Making Hard Cash in a Soft Real Estate Market: Find the Next High-Growth Emerging Markets, Buy New Construction--at Big Discounts, Uncover Hidden Properties, ... Private Funds When Bank Lending is Tight

Making Hard Cash in a Soft Real Estate Market • Find the Next High-Growth Emerging Markets • Buy New Construction – at Big Discounts • Uncover Hidden Properties • Raise Private Funds When Bank Lending is Tight W E N DY PAT TO N J U S T I N RYA N

John Wiley & Sons, Inc.

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A DVA N C E

PRAISE

“This book shows you exactly how to make a lot of money now—in today’s market. Read it, do it, and you will make it.” —Robert Shemin, bestselling author, Why Is That Idiot Rich and I Am Not?? “Wendy and Justin have put together a marvelous book teaching the reader how to evaluate market changes and emerging markets. It is fantastic!” —Kendra Todd, winner of The Apprentice, host of HGTV’s My House Is Worth What?, and author of Risk & Grow Rich “This book is filled with creative strategies that work in today’s market. A must read for the real estate investor!” —Albert Lowry, Ph.D, New York Times bestselling author of How You Can Become Financially Independent by Investing in Real Estate

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Making Hard Cash in a Soft Real Estate Market

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Making Hard Cash in a Soft Real Estate Market • Find the Next High-Growth Emerging Markets • Buy New Construction – at Big Discounts • Uncover Hidden Properties • Raise Private Funds When Bank Lending is Tight W E N DY PAT TO N J U S T I N RYA N

John Wiley & Sons, Inc.

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Copyright © 2007 by Wendy Patton and Justin Ryan. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada Wiley Bicentennial Logo: Richard J. Pacifico No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750–8400, fax (978) 646–8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748–6011, fax (201) 748–6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762–2974, outside the United States at (317) 572–3993 or fax (317) 572–4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Patton, Wendy, 1964Making hard cash in a soft real estate market: find the next high-growth emerging markets, buy new construction at big discounts, uncover hidden properties, raise private funds when bank lending is tight/Wendy Patton, Justin Ryan. p. cm. Includes bibliographical references. ISBN 978–0–470–15289–8 (pbk.) 1. Real estate investment—United States. 2. Real estate investment. I. Ryan, Justin, 1974- II. Title. HD255.P378 2007 332.63'240973—dc22 2007012411 Printed in the United States of America 10

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ACKNOWLEDGMENTS

We want to thank those that assisted in multiple ways with this book, including but not limited to: Michael Gott, Pete Scheepens, Sara Lechleitner, Beth Slade, Debbie Kessler, Steven Sirop, and Mark R. Walenczyk. We want to give a special thanks to Robert Golden who was there from the beginning to the end. We could not have done this without any of these people. The life experiences we have had in real estate have motivated us to share them with the rest of the world. Wendy Patton and Justin Ryan

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CONTENTS

1

INTRODUCTION

PA R T I How You Can Still Make Good Money in a Soft Real Estate Market CHAPTER 1

CHAPTER 2

How Real Estate Investing Must Change When the Market Shifts from Hot to Cool—Why There’s Still Good Money to Be Made in a Cool Market The Secret is Out—How the Wealthy Make Their Money

7 11

PA R T I I The Psychology of Successfully Investing in a Down Market When Others Are Running Scared CHAPTER 3

CHAPTER 4

The One Thing that Stops Investors Before They Even Start

17

The Science of Risk Management for the Real Estate Investor

25

PA R T I I I The Best Investment Strategies for a Soft Market CHAPTER 5

Find the Next High Growth “Emerging Markets”

37

CHAPTER 6

Time the Market—When Will It Be Safe to Start Investing Again in Nevada, Florida, Arizona, and Other “Burst Bubbles”?

63

CHAPTER 7

The Power of Lease Options in a Soft Market

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CHAPTER 8

A New Opportunity in the Soft Market—Land Contracts & Seller Financing

81

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MAKING HARD CASH IN A SOFT REAL ESTATE MARKET CHAPTER 9

Getting the Deed from Sellers in Trouble—AKA “Subject To”

93

CHAPTER 10

Invest in Foreclosures and Other Hidden Bargains

103

CHAPTER 11

Buy Unsold, Discounted Inventory from Builders in Distressed Markets

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CHAPTER 12

The Way to “Buy and Hold” in a Down Market

121

CHAPTER 13

Our Favorite Investment Strategy—Investing in New Construction, in the Emerging Market, in a Hands-Off Fashion

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PA R T I V Creative Financing in a Soft Market When Bank Lending Is Tight Determining How Much Investing You Can Afford

137

CHAPTER 15

Successfully Financing Your Real Estate Investments

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CHAPTER 16

The Importance of Using Other Peoples’ Resources

161

CHAPTER 17

The Nuts and Bolts of Numerical Analysis

169

CHAPTER 14

PA R T V New Construction Investing: An Ideal Soft-Market Strategy The Development Process—How It All Comes Together

183

CHAPTER 19

The Power of Group Buying

195

CHAPTER 20

Exit Strategies—When and How to Sell

203

CHAPTER 21

Base Your Investing on a Foundation of Reality

215

CHAPTER 18

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APPENDIX A

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INDEX

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This book is dedicated to the real estate investor—the person who is willing to work for the most precious thing in our world—freedom.

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Introduction

T

here is nothing more important than being in the right market at the right time. This is more important than ever right now in our country. Why? Because so many markets have softened. Several years ago, a real estate investor could make one mistake after another and still make a profit, because many markets were hot. Things are different today. A new set of strategies is required. Right now, if I was investing only in my home town, profits would be dismal at best. Today, nothing is more important than knowing exactly how to invest in our current real estate climate. There is still a ton of profit to make in today’s market, if you know exactly how to do it. In fact, there is even more money to be made. In today’s market, so many people think “real estate is not a good investment right now.” This creates less competition. And people who have some very powerful “contrarian” insights will do very, very well. I started investing in real estate at the ripe old age of 21 (this is Wendy Patton writing). I started investing primarily with rental properties and single-family homes in the Detroit, Michigan area. I always thought that my ideal portfolio for these types of properties would be right in my own back yard. I wanted to be “close to them” so that I could be in control. Keeping my properties geographically close also enabled me to do something else I was not aware of at the time; it allowed me to stay in my comfort zone! I didn’t realize back then that by stretching my comfort zone, a skill that my partner Justin Ryan taught me, I could make so much more money in real estate investing while freeing up more of my time. Today my husband, Michael Gott, and I invest in many emerging markets across the United States. We research and 1

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determine where we want to invest based on many different indicators, and then we search to find the right opportunity. We are not tied specifically to our local market any longer; emerging-market investing has liberated us and given us our financial freedom. Let me tell you the story that changed the way I invest in real estate. My friend Sharon made $200,000 in a few months, and because I got in a few weeks after she did, I only made $100,000 on the same deal. Sharon was standing in the blazing hot sun. It was 90 degrees with 90 percent humidity. She was waiting with more than 1,000 other people for the chance to buy 1 of 200 units that were being made available for pre-sale in a newly developed condominium project. (When I heard Sharon recount the story from that day, I said to myself, “There must be a better way!”) As the day progressed and the heat index was still climbing, Sharon was struggling to stay out in the heat of the day, but she really wanted one of these condos. There was no place to go except back to the car to cool down, but in this lottery you had only 15 minutes to respond when your name was called. If you did not respond, your name was removed from the drawing and any hope of getting into the project at such an early stage was gone forever. The day seemed to drag on and on. When she looked at her watch, she realized she had been out in the heat for six hours. Then suddenly, like a shot in the dark, she heard her number called! She ran to the trailer where she put down her reservation deposit to buy the condo. During the waiting, another name was called out: Carleton Sheets, the man himself. She thought to herself, “If Carleton is buying one of these units, then this truly must be a good investment; he is no dummy when it comes to real estate investing.” Figuring he lived nearby and he really knew and understood the market, she felt that she was on her way to an outstanding investment, and that’s exactly how it turned out to be. The unit Sharon picked that day ended up increasing in value more than $100,000 in weeks! A good investment? I would say so! It wasn’t even built, and she had nearly doubled her money! After hearing this story from Sharon, I thought to myself, I want one of those units! This was the launching point for my personal pre-construction investment portfolio, and although I’ve been a successful real estate investor for many years, this experience changed the way that I invest.

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3

Introduction

It wasn’t long before my first opportunity came. Shortly after hearing this story, one of the units in that same development became available, as someone who had reserved a unit on that hot summer day could not come up with the 20 percent down required. So I stepped in and purchased it. On that day, only the reservation fee of $10,000 was required. In a few weeks, the remainder of the 20 percent down was required. At that time, some of the original buyers were not able to complete the transaction. When the developer went to resell those units, he did not sell them for the same price. He sold them for $100,000 more! Even though a big increase came that quickly, still we decided to purchase our unit. And I sure am glad that we did, because here’s what happened next. Just months after we had locked up our unit, values had increased by another $100,000. My friend Sharon and Carleton Sheets received $200,000 of increased value. We received $100,000 of appreciation, and the unit was not even built yet. Getting in early is very important—the earlier the better. Imagine the profit potential if we had gotten in before Carleton or our friends even knew about this project? That is what we do now. No lines, no heat, no negotiating, and we get all of the profit on our property before the shovel hits the ground. This book covers many strategies for making money in a soft real estate market, but we explain the details of this “new construction investing strategy” in detail in Part III of this book. My husband and I met Justin Ryan in the year 2000 at a real estate conference that we were hosting. He impressed me as a talented, creative, lifelong real estate investor, speaker, and coach. One day he approached me about investing in real estate as he was evaluating his own portfolio. He felt that he was in a rut after many years of being a traditional landlord, and he wanted something new. I could totally relate, and I shared with him what we were doing with new construction investing in emerging markets. I shared how it was a hands-off type of investing strategy. This was all Justin needed to hear, and he soon joined us in this fantastic venture. In 2005, we formed a company that takes new and seasoned investors on tours into emerging markets and shows them prescreened opportunities from developers. We work directly with developers so that our attendees get a solid investment opportunity without standing out in the hot sun, and don’t have to compete with 1,000 other people to buy 200 units. On our tour they get to pick a unit or home before the public offering and usually below

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public pricing. This concept is good for the developers, as it helps with their marketing expenses and also their holding costs, which we will explain in more detail in this book. Our customers can, and do in many cases, purchase investment real estate, or their secondary or primary residence at a great discount before the public is even aware of the project. This, combined with the development being in an emerging market, or a market that has been appreciating consistently, can be a very powerful strategy for making substantial profits. This book was written to share with our readers how to invest in a soft real estate market. This is, by far, the most important topic for today’s real estate investor. Investors who know how to invest in the right emerging markets put themselves in a very powerful position. We have a passion for sharing our knowledge and the information we have learned over the years. In this book, we have also detailed how to use various strategies in soft markets, negotiating with developers, how to raise extra funds for real estate transactions, the power of investing in hidden properties, and most important, how and when to exit from your investment. We both look forward to taking this educational journey with you! We hope you enjoy reading it as much as we enjoyed writing it! Wendy Patton and Justin Ryan www.InvestingTours.com

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PART

I

How You Can Still Make Good Money in a Soft Real Estate Market

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CHAPTER

1

How Real Estate Investing Must Change When the Market Shifts from Hot to Cool Why There’s Still Good Money to Be Made in a Cool Market

I

n recent years, many real estate markets in our country were hot. We saw record levels of appreciation and a lot of people made a lot of money. This caused a certain belief system to develop. This inaccurate belief looks something like this: Now that the real estate markets have slowed down, it’s not possible to do well as a real estate investor. This is not true, but market conditions have caused many folks to believe that it is true. All of the real estate pros, who have been around awhile, know the truth: We make great money in any market. Our strategies just change. This next statement may shock you. Not only is it an excellent time to invest in real estate, in many ways, it is actually a better time to invest!

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You may have just thought “You have got to be kidding me. That isn’t true at all.” We commonly hear that reaction from our inexperienced real estate investors. Our experienced folks know the truth. More money has always been made in a down market than in an up market. If you are an experienced real estate investor, you know this statement is accurate. If you’re newer to real estate, you feel that it’s so, maybe without knowing exactly why. Why are markets softer? We’ll talk about that during our time together. But we’ll spend most of our time exploring a more important topic: How do I invest in today’s softer market and still make a good profit? Very few of us have control over the real estate market. However, all of us have an enormous amount of control over how we invest. In fact, we have 100 percent control over what investments we select. Therefore, this book will focus on the very important topic of how we invest in today’s soft market, and less on why today’s market is the way it is. We will be teaching many fundamentals for making wise decisions and choices for investing in this particular market. When markets go soft, things get interesting. Even though an abundance of opportunity exists in a soft market, many people still won’t take action. Why is this? Because by nature, people follow a “herd” mentality. Most people believe that for something to be the “right” thing to do, many people need to be doing it. Actually, this is not true at all. But this is generally how people think and act. We are going to teach you why you want to be in a market before the herd gets there. Good times create action by people with a herd mentality—many more people become interested in real estate investing and thousands of new investors enter the market. This, in turn, creates a lot of competition. All this competition from these newbies makes it harder to negotiate good deals, because so many people are looking to buy, buy, buy. As a result, the good times eventually end. The real estate market becomes “oversaturated” with investors and eventually the market needs to “adjust.” This happened in many markets in 2006 (such as Florida, Arizona, and Nevada). Believe it or not, this is a good thing.

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9

How Real Estate Investing Must Change

An experienced insider’s secret—that many folks don’t want you to know—is this . . . When the markets go soft the playing field is being “reset.” Short-term opportunists are removed and an abundance of opportunity gets created for the seasoned investors who know how things really work. And here is where you really create opportunity for yourself. By using the strategies in this book, you will be able to embark on investments that are in the right place . . . at the bottom. Once you have entered, you wait. You manage your investments, and add to your portfolio. And eventually something will begin to happen. The market will begin to come back. And when the market does come back, here’s what you do . . . You exit from your transaction when the frenzy is still in its early phases. We will talk more about this during our discussion of market timing. In the early stages of a market rebound, all the short-term opportunists become active again. And your exit strategy is ready. Don’t be greedy. Exit when the frenzy is still in its early phases. One of our favorite expressions is this one: “Pigs get fed, but hogs go to slaughter.” There is a lot of truth to that in the real estate business. But it doesn’t have to be that way for you. There is an abundance of opportunity in our country in good times and bad. When the market changes, our strategies simply must change with the market. This book will outline each of those strategies for you. This is how the wealthy make their money. They know when and how to change. After reading this book, you will also know when to enter a market and when to leave it.

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CHAPTER

2

The Secret Is Out How the Wealthy Make Their Money

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ovice real estate investors make one big mistake: they hunt for property only in their own backyard. If your own backyard is not in one of our country’s best markets to invest in, you are missing out on the most profitable investments in our country. When you invest in the stock market, do you care where the company you’re investing in is located geographically? Of course not. We only care where that company is located financially so we can make an intelligent investment decision. If stock investors were willing to invest in companies located only in their own hometowns, it would be senseless. They would be missing out on some of the best investments for no valid reason. The wealthiest real estate investors, who have done the best in our industry, think about real estate investing exactly the same way. They couldn’t care less where their properties are located geographically. They only care where their investments are in the real estate market cycle. When you commit only to invest in the best real estate markets in our country, you have also committed to making the most profit. This is how it will always be. A person can either realize this fact and make more profit, or continue to find excuses for staying close to home, and making only mediocre profit. One of the classic reasons why so many real estate investors invest only in their own hometowns is because staying close to home keeps them inside their comfort zone. We do this because 11

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we think its “good” to stay inside our comfort zone. But it’s not good at all. Our greatest opportunities in life reside outside of our comfort zones. It’s uncomfortable to go out and get them at times, but that’s why they are opportunities. The wealthiest investors are also willing to do the things that other people are not willing to do. They have become experts at journeying outside their comfort zones. As a result, they seize opportunities that other people never see, because those other people are trapped inside their accustomed routines. You might be thinking, “But wait, real estate is different.” The properties have to be managed. They will need maintenance. I can’t do that from out of state. Whoever said that you need to do it? Do you think that Donald Trump or Robert Kiyosaki pull out the hammer and do maintenance on their own properties? Of course not. The wealthiest real estate investors have always made their money with pen and paper, not with a hammer or saw. If you have decided that you will always do your own maintenance on your properties, you have also guaranteed yourself mediocre profit. We only do transactions for which the numbers work when we hire out absolutely everything. If you have to do the work yourself to make the deal profitable, the numbers are too tight to begin with. We only do deals where the numbers are strong enough that everything can be outsourced, and the deal still works. This forces us to focus only on the deals that really work. It also allows you to keep your quality of life. And just as important, it allows you keep your brain clear. This is a secret that many wealthy people won’t reveal to you. If you are running around, fulfilling one little task after another, it’s impossible to keep your brain clutter-free. And if your brain is cluttered, you can’t think. If you can’t think—you’re in trouble. As a well-repeated story goes, a reporter once interviewed Bill Gates and it went something like this: Reporter: “What type of work do you do in an average day?” Mr. Gates: “I don’t do any work.” Reporter: “Excuse me?”

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13

The Secret Is Out

Mr. Gates: “I don’t do any work. I have people to do all the work for me.” Reporter: “So then, what do you do all day?” Mr. Gates: “I think!” We hope you recognize the power of that statement. Mr. Gates knows that his time is best spent by using his brain. All of us have been in the middle of a chaotic day, when we have 100 things to do. During that day, our brain is swimming with confusion. It is impossible to think when we are jumping chaotically from one task to the next. This is why it is so critical to outsource those tasks. When you outsource all noninvestor activities, something happens. You can remove those tasks from your life very quickly and refocus on the things that are more important. Once you know how to do that, you have just empowered yourself to invest in only the best markets in our country. As a result, you will make the most profit. The wealthiest real estate investors invest primarily in the best real estate markets in our country. And you can do exactly the same thing. Before we jump into the technical aspects of how this occurs, it’s very important for us to discuss something that causes many investors to stop before they even get started.

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PART

II

The Psychology of Successfully Investing in a Down Market When Others Are Running Scared

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CHAPTER

3

The One Thing that Stops Investors Before They Even Start

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f all the things that prevent action in our society, one thing prevents more action than anything else—the emotion of fear. Fear prevents more good things from happening than anything else, especially in real estate investing. This is because most people have never been taught exactly what fear is and what it is not. Also, most folks have never been taught the basics of risk management. This lack of risk management knowledge, combined with a brain full of fear, makes it literally impossible for some people to take the first steps that would begin to change their lives. It’s about time for us to bring these problems to an end. It is shocking to us how little work is being done in these critical problem areas. We’re going to go to work on it right now. In this section, we will achieve the following: ■

Understanding what fear really is and what it is not

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Understanding brainstorming for fear destruction

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Understanding the steps behind fear destruction and how to create desired action

The Worst Thing About Fear The very worst thing about fear is that it is an action stopper. It causes a person to stay trapped. A person certainly wants to take action. But the action never happens because the fear has stopped it. 17

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How to Address This Problem The only way to fix this problem is to identify, analyze, and understand your fears. Very few people are willing to identify, analyze, and understand their fears. If you are willing to do this, all of life will be abundant to you. You will end up getting closer and closer to the life of your dreams every single year. There will be literally no stopping your progress. Conversely, if you are unwilling to do this (as most people are), you will have to settle for a life that is less than the life that you deserve. We don’t want a single person to have to settle for that. So let’s get busy. Justin and Wendy’s Advice: The people who are willing to do the things that other people are unwilling to do are the people who end up getting the life that they want.

Understanding What Fear Really Is and What It Is Not Fear is, by far, the most misunderstood emotion of all time. On the surface, it appears to be something much different. On the surface, fear appears to be a reason to not do something, when in reality it is a reason to do something. Here’s what we mean. Picture a recent time when you felt fear flood into your brain. We all know what that emotion feels like. The moment it arrives inside our head, it is there for a reason. It is never there by pure random chance. We want to identify the reason the fear is there so that we can remove it. Fear communicates, more clearly than any other emotion. But because we are so scared when we feel it, we are deaf to what it is saying. In its most basic sense, your fear is saying to you … Something needs to be done! I hope you are paying very close attention at this moment. If you are distracted right now, wait until the distraction passes, because we are about to slam home a point that can alter the rest of your life if you truly understand it. Every single time that the emotion of fear enters your brain, it is saying to you … something needs to be done.

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The One Thing that Stops Investors Before They Even Start

Example: Back in our ancestors’ days, imagine we were out hunting for dinner. When we rounded a corner we saw a saber-toothed tiger coming toward us. A lot of fear started running through our heads. And guess what it was saying? It was saying the same thing it says every time we feel it. Something needs to be done. And in this example, what is the “something?” Get away from the tiger! Run! Let’s test things with another example … You look at the balance in your checkbook. And then at the stack of bills before you. You are afraid that you won’t have enough money to pay all of those bills. What is fear saying here? The same thing it says every time we feel it. Something needs to be done. What needs to be done? You need to find a way to either reduce expenses, increase income, or both—so that this fear does not reappear on a regular basis. Realize also that the emotion of fear is not a blanket statement. Sometimes we will think, “Gosh, I’m feeling nervous. That means that the thing I’m about to do is bad … which means I should not do it.” This is not what fear is. This is the damaging belief system that causes people to make decisions without truly understanding why. The emotion does all of the talking. These people stay frozen with fear for life. All big decisions in life will make you feel nervous. Fear talks to us. And if you listen very carefully, you will hear what it has to say. Unfortunately, many people are not able to hear what fear has to say. This is for two reasons: ■

They simply don’t know how well fear communicates (or)

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They are too “emotional” at the moment to hear clearly

Here is the trick to hearing exactly what fear has to say . . . Wait. A pause in time separates us from emotion. All you have to do is patiently wait as long as you need to for the emotion of fear to gently pass, and then you will be able to hear clearly. The moment the initial rush of fear has passed, you softly ask: “What did my fear just say?” And now, you will be able to hear. Fear blocks our ability to think clearly. And many times fear leads to anger, and now there is absolutely no hope of analysis. Instead of allowing your fear to sidetrack you, do this instead … Allow your fear to gently pass. Then genuinely ask yourself, “What needs to be done?”

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Some people perceive their own fear to be an annoyance, or an emotion that irritates them for no reason. We see fear as a gentle tap on the shoulder that is kindly reminding us that something needs to be done. If you view your fear this way, your entire life changes. You are no longer just “running scared.” You are now engaged in an analytical process that produces results. Your fear speaks to you. Will you be able to hear what it is saying? Fear doesn’t always communicate clearly “right away.” Many times it needs some coaxing and some patience to communicate its message clearly. So you will have to be patient with yourself to discover the message. You might need “more information.” You might need “different information.” You might need to understand something better. Whatever it is, simply go get it. Then, and only then, will you no longer be frozen with fear. The bottom line is, when it comes to understanding what fear really is, and what it is not … The emotion of fear is simply a set of instructions, which tell you: ■

You need to do something

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You need to find out what that “something” is

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You need to get busy doing exactly that

Let’s recap how to ensure that you will never be trapped by fear: When you feel the emotion of fear enter your mind, simply pause. ↓ A pause in time will carry away the initial flood of emotion ↓ After the flood is gone, calmly ask, “what needs to be done?”

Understanding Brainstorming for Fear Destruction When you ask yourself “what needs to be done?” be as specific as humanly possible. Specificity creates precise, usable solutions that work. General statements do not work. “Well, I don’t really know

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what I’m concerned about, it just doesn’t feel good.” This sort of response will get you nowhere. Get specific! For example: What if the property doesn’t rent right away? Now we’re getting somewhere. This is very easy to solve, but it can be scary at first. The simple answer: maintain cash reserves. Seems obvious, right? We use the cash reserves to cover the rent ourselves until the property is filled, but it is not always that easy to come up with that solution. Let’s examine this fear in greater detail: What if the property doesn’t rent right away? Here are some of our favorite solutions: 1. Focus only in geographical areas where there is a strong demand for rental properties and a lower supply of properties. These are the only types of markets we focus in. By implementing solution #1, you are already ahead of the curve. 2. Focus mostly on new construction (or at least on homes that appear to be new construction—rehabbed, and attractive on the inside). This is because you immediately gain a strong competitive advantage when you deal with new properties. These properties are much easier to rent. Most renters want a “new” or newer home. It looks fresh and clean. It is the most desirable type of real estate. Too many investors try to rent mediocre properties at high rents, and they wonder why they can’t get them rented. Every property that we take is either new construction, or appears to be new construction. Don’t fight reality. Here is the reality: All of the qualified tenants, who pay on time, want nice properties. The less desirable properties only rent to less desirable tenants. 3. Focus only on properties that are close to major “employment hubs.” All qualified tenants have jobs. These jobs need to be close to your property to attract these qualified tenants. 4. Focus only on properties that have strong sustainability of rents in the local community. You want to be able to hold the property long term. Anytime you have set yourself up to go long term, you have set yourself up for success. When you think long term, you will always be able to hold a property as long as needed to realize your desired profit. Investors who think long term always make the most wealth in our business.

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Within these first four solutions, we are setting ourselves up for success by selecting only the right properties to begin with. This eliminates the vast majority of risk before we even acquire the property. After the property has been acquired, we then add … 5. Maintain plenty of cash reserves, so you can cover rents yourself as needed. Look at what you have just accomplished here. Before you understood this process, your brain might have been filled with fear in a very “random” fashion. When a large number of fears are buzzing around in our heads, simultaneously we get frozen. We are just simply “scared” without knowing why. We have just unveiled a new process here. Simply pull out a piece of paper. Ask yourself what needs to be done. And begin listing, one by one, all of the things that you are concerned about. This list of concerns just became something. It just became your to-do list. The fear is now out of your head and onto paper, where it can be analyzed, where it can be understood, where a solution can be developed for every single fear, individually. A lot of people try to analyze all of their fears at once. After you reach the third fear, here is what happens … Ahhh, forget it! This is too hard! And then all progress stops.

Understanding the Steps Behind Fear Destruction and How to Create Desired Action Steps for fear destruction:

When you feel the emotion of fear enter your mind, simply pause. ↓ A pause in time will carry away the initial flood of emotion. ↓ After the flood is gone, calmly ask … what needs to be done? ↓ Put each of your individual concerns on paper. ↓ They are now out of your head, and an individual solution can be developed for each one.

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Even after a fear has been identified, and a solution developed, fear still doesn’t “disappear entirely.” It also doesn’t need to disappear entirely. Remember that fear is so powerful that it is usually impossible to get rid of it entirely. Let’s look at our example above, where we discussed the fear of the property “not renting right away.” Even after applying the solution, and having more than enough cash reserves in place, the fear will still linger. Why? Because fear is a very powerful emotion, and it usually “sticks around” even after the solution has been implemented. This is OK. Here is one of the most powerful things you will ever learn about fear: There is no need to get rid of fear entirely. It would be nice, but it’s truly impossible—so don’t even worry about that. You don’t need to get rid of it entirely. All you need to do is this … 1. Identify it, understand it, implement a solution, and reduce it … 2. To the point where you can get yourself to take the action that you desire. This is all that is necessary. You don’t need to “get rid of your fear.” You just need to manage it, so that you can effectively reduce it beneath the “fear action threshold.” Once you reduce your fear beneath the fear action threshold, you will take action.

Wendy & Justin’s Advice on Fear: Our goal is not to get rid of fear entirely, for that is impossible. Our goal is to simply reduce our fear to the point where we will take action.

Mission accomplished. You got yourself to take the action that you wanted to take. You win. It feels really good to know that “total removal” of fear is not necessary. The only thing needed is action, and action is achieved far before fear is ever removed. Every single one of the greatest leaders in our country has fear. It is not the absence of fear that makes a leader. The thing that makes a leader is the taking of action in spite of the fear.

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During the discussion above, we touched on risk management. Risk management is a very important topic to the real estate investor. This is a very critical topic for us to discuss next, so that you can understand what risk truly is.

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CHAPTER

4

The Science of Risk Management for the Real Estate Investor

L

iterally thousands and thousands of people in our world are petrified by the thought of “risk” without even understanding what risk truly is. Surprisingly, risk for the real estate investor is actually very easy to manage. And once you know how to execute effective risk management within your own portfolio, the barriers of fear are lifted. In Chapter 3, we discussed fear destruction. Now we will cover risk management.

Understanding Statistical Probabilities Our purpose here is not to develop a detailed understanding of statistics, but rather to quickly understand one main concept: During the execution of a real estate investment, many, many things could go wrong, but far fewer actually happen. For our purposes, we need to understand the difference between things that have a decent likelihood of actually happening and things that probably never will happen. For example, I, Justin, am sitting in a room right now. This room has a ceiling above my head. At any moment, this ceiling could collapse, fall down, and crush me to death. This is something that could happen. Yet, I have absolutely no fear of it happening. Why 25

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not? Because the statistical probability of it actually happening is outrageously small. You might have never thought about it like this before, but we are not worried about the ceiling falling because a lot of risk management has been done on that ceiling. And all of that risk management ensures that collapse of the ceiling will remain an incredibly low statistical probability. What risk management has been done? All of the construction standards, for one. The ceiling is properly secured. The house is structurally sound. The correct materials were used. The proper assembly was used during the construction process, and so on. All of these things that were finished constitute a risk management process. A risk management process is a series of events conducted with one purpose in mind—to reduce the likelihood that a particular event will happen. This risk management process can be applied to any type of event, including real estate investing. I have always applied risk management to my real estate investing. It is actually quite easy to do, and well worth the short amount of time it takes because it provides so much peace of mind. Keep in mind that, just as with fear, it is impossible to completely remove risk. The good news is, however, that we do not need to remove it completely. All we need to do is manage the risk, and reduce it to a level that is acceptable. I have never had a problem managing risk to a level of acceptability in any investment I have done. If there is a problem doing so, then do not do the investment. And instead, focus only on the investments where you can reduce the risk into your range of acceptability. Let’s examine the specific risk management process for the real estate investor. Step 1: Make a list and identify as many things as we can that have a reasonable likelihood of occurring. Step 2: Examine each of the identified items individually and ask ourselves, “What (if anything) can I do to prevent the likelihood of this particular event happening?” Step 3: Implement a set of procedures that allow us to accomplish what we can to prevent the likelihood of this particular event happening.

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After we identify the things that are in our power to do, and set up a procedure to accomplish them, we next ask ourselves, “With our preventative procedures in place, if this particular event still occurs, what do we do in response to this occurrence?” Step 4: Even if I’m doing everything I can do, stuff still “happens” in life. If this event were to happen, what do I do in response? This might seem like a complicated process, but it’s actually quite simple. Let’s look at our initial example: Step 1: What if the property doesn’t rent right away? Step 2: What (if anything) can I do to prevent the likelihood that the property doesn’t rent right away? Below are several things that we can do to reduce this likelihood, and increase the chances that the property will rent quickly: 1. First focus only on the right properties, in the right markets. This eliminates much of the battle before we even start. 2. Employ a competent property manager. This person rents properties for a living. This is a very good first step. Sometimes it’s the only step we need. 3. If you have a “low tolerance for risk,” you might want to be “doing more.” For example, you could run your own advertising, in addition to what the property manager is doing. You could even run your own advertising 30 days before the property is even ready to rent. You could pay someone in the community to put out road signs that bring in even more calls. Step 3: To implement a set of procedures that allow us to accomplish the things that we can do (to prevent the likelihood of this particular event happening). Depending on your individual “level of tolerance” for risk, you can decide exactly “how much” of the identified solutions you want to be doing. After we have determined what we want to do, write down the immediate action that needs to be done and go do it. On to our final step . . .

