The Conservative, Common Sense Way to Invest in Rental Real Estate
Investing in real estate is a time-tested way for regular people to build large fortunes. Almost everyone has a friend or family member who has made great money with a rental property.
However, it's very easy to go wrong in real estate. Some people take an amateur approach. Some take a professional's common sense, conservative approach.
To learn why the latter approach is best, read the following interview with professional real estate investor Justin Ford. It's a quick read... and could help you safely make hundreds of thousands – even millions – of dollars in real estate.
Stansberry Research: Justin... buying rental real estate is a time-tested way to preserve and grow wealth. But people can go very wrong in real estate if they focus on the wrong things. You've developed a great, common sense way to invest in real estate. Could you describe this approach?
Justin Ford: Sure.
There's an acronym I use to tell people what I think the four most important aspects of real estate are. The acronym is CAPA. It stands for cash flow, amortization, positive leverage, and appreciation.
The first three you can control. You can control whether you buy a property that has cash flow or not, whether you put a loan on it that amortizes or not, and whether that loan has positive leverage or not.
The only thing you can't control is the fourth item, which is appreciation. Unfortunately, that's the one thing that everyone focuses on. Everyone plays appreciation as if it were a point-and-click game in the stock market. It's not. And that's why many people got into trouble during the housing bust.
The good news is, if you focus on the first three things – cash flow, amortization, and positive leverage – you can almost guarantee a positive return.
A lot of things would have to go wrong for you not to be successful. You'd have to have a lot of bad luck or you'd have to be a very bad practitioner, one or the other, or a combination of the two.
But if you're a moderately successful practitioner with just average luck and you focus on those three things, you should have a positive outcome. And the sharper you are as a practitioner, the better the outcome.
Stansberry Research: Let's cover cash flow first. Could you walk us through the numbers to keep in mind when computing cash flow for a potential investment?
Ford: Absolutely. Positive cash flow is just like anything else in any business you run. You have to make enough money to pay your expenses, and then you have to have a little left over for the unexpected. Whether it's a Laundromat, a dog kennel, or a candy store, cash flow is king. It's the same thing with property.
Now, people don't think of it that way with property because many new investors in real estate have been conditioned to invest in the stock market. They're not really prepared. They're just trained to invest the way brokers want them to invest, which is point-and-click, buy, sell, buy, sell. It's all price driven.
Stansberry Research: Most people in the stock market are obsessed with capital appreciation. They want to double their money on some hot growth stock rather than focusing on cash flow and income from dividends.
Ford: Right. And here's the proof. If I ask the average stock investor "Do you own Google?" and they say yes, then I'll ask, "Well, how much did Google earn last year and how much did it earn this year?"
They won't know Google's cash flow. But if you ask them what the shares are trading for, they'll know the answer. That's because they are focused on share price and share price appreciation... and not much else.
Of course, if you're involved in the day-to-day operation of a business or a property, then you're focusing on cash flow. Whether it's a house, an apartment building, a mobile-home park, or an office building, cash flow is king. Your cash flow must at least pay your expenses.
Let's take a $100,000 property as an example. We'll imagine it's a house and $100,000 is your investment. And let's say that that property produces $20,000 a year in gross potential income, meaning every month you can rent it out for around $1,600. By the end of the year, you receive around $20,000 if your property is rented out every month.
Now, things never go perfectly, so you're going to have some vacancies. You're going to have this, that, and the other happen. You'll also have normal expenses – things like real estate taxes, insurance, maintenance, repairs, minor things like license fees, maybe accounting fees, and if you're not managing it yourself you'll have a management fee, etc.
It's not unusual for about 50% of a property's gross income to go towards expenses. Let's say of this $20,000, $10,000 is consumed by expenses, vacancy, and collection losses. That means you're left over with $10,000 as net operating income. That's a really good deal. You spent $100,000 and you got $10,000 back that you can theoretically put in your pocket, so that's a 10% return.
Now, being a prudent investor you're not going to put all $10,000 in your pocket. You're going to keep $2,000-$4,000 – depending on what you foresee in the future – as reserves. But still that $10,000 right now belongs to you. It's your net operating income. And that's a good return. That's cash flow.
