The Mirror Effect

Do you ever wonder how to deal with someone else’s opinion of you – especially if it’s negative?  Not how to handle a negative or even rude opinion; early on you should have learned that politeness is how we handle almost any situation.  No, I’m asking if you have a mechanism or coping skill for those times when you discover what someone else thinks about you and it’s painful in some way?  This is not an uncommon experience and might be especially common for real estate agents!  (I’ll leave you to find your own context on that one.)  Personally, I’ve heard a number of answers to this question and they are usually similar to the one found in The Four Agreements by Don Miguel Ruiz.  While not completely representative of everyone’s answer, it’s close enough. This solution seems to lie in finding ways to ignore, become indifferent to, or otherwise devalue the offending expression.  (Mr. Ruiz, for example, points out that when someone says something about us, we should remember they are limited by their own view of the world – their own prism – and realize what they say, says a lot more about them, than us.)  This is both obvious and oblivious.  May I suggest something a little different?

The Mirror Effect
Of course other people see things through their own prism; so what?  Their opinions can not – and do not – hurt me in the least. How could they?  They are only words and, depending on your philosophical bent, the person saying them may or may not even exist!  If I feel hurt or pain (or happiness for that matter), you can be sure I am the sole cause.  I hear the words, I interpret them (through my own prism Mr. Ruiz) and I create feelings in reaction to my interpretation.  I create…  That’s where the wonderful opportunity lies.  The negative or painful (or happy) feelings are created from within.  That’s not just a difference regarding who is in control (per Mr. Ruiz and the rest, I am to develop some ability that will counter the hurt caused by the words or expressions of others – thus giving them the control and me the dependent action).  It’s more than that.  It is how we evolve and become happier and more peaceful; how we become more succesful possibly, and more free definitely.

Suppose someone says to me: “Sean, you are not much of an athlete.”  I would not be stirred by this.  I know my athletic accomplishments.  I know my athletic abilities.  I am comfortable with who I am as an athlete.  I may believe this person to be mistaken or misinformed or ignorant, but I do not take their expression personally – I am not hurt by it. They could have also said: “You are not as good an athlete as Michael Jordan.”  Again, I would not be stirred by this.  Just as I know who I am as an athlete, I know who I am not and my self worth is not dimished by this comparison.  If, however, ten minutes later this exact same person said to me: “Sean, you are a bad father,” I may indeed walk away in pain.  I am divorced and a single dad; I have doubts about whether or not I am being everything my boys deserve.  So when I hear this I may feel angry or hurt; maybe I’ll want to argue and “convince” this person how wrong he is.  Why is that?  Why didn’t I want to convince him of how wrong he was ten minutes ago when he brought up my athleticism?   This is the same person after all, yet what he thought of me as an athlete had no affect and what he thought of me as a father did.  What changed?  Obviously, what changed was my interpretation; my reaction; my feelings on the subject at hand.  The problem does not lie with other people’s opinions, otherwise I would have been hurt both times.  No, the diffence in those two scenarios is… me.

When confronted by an opinion I knew to be false (or at least believed to be false), I was not bothered.  My vision of myself, athletically speaking, was in alignment with my day-to-day experience.  But that last opinion, the one about my being a bad father, that bothered me a great deal.  Why?  Because there is a truth to it – or at the very least I fear there is a truth to it – that I do not wish to face.  This is, in effect, a mirror held up to me – and I don’t like what I see.  That’s why we can’t cultivate an indifference; the indifference would be to ourselves.  That’s why Mr. Ruiz’s answer is so off track too: how do I devalue the prism when it is my own?  I cannot.  Even if I could… what an opportunity I would miss.  What a blessing upon myself I would be throwing away.

The Opportunity!
The next time someone lets you know what they think about you and it hurts, don’t argue with them or run away from the pain or try to devalue what was said.  What’s needed isn’t a coping method.  Instead, thank them!  Thank them and mean it.  (After all, they were merely the person holding the mirror and nothing more.   Besides, this has the added benefit of messing with their heads.)  Then walk away and realize you’ve just been blessed with an intimate look at yourself.  A look we don’t like, no question; we’re face to face with how badly our internal vision of ourselves does not match our external expression of ourselves.  But if we’re honest about it, that look is also a revelation – and a roadmap to greater happiness and success.

Live a Life that POPs

Filed under: BUYERS, INVESTORS, LENDERS, LIFE THAT POPs, REALTORS, SELLERS

The NAR Backs the FHA… Who’s Backing You?