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Step 4: Even if I’m doing everything I can do, stuff still “happens” in life. If this event were to happen, what do I do in response? This one is easy. If you are doing everything you can do, and the property has not been filled yet, you do the only thing you can do—cover the payment until the property is filled. You can also reduce the rent until you guarantee yourself a tenant. We complete either one of these choices using the same solution—cash reserves. This is the one that I give the most focus to personally. I am very busy, so typically, I turn the property over to a property manager. I then use my cash reserves until the property is rented (which is usually rather quickly in the markets in which we work). Take a look at what we have just done. Using our risk management process, we have just effectively outlined a process we’ll use to tackle one of the items on our list. You simply go through your list, one by one, outlining a risk management process for each item. The result of this analysis and planning is outstanding. We are no longer just “running scared” from some sort of generic fear. We have outlined every single thing we are concerned about and have mapped out a set of actions for each one. This set of analysis puts us in a very powerful position—we can take action safely and comfortably. It is comfortable because we understand the things that “can happen.” And most important, we know precisely how to prevent these scenarios from happening, and we know exactly how to respond if they do occur. After you have conducted your risk analysis, it’s very important to conduct your reward analysis. We need to protect ourselves from risk, but it’s also important to look at the upside, which motivates us to take positive action. The great thing about real estate investing is that even at conservative rates of return, the rate of return is far above other forms of investing—not to mention the tax incentives that are provided with owning real estate. When you conduct your reward analysis on a property, look at the overall numbers and ask yourself, “is there a better way to invest my money?” To date, I have not been able to find a better investment than real estate in the manner that we perform it. If you find one, please let me know what it is. I am an investor. I am not partial to the type of investing I’m doing. I am partial to the success of the investing I’m doing.

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Your combined risk/reward analysis will allow you to look at all sides of the investment and make an intelligent investment decision based on all factors. You are now equipped with a detailed risk management system for real estate investing. At this point, you should see that risk management is not a complicated process. And risks that can’t be identified are solved with cash reserves. When it comes right down to it, I do not want an investment to be risk-free. The risk-free investments in our society contain the worst rates of return. A certificate of deposit might be low risk, but the investment itself is very low return in exchange for that low risk. The investments that achieve outstanding rates of return always contain at least a small amount of ambiguity. This is why they pay more. You have learned here that uncertainty can be analyzed and managed effectively. This allows us to get the best of both worlds, a high return on investment, and an investment that is low risk. Another example: Step 1: What if the property needs a maintenance item completed? Step 2: What can I do to prevent the likelihood of this particular event happening? A) First of all, your property manager handles all maintenance requests, and has maintenance contacts within every trade, to make maintenance completely hands-off for investors. However, if you have a low tolerance for this type of risk, and really want to step things up, then focus mainly on new construction. New construction requires almost no maintenance because the units are brand new. I usually conduct what I call a “rotation of inventory,” where I am selling a property by the time it is five years old. The reason for this is twofold: (1) New properties have very few maintenance issues and this makes my life easier as a real estate investor. (2) People want a home that feels “new.” Once a home becomes seven, eight, nine years old, it no longer “feels” as new as it once did. Your home is now competing with all the new homes out there. All of

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the qualified retail buyers have choices and I want my home to be near the top of the competitive bracket. I like to sell my homes before the five-year point. That way there are far fewer maintenance issues, and the home still “feels new.” This allows for a much easier exit strategy. Some other ideas . . . B) Many new homes contain a one-year builder warranty where the builder will come out and repair certain items during the first year of the build. This is another reason to focus on new construction. C) You could also take out a home warranty policy on your property. This policy covers many repairs, less a small deductible for the service call. The home warranty policy is an outstanding risk management strategy. It allows you to control and reduce the amount of your out-of-pocket maintenance cost. I usually do not take a home warranty policy on new homes. They cost about $350 for the year, and the chances of recouping that money on a new home are slim, but if it gives you piece of mind to use one after your builder warranty runs out, go for it. Building your own risk management processes is all about doing what feels best to YOU as an individual. Do whatever you need to do to make yourself comfortable. If you are not comfortable, you will not take action—and that is the biggest mistake of all. Another example: Step 1: What if I have a vacancy on a property? Step 2: What can I do to prevent the likelihood of this particular event happening? Vacancies happen. They are part of the business and very easy to address. First, select the right tenants for your property. Look for people who are very stable, as this will create a stable tenant base for you. When a vacancy does occur, it is your property manager’s job to fill the vacancy. First, I have a crew reset the property to near perfect, move-in ready condition. Don’t skimp on resetting. Give the property everything it needs to be immediately attractive—if

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you don’t, you will regret it later. Properties that are move-in perfect are MUCH easier to rent than those that need work. As you’ve probably discovered, I am a very methodical person (Justin speaking). Over the years, this methodical nature has caused me to realize that there are certain rules that apply to real estate investing. There are rules that apply to doing anything successfully, and successful real estate investing contains many. During my career, there are many, many rules that have proved to be useful. There is, however, one rule that has proved to be so useful that it needs to be mentioned here. Out of all the rules I have utilized, this one has by far surfaced the most. In fact, it has surfaced so often, that I began to call it the Golden Rule of Real Estate Investing. The Golden Rule of Real Estate Investing is this … money solves all problems. In real estate investing, regardless of what the problem is, money will solve it. If a property is vacant, money will solve that problem. If a repair needs to be done, money will solve that. If a property needs to be held longer in order for the market to reach a desired level, money solves that issue as well. Regardless of the issue, money solves it. This one rule has had overwhelming value for me. To the extent that, it has become the most important rule of all. If there is one rule that you should be constantly cognizant of, it is this one. The other thing that is great about this rule, is that it’s very easy to use it. You only have to do one thing … maintain adequate cash reserves. If you maintain adequate cash reserves, this vacancy won’t bother you in the slightest—you get the property perfect again and cover the payment until it’s filled. If you want to step things up, you can begin running advertising two weeks before the property is ready to fill your “pipeline” with prospective tenants. Just make sure that you do NOT allow any showings on the property until it is picture-perfect. Tenants cannot picture a property in its “future state.” One Additional Point:

We have been talking a lot about cash reserves and the importance of maintaining them. We will discuss this topic extensively in Chapter 14, Determining How Much Investing You Can Afford To Do. If you don’t have enough cash reserves, consider bringing in a partner who does. Do the transaction with someone. I have seen too many investors “get greedy” and think they didn’t need a partnership, so they

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could keep 100 percent of the deal. This can be shortsighted if you are not liquid enough to carry any vacancies, or address other situations that might arise. You will thank yourself for it later. When that property goes vacant, it’s not just you making the monthly payment. If you have a partner, you are only making HALF of the monthly payment. You can also set it up so that your partner carries the entire financial burden and you do all of the management. Partnerships can be very flexible. You are familiar with one of our favorite expressions: Pigs get fed, but hogs go to slaughter. The investors that are most likely to get burned are the ones who stretch the numbers too aggressively. If the numbers are tight, take on a partner, and make things comfortable. You will be very glad that you did. Now you understand the process of risk management for the real estate investor. It is not complicated. It just takes a little time to put yourself in a very powerful position as an investor. Let’s discuss a couple of final things to keep in mind.

Remove Your Desire to “Predict and Solve Every Problem in Advance”

Risk management is a very powerful process. One thing to remember, which will make this process powerful and practical is this: It is impossible to predict everything in life. Things will always happen that we couldn’t possibility predict, and this is OK. This is, quite simply, how life works. Life’s unpredictability is natural. If you try to skirt this natural course of events, it will result in only one thing— you will be frozen and unable to move forward. The great thing about real estate investing is that money truly does solve the problems. We don’t even need to be able to predict everything, because there is a way to be prepared for anything, regardless of what it is. You are as prepared as you can possibly be by simply maintaining strong cash reserves. In other words, if you don’t have cash reserves, you should take a partner who does. It is the safest way to invest in real estate. Your risk management preparation is very powerful; just don’t overdo it. I have seen too many investors become too analytical, and the result is analysis-paralysis. If you maintain cash reserves, you are prepared for almost anything. So simply prepare for what you can predict and let the rest go. Overanalysis will do nothing but freeze you, and that is the worst mistake of all.

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Let Go of Your Desire for the Entire Process to be “Flawless”

Nothing is flawless in life. Nor does it need to be flawless. As real estate investors, we still make an outstanding return on investment even when the process isn’t flawless. It’s OK for mistakes to occur. You have done all of your risk management planning in advance, so you are prepared for anything. This “desire for perfection” creates numerous problems. The biggest problem is flawed thinking, like this next statement: “If there’s going to be any sort of problem, then I shouldn’t start at all.” Too many people are walking around with that flawed thinking. It is destructive and success-inhibiting. From a very early age, we have been led to believe that mistakes are bad. That’s where this “desire for perfection” comes from. This erroneous belief system causes many people to think that if it can’t be perfect the very first time that they do it, it should not be done at all. This belief system keeps many people frozen for life. But mistakes are not bad. In fact, they are the only way we learn. So, please, let go of the desire for your real estate investing to be “flawless.” It does not need to be. The desire for “immediate perfection” will keep you frozen. Instead, get yourself started. Work on the “perfection” progressively, over the course of many years, as your career advances. One of the sure-fire ways to reduce risk in real estate investing is to invest in the right market at the right time. As the old saying goes in real estate: It’s all about location, location, location. This is actually false. Location, of course, is important. But there is a different factor that is much more important. Timing—being in the right market at the right time. For a retail buyer, whose geographic market is determined, location is important. But for the real estate investor, whose goal is profit, it’s all about timing, timing, timing. When many of our country’s markets are soft, how do we find the right markets? In our next chapter, we will discuss how to locate the markets that are in the right portion of the timing cycle for the real estate investor.

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PART

III

The Best Investment Strategies for a Soft Market

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CHAPTER

5

Find the Next High Growth “Emerging Markets”

N

ow that you’ve pushed past the fears and roadblocks that inhibit you, it’s time to get started in real estate investing. The first step is to determine where to invest. Choosing your market wisely can determine whether you make a fortune in real estate or whether you lose a fortune. In real estate investing, we focus on what are called “Emerging Markets.” We can all agree that many markets in our country have slowed down. This is not a problem if you know how to respond to that change. There are always a select couple of markets in our country where things are not slowing down, but instead are getting ready to increase in value because of circumstances that are about to unfold in the market. We call these circumstances market indicators. They tell us which markets will remain flat for awhile and which ones will experience strong growth for some time. When an overwhelming abundance of these indicators “pile together” to create a strong set of positive data in a particular real estate market, this market is called an emerging market. The #1 thing we wish we knew when we began investing in real estate is this: Do the majority of your real estate investing only in the emerging markets. We could both kick ourselves for not learning this sooner. We are thankful that we did learn this when we did. When we invest only in the emerging markets, we no longer fall victim to a problem that so many investors do: having to wait around for our local market to improve so that we can make a decent living again. There are too many investors “waiting” out there. We still do deals in our home town, but only when the numbers are absolute 37

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no-brainer numbers. The majority of our investing happens only in our country’s emerging markets. Many real estate investors make the mistake of hunting for property only in their own backyards. But if your backyard is not in an emerging market (most are not), you miss out on the greatest profit center of all. When you invest in the stock market, do you care where those companies are located geographically? Of course not. We care about where they are located financially—so that we can make an intelligent investment decision. The most successful real estate investors that we know treat real estate investing the exact same way. They could not care less where their properties are located geographically. They only care about where their investing market is in the real estate cycle. The only real estate investors we know who have made the most money in our business treat real estate investing just like stock investing, and invest in only the best markets in our country. This emerging market method allows us to get into a piece of new construction at the right point in the market cycle, and exit in one to two years while the market is still on its way up. We do not “hold forever” and have to tolerate all the market fluctuations associated with holding forever. Investing in the emerging market comes down to one thing— timing. Let’s do some education on market timing so that this concept is clear.

$Value$

Graph 1

Phase 4

Phase 3

Phase 2

Phase 1 Time

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Market timing is the focal point for this discussion. The emerging market can be “emerging” for different reasons. Let’s first examine the market situation where a market begins to emerge for the very first time. This is located in Phase #1 in our diagram. Picture a market that has not been “discovered.” This market might have been a small town for decades. As population growth continues in the United States, so does market growth. Real estate markets that used to be “small towns” over time begin to grow. Growth migrates outward from large, developed areas into areas that have not been developed. Many folks in our country love to live in this type of community—one that has not gotten too “busy” yet, but also has all of the desirable factors that the larger markets do. New York City, for example, has everything a person could ever want. Every single market amenity is in place. The reason however, that many people express the belief “I could never live in New York,” is because the area is also very busy. NYC has been developing for more than 100 years. It emerged a long time ago. And because it offers so much, a lot of folks want to live there. Also, because New York emerged so long ago, so did real estate price values in the community. This does not mean that NYC is not a good investment. Long-term, that market will always grow. An investor simply needs a large downstroke on the front end to get into that market. Just think if you could have known about New York before it emerged, and you got in at that point—early in the process, before real estate prices values went wild. This is what emerging market investing is all about. We pay particular attention to timing, and enter the market before all of the “emerging” happens—when real estate prices are undervalued—and lower than they should be. The emerging market, of course, does not have to be a “small town” that is undiscovered. It can also be a market that is getting ready to increase in value for a different reason. We will discuss those other reasons, but for now we focus on this discussion, which pertains to a market that is becoming known for the first time. Eventually, that small town reaches a critical point in its development, where its infrastructure, amenities, and overall level of “living desirability” are now “in place.” At this moment, the small town begins to get “discovered.” Now it is a very desirable place to live. People begin to talk about this market and area. Word starts to spread. Now, more people become aware of the market, and decide to move there. You know what this does to real estate values. They

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$Value$

Graph 2

Phase 4

Phase 3

Phase 2

Phase 1 Time

begin to climb. There is now increased demand in this community for real estate. And this increased demand creates an upward pressure on real estate values. The moment that real estate prices values begin to increase is the most relevant part of our discussion. At this moment, we move into Phase 2. When we enter Phase 2, real estate values have just started to increase. As real estate investors, where do we want to enter this continuum? We know from experience that some of us are thinking “Phase 1,” and some of us are thinking “Phase 2.” We could invest in either of those stages. The problem with Phase 1, however, is that sometimes a market can stay in Phase 1 for 10, 20, or 30 years. And we don’t know exactly when it will end. We don’t like to have to wait 20 years to get paid as a real estate investor. We like to get paid in two to three years. We can make this possible by investing in early Phase 2, when the market has just begun to prove itself. When you are in Phase 2, you will see commercial growth. New stores will open. We always think of Home Depot as a great indicator of growth in an area (that is not statistical data, just a personal observation, but such companies do a ton of research themselves). Look for road expansions, highways especially. We have noticed that when an airport is going to expand, usually the town takes off after the expansion is complete.

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If you would like to know where we are focused with our real estate investing and what market we feel is emerging, check out: Find out Justin and Wendy’s Favorite Emerging Market www.InvestingTours.com/Market

After Phase 2, eventually we move into Phase 3. Phase 3 is when real estate price values begin to climb consistently within the market. The market is now in full growth mode, and people are talking about it. Now, let us ask you the most important question of all. After entering in early Phase 2, where do you think we like to exit? We know from experience that many of us are thinking “exit in late Phase 3.” You can probably imagine what we’re going to say in response to that. If you want, you can roll the dice, and exit in late Phase 3. But that involves risk. With Phase 3, we never know exactly when the phase is going to end. We have many clues, but we never know with absolute precision. This is why it pays to be cautious and conservative. All of us know what happened in the Florida, Arizona, and Las Vegas markets not that long ago. Many of those markets were in Phase 3 for several years. There were rapid levels of appreciation during this period. You know what happened next. Everything stopped. No market can go up and up forever. Eventually the market must stabilize and correct, as wild growth can not occur forever. These markets, when they entered Phase 4, did so very rapidly. This is why it pays to be conservative and cautious. We prefer to exit when we feel (or as indicators suggest) that we are approximately 50 percent of the way through Phase 3. You can stretch it longer if you wish. Our preference, however, is to be conservative. As a real estate investor, one of our favorite expressions is this one: “You never get hurt taking a profit.” Justin and Wendy’s Advice: Pigs get fed, but hogs go to slaughter

There is so much truth and wisdom tucked inside that statement. The real estate investors most likely to get burned are the ones that

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just have to squeeze every single dime of profit they can out of a transaction. And sometimes they wait too long. Did you know that you never get hurt taking a profit in our business? Some folks think, “Well, gosh, if I would have just held on a little longer I could have made an additional $50,000.” That might be true if the cards are in your favor, but you also could have lost your rapid exit strategy, or made no additional money at all. Just like a carton of milk, every market has an expiration date. If you “stretch the date” too far, the milk will go sour, and you’ll wind up with a mouthful of rancid moo juice. It is very important to understand this basic concept of market timing, and invest according to its powerful wisdom. Several factors affect real estate markets and determine where emerging markets will be. First we will look at the “people” trends that affect real estate. Three primary groups will have the most impact on real estate over the next decade: Three Main Population Groups That Will Have the Biggest Impact on Real Estate Demand Over the Next Decade: ■ ■ ■

Baby Boomers Echo Boomers Immigrants

Baby Boomers The Baby Boomers may be the most profitable of these three groups for the real estate investor. Baby Boomers were born between 1946 and 1964, when there was a population explosion of newborns. They comprise a population group of 82 million Americans who are in their prime years of earning and also just beginning to retire. Baby Boomers are important for the real estate investor because of their demand for vacation homes, second homes, and retirement homes. As Baby Boomers approach retirement, they are focusing on where to spend their golden years. They are showing an overwhelming trend for wanting to live in the warmer states. According to Michael Hackeling in Living Southern Style, Winter 2006, “Nearly 75 percent of potential retirees have expressed interest in moving below the 35th parallel. This could bring 50 million émigrés to the south over the next 20 years.”

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In a 1999 USA Today study, Baby Boomers were expected to buy at least 12 million housing units in 12 warm states as they neared retirement. While many Boomers are expected to stay in their current homes or buy new homes in their current states, a tremendous number are also leaning toward moving to warm climates. This trend will have significant demand on the supply of property and will result in fabulous increases in property values. Many Baby Boomers are not waiting until retirement to buy. Boomers who are buying second homes or vacation homes are often buying now, or will be buying in the near future. According to the National Association of Realtors (NAR), Baby Boomers currently own 57 percent of all vacation and seasonal homes. As of 2003, there were approximately 6.6 million second homes in the United States and Americans bought 450,000 that year. Additionally, sales of second homes have risen steadily for the past 25 years, and according to an NAR second home survey during 1999 to 2001, second homes appreciated by 27 percent, a number nearly twice as high as the appreciation rate for primary residences during the same period. There is also a new trend for Baby Boomers and their primary residences. Some Boomers who want to relocate for their retirement are doing it now, before they retire. Boomers who can continue to work via telecommuting, independent contracting, or even by taking new jobs, are relocating now. So not only is the demand for second homes growing, the demand for primary residences in those areas is growing as well. Many factors influence Baby Boomers’ determining the location of their second homes, new primary homes, and retirement home purchases. The climate is a key choice for many. In addition to climate, Boomers are planning on staying active and are looking for beach, golf, mountain, and ski resort communities. For the Boomers who can’t afford to live in those communities, they are looking for homes nearby that are more affordable. One key factor in determining where they want to live within the location they select is the amenities. Some amenities are inside their homes. First-floor master suites, 9- or 10-foot ceilings, granite countertops, tiled floors, plush carpeting, and premium kitchens influence their decisions. But just as important are the amenities of the communities and the developments in which they live. Planned communities and condominium complexes are springing up around the areas favored by Boomers, and the amenities that they offer keep them selling fast. Golf courses, tennis courts, pools, spas, exercise facilities, walking trails,

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and youth activities are very important to the Baby Boomers. Beyond the traditional amenities, Boomers are also favoring fishing, kayaking, canoeing, restaurants, lounges, private marinas, concerts, equestrian trails, billiards, volleyball courts, shooting ranges, and skiing. The Baby Boomers don’t want just nice locations, they also want plenty of activities within the locations.

Echo Boomers The second population group that will have a large impact on real estate demand over the next decade is the Echo Boomers. These are the children of the Baby Boomers, and they amount to almost as large a population, nearly 76 million. This younger generation is just beginning to enter the first-time home buyers market. The Echo Boomers are moving to the areas that have jobs. They are just beginning their earning years and are putting high demands on housing in the areas they move to. Because they are newer to the labor market and are earning less, the Echo Boomers need affordable housing. In these areas, they put pressure on the lower cost homes, condominiums, and rental units. They are looking for the technology and convenience. They want wireless Internet access, strong cell phone signals, washers and dryers in their units, lawn service, and so on. As such, the real estate investor has opportunities in affordable housing developments, townhouses, condominiums, and condo conversions (converting an apartment building to a condominium building).

Immigrants Immigrants are the third population group that will have a substantial impact on the future real estate market. Over the past decade, the U.S. government has started making minority home ownership a priority. Statistically, minorities are less likely to own homes, so many first-time buyer programs have been created to help level the playing field. A large portion of minorities who will buy their first homes are immigrants. Areas with high concentrations of immigrants will see pressure put on home supply, particularly affordable homes for the first-time buyers. Immigrants, like Echo Boomers, will be seeking affordable housing for their first homes. This type of demand

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will push prices for affordable homes higher in these emerging markets. In addition to the three population groups that will affect real estate markets, there are also national trends that will influence the future of real estate prices. National Trends Leading to Positive Growth in Real Estate ■ ■ ■ ■ ■ ■

Continued low interest rates Changes in home financing that have lowered closing costs Real estate perceived as safe for household wealth Retirees living longer Migration patterns Stock market performance

Interest Rates This past decade, America experienced, and continues to experience, a prolonged period of single-digit mortgage rates for the first time in more than four decades. We have to go all the way back to the 1950s and 1960s to identify such a golden age for the financing of real estate property. (Are You Missing the Real Estate Boom? by David Lereah) Inflationary concerns have remained low. The Federal Reserve has leveled off on raising the prime rate for the time being, therefore mortgage rates, while having increased slightly from their lowest, still remain terrifically low. Low mortgage rates translate into increased buying power. For example, a family that normally could afford a $200,000 home given an 8 percent rate of interest on a 30-year fixed loan with zero down, making monthly payments of $1,468, could afford a $244,900 home at a 6 percent rate of interest on the same 30-year fixed loan, with monthly payments remaining at $1,468. That’s $44,900 more in available buying power, with only a 2 percent reduction in interest and no changes in payments. Lower interest rates make homes more affordable for everyone, from the first-time buyer to the home owner wishing to upgrade to a larger, more expensive home, to the Baby Boomer buying a second home or retirement home.

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Changes in Financing That Have Lowered Closing Costs In the 1990s, much of the mortgage and underwriting process was computerized. This sped up the process for loan approvals significantly, and reduced the costs. As a result, the reduced cost has been, in part, passed on to the buyers. Reducing the closing costs increases the affordability of homes for buyers, which in turn increases their purchasing power. The closing costs are anticipated to continue to go down as the mortgage process continues to be made more efficient and less costly. For example, let’s say a home buyer planned on putting 5 percent, or $10,000, down on a home of $200,000. If the closing costs were reduced by $1,000, the buyer could put $11,000 down instead of $10,000. This would allow purchase of a home valued at $220,000 instead. That’s an extra $20,000 in buying power with just a $1,000 increase in down payment.

Real Estate Perceived as Safe for Household Wealth This is an important consideration for three reasons. The first is that after September 11, 2001, people have felt the need to secure their wealth in tangible assets. Even if we never have another terrorist attack in the U.S., the shadow of 9/11 will loom over us for some time yet. There were many financial repercussions from that attack. As a result, people want to have greater security with their investments. Real estate offers the highest level of security. The second reason for keeping wealth in real estate is the volatility of the stock market. The start of the recent real estate boom was timed closely with the fall of the Internet stocks. The wild speculation on Internet stocks made some people fortunes and cost many more people a great deal of their life savings. This was hardly the sole cause of the recent boom; however, it did contribute. Also, due to the development of online brokerages, where it has become easier than ever to buy and sell your own stocks without the aid of professional research, many people now are facing increased risk. This risk is especially high coupled with the high level of fluctuations seen in the stock market today. For a greater level of security and also the opportunity for exceptional

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returns, many people are choosing to invest more heavily in real estate over the stock market. The third reason is that due to the exceptionally low rates, “safe” investments such as bonds, CDs, and the like have been yielding extraordinarily low returns. The returns are so low that many conservative investors have also been turning to real estate, seeking a more profitable rate of return.

Retirees Living Longer This is a direct result of advances in the medical field. Improved medical care results in people living longer and healthier lives. This means fewer homes of seniors are coming onto the market, which keeps the supply low. This trend will only continue as the Baby Boomers age. With the Boomers living longer, their homes will not be coming onto the market as quickly and the supply will remain lower.

Migration Patterns The effect of where people move causes different markets to experience different levels of housing demand. Baby Boomers are moving toward warmer climates, creating higher demand for homes in these areas. Echo Boomers and Immigrants are moving to job-rich markets, creating demand for homes in those areas. As people migrate from one area of the country to others, they increase demand in those new areas. This helps fuel emerging markets and price appreciation.

Stock Market Performance We touched on this before. As the stock market continues to fluctuate, it increases the number of people looking to invest elsewhere. Also, as people become more educated about real estate as an investment, they are more likely to look away from the stock market for the increased security and greater potential returns in real estate. More people have been made millionaires by investing in real estate than in any other business. As these national trends continue to provide solid growth in real estate, people will continue investing and continue buying with confidence in their own homes, vacation homes, retirement homes, and investment properties. The overall favorable national trends contribute to greater potential growth. Remember, however,

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that national trends do not cause every real estate market to grow. The real estate investor looks for emerging markets to capture the greatest appreciation and highest profits. The national trends help influence the overall market. Where the Baby Boomers, Echo Boomers, and Immigrants are moving will cause areas to experience the sharpest demand and highest growth potential. These are the emerging markets. Knowing these general trends puts you in the right direction, but where do you look more specifically? For example, you know that Baby Boomers are moving to warmer climates, but that is still pretty general. It is important to know what factors to look for in markets to see what potential they might have. Several things can influence local markets. Local Market Influences ■ ■ ■ ■ ■ ■ ■ ■

Location within a market Quality of schools Amenities Condominiums versus single family homes Strength of vacation home market Businesses in a market Businesses moving to a market Population growth

Location within a Market

You’ve heard the adage in real estate about “location, location, location.” It certainly has some truth to it. When looking for potential emerging markets, the location is very important. You want to consider whatever appeal a particular market has, and the appeal of particular areas within a market. For example, Baby Boomers are looking for waterfront property, coastal properties, golf course communities, ski resorts, and the like. Echo Boomers are more likely to be looking for downtown living, with proximity to night clubs, restaurants, and other activities that appeal to them. Both groups want to be close (but not too close) to good transportation, highways, and airports in particular. Close proximity to these desirable characteristics creates high demand. There is also limited supply, which will further drive up prices. Also consider how trendy the location

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is within a market. If the area is offering something unique but only recently popular, you should ask yourself how likely is it to stay in demand. Look also for the path of progress. Where is the market moving next? Schools

High quality public schools are very important. In Thomas Stanley’s The Millionaire Mind, when millionaires were surveyed for where they chose to purchase homes, one of the top influencing factors was the quality of public schools. While this might not be as big a factor for retirees, Baby Boomers purchasing vacation homes, or Baby Boomers whose children have left the nest, it is still important for just about everyone else. Historically, neighborhoods with the best public schools show among the best rates of appreciation. Amenities

For Baby Boomers especially, the quality and variety of amenities will strongly influence the demand and subsequent prices for homes. A house on the golf course, on the waterfront, or with its own private boat slip will appreciate more strongly than a home just across the street from these features. Think also about what amenities appeal to Echo Boomers and Immigrants. Given a choice between two areas that offer them jobs with similar home prices, these groups are far more likely to choose the area that has more favorable amenities. Affordability

Certainly for first-time home buyers, affordability is of great importance. Even for a wealthy Baby Boomer, the price will be a factor, particularly if two different areas offer similar features at very different prices. Affordability does not stop areas from becoming emerging markets, however. Even areas perceived as overly expensive can be emerging markets and will appreciate very rapidly. Many areas in California are perfect examples of this. For those of us in the rest of the country, home prices in California seem outrageous, and yet during this recent real estate boom, many areas in California experienced double-digit appreciation each year. Remember that 15 percent appreciation on a $600,000 house in one year is $90,000, whereas 15 percent appreciation on a $200,000

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Which Property Do You Think Will Appreciate More Rapidly? The Average Suburban Home or These Oceanfront Condominiums?

house is only $30,000. Also, remember that much of affordability is based on perception. Paying $600,000 for a home seems very high if you are used to home prices around $200,000. However, if you live in San Francisco, $600,000 can be a downright bargain.

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Condominiums Versus Single Family Homes

Condos have come a long way in the last 25 years. They used to be such a small portion of real estate that they received very little attention. Now, however, condos span the market. First-time buyers consider condos as strong options for affording their first homes. Baby Boomers consider condos both for downsizing their empty-nest homes and also for luxury amenities. In many coastal areas, condos are about the only option for waterfront living. The land simply has become too valuable for a few single-family homes. During 2003 and 2004, condo sales skyrocketed, pushing the appreciation rate to almost double that of single-family homes. In areas of high demand, many apartment buildings were converted into condominiums, making for a rapid building period. These are referred to as “Condo-Conversions.” Many investors have favored condos in resort areas because the complexes often have rental programs, making the condo a hands-off investment. New-construction condo high-rises often can take two years or more to build. This can give a real estate investor more time to capture appreciation. Also, there are no maintenance issues or vacancies (during construction), as discussed in Chapter 4, on Risk Management. Condos can be a very lucrative option when it comes to investing. However, when a market changes, it appears that it can change more quickly for condos than for single-family homes due to the ability to build larger volumes and the lack of differentiation. In the recent downturn, the national existing months supply (a statistic that shows how long it would take to sell all of the units on market at the current sales pace) of condos has spiked from a 2004 low of 4.1 months supply, to the fourth quarter of 2006 at 9.1 months. This means it would take 9.1 months to sell every condo currently on the market based on the present sales pace. Whereas single-family homes had a low point also in 2004 with 4.3 months supply and a fourth-quarter 2006 level of 7.2 months, according to NAR market data. During 2004, when sales hit their high point nationally, both condos and singlefamily homes had exceptionally low supply. When the national trend reversed, it was much more significant for condos than for singlefamily homes. Additionally, although condominium prominence has grown in the last 25 years, condos still represent the smallest sector of

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residential real estate. Existing-home sales represent 75 percent of the residential market, new-home sales are 14 percent, and condo sales are 11 percent. From an investor standpoint, condos draw lower rents and have higher maintenance costs (due to association fees) than comparable single-family homes. When considering condos versus single family homes as a real estate investor, it is best to consider your target market, build time, forecasted available supply, and end user. Either type of property can be very lucrative. If condos are in short supply in your emerging market, they have the ability to appreciate at faster rates than single-family homes. If you plan to hold longer term, you need to take into account the rental income differential to determine what investment is best for you. Strength of Vacation Home Market

This market influence is particularly relevant for the Baby Boomers because they are the primary buyers of vacation homes at this time. Given that vacation homes have demonstrated significantly higher appreciation rates than primary homes in recent years, choosing an emerging market with a strong second home/vacation home presence is likely to give you substantially higher returns. What Businesses Are in a Market and What Businesses Are Moving to a Market

This has an enormous impact on employment, and consequently on demand for housing. It is critical for your Echo Boomer and Immigrant markets, as these population groups won’t move to areas where there are no jobs. However, it is also important for the Baby Boomer markets, because not all Baby Boomers are retiring yet (they have only just begun) and local economies are tied strongly to employment whether there is a high level of retirees in the area or not. It is wise to choose areas that are not solely dependent on one or two types of industry. If that type of business suffers an economic setback, it will have a huge influence on the local housing market. For example, Southeastern Michigan is heavily dependent on the automotive industry. Due to the struggles of the automakers in the last few years, the real estate market in that area has paid a heavy price.

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Population Growth

Population growth is perhaps the strongest contributor to emerging markets. Localized markets with high levels of population growth and population migration into the market see higher rates of appreciation than markets with low or stagnant population growth levels. Population growth affects not only affordable housing consumers but also higher-end housing consumers. Areas with high levels of population growth are likely to see exceptional appreciation in all types of residential housing due to significantly higher levels of demand.