Now, let me tell you what happened in the bubble (2003-2007). In the bubble, people didn't do cash flow. They would buy some ridiculous $400,000 home that used to sell for $150,000, and they were hoping to sell it for $500,000. And the rents on that thing were maybe $15,000 to $20,000 a year. They weren't even good operators, so they wouldn't get the $15,000 or $20,000. They might only get $10,000 in rent out of that house.
And then all of a sudden that house that used to be worth $150,000 is now worth $400,000. The taxes have gone up, the insurance has gone up. So now the $10,000 they're squeezing out of there on the rents while they're hoping to flip it doesn't even pay their bills. It doesn't pay their maintenance, their repairs, their license, their accounting, their advertising. It doesn't pay a lot of things. So they're negative.
So they're coming out of pocket, but it's OK. They still think, "It's only a few grand and we all know real estate goes up forever, so who cares?" They "know" they can sell it for $500,000. And they do it once or twice and it works, and they're geniuses.
But then once it all stops, you have nothing but cash flow going out, not coming in. We all know what happens then: The value of the property goes down. They may have loans on it, so now they owe more than the house, and they're hurting. And then they end up with their credit destroyed. They lose all the properties they had.
The moral of the story: If you focus on cash flow – even if you're a flipper, even if you like to buy and sell and never want to be a landlord – flip cash flow. Flip cash flow properties. Don't flip non-cash flow properties. If your flip "flops" you want to have a Plan B.
If your flip doesn't work out – if the market peaks, if some disaster happens and all of a sudden the market becomes scared and no one buys anything – you're OK. You'll be able to bide your time and break even. I have a few properties that went underwater, that are worth less than the loans on them. But they all produce cash flow, and so they carried themselves through that tough time.
Stansberry Research: Okay... how about the first "A" in CAPA?
Ford: The "A" of CAPA stands for amortization.
Amortization is basically the gradual, steady reduction of the loan balance. That's all it is.
It comes from the Latin mors, meaning "death." So basically, I think about killing off the debt. If you borrow $100,000 at 6%, your monthly payment's going to be $600.
At the very beginning of the loan, $500 and change of that will be interest and the rest will be principal, slightly reducing it. Because you're only charged interest on the principal, as the principal goes down the interest on your next payment is less. But the payment is always $600. So in the beginning of the loan, maybe $540 or so is interest and $60 is principal. Ten years later, maybe $450 is interest, $150 is principal. Ten years after that it might be half and half. And then, the last five years or so, the thing might be 80% principal and 20% interest.
It seems like few people really understand the power of amortization. Of the people flipping real estate and so forth, most of them aren't even familiar with what the term means. And it's a shame because it's the slowest but surest form of wealth growth.
If you buy a $100,000 property with $20,000 down and you put an amortizing loan on it for 30 years... 30 years later the balance will be zero. Your tenants will have paid it off. And in effect, you will have turned $20,000 into $100,000 in 30 years' time, basically guaranteed – assuming you're operating as you expect it to operate.
And that's not assuming any appreciation. With zero appreciation you turn $20,000 into $100,000. Let's say you use a little more leverage and just put $10,000 down. Now you're turning $10,000 into $100,000, with zero appreciation. How powerful is that?
I mean, look at your retirement plan. You're young. 30 years from now, any property you bought for 20% down is going to be worth 100%, assuming zero appreciation.
And if you do have appreciation, you turn $20,000 into $200,000 or $300,000. So that's the power of amortization, reducing the loan balance as you go along. Whenever you have that opportunity, you should take advantage of it.
Stansberry Research: OK, is there anything else we should touch on with amortization?
Ford: Just that the gains that come from amortization are essentially tax free. You get the tax-free benefit of having someone else pay off your loan.
Stansberry Research: Let's move onto the "P" in CAPA.
Ford: The "P" in the CAPA acronym stands for positive leverage.
This is basically where the cost of your borrowing money is less than your cash flow and it's going to stay that way because you fix your interest rate. Put simply, the cost of your debt is less than your cash flow.
So let's go back to that $100,000 property. It generates $20,000 per year in revenue and there's $10,000 in expenses, so you have $10,000 in net operating income. If you're an all-cash buyer, meaning you're making 10% annually, that's your cash yield.