Late last week the House of Representatives passed H.R. 5072, the so-called FHA Reform Bill.  One of the major components of that bill (you can read the text of the bill here), raises the monthly insurance premium for all FHA buyers.  What does that mean to your bottom line?

 

Currently, the FHA monthly premium is .55% and the new legislation Congress is looking at will raise the premium a wopping 272% to 1.5%.  What does this mean to your buyer?  If they are at the limit of their eligibility on a $300,000 purchase price now, they would have to lower their interest rate by over 1.25% to still qualify for that house.  In other words, if the current market rate is 5.00%, it would have to drop to 3.75%!  If you think you might have trouble locating a lender who will do 30 year fixed loans at 3.75%, don’t worry; you can also lower their purchase price to bring them back into eligibility.  Their new price would only have to drop 10%!  A buyer looking at $300,000 today will be looking at $265,000 to $270.000 as soon as this bill passes. Does that change your market opportunities for the better… or the worse?

 

I understand why the NAR supports this, it keeps FHA alive and well, doing sub-prime loans for people who can’t afford to buy a home, which in turn keeps dues paying agents busy and coughing up their fair share.  But why do agents support it?  It’s going to have a devestating affect on your clients, and therefore on you.  Do you support it?  Have you let anybody know?

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

A Scary Thought on the (Non-Existent?) Shadow Inventory

The shadow inventory has been a topic of interest with almost every agent I talk to lately.  Most believe it is large and few understand why it isn’t in the marketplace rather than held by the banks.  Russell Shaw recently wrote about the shadow inventory being gibberish.   It is an interesting article and one I recommend reading.

I rarely disagree with Mr. Shaw, and rather than do so now I’ll simply suggest that we are talking past one another.  As I read it, he is suggesting that this inventory doesn’t exist because it is, for the most part, out there already; just not listed as REO.  He makes it quite clear, however, that he is not talking about foreclosures still to come. (Apologies to Russell for over-simplifying.)  This is where we begin to part ways.  I submit that the shadow inventory must necessarily include not only actual REOs (or REOs not listed as REOs), but the entire picture.

More to the point, if we look at all the homes that have been foreclosed on, are in foreclosure and should be in foreclosure, we are left scratching our heads and find ourselves back to the same question: why aren’t the banks taking these homes in, putting them on the market, and selling them?   (I’m talking here especially about those homes where people have stopped making their payments and continue to live for 6, 12, even more months.)

MORTGAGES IN DEFAULT
Here’s a graph courtesy of the New York Times:

Sources: Federal Reserve Board and Mortgage Bankers Association, via Haver Analytics

That is an awful lot of mortgages in foreclosure; but add to that that lower line – of mortgages in default and not yet in foreclosure – and the numbers are staggering (again, think of people staying on a year after they’ve stopped making payments).  So no matter what we call it, the question remains: What are the banks doing? Why aren’t these mortgages foreclosed?  Why isn’t this inventory on the market?

I know all real estate is local and there are plenty of areas around this country where the last thing agents want to see is more inventory.  But here in San Diego this question of  Shadow Inventory is burning a hole in people’s brains.  We are down to less than two months inventory and the effective inventory (discounting homes that are not financeable due to cracked slabs, missing kitchens, etc.) is closer to one month.  The average buyer is writing over fifteen offers before buying a home or simply walking away in frustration.  We are clamoring for this inventory; why isn’t it out there?

A THEORY
Here’s a theory I’ve been sharing over the past two months with the agents I talk to: the banks have a financial incentive NOT to sell these homes for the same reason they have a financial incentive NOT to lend money.  Let me ask you: if you could borrow money right now from the Fed at roughly 0%, and through carry trades create a very low risk return of 3%, would you do it?  Of course you would; that would certainly be more prudent than putting the money out there in relatively risky mortgages?  More important to our discussion of Shadow Inventory:  you can borrow that money at 0% so long as your balance sheet and reserves are in order. When you have a non-performing asset (like a mortgage not being paid) you can carry that for quite a while.  But, if you sell that home in foreclosure you book the loss.  I don’t know about you, but if I were a bank I would happily carry a non-performing asset and continue to borrow money at 0%.