Understanding the Local Market Indicators Now it’s time to add an additional set of criteria to our understanding of emerging markets. It’s time to focus on what indicators will help you predict where any market is in the cycle. These indicators will help you measure activity in the market, and make your analysis even more accurate. Local Real Estate Market Indicators ■ ■ ■ ■ ■ ■

Sales of existing homes Permits for new home construction Months supply of homes/condos Mortgage loan defaults and foreclosures Days on market Interest rates

Sales of Existing Homes

This indicator will allow you to feel the pulse of the local market. It is one of the most critical indicators. Existing homes sales is a statistic that shows how many homes have sold in a given month, and it tells us how many buyers are coming to the market. By looking at monthly sales data, you will be able to determine when a sales slump has started to turn. Monthly sales data is collected by local real estate boards as tracked in the Multiple Listing Service (MLS) and can be obtained either from a local Realtor or from a local newspaper. You can also obtain this information from the local city or county assessor’s office. Bear in mind that sales are typically seasonally affected. Most areas will see an increase in sales in the

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spring, so that families with children can move to the new home during the summer and not interrupt the school year. In this data set, you are looking for a trend over time, adjusting for seasonal changes. A brief spike of sales in one month does not make for an emerging market. In addition to knowing when a sales slump has started to turn due to an increased sales volume, you can also determine when sales have peaked. The buying frenzy at the peak of the market cycle will start to show slower sales volume before the public or media are even aware that the tide has turned. If sales volume starts to slow, this is an indicator that it could be time to sell. Permits for New Home Construction

Real estate construction is the largest industry in the United States. It affects the national and local economies tremendously. Construction companies, especially the larger ones, are very tuned into real estate markets. As such, when they perceive that a market slump is starting to turn for the better they will increase their building, consequently pulling more building permits. As demand for homes increases, they will continue to build more and more. Once the market has reached its peak, permits will start to decline. Due to the length of time in construction, builders need to cut back on construction before the market sinks into the downswing. The builders who aren’t as tuned into the market will be stuck with lots of inventory in a market where prices are dropping quickly. Chapter 11 focuses on how to buy from these builders in a distressed or slower market. By tracking the numbers of building permits pulled, an investor can use this data to watch as the market goes through lows, upswings, peaks, and downswings. Building may be seasonal in areas, so be sure to take seasonal variations into account. The U.S. Census Bureau tracks building permit activity for major metropolitan areas. For smaller areas, building permit data can be obtained from either city or county government building departments. Months Supply of Homes/Condos

The National Association of Realtors tracks the Months Supply data. This indicator tells us how many months it would take to sell all of the homes or condos that are currently on the market at the current sales

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pace. This data is tracked separately for condos and single-family homes. Typically, when the months supply is below 5½ months (that is, it would take 5½ months to sell all of the homes on the market at the existing sales pace) a market is experiencing high demand. If the supply is greater than 6½ months, the market is experiencing low demand. By tracking the supply data you can watch as the trend moves to dropping below the 5½-month supply level. This will tell you when to buy. Conversely, as the trend moves toward the 6½month level, you know it might be time to sell. The best source for this data would be a local Realtor, as this data is typically tracked by NAR or local Realty Boards.

Mortgage Loan Defaults and Foreclosures

These two indicators go hand in hand with mortgage loan defaults leading in time over foreclosures. When the economy starts to change and unemployment starts to rise, more and more homeowners in a market will be unable to make their mortgage payments. When they fall behind on their payments, the lender records a default. Often when homeowners default, they will try to sell their homes before the bank forecloses. An increase in defaults results in a large number of homes being put on the market with the need to sell quickly. This starts to drive prices down as desperate owners will try to sell for what they owe or slightly more. If the homes don’t sell and the owners remain unable to make their payments, the lender is forced to foreclose. When lenders foreclose, they are now stuck with properties that they need to sell. This will continue to drive values down in two ways. First, the homes are usually resold in less than perfect condition (the previous owners didn’t have the money to fix them up and the banks usually won’t spend the money to fix them up either), thereby commanding an even lower price. Second, because unemployment has risen, fewer buyers can afford or are willing to pay for homes that were at their peak prices. When more and more foreclosed properties hit the market, it is a sure sign that the market is heading down. Conversely, lowering rates of mortgage loan defaults will help you to determine that a market is moving into or is in an upswing. Foreclosure data is not a good indicator for a market peak, due to the length of time it takes to foreclose on property. Foreclosures lag

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behind the market trend at the peak and thus will be telling you too late that the peak has passed. However, foreclosures can be a good indicator for when to buy at the bottom. As soon as foreclosure rates start to drop off, you know that a market is beginning to turn around and it might be time to buy. The best source for mortgage loan defaults and foreclosure data is a local newspaper that posts legal notices, or the County Recorder’s Office. You can also subscribe to a local service that will provide the foreclosure listings to you. Check with your local real estate investor group. Days on Market

The number of days on the market is the amount of time it takes for a home to sell from the day it’s listed until the day it receives an offer. In some areas it will be the time until the actual closing occurs. If the average number of days on the market is long, say 120 or more days, this indicates that the market is moving fairly slow and that it takes time to sell homes. If the time on market is 60 days or less, then homes are selling more quickly. By watching the days on market trends you will be able to watch as a market shifts from homes selling slowly toward homes selling more quickly, indicating increased demand and price appreciation. Conversely, as the days on market time lengthens, you will see that the market is passing its peak and that home prices are headed downward. The days on market data is compiled by both local Multiple Listing Services and by NAR, and can be obtained from a local Realtor. Interest Rates

We discussed interest rates earlier in this chapter as part of national trends. Even though interest rates are national, they do affect local markets. Interest rates as an indicator will not tell you if a market is emerging, or if it has peaked and is heading downward. Interest rates help you determine the speed and intensity of growth or decline. When a market begins to emerge and interest rates are low, it increases affordability for buyers, thereby allowing the market to appreciate higher and more quickly before it peaks. If a market peaks and is heading downward and interest rates are low, it will help to soften the price declines. Conversely, if a market is on the

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upswing and interest rates are high, the market will not be able to explode as high because higher rates limit buyers’ spending power. And if the market is on a downswing and rates are high, watch out. This combination will result in the most significant home value drops. As an investor, you definitely don’t want to be caught holding property when this happens. Interest rate data can be tracked in any financial newspaper or even many local newspapers. Also, a great Web site of historical mortgage data, including current average rates, is www.hsh.com. The key rate to watch is the rate for 30-year fixed loans. Now that you have the information to measure the indicators, you need to assemble it all to help you determine when to buy and more important, when to sell.

Knowing When to Buy As mentioned before, the best place to enter the market cycle is early. Once the market has been completely developed and the media have been screaming about “record levels of appreciation,” most of the appreciation has been removed from the table. You will want to enter the market when the market is still relatively quiet. The market might not look perfect. This is why prices haven’t taken off yet. It is very important to invest in a counterintuitive type of way. J. Paul Getty, the world’s first billionaire, once said: “If you want to make money, really big money, do what nobody else is doing. Buy when everyone else is selling and hold until everyone else is buying.” One group of people always finds itself “behind the curve.” We call this group the skeptics. They want to wait around until something is a “sure thing.” And this sure thing occurs in their mind once everyone else has been doing it. But once everyone else is doing it, it is usually no longer a good deal. The investors who make all the money arrive early and exit early. They understand the basic fundamentals of successful investing, and invest accordingly, without waiting for societal approval. Once societal approval is in place, it might be too late. As a real estate investor, this is the time to buy. You must be countercyclical. It takes a lot of courage to buy in this kind of market, when almost no one else is buying. You will have one advantage

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over the local people and the media—the information that tells you that this market is poised to turn around and grow. Let’s see how the indicators tell you it’s time to buy. Sales of Existing Homes. This data is starting to trend upward

(adjusted for any seasonal buying activity). Permits for New Construction. This data is trending upward.

Timewise it will, typically, lag slightly behind existing home sales. Once it starts to trend upward, this is another indicator that points favorably to buying. Months Supply of Homes/Condos. The months supply has

moved below 6½ months and is creeping toward 5½ months. As the supply starts to dwindle, it means two things. The desperate sellers are starting to clear out and there are more buyers on the market. Mortgage Loan Defaults and Foreclosures. At the bottom of the cycle, the mortgage loan defaults will be high but starting to move down. Foreclosures will be at their peak due to the time lag in foreclosing. Days on Market. The time on market data will have been very high. In the first quarter of 2007, the average time on the market in Southeastern Michigan was close to 270 days. Once the time on market starts to move below 90 days, this indicator is pointing favorably toward buying. Interest Rates. Remember that interest rates alone won’t tell

you if a market is going to grow. We have been experiencing low interest rates nationally for some time now and many markets are still slumping. Interest rates help you to determine the level of aggressiveness with which a market will rise or fall. If the rates are low, your emerging market is poised to grow higher and more quickly than if the rates are high. In an ideal world, all of these indicators will line up perfectly in one month, all pointing toward buying. Of course in the real world, there is a time lag between certain indicators. One month you might see existing home sales and time on market start to point toward buying. Three months later, the months supply might give you signals

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to buy. And two months after that, construction permits will be on the rise. In some cases you might get conflicting signals from different indicators. If several indicators point toward buying, particularly existing home sales, months supply, and construction permits, you can feel quite confident that your market is headed upward. Wendy & Justin’s Advice: When several indicators point toward buying, this is the signal that a market has started to turn. Be countercyclical and start buying!

Once you have determined that your target market is emerging and you make the decision to buy, you need to consider what type of property to buy and where to buy in your target market. Will the property be an investment property, your primary residence, a single family home, or a condo? Will you buy on the waterfront, will it be affordable housing, what kind of amenities will the property feature, and who is your target end buyer (Baby Boomer, Echo Boomer, Immigrant)? We discussed these buying choices earlier in the chapter. Use that information to make the best informed decision possible to maximize your growth potential. Also important at the time you buy is to determine your exit strategy. In other words, what do you plan to do with your property once it is built? Begin with the end result in mind. Decide on your exit strategy at the time you buy, because it affects the type of property you will buy and, possibly, how you will buy it. If you are buying the property as your primary residence, your exit strategy is clear. You will live in the house. If you will be buying it as a vacation or second home for yourself, perhaps you will need to consider renting the property when you are not using it. If you will be renting, you need to factor the amount of rental income you can expect and the costs associated with renting (property management, repairs, cleaning, and so on). If you are buying as an investment, will you be selling the property as soon as construction is complete? Or, perhaps, even assigning the contract during construction? Will you be renting it for a period? Will you be lease optioning it to an end buyer? All of these choices are viable exit strategies and can affect what type of property you buy. It is always important to know your potential exit strategies before you purchase. We will discuss exit strategies in detail in Chapter 20.

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Even more important than knowing when to buy is knowing when to sell. You can buy anywhere from a little before rock bottom to partway into the upswing and make money if you sell at the right time. Whereas, if you sell at the wrong time, not only could you be giving up substantial profit but you could also lose money. Fortunately, the market indicators also tell us when to sell. Wendy & Justin’s Advice: Knowing when to sell is of critical importance. It is even more important than knowing when to buy!

The peak of the market cycle is also countercyclical for the investor. You will be selling when everyone is buying. When the market is at its peak, optimism runs high. People know that prices are high, yet they expect them to go higher. The media are saying that real estate is doing great, will continue to do great, and that you should be buying. Sales activity is at multiyear high levels with people in a frenzy to buy, often paying more than asking price. The unemployment rate is low, people are earning more, and the local economy is strong. The banks have few foreclosures in the area, so they are lending to almost anyone who submits an application. It’s hard to believe you should be selling when the outlook is so optimistic. Fortunately, the act of selling at this point is easier than the act of buying when things are so bad. Even if you are wrong about the market reaching its peak and sell early, you will still be making a very nice profit if you bought right. Here is how the market indicators will look when it’s time to sell: Sales of Existing Homes. If the seasonally adjusted monthly sales data is starting to slip down, it is pointing toward the market weakening. Permits for New Construction. The number of permits pulled

by builders will drop as they see the market starting to decline. The last thing builders want is to be stuck with inventory they can’t sell. Months Supply. As the months supply of existing homes starts

to creep back above 5½ months, you should focus on selling. If you wait until it gets closer to 6½ months (the indicator level for a downswing), you will probably be selling too late.

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Mortgage Loan Defaults and Foreclosures. Mortgage loan

defaults will be starting to creep up at the peak of the market. People will have bought at the very upper end of what they can afford and an upset in their finances (such as job loss) will quickly put them in the position of being unable to pay the mortgage. Remember that foreclosures, due to the length of time of the foreclosure process, will lag behind and not give you a clear indicator of the market peak. Each state has a different length of time to foreclose, as discussed in Chapter 10, “Invest in Foreclosures and Other Hidden Bargains.” Days on Market. This is a big clue as to when the market has begun to turn. Optimism might still be high, but as the asking prices of homes begin to peak, the amount of time it takes to sell will start to drag out. Interest Rates. The interest rates will help you to gauge the

severity of the downturn. If rates are low, properties will lose less value than if the rates move up. As with buying at the bottom, this data will not line up perfectly, telling you exactly when to sell. However, after a couple of the indicators point toward selling, it is time to take your profit. If you wait for too many to line up, you might find that by the time your property has sold, the market could change more. Justin & Wendy’s Advice: It’s time to sell when a few of the indicators start to change and point towards selling. Optimism will still be high, so you must be countercyclical. Don’t be greedy; take your profit before the market swings down!!

An excellent resource for using some of the indicators we talked about to calculate actual formulas for when to buy and when to sell is the book Timing the Real Estate Market by Robert M. Campbell. Now that you understand how to find emerging markets and when to buy and sell, it’s time to take a look at some of the markets in our country that have hit bottom. When might they come back?

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CHAPTER

6

Time the Market When Will It Be Safe to Start Investing Again in Nevada, Florida, Arizona, and Other “Burst Bubbles”?

I

f you live in one of these markets or bought in one of these markets too late and are stuck holding a property, or are just looking for a good deal, you are probably wondering what will happen with the former boom markets. Many areas that experienced the highest rates of appreciation in 2003 through 2005 are now sitting cold, with prices either flat or declining. So when will it be safe to invest again in Nevada, Florida, Arizona, and other former boom markets? In some cases it may be safe to invest now! That’s hard to believe when we just said those markets are flat or declining, isn’t it? Throughout this book we talk about how to make money in down markets, so can we apply those principles to these markets? Certainly! Does that mean it’s safe to just buy up anything in those markets in the hopes it will rebound? Definitely not. After all, we did say that those markets are cold right now. When the markets were hot you could have bought just about anything and watched it appreciate at an almost absurd rate. When markets aren’t hot, you have to work a little harder and exercise better judgment in selecting your investments, but in most cases you do want to buy when others are selling and sell when others are buying. Here is how to be selective in these markets. First of all, these markets got hot for a reason. All of the former boom markets are

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desirable places to live. Look at them for a moment: Las Vegas, Miami, Phoenix—all very desirable places to live! And these places were undervalued compared to where they should have been. These two factors, combined with a myriad of other factors, caused these markets to soar so rapidly. Let’s jump back to factor #1 for a moment. All of the former boom markets are desirable places to live. Guess what? That is never going to change. People will always want to live in Miami. There is just no other place like it. It offers a set of unique factors. It contains a level of “appeal” that literally no other market in the country can offer. And this factor will never change. So what did change in this market? Prices got too hot, too fast, and demand couldn’t keep up with the increases. When real estate prices go too high, something happens. Far fewer people can afford the new prices. This causes sales to stall. Even if people want to live in Miami, they can’t buy a piece of real estate there if they can’t afford it. The economy plays an important role here as well. If wages can’t keep up with real estate price values, the same softening phenomenon occurs. At this point, the market needs to correct. Not enough people can afford the high-priced real estate, and the available inventory stops selling. The market then must correct. Sellers begin to reduce their prices. Their homes haven’t sold, so they begin dropping the price—hoping that the reduced price will entice a buyer. Any equity that they had acquired when the market was hot begins to disappear. Eventually sellers would rather cut their price to the point of “breaking even,” just so they don’t have to continue to pay the mortgage every month on a vacant property. Real estate price values come down. And they continue to come down, until they reach a level where more people can afford the price. Then something else happens. Bargains start to happen. Over time, real estate prices continue to adjust downward in several different ways. Some sellers become sick of covering monthly payments. They decide to give up all their equity, and sell at a bargain to get rid of the property. Short sales happen. Some sellers default on their loans and the banks have no choice but to give up these properties to mitigate their losses. Bargains start to happen, sales pick up, and eventually the market turns itself around. Recall from a moment ago when we discussed the fact that Miami will always be a desirable place to live. This means that people will

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always move to Miami. These consistent incoming buyers cause the market to eventually turn around—especially for certain types of properties: ■

Properties that are unique (in terms of their level of desirability)

■

Properties purchased at the right price

■

Properties that are also within the “range of affordability” for a large number of people

Unique Properties Certain properties in a community will always be desirable. These properties are most commonly in a desirable location. They might be near the water, or a desirable retail hub, or a desirable corporate cente, or in an exclusive area of nice homes. But they have desirable location in common. These homes have stable, long-term desirability. If you can get a home in one of these areas at the right price, you are in a great position.

The Right Price What exactly is the right price? For this section we are talking primarily about new construction pricing, not foreclosures or other techniques. Everyone has an opinion on that, but here is our opinion. A price that is below current market value is obvious. We need to look further than that. Let’s say the current retail price of a property is $249,000. That might be below fair market price, but it doesn’t necessarily mean that you want to pay it. Go a step farther. We determine the price that we think the market will bottom out at. This is the price that, in our opinion, the market will not possibly drop below. How do you determine that price? That’s how you make your money as a real estate investor. Begin reducing the price, and compare that price to what homes are actually selling for in a reasonable period of time in that community. Let’s say you determine that this type of home is selling quickly at a price of $209,000, sitting for awhile at $219,000, and sitting longer at $229,000. Then we decide that this type of property would fly off the shelf at $199,000, and that this home would also be very unlikely to go lower than $199,000 when the market “bottoms out.” That is the price that we are going to pay (or lower when possible). If we feel that

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the market can’t possibly go lower than $199,000, then we can’t get hurt. It’s only upward from there. You just successfully determined exactly what price you’re willing to pay for that property. You could also attempt to get a better price, such as $189,000. It never hurts to try, but you want to be careful of lost opportunity. You don’t want to be inflexible to the point of demanding an unreasonable bargain. If you demand an unreasonable bargain, it becomes difficult to get a deal, and you could lose out on what was a good deal by being too aggressive. It also takes a lot of time and money to find outrageously low-priced bargains. The amount of time and money that have to be expended in direct mail cost, time, and frustration usually defeat the additional discount. If you are looking for many, many properties, it might be worth your while to start an expensive marketing campaign. But if you’re looking for just a few, it’s usually a better option to be satisfied with the good price that you’re getting. This way you can actually get the investment started, at a good price, and move upward from there.

Properties in the “Range of Affordability” for a Large Number of People I, Justin, have always liked focusing on this type of real estate product. There is a much larger “buyer pool” for the $200,000 home than there is for the $800,000 home (in most parts of the country). When you invest in the real estate product that has the larger buyer pool, there are more people who can buy the home from you. This makes your exit strategy easier. Now, easier is not necessarily better. Plenty of investors focus on high-end properties and make a fortune. It’s easier to create a “spread” on a high-end property and that can make your profit much larger. I prefer the more conservative approach of focusing on properties that fall into the price range that many people can afford. You must decide which method is best for you. Remember that former boom markets are individual markets, not a collective unit. Different markets will be turning around faster than others; some might experience price declines, and some already might have bottomed out. In the last chapter we talked about how to find emerging markets by analyzing market data. But you should look at market data for any market you are thinking about investing in, to be aware of what is going on in that market. Each of these markets, for instance, has

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similar characteristics; they all still have a good influx of people moving to certain areas within those states. We believe those states took a downturn because they had a surplus (which usually is a big reason—supply and demand). Too many investors started to purchase properties in those areas, which created demand, which caused many builders to build, which created a large inventory of supply. There was not enough demand for the number of properties built. The builders, Realtors, mortgage brokers, and others got aggressive with the influx of buyers, and sold, sold, sold. Now it is taking several years to use up that surplus, plus the supply that is still being built. Depending on the new housing starts, plus the existing inventory, will determine how long there will be a surplus in each of these markets. Are foreclosures on the rise? If so, that might indicate that a market is still going down. Have existing home sales dropped but leveled off? If so, the market could be moving towards recovery. As of January 2007, Nevada topped the list for properties in foreclosure, according to the RealtyTrac January 2007 market report. In 2006, Florida was also in the top five states in the country for foreclosures. This means two things: 1) The former boom towns of Las Vegas and Reno are now excellent opportunities for foreclosed properties; 2) Property values may still be going down while excess inventory is gradually bought. In fact, CNNMoney.com is projecting an 8.9 percent drop in median home prices in Reno and a 7.1 percent drop in median home prices in Las Vegas during 2007. This may mean that both of these markets have reached close to bottom by the end of 2007. At the same time, people are still moving to this market and the population is growing, Las Vegas in particular. Employment is still strong. Rental rates have increased. This says that although the market is declining right now, the overall driving factors that make a market strong are still there! It is difficult to say when prices might start to go up again. In a distressed market, you should not be buying and anticipating appreciation anytime soon. This is not a smart exit strategy. However, using the creative strategies we talk about for buying properties in soft markets (Part III) can position you with equity in a home in a market that is not as strong as an “emerging market.” We currently have properties in several of those markets and are holding them. We are also acquiring new properties in those markets, but they must have good equity for us to consider them.

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If you want to invest in a former boom market, there are several factors to consider: ■ ■ ■ ■ ■

■

What are the market indicators currently showing? What is the current population and migration pattern? What does the employment picture look like? Might other factors be influencing this market? What soft market techniques do you want to implement to purchase? What is your exit strategy?

We have used the Nevada market as an example to get you thinking about how to look for opportunities in a market where everyone else is selling in panic.

What Are the Market Indicators Currently Showing? You need to examine the market data to get an accurate picture of the real estate market in the location you are looking at. What are the patterns for existing home sales, new home building permits, foreclosures, and so on? Because these markets have cooled, you are likely to see that the market data is down. This is to be expected. However, you are looking to find out whether the market is still going down or leveled out. This will help you determine if home prices are likely to decline or be flat.

What Is the Current Population and Migration Pattern? If an area is experiencing strong population growth and migration, it can stay down for only so long. Housing is one of the most fundamental needs people have. The excess inventory that helped fuel the “bubble burst” will exist for only so long. Once the inventory is sold, we will start to see the balance of supply and demand tipping favorably. We are not predicting that in two years the demand will far outpace the supply, and appreciation rates will skyrocket again. The rate of population growth can help us determine the overall strength of a market. If population growth is strong, a depressed market is likely to turn around sooner than a market when population

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growth is slower. If population growth is negative, you should exercise great caution when purchasing. Many of the former boom markets such as Arizona, Nevada, and Florida, are experiencing strong population growth, which makes their long-term outlook favorable.

What Does the Employment Picture Look Like? Employment goes hand in hand with population growth. If employment is strong, people will move to a location and are less likely to move away. If a market is depressed but has strong employment, it is likely to turn around more quickly than a depressed market with weak employment. To find employment information, you can call the Economic Development Committee in the area you are interested in.

Might Other Factors Be Influencing This Market? One of the big factors that influences some markets is the Baby Boomer population. Baby Boomers who are buying second homes or future retirement homes, but are not moving to the area fulltime yet, defy both employment and population migration data. Depressed areas that are experiencing Baby Boomer demand might start to recover in spite of other market data. On the opposite side, influences can depress a market, too. Take Florida, for example, where property insurance rates have increased anywhere from 200 percent to 1,100 percent in the past two years! Dramatic rises in insurance costs can have a serious affect on affordability. If a prospective home buyer was expecting to pay about $100 per month in homeowner’s insurance and suddenly finds that the rate will be $350 per month, that is $250 per month less to put toward a mortgage payment. How much buying power does that cost? With a 30-year mortgage at 6.25 percent interest, a buyer who previously was approved for a $250,000 loan could afford only $218,000 after the insurance increase. That’s a $32,000 drop! Florida and other hurricane affected areas are taking steps now to get insurance rates under control. Until that time, high insurance costs might slow the market recovery.

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Remember that external influences may affect housing, whether they are positive or negative. Being informed helps contain your risk and allows you to make smarter investments.

What Soft Market Techniques Do You Want to Implement to Purchase? Now that we’ve reviewed being informed about a market, we need to look at how to start buying your investments. We cover many different techniques for buying real estate in soft markets in this book. You will need to choose the ones that work best for you and implement them.

What Is Your Exit Strategy? In Chapter 20, we cover exit strategies in depth. It is critical to plan your exit strategy when you buy, and incorporate it with the techniques you want to use. As we said, each market will be different and will recover at different times. By looking at the individual market data, and considering the employment and population growth and external factors, you can implement an investment strategy in any of these markets. To answer the question we asked at the beginning: “When will it be safe to start investing again in burst bubble markets?” We would say that for the most part, it already is. Real estate investors make money in every single market in the country, whether the market is growing or declining. You just have to buy right. In the next seven chapters in Part III, we will be discussing different strategies to buy right. Justin and Wendy’s Advice: Money is made on the buy in Real Estate. Buy right and you will be OK.

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CHAPTER

7

The Power of Lease Options in a Soft Market

I

n this chapter, we will focus on lease options as an acquisition strategy; however, later we will discuss lease options as an exit strategy. This is a powerful strategy, and we like it because soft markets are ideal for finding lease option investments, and personal or second-home residences. Lease options are also used heavily in the commercial market for developers, but this chapter will focus on residential properties. Many sellers in a soft market have had their homes for sale for some time and really want and desire a solution. They need something like a lease option. Michigan is a prime example of this. With more than 17 months of inventory on the market (at this time) and many of the homes for sale being vacant, sellers are realizing the need to be flexible. It is becoming fairly common to see two listings for homes; one listing for sale and one listing for rent. The sellers have already accepted the idea of renting to cover part or all of their payments and then selling when things get better. By approaching them with the offer of a lease option, you are giving them a better solution than just renting. We’ll explain a bit about a lease option, or more specifically, a sandwich lease option. A sandwich lease option involves gaining “control” of a property, but not ownership—just the right to possess a property now and purchase that property at some future date with terms that you define today. Lease Option Pro: Control without ownership! This gives you tremendous freedom.

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Figure 7.1: Lease Options Seller

Options to

Investor

Options to

Buyer

How Lease Options Work A sandwich lease option, as shown above in figure 7.1, is where you are acting as the intermediary. You option the property from the seller and then option it to a buyer. The seller and buyer are the bread of the sandwich, and you as the investor are the meat. By only optioning the property, you don’t have to ever take ownership unless you choose to. This is where the “control” comes in. Here’s how this works. You sign an option contract with a seller. You also sign a lease agreement, stipulating that you may lease the property for the option period, giving you the right to exercise the option at any point during the lease. You will then find a rentto-own tenant, to whom you provide an option and lease agreement. The difference in purchase price from the seller to your purchase price to your buyer, plus any positive cash flow, is your profit. Other things can be added to a lease option to increase profit, but they are more detailed than this book will allow for. Lease Option Con: The title is not in your name, so you are vulnerable to seller situations. You must be careful to screen the seller. Only option from strong sellers, not those in trouble or headed for financial trouble. The best ways to find lease option properties are through the Realtors’ Multiple Listing Service (MLS), the classified ads, and direct mail. Let’s take a look at each:

MLS When finding sandwich lease option properties through the MLS, you must first deal with the seller’s listing agent. The listing agents want to get paid their commissions; you must make sure they understand that with a sandwich lease option, they will get paid once the buyer or you exercises the option. Also, you can

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find creative ways to pay the Realtor for part of their commission when the option agreement starts, and the remainder when the property closes. If you want more information, you can review a free article at www.WendyPatton.com. If you can win over the listing agent, you’ve won at least half the battle. They will present your offer, and you will want it presented in a favorable light to the seller. This is almost a necessity to make lease options through Realtors successful. If the seller has the home listed both for sale and for rent, you might find the listing agents even easier to deal with. They know that if they only rent the home, their commission will be much smaller than if they can eventually sell the home. Also, they know that their seller is amenable to having tenants in the home. Even if the home isn’t listed as both for sale and for rent, there are other ways to find lease option prospects in the MLS. Look for listings that have been on the market a long time or look for listings that are vacant. Either way, you know you are likely dealing with motivated sellers.

Classified Ads Two sections of the classified ads can be useful for finding potential lease options, the “for sale” and the “for rent” sections. When you call, you want to determine how motivated the owner is, as you begin to talk about the property and build rapport. The following is the script that I, Wendy, use when I make calls about homes in the “for rent” section: Hi, my name is ________. I’m calling about your home for rent. Can you tell me if it is still available? Giving your name sounds warmer and will help put the owner at ease with you. It is a great way to begin building rapport. When is it available? Can you tell me a little about the home? Let them volunteer some information about the home or ask them to expand on some of the information in the ad. You are building rapport with the owner. Talk and let them talk. People warm up when they are the ones talking. Listen and sound interested. When was the home built? This question gives you an indication of any decorating or maintenance problems you might run into, such as whether it might need

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to be updated. If the house is older, ask the next question; if not, skip to the one after. Have the kitchen and bath(s) been updated since it was built? If it was built in the 1970s, I often ask if the baths or kitchens are yellow/green/brown or if they have been updated. Does it have a garage or basement? Is the yard fenced? This might prompt them to ask whether you have pets. At this point, they still think you will be living there. I don’t change that assumption until we have developed enough rapport and trust. They might ask how many people will be living in the home. In that case, I don’t want to lie, but I don’t want to be totally direct either. If you say, “I don’t know, I am going to rent it to someone else,” you can be sure they will not show you the home. Each time these questions come up you will answer them differently, based on the owner. Here are three ways you could handle their questions: 1. Answer as if you really were going to live there. 2. Try to change the subject or slightly avoid the question. 3. Try to answer using your best guess of who might be renting from you later. I am not recommending deliberate deception. I am very honest and straightforward with my sellers—but only after we meet in person or when I feel that they are open to discussion about the entire situation. Everything will eventually be in writing, so they will know that you are not occupying the residence before they sign the documents. If the home sounds like something you would like to own, then pop the next question. If it doesn’t, just be polite and say you will call back later if you are interested. Wow, this home sounds really nice, would you consider selling it? If they say no, then say, “Thanks, but I am really looking for something I can buy.” Leave them your name and number so they can contact you later if they change their mind about selling. If they seem interested and say “yes,” then set up a meeting to go and see the home. Review property and rental values in the area and make an offer.

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Do you know how much you would want for the home? Start to feel out the owners for the type of terms they would consider, but be careful not to make any verbal offers. This isn’t the time for negotiation—you are still just gathering information and building rapport. Construct your offer later when you are not on the spot. When could I come and look at the home to see if I would be interested in it? Make arrangements to go as soon as possible. This shows the seller that you have more than casual interest in the property. Set an appointment and keep it. If you must change your schedule, be sure to let the seller know ahead of time and make alternate arrangements for as close to the original date as possible. This courtesy will also demonstrate your genuine interest. Something we should mention here is tenacity. To be successful in real estate investing, you need to be tenacious. You will be making a lot of calls, and many of the owners will flat-out tell you no. If you get discouraged by a no you will never get to a yes. Even experienced investors get more nos than they do yeses. It’s just a part of the business. If you don’t take the nos personally and just accept them as part of the business, you will enjoy a much more fulfilling investing career. You can also run your own classified ads to attract motivated sellers. You can place them in the “for rent” or “rentals wanted” section. An ad might look something like this: Company looking for 3 - 4 homes in this area for long-term lease. Call 123–456–7890. When you run your own ad, you can effectively pre-screen sellers before you even talk with them. If they call this ad, they are already willing to consider renting their home, which is half the battle. It also means that they do not need any cash out of their home right away, because if they did, they wouldn’t have responded to the ad.

Direct Mail Direct mail is a letter or card sent through the postal service or across e-mail. The focus of your direct mail is to send letters to

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Note from Wendy: I use the same script to screen the seller on the above ad as the one used to call the sellers in the newspaper. The bottom line is, are you interested in selling your home? (My goal is to build rapport with the seller before asking that question.)

property owners whose listings have expired (or have ones they’ve been sitting on for a long time). Direct mail can be very effective for sellers frustrated with the lack of results. You are offering them a solution for a home they have been unable to sell. The point of the direct mail letter is to get the seller to call you. You would then use the same script that was described earlier in this chapter. It is critical to check the title work on a house you are going to lease option to make sure the person you are working with is actually the owner, but also to make sure that there are no unexpected liens or encumbrances that might affect you later. Lease Option Pro: More sellers will do an option rather than give up a deed—especially on nicer homes. Once you have found a good lease option prospect, an important clause to include in the paperwork is that the option should not begin until you find someone to rent from you. This is very important to you, as the investor, because if the lease starts right away, you will have to make the payments until you place a tenant. This can cost you a lot of money out of your own pocket. It can also make you more likely to place a tenant who either will not or cannot perform on the option at the end of the lease, simply because you want anyone in the house to keep you from having to make the payment yourself. It is also advantageous to the seller because you can allow them to keep trying to sell their house normally while you are simultaneously looking for a lease option tenant. It provides you both with a win-win situation, and that is the best way to do real estate investing.

