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Author: babyfrog Big red star, 1000 posts Old School Fool Home Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75624  
Subject: Re: Allocation Advice Date: 10/4/2003 2:46 AM
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Cesar,

I am still very intrigued by the idea of concentrating my asset building plan on real estate. Any thoughts on this?

Having investigated a few landlord deals with some friends of mine, I'll tell you that my personal research indicates that it normally takes a lot of money, a lot of time and effort, and/or a fair mix of all of the above to be successful in real estate. Personally, I include some REITs (Real Estate Investment Trusts) as part of my overall and diversified portfolio, but I passed on the direct apartment ownership.

Here's what I've found in my experience. Bank financing is more difficult for (new) landlords than it is for owner occupied buildings. At least around here, many banks won't touch you if you can't come up with a 30% down payment, and they won't talk to anyone just starting out who is looking at anything above a 4 unit dwelling.

Of course, the bigger buildings have much better return projections than single family residences or duplexes, but they are a lot tougher for the 'little guy' to get without getting creative with the financing.

When my friends finally found a building that met their needs and projected out well, the only way they could finance it was via the seller, who charged them a pretty hefty rate. Did I mention that the building is in a not so nice part of town, and the reason the seller was selling is because it had been trashed by previous tennants and the ravages of time? As a result, the previous owner was having trouble renting out units in it...

Yeah, given the number of units in the building and neighborhood rents, if it reaches around 70% occupancy and maintenance remains reasonable, the building will throw off a nice return. To get it to that point will require further cash investment and elbow grease, all the while the guys will still be paying the note, insurance, utilities, tax, and other miscellaneous, essentially fixed expenses associated with their business and the property itself. Oh, and that 70% number? That presumes that the tennants pay their rent on time and that my friends manage the property themselves.... Add in delinquent or non paying tennants (remember, this isn't exactly the best part of town) and their associated eviction costs, and/or the additional costs of professional apartment management, and the cash flows start to sour, quickly. Granted, if the guys get the place fixed up and if their repairs hold and if they get it rented out 100% and if the tennants all act nice, pay their rents on time, and treat the place with respect, the guys look to do quite well.

If you have the time, willingness, and ability to do the work yourself, or if you have access to enough capital to buy a large enough property where it can make sense to hire professional management, then direct real estate can make sense. Please don't let me sour you on the concept - people can make some very good money in direct real estate investing, but my personal research leads me to believe it's not as easy as those late night infomercials may imply.

Personally, my ambition and skills do not lead me to be a property manager, and my capital base is limited enough that I can't afford a complex large enough to justify professional management. So while I like the idea of Real Estate, I choose to do my Real Estate Investing via Real Estate Investment Trusts (REITs).

My friends may very well be successful landlords. They may make a killing at it. If it does work for them, it will take them a lot more time and effort that I was willing to give. I, on the other hand, know that in the (slightly less than) five months since I bought my first REIT, I've seen about 4% of my total invested capital come back to me in the form of dividends and return of capital distributions from my REITs (including ex-dividend payments not yet distributed), and in spite of a recent 12% (or so) one day haircut in one REIT I hold, overall, the portion of my portfolio allocated to REITs has held its own.

And that's another thing... Even staying in 'real estate', I can diversify via REITs a lot easier than I can in direct ownership. Yes, I took a huge one day hit in that one REIT, but that one hit didn't rub out my holdings or really hurt any of my other REITs. Additionally, I fully expect that REIT to recover over time. Contrast that with this news story from around here:

http://www.wcpo.com/news/2003/local/09/23/norwood_late.html

In a nutshell, the City of Norwood decided to sieze (via Eminent Domain) nine properties at 'court ordered prices' to make room for new 'upscale' development. Imagine having just purchased your first piece of investment property there, only to be told by some judge that you have to sell your land to the city. Oh, and because the land has to go to the city, it's worth much less than it would have been otherwise, since there are no alternative buyers for the property. Bet you wouldn't be happy.

The few thousand dollars I've put into REITs own a fraction of several buildings and/or mortgages (on the financing side) in geographically diverse locations around the country. Plus, the REITs come equipped with professional management and a corporate structure that requires that at least 90% of their taxable income to be paid out as dividends.

Knowing what I know about myself and my exposure to the dynamics of the local real estate market, direct real estate ownership is not for me, aside from my house. I don't know your temperment, your skills, your local real estate market, or the financing norms in your part of the country.

