investment, Real Estate Investing 101, timing

Insult to Injury?

Did you ever have the feeling something very bad just happened?  You can’t quite put your finger on it, but you sense something is wrong.  Or worse, there’s that feeling you sometimes get that not only is something bad happening, but someone, somewhere is orchestrating it.  Very eerie: the hint of impending doom, the frustration, the uneasy awareness  something dreadful has been laid out for you and there’s nothing you can do.

As painful as those feelings may be, they’re not normally accompanied by anger – not unless there’s also a sense of outrage.  To be really and truly angry, you must not only sense something very bad is happening and someone else is causing it to happen – but the added insult that they enjoyed doing it.

As if maybe they were laughing at you…

Democratic House members, including Speaker Nancy Pelosi (second from left) and Rep. Charles Rangel of New York (right), laughed at a news conference Thursday after the House had approved the stimulus bill.

Filed under: POLITICAL & ECONOMIC FOLLY

Real Estate Investing: Fundamental Value

In the Introduction to San Diego Real Estate Investing, we discussed the Fundamental value as the key component of an investment analysis.  Now that we’ve defined the Four Values, let’s take a closer look at how to calculate and use the Fundamental value.

Methodology
While creating four values per property involves extra work, it is not as difficult as it appears.  The first two values – Break-up and Intrinsic – can be calculated using cost-per-square-foot estimates, which you update from time to time with local contractor clients.   The final value – Utilitarian – is based on a standard CMA and can be calculated by any competent real estate agent or appraiser.  Remember: it will reflect not only the comps, but the difference between what an investor and an owner-occupant will pay.  It should be tracked in relation to the other values to define arbitrage opportunities.

The Fundamental Value is our most important tool and requires you to get tapped into the investment side of the neighborhood.  There are three basic steps to reaching a Fundamental Value.  First, find the average rental income paid for a similar home in the same specific area of the potential investment.  This rental amount will serve as your baseline PITI.  Second, work a loan scenario backwards to arrive at a loan amount that, given the prevailing rates and terms, will produce that PITI payment.  Finally, add a down payment to the loan amount.  Let’s take a close look at each step:

1. The first step is often the misstep.  It takes some experience and longevity to know, with a reasonable level of certainty, what a particular property will rent for on the open market.  If the investment is in an area one knows well, it shouldn’t be much of a problem to look up equivalent rents on various online sites.  If you are not familiar with the area, all rental research should be accompanied by a drive-by of the rental properties.  Better still, make an appointment with the landlord or current owner to see the inside.  The more accurate and specific you can be at this step, the safer your investment will be going forward.  If you are not familiar with an area you can also search out those who are: realtors, leasing agents, appraiser, etc.; pay them a small consulting fee to “access” their knowledge.
2. The second step is the most straightforward.  Mortgage calculators, which can be found online, require you to enter three of four variables in order to solve for the fourth.  Enter the term of the loan (for simplicity sake we will always use 30 year fixed, but there are scenarios when a shorter term loan would be appropriate), the prevailing interest rate and the desired payment.  The calculator will provide the corresponding loan amount.  (Warning: Although straitfoward, there is a great  possibility for error during this step.  Most mortgage calculators base their computation on only the principle & interest portion of the total payment.  If this is the case, make sure you back the insurance and tax payment out of your PITI before entering it into the calculator.)
3. Adding the down payment is the final step.  The Fundamental value you arrive at is the sum of the loan amount and the down payment.  Simple, yes?  But not easy.  The down payment is a variable and the number you use is based on your client’s risk aversion, liquidity and long-term plans.  On top of which, you can also use this method to get a Fundamental Floor Value which I will explain in a moment.  So, how do you choose a down payment number?

The Down Payment

 Most non-owner occupied home loans require a minimum 20% down.  The rate and fees are generally better at 25% down and better still at 30% down.  Yet a greater down payment is not always the answer.  You have to look at your client’s overall liquidity, what work, if any, must be done to the investment property and what your client’s long term goals are.  If your client only plans on buying one investment and can put 30% down while maintaining adequate liquidity, this will create a very safe, long term cash flow.   On the other hand, putting only 20% down lowers the cash flow and increases the cash-on-cash return of equity appreciation.  Add to which, your client may be looking to purchase more than one investment property, in which case the slightly higher interest rate and payment stemming from a lower down payment is offset by the increased remaining liquidity available for the next purchase.  Beyond all of that, you have the matter of rehabbing.  If a property requires work the investor may opt for a lower down payment in order to increase available funds for materials and labor.  If the investor is planning to refinance the property after the work is done (as we do in the Infinite Investment Strategy) then the initial down payment should be minimized, as liquidity is more important than interest rate.