CONCLUSION
When the Fed begins to raise rates -expected to be late 2nd quarter or early 3rd – the banks will thank them for the ride and begin clearing their books of these non-performing assets in a hurry.  If we follow this theory to its inevitable conclusion, we are looking at a scenario wherein inventory is going up (and home prices are dropping) while at the same time rates are rising.  Falling home prices and rising interest rates. Not the summer I want… and I hope to hell I am as wrong as I have ever been.

Filed under: BUYERS, INVESTORS, LENDERS, REALTORS, SELLERS

How to Run a Real Estate Business: Finding Wisdom in a Baseball Storm

“Last night I went to a boxing match and a hockey game broke out.”  (Ba-da-bum-ching.) That’s an oldie but a goodie.  I had a similar experience recently:  I went to a baseball game and a business class broke out.  About an hour north of me is the Padres Single A affiliate, The Storm.  If you’re a fan of baseball and haven’t made it to a minor league game, you really should; they are a blast.  But that’s a different story.  Because I attended the game with a friend from the Padres organization, I was lucky enough to meet the Storm’s President, Dave Oster and we got to talk a little business.

What’s that you say?  What does minor league baseball have to do with real estate?  By now you should know that business is business.  In the end, if you’re an agent, you’re running a business and I suggest we take every opportunity we get to learn from other successful business people.  As a matter of fact, I’m going to come right out and say you learn more from someone running a business different from yours than you’ll ever learn going to another 5000 seat auditorium and listening to some “real estate expert” who hasn’t sold anything but seats for years.  (Sorry… another tangent).

When Dave and I first got to talking, my goal was to ask him about his marketing philosophy.  I am always interested in learning what someone can share on marketing.  It’s been my experience that most people (and agents in particular) do a poor job of it.  Actually, that’s misleading.  The problem most people have is they don’t know the difference between advertising and marketing.  Genuine Chris Johnson wrote a post yesterday (and Jeff Brown is famous for them ) wherein they lay out that difference, but I wonder how many people are seeing it.  In any case, that’s another post for another day because Dave gave me a humdinger of an answer.  During the course of our conversation though, he said something you almost never hear, yet it may be the most important concept in running a business.  That’s today’s topic.

I was asking, in a very general way, about the group of people who work for him.  After a bit of hesitation Dave said (and I’m paraphrasing):  “It’s hard for me to answer questions about everyone who works here as a whole.  I see them as two very distinct groups: there’s those who create revenue and then there’s everyone else…  everyone else being a cost.”  That is probably the most important concept any one of us will ever learn about running a business.  Sound simple?  Play it through.  Let’s stick to baseball for a moment: the people taking tickets are certainly taking in revenue; so are they creating revenue or are they a cost?  That’s right, they’re on the debit side.  Same goes for the people behind the hot dog window and the ushers and even the guy who turns the lights on.  They may all be important (God knows the beer vendors are important) but they all count as costs.  Who creates revenue?  Anyone whose actions or ideas directly translate into more people coming through the gates.  This is so rarely understood that even the big guys get it wrong.  But if you start to view business, any business… your business, through this lens – profits go up.

Real estate, believe it or not, adapts to this way of thinking quite easily.  If you are a rainmaker, which is to say: if you are someone who goes out and brings in closed business, then you are a revenue creator.  Everyone surrounding you, however, represents a cost no matter how important they might be.  Your transaction coordinator? Cost.  Your trusted assistant?  Cost.  Your buyer’s agent, your receptionist, even your broker?  They are all a drain on your revenue.  Why is this important?  Because small business owners often lose track of the bottom line.  We lose track of who’s important – and that’s a sure way to lose your money too.  The first thing any business owner should do is take a look around and categorize every single person who gets paid… including themselves.  You will normally find there is one, maybe two people who are generating closed sales: revenue.  Everyone else who gets paid is getting paid out of those revenues.  That does not mean what they do is unimportant.  It might even be integral.  But it does allow you to assess your resources with a much more accurate eye.  It also aides in creating chains of command.  Far, far too many people in the work-a-day world believe they are important to a company when in fact their position might be important.  They themselves are simply a cost and their importance is tenuous at best.

There’s one other way to look at this and maybe it will help.  Those who generate revenue are integral to the firm.  Those who are a cost might fill a role that is integral, but they themselves are replaceable.  Get it?  Your assistant might be very important to your success, but he can be replaced.  How do you replace the person who generates actual revenue?  Never lose sight of the ledger in your business.

Filed under: INVESTORS, LENDERS, REALTORS, Rainmaker, Success

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

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

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