I will tell you this, though... The last apartment I lived in needed a new air conditioner (after several repair attempts failed), a new roof (after it kept leaking, in spite of multiple repair attempts), and it got a new paint job and carpeting when I moved out. A combination of the aforementioned air conditioner - which leaked when its condensation pipes and/or pan sprung a hole, and the leaky roof caused a flood that damaged the carpet beyond use (mold and mildew) and caused water stains on the walls). There is no way that my apartment complex made any money on my unit while I lived there; the combination of the property taxes plus the cost of needed repairs/replacements easily exceeded the money I spent on rent over the year I lived there.

I believe that across the whole enterprise, the apartment owners made money, but I also think they had in the neighborhood of 200 units in that complex and a total of 40+ different complexes in the metropolitan region.

My anecdotes and personal experiences are just that. Anecdotes and personal experiences. Your mileage may vary, and you may find out that you're a brilliant property picker and manager, in a region of the country where all the timing works in your favor. And I'm sure that the infomercials do produce some successes, but if the "Quick and Easy" methods were so successful, why would the folks spend their time marketing and selling their methods, rather than using the methods to make even more money?

Additionally, in finance, there is a concept called "arbitrage". Arbitrage is a risk free profit that arises from temporary market inefficiencies. Abitrage is very real but it is also very fleeting. An example of arbitrage is this: Say gold is trading at $400 per ounce on one exchange, and at $399.95 per ounce on another exchange. An arbitrage trade exists because an investor can buy gold at $399.95 on one exchange and simultaneously sell it for $400 on the other, pocketing the $0.05 per ounce without taking on any personal risk.

The opportunity lasts only until the excess demand at the lower price market causes prices there to rise, and/or the excess supply at the higher price market causes prices there to fall. In effect, by taking advantage of the arbitrage opportunity, the trader's own actions are causing the opportunity to vanish by impacting supply and demand on each market.

What does this have to do with real estate? Well, from what I've seen, similar market rules apply. If it were really quick and easy to 'flip' properties for a profit at no risk, the competition for those flippable properties would soon drive up their prices to the point where flipping would not be a sure bet. And if it were really quick and easy to buy rental properties with bank financing and no money down, the price of those rental properties would soon rise to the point where the profits would diminish dramatically.

Yes, bargains can be found in real estate. My house was a tremendous bargain. The house across the street from mine just sold, less than a month ago, for 23% more than I bought my house for, just over four months ago. And that house has fewer square feet and a smaller plot of land than I do, although it is a year or so younger and I think that it has an upgraded kitchen. My fiancee and I looked at many, many homes, spending hundreds of hours over several months, before this one came on the market. And if we hadn't done our homework previously, we wouldn't have been able to quickly pick up on the value in this property. So while this house may have been a financial deal, the deal did not come without significant effort.

Aiding us in the effort were a few critical mistakes that the listing agent made in the advertisement. First of all, the listing agent advertised the house as being in an incorporated city with a local income tax and higher property taxes. The house is, in fact, in a township with slightly lower property taxes and no local income taxes, a fact we verified with the county auditor before we got started. Additionally, the advertisement undersold the square footage of the house by about 10%. To compound the error, the advertisement underlisted the number of rooms in the house!

It was a corporate relocation house, and I think the relocation company never saw the house, never did any independent research on the house, but priced it based on the information provided to it by the real estate agent. If that was the same information that we saw in the ad, it was WAY wrong. I do know that at the closing, the relocation company's representative was about as useful as a pet rock when I uncovered several errors in her paperwork. So it wouldn't surprise me to find that the relocation company relied on less than perfect information in pricing the property...

We went on a walk through just after the property got listed, and it was immediately obvious (compared to the other properties in the area and price range that we were looking at), that this house was priced to move. Although I submitted my bid very quickly after the house went on the market, I found myself in a bidding war, because the house was priced to move. Oh by the way, I understand from neighborhood gossip that I was outbid for the house, but because I had a large unencumbered CASH downpayment and the remaining financing already lined up, the seller went with me, instead of the less qualified alternative. Once again, having ready cash helped a lot.

Yet another anecdote and personal story. I'm sorry. All I'm really trying to say is that everything I've seen in real estate indicates to me that there is money to be made, for people willing to do the hands on management and maintenance work themselves or for people with enough capital to purchase enough real estate to make it worthwhile to hire someone to do the management work for them. For my own personal investment in Real Estate though, I'll take advantage of the low cost of entry, easy diversification, professional management, and essentially passive nature of REIT investing.

Are REITs 'the best' way to invest in real estate? Well, for me they are. For you, that's a question you'll have to answer for yourself, based on the factors I've touched on above and any other factors that you may uncover in your own research.

Should you invest only in Real Estate? I can't answer that question for you. I can tell you that I personally would not put all of my money into Real Estate, simply because I am a very firm believer in the power of diversification (but I'm no fan of indexing. That's a topic for another night of insomnia, however).

Best of luck to you,
-Chuck
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