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Lease Option Con: Some sellers might feel that an option is not closure on their home. Some will feel better with a deed being transferred or a lease purchase (which is a guarantee vs. an option). In a lease option situation you are not required to follow through with the option to purchase at the end of the lease. If the market should change and head further downward, making the house worth much less than your option price, you are not obligated to close on the property. This protects you as an investor. That being said, however, you should always strive to complete the deals you put together. Lease Option Pro: You don’t have to buy later if the market drops or there is something wrong with the home. You can get out. Also, you should seek to place into the home only tenant buyers who have the capability to purchase the home down the road. They might not always follow through; after all, you cannot control their actions. But placing tenant buyers into homes that they have no chance of buying, simply so you can collect a large option fee, is utterly unethical. As soon as you place a tenant buyer and begin the lease option, you would record a memorandum of option against the title. This starts seasoning of the title and the payments that most lenders require. Down the road, should you elect to purchase the house or need to refinance the property into your own name, the history of payments allows you to use the appraisal value of a refinance versus the purchase price of the home. Lease Option Con: You will have short-term capital gains versus long-term if you are not on the title. Here is an example of a possible lease option deal: An executive who received a large year-end bonus decided to upgrade to a larger home. His old home is worth $295,000 and he only owes $150,000. Because of the large bonus, he did not need

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his equity to buy the new home. With $145,000 in equity, he is not going to walk away from his equity. His salary is large enough to enable him to get financing on the new home even with the existing payment on his old home. He can afford both payments, but does feel the sting each month in paying for his old home to sit empty. The house is listed with a Realtor, but due to the slowness of the market, it has not yet sold. He is an excellent candidate for a lease option. His house is well cared for and move-in ready. He wants his equity out of the house but does not need it right away. When you lease option this house, he may get most of his equity back—although not until you sell or close on the property. The deal would look like this: You option the property for $280,000, and make payments to the seller that are equal to his total mortgage payments (because he only owes $150,000, they should be rather low—but this is not to imply that we would normally make the seller’s payments if they are too high). You sell the property on an 18-month lease option for $322,000 with payments to match. You get cash flow plus $42,000 in profit when your tenant/buyer buys the property; the seller gets his payments taken care of for a couple of years, then gets his equity out. And in the meantime, he doesn’t have to worry about management, vandals, frozen pipes (if in the North), air conditioning going out (if in the South), and all of the other things that owners of vacant houses have to deal with. One nice thing about lease options is that you can more likely do a lease option on a high-end home versus other types of creative investing. High-end homes often attract a different caliber of tenants, may be better taken care of, and can have a substantially larger profit potential. If you do a sandwich lease option in a distressed market where things are about to turn around, you might find it advantageous to simply lease the home for one year and then, when the market is starting to take off, you can find a tenant buyer for a higher price, with a higher rent and option fee. Remember, 10 percent appreciation on a $400,000 house will make you $40,000, whereas 10 percent appreciation on a $100,000 house will make you only $10,000. Lease Option Pro: A way to get nicer homes with large profit potential—more likely the seller is not behind on mortgage payments and has taken better care of the home.

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Lease options can require very little cash out of pocket provided the lease doesn’t begin until you find a tenant buyer. However, it is wise to exercise caution. Keep reserves available and pace yourself in your deal-making to a level that is manageable. Although you are not obligated to exercise the option and close on the property, you are still responsible for the payments during the lease period. If you put together four lease option deals with payments of $2,000 per month each, how long would you be able to afford the additional payments if three of the four properties went vacant at the same time? That’s an extra $6,000 per month out of your pocket. Again, just as with any investing strategy, exercise caution. If you are in California, $2,000 a month would be low, but if you are in Ohio, it could be high. Evaluate each deal on its own and make sure it works for you and your investment strategies. Just because a seller is willing to do a lease option does not mean it is a good deal for you; but with that said, there are many great deals that can be negotiated with sellers on lease options. For more information about lease options, and especially ways to work with Realtors, read Investing in Real Estate with Lease Options and “Subject-To” Deals by Wendy Patton, or visit her Web site, www.WendyPatton.com. When you can’t lease option the property or it doesn’t make sense to do so, consider seller financing or a land contract. Land contracts, sometimes called contract for deeds, are also a great way to purchase properties. We will discuss them in the next chapter.

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CHAPTER

8

A New Opportunity in the Soft Market Land Contracts & Seller Financing

L

and contracts are a popular investment strategy in any real estate market, whether hot or cold. The land contract provides many benefits in hot markets but also can provide excellent solutions in slow or even declining markets. It can be used as a strategy to make money with virtually any type of real estate, whether it is a low-priced single-family residence, a small multifamily project, a large apartment building, a commercial or business property, multimillion-dollar homes, or vacant land. It can be used in virtually any type of real estate deal if the buyer and seller are willing and able. A good friend of ours, Pete Scheepens, an expert in land contracts, co-wrote this chapter. He has done hundreds of land contracts. He has a Web site and course that you can refer to for more information on land contracts: www.landcontractsystems.com When we speak of land contracts, you might have heard of the concept before as land installment sale, contract for deed, or any other one of a handful of names, but all these titles describe the same strategies and the same solutions that a buyer and seller can achieve. For this chapter, we will call this technique a land contract. To understand what land contracts can do for you, first let’s define them. A land contract (a.k.a. contract for deed or “installment sale agreement”) is a contract between the owner of the real property (called the “vendor” or the “seller”) and 81

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a person who wants to buy the property (the “vendee,” “contract purchaser,” “purchaser,” or “buyer”) for an agreed-upon purchase price. In simple terms, it is truly seller financing versus using a bank or mortgage company. The seller has a contract with the buyer on the property for a set time with a set interest rate. When this expires, or when the buyer pays the seller in full, the seller will give the buyer the deed to the property, hence the name contract for deed. In most cases, the seller needs to own the property free and clear (no mortgage) to do a land contract; however, this is not always the case. Under a land contract the vendor (seller) grants equitable title to the vendee (buyer). This consists of virtually all rights and benefits to the property, and the vendee agrees to pay the purchase price to the vendor over time, usually in monthly installments, by a certain date. When the full amount of the purchase price is paid, the vendor is obligated to deliver legal title to the vendee by an actual deed and upon delivery of the deed, the vendee owns equitable and legal title to the property. Sounds a little legal and confusing doesn’t it? Well let’s break it down a little bit more. It is really a great technique and can be used to your benefit in a soft market. Equitable title, for all intents and purposes, makes the purchaser the “owner” of the property. It is estimated that about 18 percent of all real property (residential & commercial) transfers by way of land contract. It is common for the installment payments of the purchase price to be similar to mortgage payments in amount and effect. The amount is often determined according to a mortgage amortization schedule. In effect, each installment payment is partial payment of the purchase price and partial payment of interest on the unpaid purchase price. This is similar to mortgage payments, which

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are part repayment of the principal amount of the mortgage loan and part interest. Often a vendor will also collect 1/12th of the estimated property tax payments with every monthly installment. The vendor will then pay the property taxes when they become due. It is a way for the vendor to make sure that taxes are paid and that unpaid taxes do not create a lien on the property. Closing costs, prepaid items, and other fees are typically a lot lower when purchasing real property through land contract. Most all of the costs paid at closing directly benefit the purchaser in one form or fashion. Compared to a mortgage loan, which typically has a lot of third-party fees to be paid by the buyer, the land contracts are a popular alternative to lower the cost of ownership and to create low or no out-of-pocket closing-cost transactions.* Covering all the possible scenarios in great detail would require us to allocate an entire book specifically on land contracts. However, you should know how to use land contracts so you can truly jump-start your career or take it to the next level. Knowing when to use each technique is very important. Land contracts are simple to understand and are easy to execute, but many myths and misconceptions surround them. These systems literally have been used for hundreds of years, and have survived the test of time as a very good tool to create win-win situations for buyers and sellers alike. You can learn how to execute land contracts to buy, sell, or control real estate in a few hours, but the flexibility of land contracts also allows you to use very creative and advanced strategies to maximize cash flow and profit potential, or to create simple solutions to otherwise complex transactions.

Buying with Land Contracts When you buy property using a land contract, one big advantage immediately becomes apparent. Because land contracts are a form of seller financing, you can bypass many of the costs, hassles, and time constraints that come with other forms of purchasing. There is no need for lengthy approval processes. As a land contract buyer you are dealing directly with the seller, and as such, typically you do not face the bureaucracy of lender applications, * Source: www.landcontracthouses.com

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bank approvals, or extensive background checks. Once the buyer and seller come to an agreement of land contract, the deal can be closed very quickly, sometimes in hours or days. Naturally, as the buyer, you also do not have to pay a long list of “junk fees” that are customary at conventional closings. With land contracts you can typically save yourself from application fees, broker fees, underwriting fees, appraisal fees, and many other charges that are imposed by third parties. Normally, all closing fees involved with land contracts directly benefit the buyer in one way or another. Land Contract Pro: By eliminating banks you save on time and money! Buying with a land contract also gives the purchaser the advantage of extreme flexibility. Because all terms of the contract are negotiable, and are not limited by corporate or institutional guidelines, you can create very desirable or creative agreements. Sometimes you can negotiate a low interest rate or a long amortization period. Other examples of favorable terms might include interest-only payments, no escrow for taxes and insurance, payment “stutter” or skipping, or payment-free periods, long balloons or none at all, lack of “due on sale” clauses, or assumption of contract by purchasers, just to name a few. You might be able to purchase through land contract without even so much as a credit check, and most of the time you can also purchase real estate directly as a “paper entity,” for instance, an LLC or corporation, instead of your own personal name. Land Contract Pro: By creating your own financing terms, you now have tremendous flexibility. Land contracts are a good strategy to purchase just one property, or hundreds of properties as part of a large portfolio. It makes no difference if you use land contracts to purchase or sell your next primary residence, or to buy, sell, or control a large volume of properties. The only limiting factor is you, and the only things that limit you are education and application. Once you are well versed on land contracts and use what you have learned, you have the potential to make or save tens of thousands of dollars on every single deal you do.

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After knowledge, your own inertia is the only thing holding you back. It is your limitation in creative application that is preventing you from moving forward. Pete Scheepens

Finding Sellers Who Offer Land Contract Terms Although it might not be immediately apparent that there are a lot of properties for sale on land contract terms, you can find a lot of sellers who offer land contract financing after you do a little bit of homework. Besides the sellers who offer land contracts from the start, a lot of conventional sellers also can be converted to land contract sellers once they understand the advantages that land contracts offer them. Land contracts are prevalent among commercial property sellers. If you are looking to purchase a strip mall, large apartment building, industrial complex, or the ice-cream shop around the corner, you will likely not have any problems finding listings with land contract terms. These sellers already expect to have to offer financing, and they can be an excellent source for purchasing real estate with very favorable terms. There are also a lot of private sellers of single-family residences who offer land contract terms on the sale of their properties. By far the easiest way to find a good percentage of these sellers is through the use of the MLS, or Multiple Listing Service. Any Realtor can do a search through the MLS system and generate a list of all homes offered with land contract terms.

Your Federal Government Sells on Land Contracts Too! “ … The vendee loan program is a successful program that allows VA to finance loans to a new veteran or non-veterans purchaser when the prior loan has been foreclosed upon and VA has received the property” “ … Requires the Department to dispose of between 50 and 85 (currently, 65) percent of such acquired properties using vendee loans. …”

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Another great source of land contracts that many people overlook is the government. A lot of government-owned homes (usually foreclosures and repossessions) are offered on land contract terms. You will be able to find very low interest rates on these programs along with flexible terms and easy qualification processes. Most programs don’t even check your credit or FICO scores. Besides the federal government, more and more institutional lenders and banks are offering land contract terms. A short time of searching on the Internet will reveal many hidden sources of land contract sellers. Apart from all these sellers who immediately tell you that they offer seller financing, tens of thousands of other sellers can easily be converted to land contract sellers. Landlords offering rent-to-own programs might be easy to convert once they see all the benefits. Sellers who cannot seem to sell their homes and have had them on the market for a long time might also be good candidates for this strategy. As you get more involved with land contracts, you will find that you can buy virtually any real property using land contracts. As with everything else in life, knowledge is power, and those who have the knowledge of land contracts surely use it on a regular basis with good reason. Land Contract Pro: Sellers perceive a sense of closure by the transference of ownership.

Selling with Land Contracts As we have already seen, it is fairly easy and desirable to purchase real estate by using land contracts, but because land contracts truly create win-win situations, there are also many benefits to selling on land contract. The seller or vendor who offers this type of financing obviously does so for good reasons. Such opportunities are likely to reach a larger prospect pool of purchasers and therefore create a quicker sale, and to sell property at premium prices. There are many more, less obvious, benefits with land contracts. Because the seller is financing the deal, the seller will also be able to collect interest on the unpaid balance of the land contract. A lot of land contracts also include balloon payments that require the

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unpaid balance to be paid off before it is fully amortized. Over time this increases the yield on the note or repayment agreement dramatically, and therefore land contracts are excellent tools to create steady and secure cash flow with higher-than-normal yields. When it comes to the IRS and taxes, land contracts may also provide many benefits. Land contracts are usually regarded as installment sales for tax purposes, the capital gains that are realized with the sale of real property are spread over time and are repaid in small increments versus a large lump sum payment, as with a conventional sale. Depending on how the contracts are written, many of the same benefits that you get from rent-to-own programs can also be gained with land contracts, but land contracts have much more to offer. When comparing land contracts to rent-to-own programs, the biggest benefit by far is liability. No matter how well your rentto-own agreement is written, you are still operating in the realm of landlord-tenant law and you are still exposed to liability and landlord responsibilities. With land contracts you sell the real property, and as such, ownership is conveyed, therefore the landlord issues have truly become a non-issue while you still retain most of the core benefits of rent-to-own programs. Land Contract Pro: Landlord-tenant laws do not apply as far as liability. The disadvantages of selling on a land contract would be that if the buyer did not make a payment, the vendor would usually have to go through foreclosure or forfeiture in court to retain the property. This can be stressful for many investors and sellers, but the easiest way to do this is quickly (well, as quickly as the court will allow) and with an attorney, and to get the buyer out as quickly as possible. This way you can resell the home and get someone in that is paying. Land Contract Con: If a buyer fails to pay you must either go through foreclosure or forfeiture. Both take longer than evictions and can end up costing you more money. (Some states allow for an eviction depending on the buyer’s percentage of equity.)

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Also, if the property has a mortgage on it or is not owned free and clear, there may be a “due on sale” clause in the mortgage, and this could cause problems for the seller when selling on a land contract. This is fairly rare, but it could happen, and it is a risk for those sellers who have an underlying mortgage. We have sold some of our properties using land contracts and have not had any problems with our lenders calling the mortgages due. It is usually something that is more of an issue when the note is not being paid on time, or if the mortgage note has a very low interest rate and interest rates have increased drastically. Land Contract Con: Land contracts can trigger the “due on sale” clause of an underlying mortgage.

Advanced Land Contract Strategies As we already have mentioned, land contracts are simple to use and understand, and can be implemented quickly after a little bit of education, but the real power of land contracts will be unleashed in the advanced applications. Because land contracts are fairly safe and secure, you will also find a complete secondary market purchasing land contracts, not unlike the secondary mortgage market where mortgages are bought and sold as investment products. Land contracts are products that can be purchased, sold, and brokered by themselves and as such, a lot of new opportunities present themselves to make money with land contracts. You will be able to find many buyers who are willing to purchase land contract notes, either partially or completely. This opens up advanced strategies like some of the ones below: Smart Seller

You can sell on land contract with seller financing while having no intention whatsoever to hold the note or wait for your installment payments to come in. You sell real property at premium pricing due to land contract terms, and at the time of closing you instantly sell the land contract to a note buyer. You as the seller get cashed out completely, and are done. You have sold your home a lot more quickly, and likely at a very good price, even after taking the discount for the note buyer into consideration.

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Note Broker

Note brokers match land contract buyers and sellers. They may collect fees on either side or both sides for their services. Smart Buyer

You contact a note buyer ahead of time and negotiate your land contract terms with that buyer. The note holder will tell you how much house you can shop for, and you scout the market. Once you find a home, you offer cash to the seller. Because you offer cash, you can negotiate lower pricing and better sales terms. At the time of closing, the note buyer purchases the home with his cash and sells it to you minutes later on land contract terms. Land Contract Pro: With these advanced techniques, it is possible to find creative solutions while minimizing your legal exposure. These are just a few of the strategies that you can employ to use land contracts in creative ways by using note buyers. Another favorite is the land contract wrap, wherein you purchase a home using a land contract and then sell the same home to someone else for a higher price, a higher down payment, and a higher interest rate by wrapping a new land contract around the existing one. This wrap or sandwich is preferred over many other sandwich strategies that leave a lot of legal exposure. With land contract wraps you benefit from: ■

Being a principal in the deal when you need to be

■

Being able to set terms on both sides

■

Having no legal exposure because you no longer own the property

■

Being able to play bank without having to adhere to many regulations

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Favorable tax issues

■

Having liquid investments because you can always sell your contract for cash quickly when needed

■

Not having to deal with institutional underwriting guidelines

And there’s much, much more.

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Myths About Land Contracts While we close this chapter on land contracts, we want to leave you with a better understanding of some of the misconceptions and myths that surround them. These myths are very stubborn and seem to recirculate without ending, but anyone who is willing to spend a little bit of time looking up the facts instead of listening to the static around them will quickly find that nothing holds you back from making land contracts a part of your future. As always, though, laws differ vastly from state to state, and depending on where you execute your land contract, you also might have to deal with local or municipal rulings and regulation. It is exactly for this reason that local legal counsel exists everywhere. We strongly advise you to use it before you make legal commitments! Myth: When a Buyer Does Not Pay on a Land Contract I Have to Use Foreclosure

Although foreclosure is definitely an option to deal with vendees who do not pay, it is not the only way to deal with nonpayment. Forfeiture may be available as a good alternative to foreclosures in some states. Forfeiture proceedings are a lot simpler and cheaper, and typically execute twice as quickly as foreclosures. Best of all, you get the property back and can resell on another land contract with another large down payment. Besides foreclosures and forfeitures, the deed-in-lieu may also provide a very quick and easy solution to take the real property back. (A deed-in-lieu is when the buyer gives the seller a deed in lieu of a foreclosure.) Some states may even allow for simple evictions. Myth: I Have to Be Licensed to Buy or Sell with a Land Contract

In many states, land contracts can be used by anyone without any special type of license. Usually, you may only need to have a license when you are dealing with large volumes of land contracts in a given year. Check with your state to find out the regulations regarding land contracts.

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Myth: I Have to Use a Licensed Broker or Escrow Company to Execute My Contract

Although it is recommended that land contracts be closed at an escrow or title agency or through a real-estate attorney so that the documents get recorded properly, there are usually no requirements that force you to do so. Land contracts between two competent parties are valid legal agreements, even if they are not recorded, and even if they were executed by private parties without counsel. We hope that you have come to see that land contracts can be— no, MUST be—a tool in your toolbox. If you are serious about real estate, you simply cannot afford not to have land contracts at your disposal. Land contracts can offer solutions where other systems do not fit; they can also achieve great benefits where banks or other institutional lenders will not or can not provide. To learn more about land contracts, please visit www.landcontractsystems.com. In the past two chapters we have talked about lease options and land contracts. In the next chapter we will talk about something very different. It is the topic of getting sellers to give you the deed to their homes! That’s right—the deed!

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CHAPTER

9

Getting the Deed from Sellers in Trouble AKA “Subject To”

G

etting the deed? What? AKA “Subject to?” It sounds odd, but yes, this is another great technique for working with sellers in markets that are soft. However, this technique, like all of the other techniques, works in soft or strong markets. They all seem to work much better in soft markets, from the purchasing end. Many sellers will just give you the deed to their homes. That’s right, they will just give you the deed to their homes. You take over their mortgage payments and they move on. This is what is called getting the deed “subject to” the underlying mortgage. As illustrated by figure 9.1, the mortgage stays in their name, but the deed goes into your name. It is a beautiful technique that works very well for many investors and many sellers. Why in the world would someone just give you the deed to their home? For many reasons, and surprisingly, this happens all the time. There are advantages to sellers in doing this. If sellers have not been able to sell their homes, or are behind on their mortgage payments, you as the investor can catch up their payments and now make

Figure 9.1: How “Subject Tos” Work Seller

Gives title to

Investor (who now owns)

Lease options to

Buyer

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their payments on time. If the sellers were behind on their mortgage payments, their credit would have been affected negatively. When you come along and start making their payments on time, their credit could be restored, at least as far as their mortgages go. This could help them tremendously. Also, many sellers who use this technique are not in trouble at all; they just want to move on and are willing to sign over the deed to their home. “Subject to” Pro: Title is in your name—full ownership The biggest factor in this technique is that it is not control without ownership, like a lease option. You do own it! You have responsibility to the seller. You commit to the seller to pay that seller’s mortgage. If you employ this technique, make sure you can pay their payment, or don’t do the deal. This form of investing requires perhaps the most substantial level of integrity from an investor. The sellers are entrusting you with both their credit and their homes. Be worthy of that trust. “Subject to” Con: You own it and have ethical responsibility to the seller even if the market changes or you can’t sell the home. There is no changing your mind on this one. The entire key to executing a successful “subject to” transaction is to get the right price on the home. In a soft market, you might want to be conservative and assume zero appreciation for 5 to 7 years. If you assume zero appreciation, make sure you get the right purchase price from the seller. As we just mentioned, you have the ethical and financial obligation to continue making the seller’s mortgage payments. This obligation is easy to fulfill as long as you: (1) have the cash, and (2) bought the house at a good price. Obviously, having the cash contributes to this obligation, but “buying at the right price” also matters. Let’s say you just acquired a home “subject to” that is conservatively worth $200,000, and the seller owes only $145,000 on the mortgage. You just acquired the home for 72.5 percent of its conservative value. Because you acquired the home at the right price, if you ever need to, you can refinance the home. You can take a

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mortgage on the home yourself, at a nice low loan-to-value of 80 percent, cash out the seller’s original mortgage, and also receive cash yourself when you refinance. By acquiring only deals where the numbers really work, you put yourself in a great position. If you ever need to, you can take out a new mortgage, and pull cash right out of that home. That cash can be used for a multitude of investing purposes. Always buy right! Although lease options and “subject tos” can build you tremendous wealth, they shouldn’t be considered a short-term investing strategy. We define a short-term strategy as the time that passes from the start of the transaction to completion (cashing out) being less than one year. A classic example of this would be a rehabbing project (fixing up a home and reselling it). The other side of the spectrum would be a longer-term strategy—buying a rental property and renting it over many years. We consider lease options and “subject tos” to be in the center of that spectrum, usually requiring one to three years for the best payoff. In a severely depressed market, you might find plenty of people who are willing to give you the deed to their homes. This allows sellers to get out of homes that they either cannot sell or no longer want. That makes it a win for them. “Subject to” Pro: Sometimes sellers will pay you to take the deed! As the investor, you are looking to make a profit. You must make sure that a profit exists for you either in the value of the property or in the terms of the deal. In depressed markets, some sellers owe more on their home than what the home is worth. If the market were flat or declining, you would not want to take the deeds on these homes unless you could rent them for a substantial positive cash flow. Just because someone is willing to give you their home doesn’t mean you should take it. This is usually where eager new investors will get their first tough lesson. Ensure that there is a profit for you so that the situation is a win for you. This might sound obvious, but investors sometimes get so excited by the prospect of someone deeding their home “subject to” that they forget to make sure that they can make a profit! Again, make sure that the numbers really work. It should be a win-win for both parties.

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One risk of a “subject to” is that it can invoke the “due on sale” clause of a mortgage. By transferring the deed to the property, the lending company may require the mortgage to be paid off. Typically, if the payments are being made the lenders will not invoke this clause. We have rarely heard of this happening, but it is a risk with this technique. Just have your backup plan ready. Be prepared to refinance, if needed. “Subject to” Con: Possible due on sale clause being called—therefore you might have to refinance or sell the property. Finding “subject to” deals in distressed markets is often easier than in strong markets, simply because it is harder to sell and usually harder to rent in a soft market. “Subject tos” are best found through certain forms of advertising. We like newspaper ads, signs, calling FSBOs (For Sale By Owners), direct-mail marketing, and even driving for dollars. “Subject tos” are not advisable through the Realtors’ Multiple Listing Service, as it can be an ethical violation for a Realtor to participate in a “subject to” deal. “Subject To” Con: In some states, mortgage brokers and Realtors could be fined and/or be subject to revocation of their licenses. It could be considered against their code of ethics to assist a person in violating a clause in a contract (the “due on sale” clause in the underlying mortgage contract).

Newspaper Ads Here is an example of a newspaper ad I, Wendy, like to use: Tired of Monthly Payments? We can help. We will make your payments. Call Today. Call 123–222–2222. In a distressed market, newspaper ads can generate a lot of calls. You can run the ad in either the “For Sale” or “For Rent” section of

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the paper. It is a good idea to pre-screen your callers to determine how motivated they are as sellers before you go out to look at a home. If the sellers are motivated, then go meet with them to build rapport and introduce the idea of accepting the deed “subject to,” if they seem like a good fit for this option.

Signs Commonly called “bandit signs,” these signs are popular at busy intersections and freeway exits. The most popular version says something like, “We Buy Houses. Cash. 123–222–2222.” You might want to change the text to reflect something similar to the newspaper ad. The biggest obstacle you will have to overcome with signs is the seller’s disbelief that they are actually calling. Many sellers do not believe they have a “problem.” Many sellers are also skeptical about calling a roadside sign. However, these sellers are usually motivated if they are making the call. You will need to build rapport with them and establish some credibility about what you do to overcome the skepticism. Also, note that many cities will not allow these types of signs to be posted. Check with your city first before putting these signs out. The fines can be steep for a violation.

Calling FSBOs In a down market, For Sale By Owners face very little chance of successfully selling their homes. There are few buyers out there, and FSBOs simply don’t have enough market exposure to get enough showings to find a buyer. A smart tactic with FSBOs is to cut out the ads and then call them a month or so later. When they first put their homes on the market, they usually aren’t motivated enough to consider a “subject to.” However, after enough time passes, they become much more receptive to alternative methods of moving their homes.

Direct Mail One of the most effective ways to find motivated sellers is to send handwritten letters to sellers whose listings have expired on the MLS. After having had their homes listed for months with no activity, they usually are eager to find a solution if they really need

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to sell. Owners of expired listings receive a lot of mail and calls from Realtors looking to relist their homes. Sellers are often frustrated at this point with the lack of results. If you can offer them a solution to their problem instead of just another offer to list their homes, they might be very receptive. Handwriting the letters and the envelopes is an important trick to get the mail opened and read. If the envelopes or letters are typed or printed, they often are thrown away without even being opened.

Driving for Dollars This fancily named technique simply involves getting into your car and looking for motivated sellers. You can do this on your way to work or on your way to the grocery store, or wherever. It can be a part of your daily routine. Simply look for houses that have had “For Sale” signs in the yard for a long time. Weeds growing up around a sign are a telltale signal that the home has been on the market for a while and the owner is starting to despair of ever selling. When you see this type of property, either go up and knock on the door, or call the number.

Sample Deal Here is an example of a “subject to” deal to guide you through the process. Let’s say you, as the investor, live in a market that is currently distressed. Periodically you drive through a nice subdivision where you see a new home being built on a vacant lot in an established neighborhood. Construction started when your market was at its peak, and almost immediately afterward things went downhill. Because the home is the only one being built, you surmise that the builder must be much smaller in scale. By the time the home is complete, your local market has become truly distressed. Once the home is done, you see the “For Sale By Owner” sign go up in the front yard. Either the builder built the home on spec or his intended buyers backed out of their contract when the market went down. The “For Sale By Owner” sign is your first clue that this builder is in trouble. This very well could mean that the market has gone down enough that the builder doesn’t want to pay a Realtor’s commission on the house so that he can still make a profit.

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One month later, the sign has a big, handwritten “Reduced!” rider attached. Now you know the builder is motivated. So you call the number and the builder, we’ll call him Joseph, is obviously eager to show you the house. As you walk through the beautiful new home, you talk to Joseph and establish rapport. He confesses that when he started building the house he thought he would have it sold by now. Once he finished it, he says, he had to take a permanent loan, and the $2,500 per month payments are getting painful. Joseph tells you that his price is negotiable and to please make an offer if you like the house. Joseph’s face becomes crestfallen as you explain that you are a real estate investor and you would consider taking the house “subject to,” and explain what that means. You tell him you could take the house and start making the payments for him to relieve him of the burden. He thanks you for coming out to see it but explains that he really wants to sell the house. You reply that you understand completely, and tell him that should he change his mind in a month or so, he should feel free to call you. You wish him the best of luck in selling the house. Seven weeks later you receive a phone call from Joseph, and he asks you to explain how the “subject to” process works again. He says he barely made the last payment and he can’t make the next one, which will be late in one week. He really doesn’t want to mess up his credit. Joseph originally thought he was going to make close to $70,000 on the house when it sold. But due to the market downturn it was worth $30,000 less, which eliminated being able to pay the Realtor’s commission, so he put it up “For Sale By Owner.” Then he reduced it and reduced it again. Realtors have been calling him about listing the house, but he hasn’t been willing to do that because he didn’t want to give up his profit. Now he has to move it or he’ll ruin his credit and won’t be able to build anymore. He says he would be willing to walk away from the house and give the deed to you if you could give him $10,000 so that he could recover his reserves and walk away with some money. After some negotiations, you agree to give him $5,000 and make the payment that is due next week. Relieved to be free of the house, Joseph signs it over to you with the understanding that you will either refinance it or have it sold within three years.

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“Subject To” Pro: Easier to prove “seasoning of title” when you are the title holder; easier to refinance. There are some things to consider before taking over the deed. You will want to check out the title to make sure the owner is on title, and that there are no other liens on the title that you are not willing to take over. Also, you will have the owner sign an authorization to allow you to have access to their mortgage information. You will need this, as you will be responsible for the remainder of the mortgage. Because of the short notice, you were not able to start advertising in advance, but quickly put the house on the market as a rentto-own home or listed it with a Realtor if you wanted. Unlike Joseph, who advertised only by the “For Sale By Owner” sign in the front yard, you advertise heavily using newspaper ads, putting flyers up at a nearby hospital (as the neighborhood appeals to doctors), and multiple signs. Soon enough, you receive some calls and have several showings. About four months later (remember, this is a slow market), a new doctor at the hospital, named Ellen, who has not-so-good credit, is interested in the house and fills out a rent-to-own application. Because the market is down, option fees tend to be lower and premiums over the purchase price aren’t quite as high. After reviewing the application, you approve it and Ellen gives you a 1½ percent option fee and a monthly rent of $2,695, with a $400 per month credit toward the purchase price. The agreed-upon purchase price is 3 percent above market value for the home. Because you had some equity spread when you accepted the deed from Joseph, and you are receiving a slightly positive cash flow in rent from Ellen, you stand to make a nice profit. “Subject To” Pro: By being on title you qualify for longterm capital gains tax rate versus short-term, if you hold the home for longer than 12 months. As you can see, when you find the right property, “subject tos” can be very lucrative. In this example, we had a win-win-win. Joseph won because we saved his credit and he got a little money back to

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replenish his reserves. You won because you made a nice profit. Ellen won because she was able to get into a nice, new home despite having poor credit. Depending on where you live in the country, this could be a higher-end example, but many times “subject tos” can be very creative. Some sellers will pay you to take the deed to their homes if there is not enough equity in the homes, or they might need to pay the second mortgage payment, for a certain number of payments, and so on. You can do so many creative things with this technique. More information on “subject tos” can be found in Investing in Real Estate with Lease Options and “Subject To” Deals, by Wendy Patton, but the most important thing with “subject tos” is to be ethical and live up to the trust that the seller placed in you. The best way to do that is to make sure that the numbers add up to a profit for you. If you have structured the deal wisely in the beginning, it will be very easy to follow through on your word and keep the seller happy. There are many ways to tie in getting the deed and also shortselling and foreclosures, which we will discuss in the next chapter. They go together very well in many cases.