Those are some involved calculations to make, but as I said they are based on a few simple ideas like risk aversion, liquidit and long-term plans.  This is one area where an experienced investment advisor will pay great dividends.  There is a secondary calculation that can be done while creating the Fundamental value and weighing various down payment scenarios: the Fundamental Floor value.  This can be very useful and deserves some explanation.

The Fundamental Floor Value

If, at step 3 above, you were to add 3.5% as the down payment, you would effectively be calculating an investment’s value in relation to a homeowner’s FHA purchase loan.  This is going to be a much lower value than those calculated for the Fundamental value due to the small down payment.  But, it will give you a virtual floor for pricing in a falling market.  Put another way, the Fundamental Floor value tells you how low home values have to fall for a potential owner occupied purchaser to feel safe buying a house, knowing that if something unforseen happens they can rent it out rather than lose it to a short sale or foreclosure.  This is a little understood but extremely important value to understand when you are in a declining market and the supply of homes, even though priced below fundamental value, is too great for the demand - thus keeping everyone on the sidelines.  I don’t often advocate “timing” the market, but the Fundamental Floor value will give you some idea of when the floor is near.  (Warning: This type of evaluation is predicated on the idea that the area itself is not fundamentally flawed.  If the economic fundamentals of an area have failed, this calculation carries little value.)

Final Thoughts

The importance of the Fundamental value cannot be overemphasized.  Nor can I state strongly enough the importance of understand your (or your client’s) degree of risk aversion and goals.  Finally, if you are unsure about the lending side of this equation, contact your lender and allow them to do it.  Fundamental value is too important to get wrong because of a math error.

Filed under: INVESTORS , Fundamental Floor, Fundamental Value, investor's down payment

Real Estate Investing: The Four Values

Most small to mid-size real estate investors are forced to rely on “comps” for their valuation of a potential investment.  This is the method commonly employed by appraisers and the real estate industry as a whole so it’s really been the only choice available… until now.  If you are a regular reader, you know I have found the existing tools in real estate to be inadequate for the needs of myself, my partners and my clients.  The following is an explanation of how I value properties when we are deciding which property to write an offer on or where to cap our offer price.

CMAs
Over the past six months I have been discussing with my partner Brian Brady different ways to value a property.  Having both come out of the securities field (I enjoyed some pretty exciting [read: stressful] years as an options trader - he was a bond trader), our discussion revolved around how property would be valued if it were a security investment.  First, a Comparative Market Analysis or CMA – which is based on comparable properties or “comps” – would be used only as a qualifier or a secondary validation.  They are circularly self-serving and relationally compromised.  Instead of comps, we should be looking at a more financiallyuseful value.

A New Method
There are actually four values to any property.  The first may be interesting, but is not often directly helpful for our investments.  The next three should, however, be calculated every time we look at a property.  Here are the four values in ascending order:

BREAK-UP VALUE – this is the value of the land itself along with any profits to be made selling pieces of the home before tearing it down, minus the cost of tearing it down.  In Illinois, for example, there are companies that advertise a home about to go under a radical rehab.  Buyers come to the home and everything is auctioned off: staircases, doors, windows, cabinets, etc.  After such an auction you combine the money in your hand plus the value in your land and subtract the expected cost of your demo contractor to arrive at the break-up value of your property.

INTRINSIC VALUE – this is the value of the land plus the actual cost to build a model match home using today’s material and labor costs.  Don’t forget the fees, permits and so on plus the potential for temporary housing costs incurred while building the home  (loss-of-use cost).  This is most often calculated by ascertaining the value of the land itself and then multiplying a “per square foot” cost for construction.  (Your local General Contractor can give you such a number.  As always, try to find three “per square foot” costs and average them.)  Total those costs and you know what a property is worth intrinsically.