Now if you put a loan on it, you're going to increase your total expenses because you're going to have an interest expense, but you're going to decrease the amount of capital you outlay – the borrowing money. And that return, when using positive leverage, is going to go up. So instead of 10% you might end up with 22% in yield per year.
So let's see how it works. Let's say you're borrowing $80,000 at 5.5% percent. Well, your payments every year, including principal and interest, are going to be roughly around $5,600. And that's going to be paid from that $10,000 cash flow that we talked about, right?
So now, you're left over with $4,400. But instead of putting $100,000 in, you only put in $20,000. So $4,400 divided by $20,000 is 22%. So your cash-on-cash yield went up from 10% to 22%.
Now, let's imagine you get lucky and the property goes up 10% in the first two years you own it – not far from the long-term average. In the first case, where you were an all-cash buyer, that 10% rise was a 10% return on your capital.
With no positive leverage, you put $100,000 in, and you made an extra 10%. In the second case scenario, you made an extra 50%, because it's $10,000 on the $20,000 that you put down. That's the power of positive leverage. In this case, you made 22% two years in a row. And then you made 50% on your amortization. You made 94% gross – we're not doing taxes or anything else right now; we're just talking gross numbers – because you had positive leverage working that property. If you were an all-cash buyer, you would've made 30%. You still would've made a decent return, but not a great return. That's positive leverage.
What's negative leverage? Negative leverage is when you borrow money and you have $10,000 in net operating income – the same example – but your cost of money is $15,000. In this case, you have to come out of pocket just to pay it.
Back in the boom years, no one cared about negative leverage because they "knew" that they would be able to flip for a higher price. The moment that stopped being true, they were stuck with the negative leverage. And then when they tried to sell the property, the property was worth less than before. So not only did they have negative cash flow, they had negative equity. And eventually, they lost their credit and everything else.
So one of the takeaways here: Fix your interest rate so you have positive leverage for as long as you can. I have loans from 2003/2004 that were 6% loans that are fixed for 30 years, and they're just working away. They're chipping away at their payoff date. A lot of these properties still have good, positive equity, and some are a little less than that. But they're all fixed. And that's the conservative route.
Stansberry Research: Terrific. And now we should move on to...
Stansberry Research: Yes, the last "A" of your CAPA acronym. I have a feeling this will be the shortest discussion, because the other three are the most important, correct?
Ford: That's correct. Appreciation is what can make you the richest, combined with positive leverage. But it's the one that you have no control over, and so it's the one that you should not focus on.
However, it's the one that most people focus on. And that's a shame because they neglected all the things they can control. They shoot for the thing they can't, and then they get hammered.
But if you get appreciation in addition to those three things we talked about – cash flow, amortization, and positive leverage – you should do well.
If you get appreciation to boot, you could do extremely well – in investor terms, you could do 20%, 30%, 40%, 50% annual returns in many cases when you're getting appreciation combined with those other factors. Long term, you're not going to get that. But long term, you could certainly get 20% returns per year compounded, if you're getting appreciation combined with everything else.
But don't hang your hat on appreciation. Go into everything you buy where if it never appreciated by a dollar you'd still be OK. There are many properties I buy today where I have every reason to believe that they will probably appreciate. For instance, they're selling at less than the cost of replacement value.
If they gave you the land for free, you still couldn't build it at the cost you're buying it. The cost to own is now much cheaper than the cost to rent. So eventually that will create buying pressure because people will stop renting and they'll move to buying and they'll create demand for the actual property.
And then of course, there is the whole inflationary scenario. When you talk about the prospect of inflation, housing is one of the most sensitive inflation indicators in the economy. Much of what the inflation index is made of is in housing – concrete and lumber and steel and labor and tar and petroleum products. And it's almost impossible to imagine those things going up without housing going up.
If we do have appreciation, we'll do extremely well. But if for some reason appreciation goes nowhere and we stay flat, you can still do well. If for some reason, we go nowhere and we go into some great depression of demand and our prices continue to fall and stay low for a long time, you could still do well with the first three things we talked about. You could still make a positive cash flow and have your loan paid off. Obviously, it's not the best scenario. But that to me is smart investing, focusing on those three things.
|What You Need to Know About Buying Silver||Why Value Investors Should Buy Gold|