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CHAPTER

10

Invest in Foreclosures and Other Hidden Bargains

F

oreclosures are the booming industry of depressed real estate markets. When markets slow down, invariably the foreclosure rate goes up as more people are unable or unwilling to make their payments. As we talked about in the chapter on market cycles, the peak of foreclosure activity usually means we are near the bottom of a real estate market. RealtyTrac, a national foreclosure monitoring service, is reporting unprecedented numbers of foreclosures in some parts of the country. Many of the biggest previous boom markets are high on the list. This is due in some part to builders overbuilding, with hopes to sell to investors and speculators in these markets during the boom. Foreclosure Pro: There are lots of them in today’s market! Down markets produce high numbers of foreclosures, allowing you to pick and choose your deals. Let’s talk some about the foreclosure process. This is a very simplified version of foreclosure steps. An entire book could have been written on this topic in addition to the other strategies. The intent here is to make you familiar with the process of foreclosures, but you will not be an expert. As we talk about the process of foreclosure, we will also go over the four main stages when you can buy a property that is in pre-foreclosure or post-foreclosure. Keep in mind that becoming a foreclosure investor is a lot of work. It is quite possibly the most complicated form of real estate investing. If you’re looking for a hands-off way to invest in real estate, this is 103

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Four Stages to Buy a Property in Foreclosure ■ ■ ■ ■

Pre-foreclosure Buying at auction Buying during redemption (if applicable) Bank owned

not it, but it will be valuable for you to have a working knowledge of the foreclosure business.

Stage 1: Pre-Foreclosure Foreclosures will vary from state to state because the laws are different. Generally, however, when homeowners fall behind on their payments by three months or so, the bank’s representative will enter a Lis Pendens (lawsuit) with the county clerk’s office (this may be a different office in some states). This means the homeowners have officially defaulted on their promise to pay the loan. It is still possible for the homeowners to pay all of the back payments and any fees at this point and keep their homes. Lis Pendens must be posted. They can be found in local newspapers that publish legal notices. To buy at this stage, the investor will need to reach an agreement with the homeowner. The homeowner still owns the home. You also might need cooperation from the bank because most folks owe more than the home is worth. If that’s the case, you will negotiate a short sale with the lending institution to buy the property for less than the amount owed. In some cases you may negotiate a short sale with the bank even if the homeowner owes less than what the house is worth. If more than one mortgage exists, the investor may negotiate a short sale with each lender. Often lenders of second, third, or fourth mortgages will accept large discounts off the original loan amount, creating the potential for large profits for the investor. They do this because if the home is sold at auction or foreclosed on, they might not receive their loan back at all, or might receive very little. The farther down the line, the more they are willing and ready to negotiate.

Stage 2: Buying at Auction After the Lis Pendens (the lawsuit filed by the bank to foreclose), more time passes (typically one to three more months). At that

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point the bank may foreclose on the property. In most states, this means that the property is put up for auction at the courthouse. The bank will set a minimum bid for the amount it is owed. Anyone else is free to bid higher to buy the house. For the investor to buy at auction, the investor must overbid the bank and any other buyers to purchase the home. The Lis Pendens that are posted contain the date of the auction, if the debt hasn’t been satisfied. This particular method requires deep pockets or readily available private funds, as any home purchased at auction typically must be paid in full that same day. This method is probably also the most risky simply because you, as the investor, are rarely able to get inside the home beforehand to assess its condition. Many of today’s auctions are also very competitive, which drives up prices. Buying at the auction is not usually a good method for a newer investor. The only time when it might become relevant for you is if you’ve already been through the home, and you have something in the works with the homeowner. When discussing foreclosure, we also need to address properties with multiple liens, which can be quite common if a homeowner is falling behind in payments. Possible liens are: first mortgage, second mortgage, third or fourth mortgages, tax liens, contractor liens, city grants or mortgages, and homeowner association dues. If the homeowner fails to pay, for example, on a second mortgage while keeping the primary loan current, it is possible to foreclose and auction the property. In this case the primary mortgage holder typically will buy back the property to protect its interest if there is still large debt owed on the first. Liens are positioned or ranked. A primary mortgage would be a first position, meaning it takes precedence over all other liens. The second position typically would be a second mortgage, if one exists. It would take precedence over all other liens except the primary mortgage. Liens are given precedence based on the order in which they are recorded. When a debt is foreclosed that takes away the property, many of the liens positioned below that debt will be wiped out as a loss. Not all liens are subjugated, however. Property tax liens, for example, must be satisfied no matter what position they hold. For an investor, it is critical to check the title work of a property in foreclosure or being auctioned. It is solely your responsibility to make sure that the title is unencumbered or at least that nothing

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unexpected is recorded against the title. If you buy a property in foreclosure, you are taking responsibility for any other debt against the property! If you buy a property in foreclosure that has $12,000 in unpaid property taxes and $750 in unpaid water and sewer bills, you have just agreed to pay those debts as well. Foreclosure Con: Foreclosures can be high risk if you don’t do your homework. Make sure you check the title before you buy!

Stage 3: During Redemption In some states, after the sale the owner will have what is called a redemption period. This is a period during which the owner can “redeem” the property by paying the full balance due. This doesn’t happen very often. Occasionally, a homeowner can refinance and keep the home. Many states do not have a redemption period. In those states, the high bidder or the bank itself receives title to the home much more quickly. The only person who has the right to redeem is the homeowner, who was foreclosed on. If you, as the investor, wanted to redeem, you would have to work in conjunction with the former homeowner. It is also possible to buy the property from the foreclosing lender during this stage. Not all lenders will work with you during redemption, but sometimes persistence pays off and you can buy the property before it is put up on the market (sometimes a short sale is still possible).

Stage 4: Bank-owned Properties After the redemption period, if there is one, the bank is free to dispose of the home in whatever way it sees fit. Typically it is listed by a Realtor on the MLS. Other times it may be put up for auction or sold as a block of properties to a large investor. At this point the process is very much like buying a regular home for sale. The property typically would be listed on the MLS by a Realtor. In many areas, the banks are exempt from providing required seller’s disclosures that a homeowner would need to provide. These disclosures tell of any known defects or issues with the property. It is very important to have a home inspection performed to be aware of any potential problems, especially

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when buying a bank-owned property. One advantage to buying at this stage is that the purchase will come with a clean title. Any other liens against the property will be paid by the seller and not passed on to the buyer, unless specifically disclosed. This can help reduce risk. The downside to this method is that in recent years, as foreclosures have soared, so has the listing price of these homes. It has become much more difficult to get bargains. The listing price of these homes many times is right at full retail price, at least initially. This is where making a lot of offers comes in. Eventually, you might get a bank to accept a low offer and get a good deal. When a bank takes a home back, it is often in less than perfect condition. For anyone who has bought a foreclosed home, you know that can be a huge understatement. Foreclosed homes can sometimes be in horrible condition! Resentful owners who lose their homes can maliciously damage the property. Vandals can damage the property when it sits vacant. The bank itself can damage the property. This sounds funny, but in northern climates banks will not pay to heat most foreclosed properties during the winter. If they fail to winterize the property in time, or if the winterization is not done well, the result is burst plumbing. The water is left to soak into the house and can cause thousands to tens of thousands of dollars in damage. The result of this damage, wherever it comes from, will lessen the value of the home. When a bank puts a house on the market, it knows that if it is in poor condition it cannot get full price. And the longer the house sits on the market, the more the bank will reduce the price. Foreclosure Pro: In a down market banks are motivated sellers! The longer a home sits on the market the more the bank will reduce the price and the more it is willing to negotiate. At the same time, when a market is down, there is a glut of foreclosed homes coming onto the market. Combine that with the many regular sellers already trying to sell their homes, and you will find that the supply far outstrips the demand. This pushes prices down. Hence the bottom of our market cycle.

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The key to buying a home in foreclosure, as with any other real estate investment, is making sure the numbers work and planning your exit strategy. Because of the substantial rise in foreclosures, this creates tremendous opportunity. Foreclosures are more likely to need renovation work than many of the other forms of real estate investing we’ve discussed so far. If you do not have much experience with budgeting for renovations, we strongly recommend that you get one or more contractors whom you trust to help with estimates. Not budgeting enough for renovations is the most likely way for an investor to go over budget, cutting into profits. In addition to the boom of foreclosures, there are other hidden bargains in distressed real estate markets. These bargains also exist in strong markets, but they are less frequent and there is more competition for them. We call them hidden because they are less well known than many other common investing techniques, and as such can create wonderful opportunities, with less competition.

Tax Forfeiture When a homeowner fails to pay property tax, the local government may take the property and sell it to recover the unpaid taxes. Unpaid taxes take precedence over any other type of lien, so they must be satisfied first. These properties are usually sold at auction. Mostly you will see vacant land being forfeited to taxes, but sometimes homes, too, are lost. Local governments typically will post notices of sales on their Web sites.

Law Enforcement Seizures The Racketeer Influenced and Corrupt Organizations Act, or RICO Act, allows (among other things) law enforcement agencies to seize personal property, including real estate, from arrested criminals in organizations such as the Mafia and drug rings. The law enforcement agencies can range from local law enforcement, like police and sheriff’s departments, up to the U.S. Marshals. This property is then sold at auction. Unlike foreclosure auctions, typically you can view this property before bidding. For more information about U.S. Marshals property sales, go to www.usdoj.gov/marshals/assets/nsl. htm. Local law enforcement agencies often post notices of sales on their Web sites, too.

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Probate Estate properties that are tied up in probate can be a great option for investors. Often the heirs of these properties want them sold quickly, particularly for heirs who live out of state. An investor with deep pockets or using OPM (Other People’s Money) can work with probate attorneys to find bargains if the deal can close quickly. These homes may need some updating, but often are fairly well cared for.

Vacant Properties The best way to find vacant properties is to drive around (or have someone else drive around for you) to look for run-down, vacant, or abandoned properties. Every city has them. Once you identify them, you can look the owner up on local public records. Many times the tax bills are sent to a different address because the owner has moved. By sending handwritten letters to the owner, you can try to establish contact and purchase the property. Like foreclosures, vacant properties often need more renovation work than any other type of properties because they have been sitting empty and neglected. Because of this, however, you can often purchase them at substantial discounts.

HUD Auctions The Department of Housing and Urban Development also is forced to foreclose on properties. Often they will list them initially on the MLS through a realty company, which is one way to buy them. Periodically, however, they will hold auctions to move property. Investors can view these properties before bidding. To view HUD homes for sale in your area, go to www.hud. gov/homes/.

VA Auctions The Veterans Administration forecloses on defaulted property purchased with VA loans. Like HUD, they will often list the property initially on the MLS, but periodically hold auctions. VA homes can be seen at www.homeloans.va.gov/pm.htm.

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Internal Revenue Service The IRS seizes property for nonpayment of taxes and auctions them. Per the IRS, “the right, title, and interest of the taxpayer in and to the property is offered for sale subject to any prior valid outstanding mortgages, encumbrances, or other liens in favor of third parties against the taxpayer that are superior to the lien of the United States.” Property bought through IRS auction is subject to a redemption period of 180 days. To view a list of property being sold by the IRS, go to www.treas.gov/auctions/irs/cat_Real7.htm. Seasoned full-time investors are often aware of these hidden bargains, but the average or beginning investor is not. This reduces competition. Also, many full-time investors only pursue particular avenues for buying property, and there simply isn’t time to stay on top of all of them. Combine that with the higher property volumes in down markets, and it makes for tremendous opportunities for investors looking for bargains to add to their portfolios. Again, none of these strategies are hands-off strategies. However, if you’re looking to spend lots of time on your real estate investing— one or more of these will be outstanding for you. You can also use the multiple streams of income approach. This approach is very powerful. A large number of the major real estate players use it to run their lives. Here’s how it works. You spend your time on one of the real estate investing strategies that we’ve discussed here. You generate revenue using that strategy, and then take that revenue and send it into a hands-off real estate investment. This method is very profitable. You use one real estate investing method to generate revenue. And then you send that revenue into a hands-off investment that runs itself! This is why the hands-off investment is so powerful. It works for both the experienced and novice real estate investor. The experienced investors should keep doing the real estate investing that they like and are comfortable with. They can do the hands-off investments also. Let’s talk about the brand-new investor. This is the person who has a full-time career of some sort, possibly a family, too, and has very little time to invest in real estate. The hands-off investment is absolutely golden for this person. In fact, this might be the only way this person ever gets started in real estate investing. The daunting thing for novice investors is getting started. Getting started is very difficult when you have a full-time job and a family. The hands-off

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real estate investment allows novice investors to get started. It also allows them to gradually ease themselves out of their jobs if they want to. On our investing tours, which we discuss in Chapter 19, The Power of Group Buying, we focus exclusively on these types of hands-off investments. They work beautifully for both the full-time investor and the brand-new person. In the next chapter, we will cover how to find builders in distressed markets and how to negotiate different types of discounts from them.

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CHAPTER

11

Buy Unsold, Discounted Inventory from Builders in Distressed Markets

A

mid endless media speculation about whether there was a real estate bubble, and if there was, when it would burst throughout many of the hottest real estate markets of 2004 and 2005, the bubble either burst or deflated rapidly. Home builders had been building at unheard of rates. In areas such as Las Vegas, Phoenix, Washington D.C., and much of California and Florida, real estate was appreciating at more than 20 percent per year. In some cases, appreciation was nearly 50 percent in some years! It was a boom in which you could throw money at a property in any of those areas and be practically guaranteed to make a huge return. A buyer would put a deposit on a home and by the time it was built, it would have increased in value by tens, if not hundreds of thousands of dollars. Now, in those same areas and others in similar situations, we have seen the market change dramatically. Buyers who came in late, trying to speculate on homes in hopes of making huge profits, found themselves stuck. Their investment hadn’t gone up in value. They weren’t poised to sell and make tens of thousands of dollars. In some cases, their properties were worth LESS than the contract price. Builders found themselves in the same boat. Suddenly they were unable to move inventory. In the boom times, prices were nonnegotiable and covering closing costs or providing free upgrades was unheard of. Buyers have now started to demand such concessions. In a study by the National Association of Home Builders, surveying

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450 builders, 44 percent of builders were reducing prices, 55 percent offered free upgrades, 26 percent absorbed all financing points for their buyers, and 43 percent paid closing costs or fees. Some builders, desperate to sell homes, were offering free vacations or even cars! Also, buyers in some markets started canceling their construction contracts, often giving up large deposits in preference to closing on properties that were currently selling for less than their contract prices of a year or more before. According to the Wall Street Journal’s Real Estate Journal in November 2006, Texas-based builder D. R. Horton Inc., the nation’s biggest developer, reported in Fall 2006 that contract cancellation rates were at 40 percent. Standard Pacific Corp. had 50 percent of its contracts fall through in the third quarter of 2006. From the third quarter of 2005 to the third quarter of 2006, median home prices nationally were down 9.7 percent. Seasoned investors pulled out of many markets, and would-be investors quite often got burned. The real estate “boom” was over. Or was it? Real estate is, if anything, location-based. In 2004 and 2005, while most of the country was experiencing rapid appreciation, in Michigan it was anything but. Appreciation rates were hovering around zero, and in some cases property values were declining. Now, when the hottest markets of the “boom” time have gone cold, the new hot markets are emerging. Just as Las Vegas, Phoenix, San Diego, and Miami, to name a few, were the hot markets of 2004 and 2005, areas such as Biloxi, Mississippi, New Orleans, and Houston show evidence of being new hot markets in 2006, going into 2007. Some would-be investors will get out of real estate, but many seasoned investors will go right on making terrific sums of money by choosing their markets wisely. Will all the seasoned investors target the new hot markets? What happens with all of the properties that the builders are having trouble selling in the newly depressed markets? A savvy investor finds opportunity where the novices overlook. The builders stuck with inventory that they can’t sell are motivated sellers, and hearing “motivated seller” is like music to the smart investor’s ears. The builders already are offering price reductions,

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free upgrades, up to four years of rental payments, closing assistance, and more to sell their homes in the markets that suddenly went cold. All of those bonuses do not necessarily add up to a good deal for an investor, but they might if you are going to occupy the home yourself. The market value has gone down in these cold markets. In some cases it is still going down. When you add up all of the concessions the builder is currently offering and the reduced price, the result is the current market value. To make money on a property like this, you can’t just buy at market value and count on appreciation. Appreciation has temporarily fled these markets. All markets do eventually come back. This is called market cycles. In fact, the current downturn in many of these markets is something of an anomaly. Many of the factors that drove the prices up are still very much in place in those areas. Employment is good, and new jobs are being created. Interest rates remain low. People are moving to those areas, so the demand for homes will continue. Many experts are predicting that these former hot areas will recover quickly.

Given that those markets are likely to recover, there is strong potential for investors. Couple that with builders being motivated sellers who can’t hold their properties waiting for the market to turn, and this creates excellent opportunities for the savvy investor or buyer.

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An investor can adopt several strategies when buying from home builders in depressed or soft markets. The best strategy will depend on both you, the investor, and the builder. Even a combination of strategies might be the best approach. Strategies When Buying from Builders in Depressed Markets: ■ ■ ■ ■

Outright purchase at a reduced price Lease option Lease purchase Short sale

Outright Purchase at a Reduced Price Obviously, the first option is to purchase the house outright from the builder. With this strategy, not only do you accept all of the closing concessions, free upgrades, and price reductions available to the public, but you would also want to negotiate the purchase price vigorously. The key here is to ensure that the deal you are buying is not only a good deal now, but will be a good deal next year if the prices haven’t recovered in that year. In addition to securing a better price, you might be able to negotiate guaranteed rents or mortgage payments for a period of time. In this case, the builder is guaranteeing rental or mortgage payments for a certain predetermined amount for a given period of time. This helps cover you, the investor, should you have trouble keeping or getting the property occupied or sold. Your exit strategy on this approach could be either to hold the property as a rental until its value has gone up enough that you are ready to sell and make your profit, or, if you have secured a low enough purchase price, to wholesale the property to a home buyer or another investor.

Lease Option and Lease Purchase Another approach would be to lease option or lease purchase from the builder. A lease option is obtaining an option to purchase a contract on a property for a specific period of time. During this time period, you rent the property from the seller. At the end of the option period, you may either purchase the property, renegotiate, or forfeit the option. A lease purchase is obtaining a purchase contract

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on a property for a time period, during which you also rent; however, during or before the end of the specific timeframe, you are obligated to purchase the house. To find out more about lease options, read Chapter 7. Let’s examine each of these advantages in greater detail. There Are Several Advantages to the Lease Option, Lease Purchase Strategy: 1. Fixed purchase price at onset and capture of appreciation during option period 2. Lower payments 3. No mortgage required! 4. Higher price when selling to a rent-to-own buyer 5. Monthly credit toward principal from builder 6. No requirement to perform on option at end of term (lease purchase would require the purchase—the only difference between the two strategies)

1. Fixed Purchase Price at Onset and Capture of Appreciation During Option Period

You determine the purchase price at the time of the contract and any appreciation during the lease period would be yours to capture as profit. 2. Lower Payments

You should be able to negotiate a monthly rent (your payment) to the builder that is lower than your payment would be if you were to buy the property outright and have to make mortgage payments to a bank. This allows you to place a tenant or rent-to-own buyer into the property to make your payments for you with less likelihood of negative cash flow. 3. No Mortgage Required!

You do not have to obtain a mortgage on the property during this time. As such, you do not incur any loan origination fees at the closing, which saves you several thousand dollars in closing costs. The only down payment you might need to make would be your option fee, which you can typically keep very low, many times nothing at all. This will save your cash so you can do more deals with other builders in the same situation.

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4. Higher Price When Selling to a Rent-to-Own Buyer

If you place a rent-to-own buyer in the property, you should be able to collect an option fee from that buyer, which is non-refundable whether the buyer chooses to purchase or not. Additionally, a typical rent-to-own buyer expects to pay a premium for the same home versus a conventional buyer. This allows you to mark up the price (slightly above retail) for an additional profit for yourself. 5. Monthly Credit toward Principal from Builder

You might be able to negotiate a monthly credit from the builder. For each month’s rental payment you can ask for a certain amount (sometimes 100 percent) to be credited toward the end purchase price by the builder, paying down your balance due when you purchase the home. It is not required to offer this credit to your tenant buyer, or if you do, you would credit much less, thereby increasing your profit margin. 6. No Requirement to Perform on Option at End of Term

If you do a lease option and the market fails to appreciate sufficiently during your lease period, you do not have to close on the property or buy from the builder. Lease options can be powerful ways to acquire real estate from motivated builders with very little money out of pocket. Given a lease period of sufficient time, the real estate market is likely to turn around and appreciate again, providing the investor with a nice profit. A lease purchase is a guaranteed purchase that would require you to purchase the home during or before the end of the lease period.

Short Sale Another possibility when buying from a motivated builder is the short sale. In this case, the builder is usually behind on payments and in the foreclosure process. One effect of the sudden swing in many of the hot markets is that foreclosure rates have climbed. In fact, just from the second quarter to the third quarter of 2006, foreclosures rose 17 percent nationally. To find information about foreclosures in your area, check local newspapers that post legal notices or check www.realtytrac.com.

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Smaller-scale builders who either built homes on spec (no prearranged end buyer) or who had their building contract canceled are most likely to be in such a position because they have limited funds. In this case, the builder completed the property but has been unable to sell due to the dramatic change in the local market. The drop in property values might have eaten up all of the potential profit and the builder now is unable to sell. He might owe more than the home is worth. He either fell behind on the payments right away, or after some time his funds dried up. Either way, the lender started the foreclosure process. A savvy investor can step in and negotiate with the lender for a reduced purchase price to buy the property. The investor documents to the lender the new current market value. For example, let’s say the builder built a single-family home to sell for $350,000. Due to the sudden change in the market the value of the home dropped 15 percent, down to $297,500. Every lender has different rules and strategies to follow when negotiating short sales. For the sake of simplicity, we’ll say that in this case there was only a primary loan. To sell the property quickly and not have to complete the expensive foreclosure process and be forced to resell later, the lender is usually willing to take a reduced price on the property. This is typically in the range of 80 to 85 percent of market value. Keep in mind, however, that a lot of things have changed in the foreclosure market. Today, we do not see lenders taking the discounts that they once did. There is no question, foreclosure investing is a detailed and complicated strategy. It takes a lot of time and experience to become an expert. In the county we live in, the average homeowner in foreclosure receives 120 letters from investors. Today, there is a fierce level of competition for these leads. That means it takes time and money just to get the leads. Foreclosure is the most time-intensive investing strategy. If you have lots of time to spend, by all means develop this skill, as it has the potential to be very profitable. If not, other strategies will be more desirable to you. Always keep timing in mind when buying from a builder in a down market. Buying while values are going down can be risky because it isn’t easy to predict how far down they will go. The optimum time to buy is when the market has hit rock bottom and is poised to start climbing back up. In many of the hot markets in 2004 and 2005, rock bottom might come quickly and the upturn could happen quickly or slowly. Most of these areas still have indicators for strong housing

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markets, such as solid employment with new jobs being created, low interest rates, new people moving to the area, and businesses coming to the area. A huge inventory of new construction, in part, caused the oversupply and resulting market change. As this inventory is reduced and with fewer homes being built due to the market downturn, the result might be a swift change where the available supply doesn’t meet the demand. Watching the market inventory can be a good way for investors or home buyers to time their purchases and maximize potential profits. To learn more about timing during market cycles and optimizing the time to buy, refer to Chapter 5. In the next chapter we will discuss when you will want to “buy and hold” your properties versus selling them quickly for a profit.

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CHAPTER

12

The Way to “Buy and Hold” in a Down Market

A

s we’ve discussed, there are enormous opportunities in the distressed markets. Because so many people are looking to sell, bargains are much easier to find than they are in strong markets. Using the “buy and hold” strategy in a distressed market can be effective. You just need to understand a few important points to make the most profit.

Make Sure You “Buy Right” to Begin With This is the most important factor for the real estate investor in the distressed market. If you don’t get the right price to begin with, you could put yourself in a very dangerous position. In a distressed market, values can stay flat, or even negative, for a long time. To be conservative, you need to assume zero appreciation for a long time. The market won’t likely be at zero appreciation forever, but it’s a good assumption to make. If you assume that it will be, you are forced to be conservative with your numbers and investment decisions. For example, the Washington, D.C. market in the 2001 to 2004 period went absolutely nuts. That market saw record levels of appreciation, and some people made an absolute fortune. Homes that were worth $300,000 went up to $600,000 in an incredibly short period of time. The important thing to realize, however, is what had to happen before all of this growth, to make the growth possible. In this market, there was essentially zero appreciation from 1990 to 1999, essentially zero appreciation for nine years. The market was building up steam during all that time. It was

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gaining market momentum. It can take time for a market to do that. And then when it finally does—you sell! But realize this … in this market it took nine years to get to that point. What would happen to investors who couldn’t hold for those nine years? They would have missed out on the big profit when it finally came. We don’t want you to miss out on that big profit. Therefore, make sure that you buy right to begin with. This will allow you to hold properties as long as you need to—and capture the big profit when it comes! How do you ensure that you’re buying at the right value? First, you determine what the home is conservatively worth. We are not interested in maximum retail value. We’re interested in what the home is conservatively worth, and what it will actually sell for in the real world. After you determine that, the second thing you do is:

Make Sure That the Property Comes Close to “Paying for Itself” Each Month This discussion, of course, is about your cash flow position on the property. If the property comes close to paying for itself each month, you are in a powerful position, because this allows you to hold the property forever, with very little cash required to do so. If you can hold the property forever, with very little cash required, you are in a safe, conservative position. It doesn’t matter how flat the market stays or how long it stays flat, because you can keep holding forever with little cash required. Too often we see investors not calculating cash flow correctly, and then finding that a property they thought would be giving them money each month turned out to be one for which they had to pay each month. To calculate cash flow, you need to factor in all of the income and then deduct all of the expenses. All of the income is typically the monthly rent. If the property is a waterfront condo with a private boat slip, you may be renting the condo and boat slip separately. If the property is in an urban area where parking is scarce and your property has a private parking spot, you may be renting the parking spot separately. Investors usually slip up when adding all the expenses. The obvious expenses are the mortgage payments, property taxes, and insurance. Other expenses include association dues if any exist; utility payments,

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if utilities are included as part of the rent, property management fees, advertising costs, lawn service, snow removal, repairs and maintenance, legal fees, and vacancies. You will know how much some of these items cost every month. Property taxes, insurance, mortgage payments, and association dues you should know as part of the buying process. Property management, snow removal, and lawn service can all be determined with a few phone calls to local providers of these services. You will need to estimate the utilities based on reasonable usage. As a general rule, do not include utilities as part of the rent. The tenant should pay them separately. Tenants will be much more conservative if they have to pay utilities out of their own pockets. Advertising costs may be included as part of the property management fee for placing a tenant. If not, you will need to estimate how much advertising you want to do and how long you think it will take to place a tenant. Each time you need to place a tenant, you will incur this cost. Legal fees usually only come about as part of evicting a tenant. Evictions are a part of the business. No matter how carefully you screen your tenants, if you hold property long enough, eventually you will need to evict someone. Save yourself the headache of doing this yourself and hire an eviction attorney. They aren’t all that expensive. The two other expenses remaining are vacancies, and repairs and maintenance. The vacancy rate will vary from market to market. If the market is strong, you might see vacancy rates from 2 percent to 5 percent. If the market is weak, the rates may be 7 percent to 10 percent (or higher). To calculate your vacancy expense, you need to take the total annual rental income for the property and multiply it by the vacancy rate. For example, a house that rents for $1,995 per month generates a gross annual income of $23,940. Multiply that by a 7 percent vacancy rate and you get an annual vacancy expense of $1,675.80. Repairs and maintenance expenses are often estimated based on the annual income. On an older property, you would estimate repairs and maintenance at 10 percent of the annual rental income, or in this case $2,394 per year. On a new construction property, your repairs and maintenance should be minimal. You may want to estimate between 2 percent and 5 percent. I, Justin, recently bought a nice home in the distressed Michigan market. It is a 2,400 square-foot home in a very desirable subdivision. All other comps in the sub were $260,000 to $309,000. I purchased

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the home for $199,000. I put $25,000 into the property and it appraised two days after that for $299,000. Obviously, this is a good deal. It is really a good deal, though, because this house pays for itself every month and will do so forever. Executive rental homes are very common in this area. It kicks off about $50 worth of positive cash flow every month—at 100 percent financing—from Day 1. It is very hard to make this happen on good homes in good areas. As you know, the only homes that show positive cash flow from Day 1 at 100 percent financing are classically the ones in less desirable areas. The real estate is cheaper in less desirable areas, so it makes it easier to get the property to show positive cash flow. I know that this area will come back in terms of appreciation. After all of my analysis, I am confident that this home will actually sell for $299,000 in four years or less. This will result in an outstanding profit. And most outstanding, the home pays for itself every month, which means I can easily hold it forever if I wish—and do something even more powerful …

Go Long-Term and Pay the Home Off Many of the wealthiest real estate investors are not interested in making a quick buck. They are interested in long-term wealth. Long-term wealth is achieved by not spending your investment dollars, and instead, rolling them back into your investing machine and turning them into more money. This is why it’s so powerful to have multiple streams of income in your life. When you have “something else” paying your daily living expenses, you can afford to sell a property in one market and use that profit check to pay down your mortgage on another property. If you keep doing this, eventually you will have homes that are paid off. Now you are in a really great position. When homes are paid off they really create cash flow. There is nothing safer than this position, debt-free real estate. We often find newer investors saying to us “This property that I’m analyzing, it has negative cash flow!” Of course it does … it’s a brand new home, in a good area, and it’s in a strong market. It is very difficult to get new construction in a good area to show positive cash flow, unless you put significant money down. Of course it’s going to have negative cash flow, and so what? As long as the

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overall numbers on the transaction work, it’s a good investment. Negative cash flow is just part of the investment. It seems that investors are happy to write a check for $10,000 on the front end to get into the transaction. They also have to be willing to write some smaller checks along the way. Those small checks that cover negative cash flow are just part of the investment. This is one reason why a lot of folks never get started. They are not willing to go long term. It takes time to build a profitable real estate portfolio. Starting out with some negative cash flow is insignificant. All you have to do is go long term and start paying the property off. Your investments have to start somewhere. People do not give away real estate for free. We also can’t turn back the clock to 1979 and start buying. But you can get yourself started, and commit to being a real estate investor for life. When I was 21 years old, I committed to being a real estate investor for life. And the result of that longterm thinking has been phenomenal. You look at things differently when you’re committed for life. You’re motivated to go long term and use your profit in the right way, on more investments that will make even more money. In the example I shared with you a moment ago, the home I purchased for $199,000, once I have that home paid off, it will kick off approximately $1,600 per month in pure profit. That’s $19,200 per year. If you have just three of those, you are financially free. Put yourself in the right frame of mind. Go long-term and pay properties off. This process does not need to happen overnight. It just needs to happen. Have multiple streams of income in your life. This would mean in both real estate and possibly other income-generating ventures. Don’t spend your real estate profit on consumables. Instead, pump it back into your investing machine and achieve true wealth and financial independence. (Visit our website, www.investingtours.com for a free article on living free and clear.) Now on to our favorite strategy of all …

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CHAPTER

13

Our Favorite Investment Strategy Investing in New Construction, in the Emerging Market, in a Hands-Off Fashion

N

ow that we’ve examined the power of investing in the emerging market, let’s look at the best way to invest in these markets. As we have discussed, there are many different strategies and avenues for real estate investing. We like them all for different reasons. It’s very important to have clarity when investing, so during this chapter we are going to explain our favorite investing method in the emerging market. Our very favorite way to invest in our emerging markets, is this … Investing in a piece of new construction in a hands-off fashion Let’s walk through this method, step by step.