FUNDAMENTAL VALUE – this is the value of most importance to an investor.  It is calculated using comparable rents for the neighborhood in relation to a property’s cost-of-carry.   It is the KEY to correctly valuing an investment property.  Once calculated we have little trouble knowing what financing is going to look like and whether the deal is a money maker.  This is how non-owner occupant investors would evaluate a property.  “Does it pencil out” is another way of asking the property’s fundamental value.  This kind of analysis will also tell us when prices are out of line.  (Details on calculating this value can be found here.)

UTILITARIAN VALUE – this is the Fundamental Value plus the non-specific value that accrues to a person owning their own home.  Brian Brady jokingly refers to this as the “purple wall” value: the added premium a person is willing to pay for the freedom to paint the walls of their home purple.  While not easily calculated; it is often easy to quantify.  Look at any area where “fixers” are being sold.  You will find a price discrepancy between what investors will pay who wish to make repairs and still earn a profit (either monthly or as a flip) and someone who actually wants the home for their own.  When you are bidding on homes to rehab and/or flip as an investor, your price is based on #3 (Fundamental Value) and you should never compete with someone looking to make it their own home because they will pay the utilitarian value.

Conclusion
Using these four valuing methods, we can make informed, rational decisions (even while missing out on some of the run-ups) that should leave us financially sound in the long term.  An investor’s comfort with and use of the fundamental valuation will, to a large degree, determine that investor’s long term profitablity.

Filed under: INVESTORS , Break-up Value, CMAs, Fundamental Value, Intrinsic Value, Property Value, Real Estate Investing 101, Utilitarian Value

Real Estate Investing: The Small-Cap Investor

As I said in the introduction to investing in San Diego real estate, I use the word ”investor” as though it were universal, but it’s not.  I see three distinct spheres or levels when I look at people buying and selling real estate.  Two of those levels are well served: the owner-occupied and the commercial.  Clients falling into either of those categories may learn from these articles too, but it’s that middle sphere or second level client I want to focus on and reach.  These are the people I call Small-Cap Investors and they are, by far, the most underserved.  So, what are these three levels specifically?

Level 1 Clients
By far the largest in number, Level 1 clients are buying or selling their own homes.  This group is well represented by the real estate industry.  It wouldn’t surprise me at all if you said there were 1.8 agents for every man, woman, child and large puppy in California.

Level 2 Clients
My target audience and I believe, one of the fastest growing segments of the real estate world.  These are primarily individual or small group investors buying single family homes and 2 or maybe 3 unit buildings.  Because this group is so inadequately served, they must look for advice where they can find it.  They either try and use the services designed for Level 3 (and are left feeling like second class citizens because of their lower net worth and limited objectives) or they settle for Level 1 representation.  In which case they are trying to make an investment decision while consulting someone more normally associated with staging open houses, comping properties and holding nervous clients together while buyers’ remorse passes.  All important tasks, to be sure, but a poor substitute for understanding debt planning and proper valuations in relation to cash flow.

Level 3 Clients
This is a set of investors buying and selling at a commercial level.  They are quite knowledgeable going in and their transactions may involve 10 unit apartment complexes and commercial buildings.  The agents at this Level work with firms that have taught them how to view their clients’ investments in much the same way we do on Wall Street.  But they are too large to work with the Small-Cap Investor and their tools are too sophisticated.  They are going to discuss things like “cap rate,” “1031 exchange” and “triple nets.”  If you’re really curious, I’d be happy to explain these concepts but here’s what’s important: they are not the right tools for Level 2 clients.  They do not provide the appropriate framework of analysis for Small-Cap Investing.

Call to Action
Here’s the bottom line.  If you are or think you may be a Small-Cap Investor, these articles are written especially for you.  If you have any questions or you are in need of a specialist, please don’t hesitate to contact me.  If you are an agent looking for a better understanding of these concepts, this is written with you in mind too.  If you are interested in gaining a much more detailed, working knowledge of Small-Cap Investors, we offer seminars and webinars through a company I co-founded called: The Real Estate Training Team (TREETT).  We are also available for office presentations.  No matter who you are, I hope this series of articles is helpful and I look forward to your comments.

Filed under: INVESTORS , comps, Small-Cap Investor