New Construction There are many benefits to investing in new construction versus an existing piece of real estate. One chief benefit is that the exit strategy is easier. All qualified retail buyers either want real estate that is new or at least feels new (especially in an emerging growth area where new construction is the norm). In established neighborhoods, this isn’t the case, of course, because all of the homes are older. This is 127

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what a buyer expects. In emerging areas, however, there is a lot of new construction, and “new” is the norm. If we don’t work that expectation into our investment selection process, we can encounter competition problems. Here is how we work this strategy. I, Justin, “rotate” my inventory— selling older properties and replacing them with brand new ones in my portfolio, with the overall goal of always being to sell a property while it’s still less than five years old. A retail buyer who walks through a home evaluates it. When a home is approximately five years old or less, it still “feels” new. To that buyer, this is a new home. Does this mean that a home can’t be sold if it’s 15 years old? Certainly not. We all know that those homes sell all the time. But to be strategic in my portfolio management process, I want to make my exit strategies as easy and profitable as possible. A 15-year-old home can still be sold, but there are a few barriers. The furnace is now 15 years old. The roof is 15 years old. The buyer knows these things, and also knows that there are other homes on the market that are only four years old. In today’s real estate climate, you need every competitive advantage you can get. And this is one of them. Also, a 15-year-old home can’t possibly look as “fresh and new” as it once did. New construction has a certain psychological “feel” to it in a buyer’s mind. And this “feeling” can last for only so long. It’s much more valuable to understand this reality, and to go along with it, than to slip into denial, and try to fight it. So my goal is to always sell a residential property before its fifth birthday. This doesn’t apply to every single property type, of course. The units that I have in high-rise condotel developments will be long-term investments. That is a different type of investment, and the rules are a bit different. I have several studio units, in unique high-rise developments, that will be in strong demand for a very long time. On these particular developments I will go ultra long-term, pay the properties off, and turn them into “free and clear cash cows.” On “retail buyer” properties, however, like the townhouse and the single-family home, I am rotating inventory and aligning my exit strategy with “retail buyer reality.” A second benefit of new construction is that you can sell the home immediately as brand-new construction that has never been lived in. I never “count” on this to happen, but it’s an additional possibility. A home or condo that has never been lived in is obviously very

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desirable. But reality states that it’s easier to sell a home after you’ve been holding it for three years (so the market can appreciate and mature) than it is to sell it immediately without a hold cycle. This is simple reality and I don’t try to fight it. This is why my quality of life is very high, and filled with minimal frustration. I make reality my partner, and not my nemesis. New construction has another benefit. We get to enjoy some benefits during the build cycle itself. That is especially beneficial on a property that has a build cycle of one year or more. We get to lock in the price of the property before construction starts and don’t have to make any mortgage payments while the property continues to appreciate. Here is another strategic factor: Our ultra-favorite investment is new construction, in a hands-off fashion, in the emerging market, on a property for which someone else is carrying the construction financing. When someone else carries the construction financing, you make no mortgage payments during the build cycle. The builder-developer has qualified for the construction financing. Therefore, he has to make the monthly payments on the loan while the unit is being built. This setup provides an additional advantage: if there are construction delays, the builder is still paying the mortgage during the delay. If you take a construction to permanent mortgage loan, and there are construction delays, and your interest allotment runs out, guess who has to start writing checks? You! With the builder-developer holding the financing, he has to start writing checks. Which one sounds better to you?

Hands-Off Fashion This investing strategy has a second benefit: It can be done so that it takes very little of our individual time as investors. Our quality of life is very precious to us. There was a time when for each of us (Justin and Wendy) our quality of life was not high. That will never happen again. If the numbers on an investment don’t work with us doing close to nothing, then they don’t work at all. We achieve this hands-off investment style in two ways: (1) We focus on new construction, where someone else is doing all of the construction management (making the build cycle hands-off for us), and (2) We use property management on every property (making the hold period hands-off). This is a great way to invest. It allows us to maintain our quality of life, and to spend our time on other things. If you’re

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wise, those other things will not consist of TV watching, but other revenue-generating or life-enriching activities. These other-revenue generating activities could be anything: a full-time high-salary corporate job, other real estate investing activities, other business ownership opportunities, and so on. You always want to have multiple streams of income in your life. These multiple streams allow you to achieve financial independence as quickly as possible. Life-enriching activities can include spending quality time with family and friends, doing volunteer work, enjoying cultural events, watching or coaching your children’s sports or activities, or a host of other things that provide fulfillment.

What Types of Real Estate? Of course we invest in many different types of real estate. They include,but are not limited to: residential (single-family, condominiumtownhouse style, high-rise), multi-family (duplex, quad, apartment building), commercial property, vacant land, and so on. We like all of these. You can do well with every single one of them. Out of all of these, we have three favorites: ■

The single family dwelling (either a true single-family home, or a townhouse)

■

The duplex

■

The unit in a luxury resort/condotel development that allows nightly rentals

Let’s look at these individually.

The Single-Family Home The single-family home certainly has some advantages as an investment. The biggest is demand. Out of all the different types of real estate, the single-family home is the most desirable when it comes to quantity. More people are looking to purchase a singlefamily home than any other individual type of real estate. This lets us appeal to the largest pool of buyers. Far more people are looking to purchase a single-family home compared to those looking to purchase a condominium. The other advantage of the single-family home or townhome is that the exit strategy on the back end is to a retail buyer. This is important because there are more retail buyers,

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and because retail buyers are not looking to make a profit. That maximizes the sales price of the home.

The Duplex The duplex also has significant investment advantages. The biggest relates to controlling cash flow. You already know that it’s very difficult to get new construction to have positive cash flow from Day 1. The duplex is the closest that we can get to making this happen. In many cases, we can engineer the financing so that we get positive monthly cash flow from Day 1 on the duplex. Now, please do not make monthly cash flow your primary goal. Judging an investment based solely on whether it “cash flows” or not is very shortsighted, old-world thinking. However, for those of us who really love the idea of getting positive cash flow from Day 1, the duplex definitely provides that advantage. The duplex is an excellent investment for someone who wants to keep cash out of pocket to a minimum. As stated before, many times we can engineer positive cash flow from Day 1, which keeps additional cash outlay to a minimum. Second, by focusing on new construction, we help ourselves even further. New construction keeps our maintenance expense as low as it can possibly be. The very first year typically will be covered by a builder’s warranty. Usually we also receive additional manufacturer’s warranties on major systems in the home. In addition, we can use a home warranty policy to further control maintenance expense. We do not use a home warranty policy on new construction. The builder covers it for the first year with a builder’s warranty. Everything is brand new, and this mitigates maintenance to begin with. The duplex also helps to mitigate vacancy expense. With a single-family home, if the home is vacant, it is entirely vacant. With a vacancy on the duplex, we still have 50 percent of the building filled.

The Resort/Condotel Development that Allows Nightly Rentals We like this investment as a longer term investment. The unique resort development has very strong long-term durability. This is typically the type of product that we will go ultra long-term with. This is one advantage. In addition, these units get rented on a nightly basis— another distinct advantage. Whenever we can rent something nightly, this increases the amount of revenue that the property generates.

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The typical hotel room is 400 square feet. If you were to take a oneyear lease on it, do you think you would be paying $100 per night? (or $3,000 a month for 400 square feet?) Of course not. The hotel can charge this much because it is writing us only a one-day lease. It’s a major convenience for us to only be obligated to one day. And for this convenience, the hotel can charge much more for that one night. An investor who owns a unit that gets rented on a nightly basis gets to “be the hotel,” and capitalizes on this wonderful advantage. Management fees, of course, are higher with this type of product because the resort is run like a hotel, and the management company is doing literally everything from filling the unit on a nightly basis to daily housekeeping service, and so on. The management typically keeps 40 to 50 percent of the revenue for this level of service. In some markets, however, just 30 percent to the management company is commonplace. This type of investment typically takes more dollars out of pocket. Twenty percent down is the best way to get access to the best financing. The condotel/nightly rental product has not been around very long, and because of this, the lending industry is still getting up to speed. They are more conservative now than they will be in five years. It is possible to get condotel financing at 90 percent. Most folks opt for 80 percent financing to get the better interest rate. This investment is an outstanding one to go long-term with— especially when you focus on a truly unique development that will have long-term demand. These resorts are also commonly on the water, where appreciation has historically been the strongest. But being on the water is not enough. It must be on the water with other amenities, such as a water park, a nearby theme park, or a casino, and so on. We focus only on unique locations. They must offer something that will drive in a high occupancy; otherwise, this investment could be a huge negative cash flow. Be cautious on these, as there are only a few markets where these are a good investment. So in summary, these are our favorite three investment types:

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■

The single-family dwelling (either a true single-family home or a townhouse)

■

The duplex

■

The unit in a luxury resort/condotel development, that allows nightly rentals.

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We have a mixture of all three in our portfolio, as we like to diversify. We also like the other types of real estate—commercial property, apartment buildings, and so on. But these types of real estate require more cash. If you have considerable funds to invest, they may be very good for you. We invest in multiple projects by spreading our capital across many investments, rather than plowing it all into a single large investment. To summarize, our favorite investment strategy is investing in a piece of new construction, in a hands-off fashion, in the emerging market, on a property for which someone else carries the construction financing. We accomplish this by diversifying properties in our portfolio, hiring a property manager, rotating our inventory, and moving the funds upon sale into a property in the next emerging market. This is a phenomenal way to invest in real estate. And when done consistently, over the long haul, this creates a very exciting asset base for the individual investor. This is how we invest the majority of our funds today. We are sure this section of the book was very exciting, with all of the different strategies we have covered. It is now time to examine how much investing you will be able to afford to do, and the details of new-construction investing.

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PART

IV

Creative Financing in a Soft Market When Bank Lending Is Tight

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CHAPTER

14

Determining How Much Investing You Can Afford

duct the following analysis:

A

s investors, we constantly con-

How much investing can I conservatively afford to do right now? This simple question possesses incredible power. We have developed an analytical process that we use over and over again during life, to determine at any moment in time: How much new investing can I afford to do right now? Of course, you can use this same process to determine how much investing you can afford. This question is critically important for several reasons. Our quality of life is very important to us. We guard it very carefully. Our society moves at such a lightning-fast pace that if you do NOT guard it, eventually it will be taken from you. This is especially true once you become skilled in a particular area. We bring up this subject because the same process applies to the real estate investor who must determine how much investing to do. Too much investing (for the amount of capital available), and the investor’s quality of life suffers. We do not want sleepless nights and constant stress. You might be wondering, “How do I keep those things out of my life?” That is what we will teach you in this chapter. Conversely, an investor who does a comfortable amount of investing (for the amount of capital available) has a beautiful quality of

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life. This is the only quality of life we are interested in. We implore you to pursue it. Thousands of people are willing to be completely miserable as long as they are rich. Usually these people haven’t gotten rich yet. Those who have—and have sacrificed their quality of life to do so—realize the importance of having both wealth and quality of life. This life thing is very short. So let’s set you up with tools that will allow you to do as much profitable investing as you can while also maintaining your quality of life at the same time.

A Nice Balance Right now you are probably thinking, “It sounds wonderful to keep my quality of life, but I also don’t want to be so conservative that I don’t get ahead quickly enough.” That point is well taken. That point has been running through my head (Justin) for more than 20 years now, and it is valid. So how have I addressed this point? Through a very specific and powerful process that I’ve developed. Two Sources of Funds

It is so important for an investor to know the basic fundamentals of successful investing. It’s just like the pharmacist who needs to know basic chemistry. Without that foundation of basic science, the pharmacist’s daily work would suffer, possibly hurting a lot of people in the process. The same is true for the investor. The best way to become an investor is gradually. I see so many investors bite off more than they can chew, with disastrous results. There is no need to become a “full-time” investor right away—or ever, for that matter. The most successful investors I’ve known go about things in a different fashion. They establish two sources of incoming funds. Investors have two sets of outgoing expenditures: 1. Living expenses 2. Investing expenses Let’s look at living expenses first. All of us have to eat. We all need a roof over our heads. We all need a car. These are our living expenses. They need to be paid for somehow. Most people pay for them with a job, or with some other form of residual income that they have built over the years.

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Let’s look at investing expenses next. Because you are an investor, or a soon-to-be investor, you realize the critical importance of pumping cash into investments on a regular basis. This is the second set of checks that a person is writing regularly. I call it the second set of checks not because it is second in importance; you know it is #1 in importance. I call it the second set because survival comes first for all of us. It is impossible to be an investor until you have your bills paid. A would-be investor who is burdened in credit card debt and struggling to pay living expenses must figure that out first to become a successful investor. We recommend a great book written by Dave Ramsey called The Total Money Makeover. He teaches you how to live debt-free. We both believe in living debt-free and striving for it each day. Our goal is to teach others how to be more conservative in their investments and to plan to pay off at least their primary residence eventually. There is nothing more liberating then being debt-free. There is a fine balance between this and Other People’s Resources (Chapter 16). This is where the power of having two sources of incoming funds comes into play. We all know how our living expenses are paid for with income from a job. But things get interesting when we examine where “source of funds for investing” should be coming from. Where do most folks get their investing capital? Most folks get their investing capital from their jobs. And for most folks it stops there. This is a gigantic mistake. For most folks, it works like this example: Scenario #1—The Employee Has a job that pays $60,000

↓ Spends $45,000 of this $60,000 per year on living expenses

↓ Spends the remaining $15,000 on investments (typically a 401K, or other hands-off investments that offer a relatively poor return)

The job provides $15,000 per year in investing capital. And that’s it. At this moment things come to a grinding halt. This is a horrific mistake. This person limits the amount of investing that is possible. And the result is a life of financial mediocrity. Expenses usually go up as

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income goes up year by year. And the result is a very mediocre financial life and the necessity to work much later in life than desired. But what if there were a way to generate additional funds that were specifically earmarked for investing only to get this person to put $30,000 to $40,000 per year, or more, into investments. The good news is—there is! As an investor, any time you wish to create additional funds for yourself, there is a very basic and essential way to do it. Do you know where funds come from? Funds come from people. That is the only place they can come from. We use two basic methods to create additional investment funds for ourselves. They are equally powerful. Strategy #1—Act Like a Bank? You find a person who has funds to invest, but who is unsatisfied with the current rate of return.

How difficult do you think it is to find folks like this in our society? They are everywhere. You probably understand the basic premise behind how banks make money. They borrow money at a low rate of interest, and lend it out at a higher rate of interest. In essence, they do not lend any of their own money. They lend other people’s money. Many folks don’t realize that … You can do exactly the same thing. This is strategy #1 for creating more and more investing capital for yourself. Here’s how it works … Again, banks borrow money at a low rate of interest and lend it out at a higher rate of interest. For you, the individual, all you have to do is find a person, who has money to invest (just like the banks do) and wishes to receive a fixed rate of return on that money. As you know, all of the fixed rates of return in our society are also the lowest rates of return. If the person wants a higher potential return, that is not fixed, there is an option for that too, which we will discuss in Strategy #2. For now … This person has a set of funds to invest. For purpose of discussion, let’s say the amount is $10,000. What is the approximate fixed rate of return that the banks offer on this amount? For discussion purposes, we can say it is roughly 5 percent.

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That means there are people sitting out there right now who are more than happy to lend you their money to invest at approximately the same rate of return. Not bad, eh? Of course, certain regulations apply, and rules must be followed. But that’s OK—those rules are in place to create safety for investors. This is exactly how it should be. During our events, we teach what the rules are and how to follow them. We also provide all of our students a system titled How to Use OPM to Fuel Your Real Estate Investing. This system has all the tools necessary to begin recruiting OPM immediately. So with our person who has $10,000 to invest, I am more than happy to provide that rate of 5 percent (or higher depending on the type of real estate investing). You will, of course, create some type of incentive for the person to lend to you instead of the bank. The lender wins by receiving a good return and you win because you have additional funds to invest that you never would have had from your job alone. This is the magic behind this strategy. We have effectively created funds. And because our living expenses are taken care of with the job, 100 percent of these funds get pumped into the investment. And our net worth continues to grow and grow. Strategy # 2—Real Estate Partnerships In Strategy #1, we discussed paying a fixed rate of return to a lender. Now we will discuss a separate strategy that allows you to access additional funds for your investing, but contains no fixed rate of return whatsoever.

Chapter 15 will provide information on forming partnerships for real estate investing. After reading that chapter, your brain should be on fire with respect to the power contained in real estate partnerships. These two strategies: (1) Recruiting additional money, and (2) Recruiting real estate partners, are the entire foundation of understanding how much investing you can afford to be doing. It is very important to have discussed these first. Because until you understand the power of obtaining new money and new partners, you will never get to the level that you should get to as a real estate investor. It’s like trying to power a boat by putting your two hands in the water and flapping them back and forth. You can try it, but that method will be miserably ineffective when compared to acquiring

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a power motor. I see people make their biggest mistakes when they analyze how much real estate investing to do by looking inside their own bank accounts, and asking: “How much money do I have?” This is one question to ask, but it is not the most important one. The most important question to ask is this one … How much money can I realistically expect to recruit within the next 6 months? Combine this number with the funds you have in your bank account and now you know the amount of funds at your disposal. Successful real estate investors have two ways to generate revenue: 1. Their “jobs,” which pay for their living expenses (and provide a few investing dollars, but mainly pays for their living expenses). 2. Their OPM and OPC recruiting machines (which provide the main source of their investing funds and partnerships). This method of keeping both revenue generators in place is the most successful real estate investing method we have seen. We see far too many investors try to become “full time” real estate investors too soon. A typical scenario looks like this: A person has a good job that pays the bills, but hates the job. So she tries to figure out how she can dump the job, and become a full time real estate investor in a very short period. For some people this is possible. But for most folks, it is very difficult to accomplish this in less than one year. It is very realistic to make this transition over the long haul (5 to 10 years). If you are doing things right, becoming a full-time real estate investor is approximately the same as becoming a medical doctor. If you are in it for the long haul, you will make it—guaranteed. If you are in it to get rich quick, you will not make it, period. For me (Wendy) it took me 10 years before I left my corporate job to be fully comfortable with my real estate income.

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Here is the problem that occurs when someone tries to make this transition too quickly: When the job is gone, so is the ability to easily pay for the living expenses. So now she has to “replace” that job income with something. This is real estate investing, not real estate money printing and investing takes time. The job income is gone. That begins to create stress, and that stress begins to show through in every type of action the person takes. Stress shows through when the person is meeting with a partner. Guess what? That person can see your stress. Maybe just subconsciously, but it’s evident that you need to do a deal. Have you ever been called on by a salesperson who needed to make a sale? You didn’t buy, did you? Your partners will behave exactly the same way if you need to do a deal. When we talk with our partners about an opportunity, we couldn’t care less if they do the deal or not. We don’t need them to. If they don’t want to do the deal, that is OK, because other partners would be interested. If we didn’t have a backup plan for the partner or the lack of money, the person on the other end would feel that something wasn’t right. Sometimes when you are in a situation that is more stressed, you will start to make more desperate decisions. These decisions can lead to long-term financial mistakes. Don’t leave your job until you are truly ready. This is the very best way to engineer your life. Whatever revenue stream you currently have in place to pay your bills, keep it in place. Reduce your living expenses. Live as inexpensively as you can. Rely on partnerships to increase your investing capital. Keep your cash reserves high. Never be in a position where you need to do a deal. Increase your investing slowly. Don’t “dump” your job right away. Simply decrease your reliance on it, slowly, year by year. If you can decrease your reliance on your job by just 10 percent per year, in 10 years you will be free. If you are making $60,000 per year in your job, you only need to earn $6,000 in Year 1 to decrease your reliance by 10 percent. And this is a very realistic, conservative number. This process does not need to happen overnight. Can it be done in less than 10 years? Certainly it can, but it does not need to. Justin & Wendy’s Advice: Slow and steady wins the race.

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You might be asking, “If I am working 50 hours a week in a fulltime job, how am I going to find the time to invest in real estate?” Here is where things get interesting—because you are absolutely correct. While working a 50-hour job, there is not much time available to do certain types of real estate investing. You wouldn’t want to try to self-manage a large rental portfolio, for example. However, there are certain types of real estate investing that DO work well for someone working a 50-hour job. You only have to focus on the right types of real estate investing. The right type is our favorite type of investing—investing in brandnew construction in an emerging market. This could be a piece of pre-construction, or a piece of single-family new construction—we love them both. This type of investment is a hands-off investment. And it works beautifully for the person working a 50-hour job. With all of that said, let’s get into the specific numerical analysis. This analysis will allow us to determine specifically “how much” real estate investing we can conservatively afford to do at any point in time.

Numerical Analysis: How Much Investing Can I Afford to Do? As you have heard many times, we are very conservative real estate investors. What does it mean to be conservative? In our minds, it means to invest safely. It means to do less real estate investing than you are able to do. It means to always maintain adequate cash reserves. These are some of the things that I do to make investing a very comfortable process and to maintain my quality of life. It is on this “mental foundation” that I base all of my numerical analysis. It is always easiest to do numerical analysis when examining a very specific situation, so let’s do that. This way, you can follow along with pen and paper, outlining your specific situation. Say a person has $50,000 to invest. Remember, this $50,000 is pure investment funds, meaning that the person does not need them to live on. Let’s say this person is considering a new construction that is very early in the process, which has a purchase price of $350,000, with a required reservation deposit of 10 percent. Some other details to consider: ■

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This project has not broken ground yet, and will not be completed for approximately two years.

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The contract is assignable with developer approval (meaning that the developer is facilitating re-sales from his sales center for a commission. And it’s typically quite easy to get his “approval” because he’s getting paid).

Step 1: First, we determine how much short-term cash (next

6 months) will be required to fund the transaction. This is a very easy step. We can see it will require a $35,000 deposit to start the transaction. No additional funds are required during the build cycle. It is “sit back and wait” until construction is complete. When construction is complete, if you are holding the property, you may or may not bring in additional funds, depending on the type of financing that you select (more on this later). Step 2: In this example, we have determined that just $35,000

is required to fund the transaction for a full two years, with no additional cash required until the project is completed. The next thing we determine is how much additional cash will be required when the project is completed and financed (with permanent financing to hold and rent the property for a period of time). You talk with your mortgage professional and determine that it makes sense to finance the property at 90 percent financing. You already have 10 percent in the transaction. Recall from earlier that just because you’re doing 90 percent financing, and already have 10 percent in, does not mean that it won’t take more cash to finance. Closing costs come with every transaction. In this example, let’s say that we estimate our closing costs to be approximately 3 percent of the purchase price, or $10,500. Running Tally of Funds Due: Let’s keep a running tally of how many funds are due (and when): Day 1—$35,000

At this point it’s important to have a sidebar discussion about an important topic, our intended exit strategy. Part of determining “what we can afford” comes from what our intended exit strategy is. There are three basic exit strategies for the new construction investment:

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1. Assign before construction is complete 2. Hold and rent short-term (1 to 2 years) 3. Hold and rent long-term (3 years
) Which one is best? That detailed discussion occurs in Chapter 20, when we talk about exit strategies in the entire chapter. For now, we’ll remain focused on the topic at hand. We are currently determining how much cash it will take to make this transaction “go” from start to finish. For exit strategy #1, the only additional cost incurred is an assignment fee to the developer for the resale. This fee is taken out of the proceeds from the sale or from our initial deposit; it is not an additional check that we have to write. So for our purposes here, with exit strategy #1, no additional cash is required beyond the $35,000 we have already calculated. For exit strategy # 2, the short-term rental hold, through our discussion with our mortgage broker, and after conducting our cash flow analysis (Chapters 15 & 17), let’s say we have determined that this property will carry a $200 negative cash flow per month and will require closing costs of 3 percent ($10,500). Let’s say that we have decided to do a one-year rental hold on the investment: $200 per month  12 months  $2,400 This $2,400 is an additional piece of the investment. As discussed before, it is not money we are losing; it is simply part of the investment (it is very rare to see new construction cash flow; in emerging markets we accept the negative cash flow payment as part of our investment). We will put these funds into our running tally. Running Tally of Funds Due: Day 1—$35,000 down Two years later: Closing costs of $10,500, plus negative cash flow of $2,400 Total Funds Invested, 3 years from today  $47,900 Plus, plan for any unexpected expenses (vacancy, repairs, and so on)

You can now run a second analysis, based upon another question. During the next two years, speaking conservatively, how much additional investment funds will I have available? I am looking at

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the period of “two years” because that is when the property should be completed, and when additional cash could be required. When answering this question, respond conservatively. We are all tempted to give the “best-case scenario” type of answer. But the best-case scenario is not always the most realistic. Be realistic. Let’s say you determine that you will conservatively have an additional $20,000 to invest in the next two years: Running Tally of Funds Due: At the three-year point (after renting the property for one year): Grand total required: $47,900 Funds available: $70,000

At the moment, these are nice, conservative numbers that work. But before you decide “you’re good to go!” let’s introduce some other factors. Sorry, it’s our job to make you prepared, not to just keep things simple. What if the home doesn’t rent right away? It takes money to solve this problem, doesn’t it? Where will it come from? You got it: from your “funds available.” You are probably starting to see how important it is to get good at recruiting other people’s money. Money can run out quickly for the professional investor. Vacancies have never scared us. They definitely irritate us once in a while, but they never scare us. We always carry plentiful cash reserves and when you do, very few problems will ever scare you. You can solve so many problems with reserves. In our next chapter we will discuss how to work with others to get more reserves. Today, the only real estate problem that truly scares me (Justin) is when a bat gets stuck in my attic. Even though the cash reserves easily pay for an exterminator, the bat itself is, well … scary. For me (Wendy), the thing that scares me, in real estate, is mold or toxic problems. These are usually not an issue with new construction. So, if you have plentiful cash reserves, you will never be truly scared. How much is enough? Let’s take a detailed look: When acquiring a new property, we always retain a minimum of three months, preferably six months worth of monthly holding costs in cash reserves. You will be able to determine your holding cost of

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the property when you talk to a mortgage lender, and after reading Chapter 17. It involves: P—Principal I—Interest T—Taxes I—Insurance Let’s say that this property has a monthly PITI of $3,000 per month. If you are aggressive, and choose to hold three months of cash reserves, you will add $9,000 to your cash required. If you are more conservative, and want to hold six months, you will add $18,000 to your cash required. Make sure you also consider any HOA (Home Owner Association) fees. The markets in which we’re investing don’t take anywhere near six months to rent a property. We would cut the rent to the “guaranteed to get a tenant” rate way in advance of six months. Then why do we sometimes hold six months of reserves? We are conservative. If you always plan for the worst case, you will always have a cushion. That cushion protects your quality of life. It will allow you to have nice, restful nights. It allows us to relax and read a book without having a meltdown about everything we have going on. You are starting to learn that investing varies greatly depending upon the individual who is doing it, and this is how it should be. All of your investing should fit your individual style. Otherwise, guess what happens? You will be uncomfortable, and that will make you frozen and you won’t do the investing. Your financial achievement might suffer for life. Do the type of investing that fits your style. Some investors are extremely aggressive. They push themselves to the brink, because they know that “I have friends who have money. I make lots of money myself and I’ll have no trouble coming up with more.” If that is who you are, that is fine, go for it. Other investors are ultra-conservative. They are thinking: “six months isn’t enough for me. I want one year of holding costs in the bank. This is fine, too. One method is not better than the other. Here is the only bad method: Taking no action at all. That method is awful! Do whatever you need to do to get yourself started. Just get started. The first few are always the hardest. And then after that, you will be over the hump for life. Just get started.

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Running Tally of Funds Due: Day 1—$35,000 down 3 years from today—$47,900 4 years from today—$50,300 6 months of holding costs: $3,000  6  $18,000 Grand total required: $68,300 Funds available: $70,000

Now you have a very comprehensive estimate of your costs. Someone who is more aggressive might only hold three months of holding costs. This person’s grand total would be $59,300. Taking the most conservative route of $68,300, realize that a property that we initially got into for $35,000 ends up requiring almost double that to take the investment to completion. You are now equipped with a very powerful analysis system that will allow you to invest safely and comfortably. Make sure that you really sink your teeth into this chapter and fully understand everything that it offers. Some of you might have read this and thought, I don’t have $70,000! Or, I want to do more than one property because I want my returns to grow faster than one property at a time. Here is the good news: In Chapter 16, we will be examining The Importance of Using Other People’s Resources. This is a very powerful strategy that allows us to do as much investing as possible, and stay very safe—all at the same time. We will also cover a powerful strategy that allows us to maintain cash reserves that we did not have to earn. In the next chapter we will discuss the best way to fund your new construction investments. There are many creative things you can do when financing real estate. This can also really affect your reserves needed, and the cash flow on your investments.

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CHAPTER

15

Successfully Financing Your Real Estate Investments

F

inancing your investment is a critical component to your investing. Not only is the financing critical, but the type of financing you secure is just as important. It can have the power to turn a good deal into a mediocre deal or vice versa. Educating yourself about financing can literally save you thousands of dollars. New construction financing has two steps: the construction financing and the end loan financing. The type of new construction investing will determine whether these steps are separate or simultaneous. First, let’s explain the differences. Construction financing is the loan obtained for the build cycle of the property. A construction loan usually will include the cost of the acquisition of the subject lot, and the cost to build the dwelling. Interest rates on construction loans typically are tied to the national prime rate and are higher-cost than regular mortgages due to the increased risk for the lender. End loan financing is very simple. It is the mortgage secured against the property once it is built that you use as your “permanent financing.” Most of the time we have the builder/developer carry the construction financing on the project, therefore, we usually don’t even have to think about it. Three Finance Options for Construction: ■ ■ ■

Builder financed Buyer financed construction-to-perm loan Buyer financed construction-only loan

When you invest in a piece of new construction, the construction financing can happen in three ways. In the first option, the builder 151

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secures the construction financing on the project. In this case you are not carrying a loan on the property while it is being built. You are required to obtain an end loan mortgage-only once construction is complete. The second option is a construction-to-perm loan, in which you secure a loan at acquisition that modifies into a traditional end loan when the home is complete. The third option is a construction-only loan, in which you secure a construction loan at the onset and once construction is complete you obtain a separate end loan. Let’s examine each option in further detail.

Option 1: Builder Financed In most cases, this option in which the builder secures the loan, is the best choice. If you are investing in a large resort development or a condominium tower, it will always be this way. Usually you would provide your own construction financing only when doing a single-family build. But with the negotiating power of our group, we have been able to negotiate for the builder to hold the construction financing—even when building our investors’ homes! One benefit of having the builder carry the financing during construction is that if there are delays, such as natural disasters or construction problems, it will usually cost the developer more money and not you. No mortgage is required for you during the build cycle. Typically, you would see the first option, in which the builder secures the financing, in a condominium project and a planned-unitdevelopment (PUD). A PUD is a planned community with common open space, such as a set of townhomes with amenities such as a swimming pool, fitness center, and so on. The builder must pre-sell a predetermined percentage of the units to obtain financing. As an investor, you help to fulfill the developer’s pre-selling quota, allowing the project to begin. Because the builder is securing the financing on the project, you as the investor are not required to get a loan during construction. This can be a huge advantage. In fact, if you resell the property before construction is complete, you will never have to secure your own mortgage. You, of course, always want to be prepared to close on every single property that you secure. Selling before construction is complete can be one of your intended exit strategies, but it should never be the only one. As an added advantage for the investor, when the builder secures financing, the investor does not make any payments or pay any

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interest during the construction process. This reduces your carrying costs on the project. You are also less likely to be burdened by unexpected additional charges during the construction. These items will vary from builder to builder and contract to contract. Review your contracts carefully to make sure the builder won’t be passing on any additional costs to you. Key Advantages to Builder Secured Financing ■ ■ ■ ■

Not using your own credit during construction No interest payments during construction Less likely to pay for unexpected charges If you sell before construction is complete, you never have to get a loan

Option 2: Buyer Financed Construction-to-Perm Loan A construction-to-perm loan is your second new construction financing option. You are more likely to see this type of financing for singlefamily home developments. In this situation, the builder is selling you the lot and a home plan he will build for you. You, as the investor, are required to obtain financing to pay for the lot and construction. A construction-to-perm loan provides you with financing during the construction process and once the home is complete, the loan modifies into a permanent end loan. The advantage to securing your own financing is you need substantially less money out of pocket, at least initially. In this case you are not giving the builder a deposit of 10 percent to 20 percent. Your actual out-of-pocket costs can be exceptionally low. Some lenders may allow you to finance your project by lending you a high percentage of the home’s projected appraised value when completed. This can substantially decrease an investor’s down payment costs. As an investor with limited funds available, this can provide you with a substantial saving; however, when you obtain your own financing, there are additional risks. The first risk is interest payments. A typical construction loan will have an amount of interest charged by the lending institution to pay for construction costs. Some lending institutions may allow you to roll these interest costs into your overall loan. This will minimize your out-of-pocket exposure on the transaction. However, should the construction period run longer than

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expected, which happens very frequently, you might incur additional interest costs or lender penalties. The next risk is additional building and materials costs. If the builder runs into additional costs, such as higher than expected site preparation costs, increased impact fees (taxes), or unexpected increases in building costs, you can be sure these costs will be passed on to you. So although securing your own financing will have lower initial costs, it might be offset by higher carrying costs during construction. Always keep reserve funds in place to allow for the unexpected. The third risk is responsibility. When you secure the financing for the property, the ultimate responsibility for paying that loan is on your shoulders. The bank expects that loan to be paid no matter what happens. If you select an unscrupulous builder, who either fails to build, or takes far longer and incurs far more costs to build than originally projected, the bank will still hold you accountable for that loan. Key Advantages to Construction-to-Perm Loan: ■ ■ ■

Less money out of pocket End loan is already in place Savings on closing costs

Option 3: Buyer Financed Construction-Only Loan Along with the construction-to-perm loan, the other financing option for which you as the investor secure is a construction-only loan. In this case, your loan does not modify into an end loan once construction is complete. Everything we discussed above about construction-toperm loans applies for the construction-only loan. But here you will be required to apply for a traditional end loan upon completion, therefore incurring a second set of closing costs. The only people who really benefit from a construction-only loan are mortgage brokers, who will get a second closing when they originate the end loan for you later. Markets change, appreciation rates change, and your needs can change. You might find that you don’t need an end loan, but the security of having one in place at the onset is well worth the additional cost. You might want to wait to lock in your interest rate, if rates are high, and you feel they will be going down.

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Key Advantages to Construction-Only Loan: ■ ■ ■

Less money out of pocket Closing cost savings May never need an end loan if you sell before construction is complete

Whichever type of project and construction financing you choose, you should plan for the end loan. Even if you plan to sell before construction is complete, be prepared to need a mortgage. The end loan allows you to hold a property for a longer time, thereby capturing additional appreciation and possibly reducing your tax burden when you sell. We will discuss this more in the chapter on exit strategies. Choosing the appropriate end loan will be driven primarily by your strategy. There are vast arrays of end loan products on the market; we will briefly go over the main ones to help you plan your financing strategy. There are two primary types of fixed-rate mortgages, the 30-year fixed and 15-year fixed. Both of these mortgages have fixed interest rates that cannot change over the duration of the loan. The 30-year and 15-year fixed mortgages typically will have higher interest rates than other options such as adjustable rate mortgages. These types of loan products are best for properties being held long-term. In other words, if you intend to own the property for the entire life of the loan, these are the best loans for you. For the new-construction investor with a shorter hold cycle, typically these are not the best loan choices. Another type of loan is the adjustable rate mortgage or ARM. This loan will have a fixed interest rate for a period of time followed by a variable-rate term where your interest rate can change. Given the current historically low interest-rate environment, you might incur some interest-rate risk when using an ARM. Typically you will see 1/1, 2/1, 3/1, 5/1, 7/1 and 10/1 ARMs. The first number represents the length of time that the interest rate is fixed. The second number represents when the rate adjustment happens. In other words, a 3/1 ARM is fixed for the first three years of the loan; after that the rate will adjust annually. A 7/1 ARM would be fixed for the first 7 years of the loan, followed by an annual interest-rate adjustment. The adjustable rate mortgage is usually the best loan product for the new-construction investor, who typically holds a property for less than five years. ARMs have the advantage of usually offering lower interest rates than fixed-rate mortgages. This keeps payments lower and helps with cash flow management.

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When choosing what financing to use, the question to ask is: What will I be doing with the property? Will I be holding it 10 years? Five years? Two years? If you’re holding it short-term, the ARM is probably the way to go (assuming all other factors are the same). If you’re going long-term (or might go long-term) the 30-year fixed will probably serve you better. The emerging market investor typically holds for less than five years. Based on the market cycles we discussed in Chapter 5, a market will certainly change cycles (probably many times) over the life of a 30-year loan. As such, an emerging market investor would plan on selling many years before the loan is paid off. In a typical yield curve environment, interest rates on ARMs will increase based on the duration of the ARM. For example, a 1/1 ARM will have the lowest rate, whereas a 10/1 ARM will have a rate very close to a 30-year fixed loan. The fixed period of the ARM you choose should be based on the length of time you plan to hold the property. An additional loan option is the interest-only loan. We like this product very much. Instead of paying principal and interest each month, you pay only the interest each month. This further allows you to reduce your monthly payment, and minimize negative monthly cash flow. Some people freak out when they hear the words “interest only” because they haven’t been educated properly. Their response of course is: “Wait a second, with an interest-only loan the home never gets paid off!” This is not true, because you can pay principal anytime you want. There is a little box on your monthly mortgage payment stub labeled “principal payment.” You simply write any number you want in this field, and you pay any amount of principal that you wish. Principal is not mandatory, just optional at your convenience. This provides additional control over monthly cash flow, giving you the control to still pay principal whenever you want. The interest rate on an interest-only loan is usually slightly higher than a traditional amortizing loan, but to us this is a small tradeoff. If you wish, have your lender quote the rate on both options for you. Then you can make an educated decision on what option works best for you. The interest-only loan program is a great product for the emerging market investor who is usually selling in less than five years, and the amount of principal paid down on an amortizing loan during the early years of a loan is very low. A third option for end loans is the negative amortization loan, or negative AM. This loan product is fairly new, dating from the recent

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real estate boom. A typical fixed rate or adjustable rate mortgage payment will consist of principal and interest payments. An interest only loan will consist of only interest payments. The negative AM loan allows the borrower payment flexibility. The borrower may choose to pay a minimum payment that is lower than the actual interest being charged by the bank. By deferring the actual interest due, the loan’s principal amount increases. This option may allow an investor to substantially reduce negative cash flow exposure. Less cash out of pocket on a deal can increase an investor’s cash on cash returns. However, negative AM loans can bear a high level of risk if used improperly. The choice of making the minimum payment rather than the fully indexed interest rate might be risky because the interest that is being deferred could increase the loan balance faster than the increase in value due to property appreciation. This result will decrease the equity upon sale of the property and sometimes can wipe out the equity completely. Because of the recent downturn in many markets, there are instances of buyers who bought at the peak of the market using negative AM loans whereby they have chosen to make the minimum monthly payment. As a result they are increasing their debt (reducing their equity) on the subject property in a depreciating real estate market. The result could be devastating and could take years to reverse. With so many markets in a downswing at this time, it is likely that high LTV negative AM loans will become much harder to obtain as mortgage lenders seek to reduce their risk. Using a negative AM loan to eliminate negative cash flow because you lack sufficient cash reserves to cover the negative cash flow is a very bad idea. If your reserves are so small that you cannot afford to cover negative cash flow, what will you do if it takes time to find a tenant or if you have to evict a tenant? The mortgage must be paid. If you are that tight on funds, find a money partner or a private lender for your deal. Do not stretch yourself so far financially. The slightest change or unpredicted occurrence could wipe you out, and it’s just not worth taking that kind of risk. One important thing to consider, in any of these options, is making a few principal payments before your first payment is due. Run the numbers and see how much it will help you reduce the mortgage payoff time. Also, there are some great programs now, using HELOCs, to pay a 30-year mortgage down in six to eight years, with no extra payments! Get that? It is incredible, but not

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something that can be discussed in detail in this book. See our Web site for more information. Another very important point about financing is working with the right lender. One of our biggest frustrations early in our career was finding the right lender to work with. So many lenders don’t want to work with investors. They want only the easy “retail” loans, where Bob and Sally Jones are buying their primary residence. You have no idea how many times both of us have nearly slammed the phone into the cradle when dealing with this sort of lender. The majority of the time, you feel as if they are working against you rather than working with you. Fortunately, we solve this problem by working with an “investor-friendly” lender. It should be one who specializes in funding real estate investments. There are literally hundreds of loan programs out there. Only a certain portion of them apply to investors. The investor loan programs can get very complicated. They are filled with very specific stipulations. If you don’t have the right lender in your arsenal, it will be like beating your head against a brick wall. We’re going to share with you the lender that we use to fund our own personal investments, with one caveat. This lender is very busy. They are very busy because they are very good.It is incredibly hard to find a lender that can do what they do. For this reason, please do not contact this lender to just “get educated” about mortgages. This is a very busy, talented group of people. If you have a mortgage approaching, or if you’re very serious about starting an investment soon, by all means contact them. That is what they are there for. But, please, be very respectful of their time. If you have equity in one or more properties, you will also want to consider contacting them regarding a home equity line of credit. The HELOC is a very powerful vehicle to fuel real estate investing. It is also a very good idea to be working with just one lender, because you don’t want multiple lenders pulling your credit report. This company has one major benefit. It can write loans in almost every single state. It has made it very easy for us to get loans anywhere through one lender. The name of the lender is Catalina Capital Mortgage, in Miami, Florida. Their phone number is 954–537–7500. Their Web site is www. CatalinaCapitalMortgage.com. They are phenomenal at what they do, an absolute gift to the real estate investor. They are so good that we wanted every one of our tour clients to receive direct access to them. To do this we formed an alliance with Catalina so that they attend every single one of our tours in person—and provide one-on-one

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live consulting with our tour attendees. If there is a way to get a loan done, this company will get it done. Wendy & Justin’s Advice on Financing Learn everything that you can about financing, and all of the programs that are available. The proper financing is the element that supercharges your real estate investment!

In the next chapter we will discuss how to supercharge your investing by using other people’s resources. You don’t have to do all of the finances alone. We have both used the techniques provided in the next chapter to partner on real estate deals and to take our personal investing to another level.

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CHAPTER

16

The Importance of Using Other Peoples’ Resources

A

ll professional investors use Other People’s Resources to fuel their real estate investing. These can include, but are not limited to: Other People’s Money (OPM), Other People’s Credit (OPC), Other People’s IRAs (OPI), and Other People’s HELOCs (OPH). Even Donald Trump, Robert Kiyosaki, and other wealthy investors who have made the bulk of their fortunes in real estate use funds that are not exclusively their own. In the book, Why We Want You to Be Rich, Robert Kiyosaki says, “Getting back to the difference between a saver and an investor, there is one word that separates them and that word is leverage. One definition of leverage is the ability to do more with less.”

Other People’s Money (OPM) There are two ways to use OPM in real estate investing, either as money partners or as private lenders. Money partners work with you on new construction; their role is to provide funds for the deal. Money partners receive a portion of the overall profit in the transaction (but not a guaranteed rate of return). Private lending is the process by which you, the investor, borrow money from a private individual (as opposed to borrowing from a bank, institution, or a “hard money” lender) and use that money to invest in real estate. The private lender is not your partner in the transaction, but rather receives a fixed rate of return.

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When you, the investor, realize your profit from the real estate deal, a portion of the proceeds pays back the lender’s principal plus interest. The remainder would be your profit. As the investor, you can pay the private lender a higher rate of interest than that lender would have received by investing that same money in a savings account, CD, or money market account, or even the stock market. These accounts might only pay 2 to 4 percent; however, with private lending, you might be willing to pay 6 to 8 percent to the lender. The higher interest to the lender would return an increase from 150 percent to 400 percent or even higher in their rate of return! Lenders can provide funds from their bank accounts, money market accounts, self-directed IRAs, 401Ks, or even Home Equity Line of Credits (HELOCs) on their homes. Private lenders can be anyone who has money available. They don’t have to be wealthy. It might take some time to build trust with someone who does not know you. You can ask someone for smaller amounts like $5,000 or $10,000. Once you have built a level of trust, if people have more funds, they may loan them to you. How do you find private money lenders? First, determine how much you are trying to raise to do new-construction investing deals. Think about how many deals you want to do at a time. Be realistic. If you have very little experience investing in new construction, start at a comfortable level. Next, determine who your potential private lenders are. Look through your entire contact list. Coworkers, family members, relatives, neighbors, friends, your doctor or dentist, your attorney, and referrals—once you have worked with people, they will be happy to refer you to others. Don’t be afraid to ask. Some of our best private lenders are from referrals. Once you’ve determined who you want to talk to, make contact. Choose a non-threatening form of contact and leave easy outs for them. Remember, most of these people are your family and friends; you don’t want to create awkward situations. You will quickly find that if they are interested in private lending they will let you know; if they are not interested, coercing them will only lead to major headaches for you. There are many ways to approach potential lenders. Explore what works best for you. You might want to have an open discussion, where you explain what you are doing and what you are looking for. You could use a gradual approach, where you talk occasionally about what you are doing and drop hints about lending until you lead up

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to ask them. You can send out periodic e-mails about your investing and the opportunities people might have as private lenders. Wendy has found great success in giving out a CD with a recording explaining about new-construction investing and opportunities in private lending. Along with the CD, she includes a note saying that if people are interested, to contact her; otherwise they can discard the CD and she won’t bother them about it. This makes it nonconfrontational and low-pressure. This strategy has been very successful for her. Wendy provides this CD to all of our tour attendees for free. She also includes it with unlimited reproduction rights. As a caution, due to SEC regulations, when you are sending out CDs or printed mailings or other forms of advertising trying to find funds, do NOT say things like “guaranteed return” or advertise a specific rate of interest. You should consult an attorney before trying to find private lenders to ensure that you stay within the law. Some people will have no interest in private lending after you’ve contacted them. However, if you approach enough people, you will find lenders. Remember that the people who are acting as your lenders are getting a great return, so this is a good deal for them. Savings accounts, CDs, bonds, and the like offer very low returns. You can offer a higher return, so your lenders feel that they are getting a good value on their money. Lenders who are loaning from IRAs or 401Ks might get comparable returns, but with much less risk and volatility than the stock market holds. Once you’ve found people interested in acting as private lenders, the next step is to go over the details with them. Before you specify a particular rate of return, it is good to ask the question “What are you currently earning on the money you want to lend?” Next, you want to ask, “What rate would you like to be earning to make it worth your while to lend to me?” You might find that they are willing to take less than what you were going to offer. Or, if they want more, you can tell them what you would normally pay and see if they are willing to accept that. Believe it or not, if some people are currently earning a low rate of return on their money and you offer too high a return, you might scare them away. The promise of a high rate of return or “the too good to be true” feeling can make your offer seem unbelievable or even fishy. If someone is making 2 percent on a CD and you offer 8 percent, that is a 400 percent higher return. If you offered 16 percent, that is 800 percent higher, and might move into the category of unbelievable

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or suspicious. There is absolutely nothing illegal or immoral about private lending. Just remember not to be overly aggressive and to not make your prospective lender feel as if something is suspicious. The details you need to resolve with your potential private lender are the rate and terms. Once you have established the interest rate, you need to work out the terms. The terms are the amount, the duration, whether the loan is to be secured against property, and whether there are to be payments during the loan. If there are payments, are they principal and interest, or interest only? Typically, you would prefer not to make payments during the loan. If the lender wants payments, you could offer a lower rate of interest. It is important, though, to be flexible with your lenders, as each one will want different arrangements. Sometimes lenders will agree to interest-only payments, but instead of collecting them every month, they might accept a payment once every six months, or annually. They might want the payment to be interest-only, but keep the principal loaned. Some just might want to keep rolling the interest into the loan so that it keeps growing. What kind of duration should you ask for? If you know the particular deal you want the money for, time it to the build cycle plus a little additional time. For example, if you are borrowing for a newconstruction high-rise condo that will take two years to build, you should ask for a term of two years and three months to two years and six months or more. You can pay the note off quicker, but you should allow yourself ample time to complete the project. If you don’t have the specific project yet, you should try to time it based on potential projects. Regarding securing the loan against property, this is completely optional. Some private lenders will feel better about lending if they can secure the note against the property. It will be much easier for you to use the funds, however, if they are not tied to a single piece of real estate. Quite often, if you don’t offer this option, the private lender will not ask for it. Initially, it might help you establish a relationship with your lender such that in the future the lender doesn’t feel the need to secure the loan. Remember when working out the details of the loan that it should be a win-win situation. Both the investor and the lender should be satisfied with the arrangement. Once you have resolved the details of the loan, you sign a promissory note with the lender. The note should cover both the rate and terms.

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If the lender wants to secure the loan to real estate, you also would need to sign a mortgage. Obviously, if the property is not built yet, then the mortgage would need to be on another property you already own. Both of these documents are provided for free to all tour attendees. If you are new to real estate investing, you might be concerned that the lender wants to see your credentials, or know what kind of experience you have, or even to see your credit report. Surprisingly, potential lenders are usually much less interested in your experience and credit than they are in how high a return they are getting on their money and the investment itself. If they are interested in your experience and you have none, you have several options. First, complete a real estate deal on your own, using your own money and credit. Then you can show them what you have done. If that isn’t an option, the best alternative is to take a partner who has the experience. You’ll have to share your profits, but then the partner can lend strong credentials to the project. In the end, if you are unable to do a deal on your own or cannot locate a partner, that lender who is overly concerned with your credentials might not be the right person to work with at that time. Once you have secured a loan, act with honor and integrity. This person trusted you; be worthy of that trust. Make sure that your partners are repaid first before you take your profit. You will find much more success in your real estate investing if you keep this in mind. It is important to arrange your OPM before you try to invest in real estate. Once you have found your deals, you will have very little time to lock them up. If you try to find your funds at that point, you just won’t have enough time.

Other People’s Credit (OPC) The other way to acquire partners on new construction deals is using Other People’s Credit (OPC). This is a true partnership versus private lending. As a real estate investor, the more bank mortgages you have against your credit, the more difficult it is to get new financing. Banks are very concerned if you overextend, no matter how good your credit score is. This limits the number of deals you can do, regardless of how much cash you have for your down payments. Another possible situation is that you might not be qualified to do any deals because your current credit score isn’t adequate. How do you get around this problem? You invest using OPC (Other People’s Credit).

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Investing with Other People’s Credit, is by far, one of most powerful hidden strategies in all of real estate investing. It takes a detailed process to do it properly. If you do it improperly, you can really create some problems for both you and your credit partner. Credit partnership is quite possibly the least understood concept in all of real estate investing. Right now you might be thinking that this sounds quasi-illegal. It is not illegal. It happens all the time. You just aren’t thinking of it in the right context. People buy real estate as partners all the time. For example, every day in America a husband and wife will qualify for the loan individually, but both the husband and the wife go on title together later. Siblings do the same thing all the time. It is very common for a first-time home buyer to have someone co-sign on the mortgage with them. We partner together also. One of us will get the mortgage on one deal and then the other on the next deal. Here’s a news flash—you do not have to have a blood relationship with someone or be married to the person to do this. You can do it with anyone. Credit partners are quite common and commonly accepted. You do need a well detailed, well documented, legally accepted process for forming your credit partnerships. This is a very detailed process that can not be taught in just a few minutes. It also requires specific legal documents. We teach the credit partnership process live on our Investing Tour with our attorneys present. All of our attendees also receive all of the legal documents and resources for free, so that they can begin forming credit partnerships immediately.

Other People’s IRAs (OPI) Another powerful source of funds is OPI. This stands for Other People’s IRAs. Earlier we mentioned that you can invest in real estate with your IRA. You can also invest with other people’s IRAs. You are probably starting to realize how big your investing can get if you want it to. About 54.4 percent of all working Americans have an IRA. When we total up all of the funds in all of those IRAs, the figure is a staggering 10 trillion dollars. For the majority of those folks, their IRA is earning a pitiful 2 to 4 percent for them each year. This is because stock brokerages and banks can earn a commission only on selling their own product. Therefore, that is what “advisors” have always pushed. Average Americans have no idea that their IRAs could instead be invested in real estate, and making a

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much better return. You are doing these people a tremendous favor by helping them invest their retirement funds conservatively in a more profitable vehicle.

Other People’s HELOCs (OPH) Earlier we mentioned using the equity in your home as investing capital. This is a very powerful strategy. Thousands upon thousands of people have a huge stack of equity sitting in their homes. For most people, that equity is sitting there as idle equity, earning them no return whatsoever. This is absolutely tragic to a person’s net worth. For most people, their primary residence is their biggest source of funding. And so many folks just let that equity sit there, doing nothing. A property that has equity should always have its equity working for you. We are not saying you “max out” the property and reinvest all the equity. You should always behave very conservatively. For example, if you have $200,000 worth of equity in a property, you might wish to invest only $100,000 of that. In our next chapter, we will help you evaluate this when we discuss numerical analysis. A HELOC is usually a variable-rate product, that adjusts with prime, so you want to be conservative. A typical interest rate is the prime rate plus 1 percent. Some lenders, however, allow you to “fix” your balance after you’ve drawn it out. This prevents your rate from going up. The benefit of a HELOC is that it does not matter how much your limit is, you are only charged interest on the funds that you have actually drawn out. If your HELOC is for $300,000, but you haven’t drawn out a dime, you aren’t paying a penny in interest. The HELOC is a very powerful investing tool, and should be used in a conservative fashion to power your investing portfolio. Back to the powerful concept of investment partnership. Your HELOC is not the only one you can invest with. It is very easy to invest with OPH, Other People’s HELOCs. You want to be even more conservative when investing with someone else’s home equity. A person’s home equity is something that they worked very hard to build. It can also take many years to build it. You want to be very respectful of that. Never try to “talk someone into” investing their home equity. You want to be in the position where you identify outstanding investment opportunities for people to invest in and it’s entirely up to those people if they want to do it or not. After someone

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has identified an investment as desirable, it will be easier for you to facilitate a partnership with that person. Through these examples, it is plain to see that using private lenders, money partners, credit partners, and even OPI and OPH partners, you can start investing if you have no money or credit of your own. Also, if you have both money and credit, you can do more deals and reap greater rewards by using the powerful avenue of partnership! Justin & Wendy: Many times we forget to look beyond our own means to accomplish our personal goals. Other people can help us meet our personal and business goals. Stretch and reach out to others and you too will accomplish so much more.

In the next chapter, we will dig deeper into the analysis of numbers.

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CHAPTER

17

The Nuts and Bolts of Numerical Analysis

D

o not let the title of this chapter scare you off. If you weren’t a math whiz growing up, that’s OK. You can still do this math and understand the basics. If you have been investing for a while, some of the math might seem simplistic to you. But don’t worry; we’ll cover some other topics in this chapter that you might not have thought to include in your analysis before. We’ve even created the Property Analyzer Software to help you analyze the properties you wish to buy. Every one of our tour attendees receives the software at no charge when they attend our Investing Tour.

Buy and Hold If you are looking to buy and hold an investment property, we are assuming that you plan to get a loan. In that case, you will need to learn how to calculate some basic numbers, including principal and interest, on your loan, plus the taxes and insurance for the property. Just as in any business, the real estate industry loves acronyms. You’ll often hear people mention P&I or PITI. This stands for Principal and Interest or Principal, Interest, Taxes, and Insurance. We’ll walk you through each of these four items. To calculate your monthly principal and interest payments, you will need to know the following information: ■

The amount of the loan

■

The interest rate of the loan

■

The amortization period or the number of years you have to repay the loan 169

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Principal and Interest

You might be wondering what amortization is if you’ve never seen that term before. Let’s look at a short simple interest example. Say you borrow $120,000 from the bank and are not required to pay any of that original principal back until the end of the loan, but instead you only have to make interest payments at a rate of 10 percent annually. The total interest you must pay over that year is found by multiplying the loan amount by the interest rate. For this example: $120,000
10 percent is $12,000. To find the monthly interest payment, divide the annual interest by 12 months. That $12,000 divided by 12 months equals $1,000 per month. So over the year you are paying $1,000 per month. And then at the end of the loan, you must repay the original amount you borrowed, in what is called a lump sum or balloon payment. When you pay a little bit every month toward principal, you are making small payments to your final balloon payment (the original loan amount that you borrowed). However, if this monthly principal payment were optional, a lot of banks would never get repaid their principal. Many people are not disciplined enough to make monthly principal payments consistently. So instead of relying on the individual, banks started amortizing loans over a certain period of time. This means that part of each monthly payment would go to pay the interest, and a separate portion would go toward principal reduction. The majority of the payment, however, will go toward interest in the first few years of the loan. Over time, the amount of the payment being designated toward interest would decrease as the amount of principal paydown would increase on a sliding scale. This scale is referred to as an amortization schedule or amortization table. You can easily do a search online for amortization calculators; there are many to use. You can also purchase a small book of amortization tables. With this approach, the individual tends to pay a lot more interest in the first 15 to 20 years of a 30-year loan and more principal during the last few years of the loan. As time goes on, the interest portion of the payment is reduced and the principal is increased. The monthly payment remains the same. Here’s a perfect example (see Figure 17.1): Let’s say an individual has a $120,000 loan with a fixed 7 percent interest rate amortized over 30 years. First, we need to use the following formula to calculate the monthly payment:

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Figure 17.1: Principal and Interest Payments by Month for a 30-Year Fixed 7% Interest Rate $120,000 Loan $900.00 Principal

Interest

$800.00 $700.00 Principal

Dollars

$600.00 $500.00 $400.00 $300.00 Interest $200.00 $100.00 $-

1 13 25 37 49 61 73 85 97 109 121 133 145 157 169 181 193 205 217 229 241 253 265 277 289 301 313 325 337 349

Month

AP

i (1 i )n Pi  (1 i )n  1 1  (1 i )n

Where: A  periodic payment amount P  amount of principal (be sure to subtract any down payments first!) i  periodic interest rate  annual interest rate divided by 12 months n  total number of payments (for a 30-year loan with monthly payments, n  30 years
12 months  360) In our example, P  $120,000, i  7% divided by 12  0.00583, and n  360. Thus, A  $120,000
0.00583 (1 0.00583)360 (1 0.00583)360  1

A  $120,000
0.00665 A  $798.36 per month

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If you assume that you are making 360 payments of $798.36 each, over the life of the 30 year loan you will have paid a total of $287,410.68 (see Figure 17.2). Because the principal was only $120,000, the difference is the amount of interest you’d have paid over the life of the loan. In this example, the total interest you’d pay over the life of the loan is $167,410.68!

Figure 17.2: Cumulative Principal and Interest Payments by Month for a 30-Year Fixed 7% Interest Rate $120,000 Loan $350,000.00 Cumulative Principal Cumulative Interest

$300,000.00

Dollars

$250,000.00 Principal

$200,000.00

$150,000.00

$100,000.00 Interest $50,000.00

$1 13 25 37 49 61 73 85 97 109 121 133 145 157 169 181 193 205 217 229 241 253 265 277 289 301 313 325 337 349

Month

During the first month, the interest payment is equal to the loan amount times the periodic interest rate. In this example, it would be $120,000 times 0.00583, which equals $700. Thus of the $798.36 monthly payment, $700 is going toward interest and the remaining $98.36 goes toward reducing the principal. In month 2, the remaining loan balance is $120,000 minus $98.36, which equals $119,901.64. This new balance is used to calculate the second month’s interest ($119,901.64 times 0.00583  $699.43). Thus for the second month you are paying $98.94 ($798.36  $699.43  $98.94). In the second month of the 20th year you will finally be paying more principal than interest each month. Now that you have a detailed understanding of how to calculate principal and interest, it’s easy to use an online amortization calculator to perform this function. Also, our Property Analyzer software performs this calculation, along with other calculations. Your principal and interest are the P&I portion of your monthly expense. Let’s take a look at how to calculate the “T” portion. This is your property taxes.

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Property Taxes

Property taxes on real estate exist everywhere in America. Cities, townships, counties, villages, and other municipalities use property taxes to fund their operations. Estimating property taxes is actually quite simple, many times as simple as picking up the telephone and calling the assessor’s office in that municipality. Some assessor’s offices have made this information available online, but many have not. Remember that with new construction and pre-construction, the property has not been built yet. If a property hasn’t been built yet, sometimes it’s not possible to just pick up the phone and get an estimate. You have to be a bit more skilled, and be able to perform a few basic calculations yourself. The other reason why you might want to perform these calculations yourself is because of human error. One time, the person who answered the phone at the assessor’s office gave one of us an incorrect estimate. If you can perform this calculation yourself, you can verify and confirm your property tax estimates. When a project has not been built, it is impossible to determine exactly what the taxes will be the day it’s completed, because taxes can change while the property is being built. But we can estimate what property taxes would be today on the property, and this typically is a good estimate. Property taxes do increase on a regular basis, but they usually don’t “soar” in a short time. Therefore, your estimate usually will be fairly accurate when the property is completed a year or two later. Property taxes are calculated differently from one area of the country to the next. In some states, you might pay more tax on an investment property than on a primary residence. The formulas and ratios also can vary a bit, but we’ll give an example below of how property tax calculations work in one particular market. In this particular market, here’s how it works. A house has a purchase price of $209,900. First, we estimate what property taxes would be today. We multiply the purchase price by 15 percent. This is the number used for investment property that is non-owner occupied. If this property were owner occupied, we would multiply the purchase price by 10 percent. This city uses this method to calculate the annual taxes on an investment property. $209,900
15% ________ $31,485

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This number of $31,485 allows us to do our next calculation. This taxable “basis” is now multiplied by the current millage rate to determine the annual amount of tax that is due. A millage rate is a number that is used to express how much property tax is paid in a certain geographical area. It is called millage because it is expressed in terms of dollars per thousand. For example, the current millage rate in this particular city is 104.62. Our taxable “basis” of $31,485 is now multiplied by the millage rate: $31,485
.10462 __________ $3,293.96 You have just estimated what your total annual property tax will be at today’s millage rate in this particular city. This figure gives us a monthly property tax expense of $274.50. As you can see, property taxes are fairly easy to estimate. Certain cities use the concept of “assessed value” to determine property taxes. Remember that a property’s assessed value can be different than the purchase price of the property. In our example above, I used the purchase price to determine what the annual property taxes would be. This is the most conservative method to use. In many areas, the purchase price does not automatically become the assessed value. We are assuming the worst case scenario: that the assessed value will come in at the full purchase price. This is not always the case. Many times the assessed value will be less than the purchase price, thereby resulting in lower property taxes to you. In many municipalities, instead of using the purchase price to determine property taxes, the assessor will “assess” the value. This can be done in numerous ways. In some areas, the assessor will drive by the property to “assess” its value. Other times, the assessor will pull up the records and examine what similar properties are assessed for in the area. That data is used to make the assessment on the subject property. There are no hard and fast rules for what method the assessor will use. This is why the estimation of property taxes can never be absolutely exact, but we can get a good estimate. The most conservative way to estimate your property taxes is to assume that your purchase price will become your assessed value. If your property taxes turn out to be lower later, then that will be a pleasant surprise.

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To estimate taxes on a property, you will need to know two things: ■

The millage rate of the area where your property is

■

The calculation method that the municipality uses for an investment property

Whoever answers the phone at the assessor’s office should be more than able to walk you through this process. When they walk you through things, provide them with the purchase price of the property (and assume this will become your assessed value). Next, give them the location of the property. If the property hasn’t been built yet, and you don’t have a physical address, give them the best crossroads that you can. After you have determined your annual property taxes, divide that number by 12 to estimate your monthly cost. You have now accounted for this cost in your investment analysis. Insurance

Insurance can be a little more time-consuming to determine. It is highly dependent on the type of real estate, the location, its proximity to water, its distance to the nearest fire department, and other factors. We like to invest in waterfront communities because historically, appreciation has always been stronger on the water. Obviously being closer to water can create a higher insurance rate, but this has never bothered us because the appreciation of the property by far usually outweighs the increased insurance cost. We recommend calling at least three insurance companies to get estimates. Your diligence will pay off. On one recent property, we had several hundred dollars difference between three of the nationally known insurance companies. Be sure to get the appropriate insurance for the area of the country in which you are purchasing the property. In addition to insuring the structure itself, your homeowner’s policy contains liability protection for the owner. Your insurance agent can help you determine how much liability protection to have. You will not need coverage for contents (furniture and so on) unless you have furniture or contents in the home. Depending on the area, you also might wish to add wind and flood coverage. Ask your insurance provider “How do I make sure I am completely and totally protected?” Then pick and choose the coverages that you feel are worthwhile.

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Other Fees Now that we’ve covered the four basic payments you’ll be making, we’ll discuss some of the other fees you might come across. Property Management Fees

Property management fees for the single-family product typically are 10 percent of the gross collected rent. If the rent isn’t collected, the property management doesn’t get paid. Many management companies also require a half month’s to a full month’s rent for filling a unit. This extra amount usually pays for the extra work to fill a vacancy and any expenses incurred, sometimes including advertising. A property management company deals with the excuses, any evictions, and all maintenance calls. But even with this full service, you will still need to manage the property management company. Be sure to check up on the management company periodically by calling the current tenant to see how everything is going, and if the property is in complete working order. We go so far as to send a follow-up survey to tenants when they leave to see how their experience was in the house and with the property management company. You can request that the management company send you pictures on a semi-regular basis. One great trick we’ve learned is to reward our tenants who keep the property in tiptop shape. We send a letter directly to the tenant every six months asking them to take photos of every room of their rental home (in excellent condition) and send them to us in exchange for a $100 reward. We recommend that the property management company send you a copy of all the advertising for the property, including the MLS listing. Our motto is “Trust, but Verify.” If you like to control more of the filling process, you can even negotiate paying for advertising directly and then having that cost subtracted out of their fee. To be paid on time, it is critical that your property management company uses monthly reminders. This helps to keep control of accounting and any late fees. If your property management doesn’t send monthly reminders, we’d recommend that you send your own reminders stating that the rent is due on the 1st. Be sure to mail these letters far enough in advance so that they arrive a week before the end of the month. We typically mail letters on the 20th so that it will arrive no later than the 23rd.

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We also recommend that you interview three or four property managers to find the one who you believe will help rent your property as quickly as possible. You will want to get references for the property management company and do a thorough check. “Managing” the property manager is also very important when it comes to qualifying for the GO Zone tax incentive, and other tax incentives. These activities allow you to qualify as an active real estate investor and receive the best tax incentives. As part of our Investing Tour, we have an attorney who speaks specifically on this topic. Home Warranty and Maintenance Fees

Because we are investing in new construction, the properties typically come with a one-year builder’s warranty plus any material manufacturer’s warranty. An additional bonus with new properties is that maintenance costs are at an absolute minimum. After the first year, you can decide if you’d like to obtain a home warranty for the next year. Condominium Costs

A monthly Homeowner’s Association fee (HOA) is paid within all condo developments. Some housing developments have a HOA fee

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also, but they usually don’t include all of the services that a condo HOA includes. The monthly condo HOA payment typically includes the following services and sometimes more: ■

Exterior insurance policy on the property

■

Insurance policy on the common areas of the property

■

Exterior maintenance on the property

■

Lawns and grounds maintenance

■

Amenities maintenance

HOAs can vary greatly depending on the level of amenities, insurance cost on the property, and many other factors. Be sure to get an estimate of what the HOA will be before going to contract on the property. When we get into a property very early, many times that information is not yet available. And that’s OK, as long as you have an estimate of it by the time you go to hard contract. Remember that HOA fees can change at any time. Prepare for this by always being conservative, and maintaining plenty of cash reserves. This allows you to be prepared even if the HOA fees go up. With respect to your master analysis, all you do is plug your monthly HOA fee into your property analyzer software on the line designated for it. Vacancy Allowance

Obviously vacancies happen. They are not something to be scared of, just something to be prepared for. Ultimately, you never know when someone will up and leave. So instead of worrying about it, simply prepare by holding adequate cash reserves. It’s a good idea to include some vacancy allowance in your master analysis. Every investor has an opinion on how much to include. Five percent is usually a decent figure. Sometimes we will sign two-year leases with our residents, so our vacancy rate is usually less than that, but 5 percent is a decent rule of thumb. Condotel (aka Condo-Hotel)

The condotel, as you came to understand earlier, is the only type of real estate that gets rented on a nightly basis. It is commonly a resort. The capacity for nightly rentals obviously adds additional expense because the management is doing everything from filling the room every night to making the beds in the morning. Property management

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is typically 50 percent of collected rents on the condotel, however in some markets it is as low as 30 percent. There is also a monthly HOA on the condotel. The unit needs to be furnished. The furniture is usually not included in the price. On our Investing Tour, we sometimes are able to get the furniture package given as a bonus at no cost, because of the size of our group. If you own your unit for a long time, obviously you will need to “refresh” the unit, and replace the furniture. Certainly the expenses are higher on this type of real estate, but collected rents are much higher, too. Ask the management company what to plan for so that you may estimate expenses for this.

Completing Your Analysis of Expenses After you have plugged all of your monthly expenses into your property analyzer software, it’s very easy to calculate what your monthly negative cash flow position will be. It’s also an option of course to put more money “down” on the property and engineer the financing so that you have break-even or positive cash flow from Day 1. It is entirely up to you how to plan your numbers. We put 20 percent down on almost all properties, but do not do that just to achieve positive cash flow. As discussed previously, we do it to get the interest rate down. Even on solid, viable investments, 20 percent down won’t always get you positive cash flow. Here is why. That property is a desirable, unique property, in a strong market. Those are the types of properties that make good investments. And they are not “cheap.” If you want cheap real estate, you can buy cheap homes all day long that will generate positive cash flow. Just because a home has positive cash flow does not mean it’s a good investment. The homes that generate cash flow at zero down are the ones in borderline war-zone areas in many cases. The property might provide cash flow on paper, but you only receive that cash flow if your tenant actually pays the rent. And that doesn’t happen nearly often enough. Additionally, these properties do not appreciate nearly as well, even in strong markets. If you want to play the positive cash flow game, that is your choice. We played that game for a long time, and it wasn’t nearly as profitable, and we lost our quality of life at the same time. Many folks think that if they are paying negative cash flow that they are “losing money.” It couldn’t be further from the truth. Negative cash flow is just part of the investment. When you wrote the check for $20,000 on the front end to get into the property, did you consider

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that losing money? Of course not. We consider that investing money. But all of a sudden, when we write a check a month later to cover negative cash flow, that’s losing money. Remember, you are going to get all that money back, assuming you are in the right market and that you purchased right. Negative cash flow is just part of the investment. You are investing money into the real estate investment just like you make monthly payments into your retirement account. Some folks think that if they purchase a property that has negative cash flow, they are being “risky” and “speculative.” That is ridiculous. We are not saying to take a negative cash flow property if you don’t have the money! That would be risky. We are saying to budget for every single dime, as we taught you how to do in Chapter 14, Determining How Much Investing You Can Afford. Be very conservative. You will have this future negative cash flow stored as cash reserves long before you ever need it. Every single dime has been accounted for, and the funds are ready. If the property is a good investment, we couldn’t care less if it has negative cash flow. Conversely, if a property is a bad investment, we couldn’t care less if it has positive cash flow! I, Justin, have owned duplexes that had $700 per month positive cash flow, on paper, that were horrible investments. The area had degraded so much that I couldn’t get a quality person into the unit to actually get the $700 per month! We don’t care what the monthly cash flow numbers are, we care about what the overall return on investment (ROI) will be. If we can get 30 percent return on our money in a hands-off fashion, that is an outstanding investment. We have achieved returns much, much higher than this on properties that had negative cash flow with 20 percent down! Our point is, don’t get stuck in the old world thinking pattern that says “negative cash flow is bad.” We have no idea if it’s bad or not until we’ve analyzed the entire investment. Most of the time, good investments take cash to get them done. People do not give away outstanding investments for free. The best way to go about your analysis is to perform the risk/reward analysis that we’ve described, and put your dollars in the investment that best suits your personal investing goals. Examine overall ROI, not just monthly cash flow, and put your dollars in the property that will have the best bottom line! In the next part of the book, we will cover new construction investing in emerging markets. We will dig into the details of how to use this strategy, and how to profit the most when buying and selling new construction.

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PART V

New Construction Investing: An Ideal Soft-Market Strategy

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CHAPTER

18

The Development Process How It All Comes Together

D

evelopers are individuals, or teams that build a large group of homes that makes up what we usually call a subdivision or neighborhood. Each developer normally specializes in one type of development or another. Developers classify themselves as vertical developers or single-family home developers. They might do both, but normally they specialize in one or the other. Many steps in the process must take place before any of the units or properties are sold. A developer can take many years to sell even one unit. It can be very time consuming and very expensive to begin a project. Developers face unique situations and particular requirements in each part of the country to get their projects approved. Very few people have the forethought and wherewithal to implement a large project individually. Developers risk much to do a project, and therefore deserve of the money they make for their efforts. We will explain most of steps in the development process and go into some detail on each of them so that you understand what happens behind the scenes in a developer’s life. This by no means will be enough for a reader to develop a project, but the reader will appreciate some of what developers go through to get their projects ready for delivery to the public. Let’s start in simple terms first. The process for a developer looks something like this:

183

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Purchase a piece of land

↓ Hire architects and engineers

↓ Get approval from the city

↓ Pre-sell units

↓ Get financing

↓ Begin development To break this down in more detail, the developer must complete certain steps:

Steps for Development (in General order): 1. Find & lock up (usually called optioning) or purchase the land outright 2. Evaluate initial financing for the project 3. Hire engineers and architects to design building or subdivision 4. Get city/township approvals (usually a multiple stage process) 5. Get state or other approvals 6. Find a marketing arm or broker for the project 7. Market the project 8. Get final construction financing 9. Get insurance 10. Pull permits 11. Build the project 12. Manage the project 13. Obtain certificate of occupancy 14. Phase out the project 15. Resolve miscellaneous items Let’s discuss each of these phases and steps in more detail.

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1. Find & Lock Up (Usually Called Optioning) or Purchase the Land Outright A developer will find a piece of land and purchase it outright, if it is zoned properly and if the developer can exercise due diligence in a reasonable time frame. The other choice would be to place an option on the land. This gives the developer a little more time to do due diligence, have the property rezoned, or rectify other issues. (Getting the property zoned properly is a very common step for developers of large parcels) This option process usually requires some form of refundable or nonrefundable money depending on the purchase price and seller. Many times developers also need to get property approval for a PUD—Planned Unit Development, which is a mixed-use development. PUDs are becoming very common now among developers and communities; they do require approval of a planning commission. PUDs usually will mix in residential properties, along with commercial and possibly multi-family dwellings. Many times they will have shopping areas for the community, green space, play areas for children, and sometimes different types of homes, such as condominiums and single-family homes. Some larger PUDs can accommodate schools, fire departments, and police stations. The intention here is to make the community a “city within a city.” Residents can do their grocery shopping, get their haircuts, and so on. PUDs can be quite comprehensive. Many times the land is very expensive. Some of the developers we have worked with report that the land cost has exceeded $20,000,000! This is not something that developers would just purchase without knowing for certain that they could get the approvals needed to build what they wanted. They would need their approvals in place before they closed on the land. Developers do much of their due diligence described in this chapter during the “option” period. They not only want to make sure the township/city will approve their plans, but also their lender.

2. Evaluate Initial Financing for the Project As soon as developers find a potential project and lock it up, they start to evaluate financing alternatives. They might even do that before locking up the land. Either way, this step comes early in the process. On a large project, a developer will evaluate many

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companies before selecting who will handle the financing. A small interest rate difference, or a small difference in the amount required as down payment, can make a huge difference to a developer for financing a loan of this size. Financing will vary from project to project. For example, if a single-family home developer plans to buy 10 acres and uses the 4 to 1 ratio, meaning 4 homes per 1 acre, that developer typically will set up financing with a local lender. When building a high-rise office building, hotel, casino, or condominium, developers will tend to use national lenders who end up syndicating the loan, as these projects will require a significant amount of construction financing. The parameters of these loans will vary with respect to type. With a condo project, for instance, more than likely the developer would be required to pre-sell a portion of the units before construction financing would occur.

3. Hire Engineers and Architects Developers must do a Phase I and II environmental survey of the property before they even close on it. These surveys cost anywhere from thousands to tens of thousands of dollars, depending on the size of the property. The environmental survey is done to protect the buyer and lender against any environmental contamination problems on the property. The owner is responsible for problems found on the property even if they were caused before they owned it, unless surveys have been completed or waivers are put into the contract prior to the purchase and closing. Therefore, developers must make sure whatever land they are purchasing is not contaminated. For instance, if it was used as a gas station and the underground tanks leaked into the ground, there could be a huge cleanup fee and expense attached to the property. If the land has never been developed the findings are pretty rare, however, there are still lender requirements. In any case, the buyer of a large parcel would be risking a huge liability not to complete them. Also, the lender and architects will usually require soil borings. These will show what types of layers and conditions exist for the foundation(s) of the structures. This might not be done in a subdivision project, but certainly would be done for a vertical subdivision or condo project, because those foundations would have to be deeper. The developer will need, and the lender will require, surveys of the property. There are several types of surveys. A staked survey

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shows the boundaries of the properties with stakes in the ground marking the exact property lines. This survey includes prints for developers to follow for construction. This way developers will stay in the property lines when building. There would be nothing worse than to build a $100,000,000 building partially on an adjacent property. That would be a financial disaster! An Alta survey shows the property, but also delineates easements such as utilities, drainage, and so on. Normally developers can’t build in easements, unless an easement allows for it. So, it is extremely important to have this survey in place prior to site work.

4. Get City/Township Approvals Once the design work has been completed, the next step is to apply to the township or city for approval of the plans. Depending on the situation, this can take months or even years. A simple project with no political issues can take a few months; a large and complex project with political issues can take years to get final approvals. Each municipality must follow certain steps. Some make it easy and some make it difficult to complete a development. There is definite truth in the phrase “it is not always what you know, but who you know.” If developers have been doing business in a town for years with no problems, the town is likely to get their plans approved more rapidly than for a developer who is new to the area and unproven. We have seen this time and time again in many cities. Developers who wine and dine the city officials tend to get their projects approved easier, and yet in other cities this is unheard of, and it would be considered offensive. Your plans are more likely to be expedited if you cooperate and work with city officials one day at a time. Get them clean, solid plans for the project the first time (which is almost impossible). Ultimately, it’s about credibility. If you do what you say, then typically government officials will be inclined to work with you. Among the political concerns that can arise are drainage issues. Where will the rain water go? Underground? Off site? On site? What trees will be cut down? Why so many? No one likes to have trees cut down and many cities have tree ordinances. For every one you cut down you have to replant one (or more) somewhere else in the town. A tree hearing might take place if a certain number or size of tree is to be removed for development. It can be tough sometimes

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for developers. We need new housing in growing communities, but we don’t want the beauty of the area changed. Keeping the trees and any landscaping is always a goal. The more trees, the more valuable the property. Developers might have to expand local roads, or create them if they don’t exist. They might have to install water, gas, and electrical lines. Sometimes, municipalities make developers do these improvements for other areas. This could include bringing water and sewer lines in to another area or paving a section of a road that has nothing to do with the developer’s parcel. Bonds are sometimes issued for the roads or utilities. If these (water and sewer) are not on or near the site, then the price will end up reflecting these extra costs. Remember, all developer costs are reflected in the pricing for their units.

5. Get State or Other Approvals The United States Army Corps of Engineers is a federal agency, but each state also has its own respective name for its environmental quality departments. They look at wetlands, marine infractions, and so on. Wetlands are protected by the government and you cannot build on them. If developers have wetlands on their properties, they have to build around them or mitigate and protect them and the wildlife living in those areas. At times, the cities or townships will allow a

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developer to “move” a wetland area from one location of their land to another—that is, trade it for equal or more wetlands somewhere else. For instance, if the wetland was right in the middle of their land, it might be difficult to develop the parcel. However, if it could be “relocated” to the back, the property could then be developed as planned. Please understand that this is an extremely simplified version of the process developers face.

6. Find a Marketing Arm or Broker This is one of the most important parts of the exit strategy for the developer. Many developers find a local Realtor who will list the project and sell the units from a trailer or a model home in the development. Depending on the size of the development, it can take years to sell it completely. The longer it takes, the more it costs the developer and the more it cuts into profits. Quicker sales and moving inventory is key, as long as developers can build as quickly as the marketing arm can sell. This is why group buying can really be a win/win for the developer, as we discuss in the next chapter.

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7. Market the Project Some of the things that can be done to market a project are: ■

Put up a sign(s) at the entrance to the subdivision or development.

■

Set up a trailer on the site, or a model home. They can demonstrate the quality of construction, color choices, samples of building materials, and so on.

■

Advertise locally and nationally.

■

Conduct open houses or broker invitations.

■

Put on presentations nationwide on the project to investor groups or a target market.

8. Get Final Construction Financing It might seem odd that this would come after the marketing of the project. However, especially in a larger project, the pre-sells and contracts in hand of the interested buyers get the developers their loans. For smaller developers of single-family homes this might not be the case, as they might sell one and build one and then sell another one and build that one. But the large vertical developers must pre-sell units to get their financing. The more units sold, the less equity the developer has to commit. The following steps are necessary to obtain construction financing: Appraisal of Project

This needs to be completed and submitted with the loan package. Title Work

This is to confirm that the title is free from encumbrances and that there will be no other liens except for the new loan from the lender at closing or other approved liens. Approval of Pre-Sold Units

The lender will review all of the contracts of the pre-sold units as an entire loan package of the project. Typically in a high-rise, the lender will require anywhere from 50 to 75 percent of the units to be pre-sold. It may vary for projects that are not attached as one single building.

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Approval of the Developer

The lender will screen each of the developers and their partners involved in the partnership. However, it is a commercial project and as such, the project will be evaluated much more highly on its own. Surveys

Are they completed and satisfactory to the lender? Are all of the types of surveys that the lender requires completed? Environmental Testing

Is it completed and will any additional testing be required? The lender will inspect all these things as part of the loan package from the developer. G-Max “Guaranteed Maximum”

This is what a GC (General Contractor) sometimes calls its bid. The contractor guarantees that it will not go over that amount for the entire project based on the specs it has been provided and has quoted. (Contractors usually quote high enough to have some wiggle room.)

9. Get Insurance To get final loan approval for the project, several other things must be in place for the developer, including multiple types of insurance policies. A lender will require different types of policies. They are: 1. Builder’s risk 2. General liability 3. Worker’s compensation

Builder’s Risk Insurance

This covers the builder should the builder “lose” something during construction—for example, a theft of materials, a storm that damages the structure, or anything else that damages the project until completion. It essentially covers the builder until the project is completed. It can be very costly on larger projects that have a lot of

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materials on site. After the project is completed, the builder would have property insurance as opposed to builder’s risk. General Liability

General liability covers the developer from liability of being sued from a slip and fall, someone getting hurt on the site, and future suits over a possible construction flaw that causes injury or duress. Worker’s Compensation

This covers the loss of wages due to an injury caused on a job site. For instance, a roofer falls off of a roof and breaks his back, and can’t work for six months. He needs income to support his family because he can’t work. Worker’s compensation covers these on-thejob injuries. Usually the General Contractor (GC) of the project carries the worker’s compensation policy and also a general liability policy; however, the builder might also be the GC in a subdivision project. In a high-rise project, a GC would be hired to build the development.

10. Pull Permits To start construction, all of the proper permits must be obtained from the local municipality.

11. Build the Project Delays happen due to: ■

Weather

■

Contractors

■

Material/supplies availability

■

Any type of historical relics or Indian artifacts found on the project site

12. Manage the Project The developer must oversee all aspects of the development during construction to ensure that it is progressing properly. It may be necessary to hire a project manager to handle this.

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13. Get Certificate of Occupancy Once construction is complete and the units have received all permit approvals and inspections, the municipality issues a certificate of occupancy. This means that the units are ready to be lived in. At this point, the buyers may close on their individual units and take possession. Additionally, if the developer held the financing during construction, at this point the buyers would need to obtain their own financing.

14. Phase Out Project When developers open a subdivision, they usually get the entrance ready first, along with the roads and common areas. They also normally have a model home. They then pick one section, which they sell first. This is called phase one. After this is sold, they pick another area and call it phase two, and so on until the development is sold out. As each phase opens, the prices continue to increase (at least in an emerging market!). Then the developer sells the last units, closes up the model, and starts the next development. (Developers would most likely prefer to start their next projects before they are done with these last units.) Many times larger developers have multiple projects being developed at one time, but they start them using this same process, over and over again.

15. Resolve Miscellaneous Items Bonding

This ensures completion. It could mean several different things relating to construction. For instance, a city might require bonding from the builder to guarantee completion of certain parts of the project, such as roads, sewer, water, and so on. The city wants to be certain that a builder will complete these items as part of the project. Also, the finance company might require a bond on the project to ensure that if anything happens to the builder/developer, the project would still get completed and the lender would not get “stuck” with a partially completed development. Housing and Urban Development (HUD) Filings

This filing was originated from the Interstate Land Sales Act. It requires the developer to fully disclose the working parts of the

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development and requires certain disclosures from the developer. On the other (buyer) side, it commits the buyer to the project and allows the developer time to complete it. Some developments may take 3 to 4 years to complete. When the buyers agree to the terms and conditions of the HUD filing, they accept and acknowledge that their respective deposits are nonrefundable, as long as the project is in development. HOA Documents

The developer must create HOA (Home Owner Association) documents, if there will be one in place. Many new residential and condo developments have associations. As you can see, there are many steps necessary for a developer to complete a project. This is by no means an easy process, and this certainly is not intended to be a road map. It is simply an overview to give the reader an appreciation for what goes on behind the scenes for a developer/builder. Next we will cover group buying and how this helps the developer to complete the project.

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CHAPTER

19

The Power Of Group Buying

W

hat does “group buying” mean in relation to new-construction investing? There are several ways to purchase new-construction property: individually, by referral, with business partners, or as part of a large group. Buying as part of a large group is, simply put, the most powerful and safest way to invest in new construction. This does not necessarily mean that you are taking other partners, but rather that you are getting the benefit of group buying power. It is like the Costco or Sam’s Club of real estate purchasing. When things are purchased in bulk, volume discounts are given by the manufacturer or seller. A typical individual, referral, or partnered buyer follows a path that goes as follows: Step One: Identify the target area. The average investors will find their target areas either when they read a news or magazine article saying it’s a hot area, when a friend or real estate professional gives them a tip, or, rarely, they may research market indicators. Unfortunately, in most cases, they will be too late. By the time the media catch on, or a tip by word of mouth comes around, the savvy investors have already made most of their money and the market has already done the bulk of its appreciation. The market has probably already emerged. If the buyers are lucky, the market will continue to appreciate, and they will still make some money, however in many cases by the time the property is built it may be too late. The market might have already peaked. Step Two: Buyers select the new construction property they would

like to purchase. To do this they likely seek the help of a Realtor, or visit the area to look for signs or sales offices posted by the builder. Realtors only know about projects that offer commissions. They don’t

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know about the projects where there aren’t even signs on the property, or about projects that haven’t received full approval by the respective city or township. Realtors or sales staff in a builder’s sales office make their money on commissions, so the only projects they will attempt to sell you are the ones that have been released to the public and are offering commissions. Those might be fine projects, but the opportunities they can present to you, the investor, are limited. Some of the best opportunities for the investor are in hidden properties that the general public does not know about yet. We like to offer these types of properties on our Investing Tour events. When a buyer gets assistance from a Realtor, it means that the development has been released to the public, or even worse, that development has begun and the Realtor is selling higher priced, later-phase offerings. One developer even tried to get our attention on a property that was in phase seven. Phase seven! No thanks! That is too late. The situation is much the same when finding signs or sales offices for a specific builder. The builder has already begun sales to the general public, or even worse, has sold out the first phase and is offering a second, third, fourth, or more phases at a much higher price than phase one. We like to offer projects on our Investing Tours in what we call phase zero. No one knows about them yet and they are pre-public. That is why we call this phase zero. We will also buy in phase one, if we get a very good discount over the general public. The individual buyer has now found an area and a builder and project, so that buyer is ready to move on to: The purchase. The buyer picks a unit. Unfortunately, the prime units are already sold, because it’s too late in the process. The builder has done a pre-public sale to friends and family and has usually done a Realtor open house. The builder then will do a public release or what might be called phase one. At this point the builder’s price to an individual is fixed and the buyer can’t negotiate a discount. If the buyer can negotiate one, it likely means the builder is having trouble selling the project and it probably isn’t a very good deal or market. At this point you know the market is softer and you are in a prime position to negotiate, but be careful. An emerging market is a much safer investment. A soft market can be good if you are skillful in negotiating with the developer and you can wait through a few years of potential vacancies or negative cash flow. If this is the case, you will want to employ strategies we

Step Three:

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discussed in regard to buying from builders in distressed markets, in Chapter 11. If buyers want upgrades to the homes they pay full price for all of them. The buyer then signs the contract and puts down a typical 20 percent on the unit. Step Four: The buyer anxiously waits for the property to be built. Step Five: Finally, the unit is completed or close to completion and the buyers need to either sell or rent their existing homes. They pick a Realtor or property manager and try to sell their properties. If everything went well and they didn’t buy too late they make a profit, otherwise they can be stuck breaking even, or worse, losing money! All in all, this looks like a lot of risk, with the potential for very little or nothing in return. Sounds pretty discouraging, doesn’t it? It can be if you don’t hit the right market and development at the right time. For the most part, many of those markets in our country have changed and are gone. This is why it is so important not just to be lucky, but to be strategically looking for the right place. So how do you invest in new-construction real estate and work to contain this risk, and vastly increase your chances of making a profit? The answer is through group buying. Group buying is participating as one of many buyers, organized together, usually traveling together to purchase new-construction real estate. For example, go to www.InvestingTours.com to find out how you can be a part of our group. The new construction investing process for a group buyer goes like this: The group buyer signs up with a group and travels to the targeted location. The location is pre-selected by our Investing Tour’s research team. We look at many markets, searching for indicators that a given market is getting ready to grow or has started to grow. We look for many factors, such as increase in new home permits, businesses moving to the area or increases in jobs, and mortgage loan default rates. These indicators allow us to select markets that the average buyer has no awareness of because the media aren’t writing articles about it yet. Friends and real estate professionals aren’t giving tips yet. Many times this market or area has not yet “emerged” as far as the public is concerned. Next, the buyers get to select the new construction investing deals they want to participate in from several deals brought to them by our

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A Group of Investors on a Recent Tour with Wendy and Justin.

tour. We find the deals before they are released to the general public, or if they are already released, we can negotiate significant advantages over the general public offering. We find numerous opportunities in the target area (an emerging market) and screen them for the best offerings and best builders. This provides group buyers far more choices and carefully screened opportunities than they would be able to find on their own. The next step for group buyers is to select the properties they want to buy. We have negotiated for them, obtaining pre-public unit selection or getting discounts of 5 to 10 percent or more off public pricing, or possibly both. Buyers will select from the best units, because those are reserved for our tour. Group buyers may be able to get upgrades for free or at a reduced fee, because our tour has already negotiated for this on their behalf. The buyers sign their contracts and make their down payments, usually around 10 percent down, because we have negotiated reduced reservation deposits, thereby increasing the cash-on-cash return for the investors. How does our tour offer the group buyer discounts on pricing, options, and down payments when the individual buyer cannot negotiate these at all? It is through the power of many. Investing Tours can

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Investors Choose a Prime Lot on an Investing Tour

negotiate for the buyer because they represent a large group of buyers, giving them far more power with the builder than the individual buyer has. As discussed in the last chapter, developers need to pre-sell a certain number of units. Our group does that for them. Now, the builder starts construction and the group buyers sit back and wait, watching their investments appreciate in value. If the project takes longer than anticipated, that’s great for the group buyers, because the builders selected by Investing Tours must carry the interest, so the buyers benefit from additional appreciation without being stuck with additional costs or payments. We discuss the construction to permanent loans in Chapter 15. Those carry more risk for the buyers, and therefore we do not usually have those on our tours. Once construction is complete, the group buyers sell or rent their investment properties. We already have pre-screened, well-qualified Realtors and property managers to assist investors if investors wish to work with them. It’s easy to see how the group buyer has substantial advantages over the individual investor. These advantages help contain risks by

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finding the right markets at the right times and by finding the best deals. They increase chances for larger profits by capturing early appreciation and negotiated discounts. They also provide a network of contacts, simplifying life for the group buying investor. Group buying

Power

One example demonstrates the advantages of group buying. This investor recently came on our tour. We’ll call him Joe. Joe had purchased a new construction investment by himself as an individual before coming on our tour (without using group buying). His story is a very valuable piece of learning. Joe had heard about how much money can be made in new construction and wanted in on the profits. After asking around and reading some news articles, he decided on a waterfront community that had been getting fabulous press lately. He wanted to try to be smart about investing. He was risking a substantial amount of money, So he traveled to the area. After looking around for a few days and seeing all of the construction signs, Joe decided to visit a Realtor for help. The Realtor told Joe about a fantastic opportunity, a high-rise condominium, right on the water with terrific amenities. “It’s so hot,” the Realtor told him, “that the first tower sold out in two days!” The builder had started construction on the first tower and was now selling units in the second tower. Wendy and Justin’s Advice: If the Realtor says it is after phase one for the release, it is usually too late for the best investment!

After Joe took a look at the project, he was excited and decided to buy a unit. He selected a two-bedroom unit with a partial view of the water for $425,000. Joe put 20 percent down to reserve his unit and signed his purchase contract (which is not assignable). The build cycle was two years, and Joe was licking his lips at the appreciation he was going to make during that time. Joe returned home and waited for construction to be completed. Because Joe was investing by himself, as an individual, he just missed out on some very important things that would have made him more profit:

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A 20 percent deposit is very common for high-rise developments on the water. This is what Joe paid. We don’t like to offer anything with 20 percent reservation fees on our tours. Most of the time, we can negotiate with the developer and have that deposit reduced, sometimes to 10 percent—half the amount of cash. This does several things for us: (1) It allows us to do more real estate transactions because we have kept more cash in our pocket, (2) It makes a phenomenal increase to our return-on-investment on the back end, because we are in a much stronger leverage position. Leverage is critical to the real estate investor. We just made a massive increase to our leverage, and can now do two of these properties if we wish, instead of just one.

■

Joe paid full price for his unit. In desirable new-construction developments that have strong demand, there is no negotiating —for the individual investor, that is. With our large group of investors, we have made it possible to actually negotiate price— and get a discount on the most desirable developments of all. We started doing something that no one else had ever done before. And it puts our investors in a very powerful position— where they have gotten into a prime unit at a discount.

■

The purchase agreement that Joe signed is not assignable, which is fairly common these days. When a contract is not assignable, that means the investor can not re-sell the contract for a fee prior to closing, and that the investor must close. Developers make this restriction so that the re-sale of investor units does not compete with the sale of their own units. It is very desirable for the investor to have an assignable contract. This gives the option of re-selling the contract before construction is completed. If the investor does this, no mortgage will ever be required. As you can see, this is a very powerful option to have available. This does not mean that an investor will assign the contract, simply that the option exists. As you know, you need to be prepared to close on every single property you take on. Nonetheless, having this option available is very powerful. Joe did not have this option available. Most of the time, our investors do get an assignable contract. This, once again, is made possible only because of the size of our group. The developer is willing to extend this privilege to a certain group of people only, near the front end of the transaction, because we are helping to get the project out of the gate quickly, and we are rewarded for that contribution.

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Remember, the project that Joe bought into had already been released to the public. This means that a buyer frenzy had already been created—and this buyer frenzy drives up prices. This public release also causes some of the prime units to get purchased. Our favorite types of properties, that are commonly on our tour, are the ones that have not been released to the public. They are hidden properties that no one knows about—except us. The hidden property is a very powerful way to invest.

People who invest by themselves, or with just a small group, can buy only the way a retail buyer buys—at full price, and according to all of the developer’s terms. When you are part of a large group, things really change: ■

Hidden properties

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At discounts

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With less cash out of pocket

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And the possibility of assignable contracts

Check out our schedule of tour dates at www.InvestingTours.com. We have no qualms saying that our methods are by far the most powerful way to invest in new construction real estate because, quite simply, they work. We have seen what we do work over and over again with our own eyes; which is why we’re so passionate about you seeing it for yourself! In the next chapter we will be covering how to exit from your properties. It is one of the most important things to consider before buying. How will I exit (get out) of this property?

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CHAPTER

20

Exit Strategies When and How to Sell

A

ny savvy investors will tell you that at the time they buy, they have their exit strategies planned. Pre-planning in investing is critical. Buying an investment property, hoping it goes up in value, and then selling at some random time is no way to build a fortune in real estate. You might not always be able to or always choose to stick to your intended exit strategy, as circumstances change, but you should always have one in place when you are buying. You plan your exit from the property (or how you will be selling the property) at the time you buy because it helps you determine what property to buy. As an investor, you will also need to consider market cycles in addition to holding costs, tax implications, and cash flow potential. For example, an investor who is looking for a quick profit with low holding costs would try to sell before construction is complete, whereas an investor who is looking for larger profit with less capital gains tax would hold the property after construction is complete as a rental property for a minimum of one year. An investor would hold the property for longer than one year if the market cycle was solid and the investor’s strategy would allow for the time frame. The timing of your sale is the most critical component. If you sell too quickly, early in the market upswing, you might be giving away the bulk of the appreciation profit to the buyer. If you sell too late, past the market peak, you’d be stuck with a property that takes a long time to sell, and for less money. As we discussed in Chapter 5, in 203

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the discussion of market cycles, it is critical to your investing success to be familiar with these cycles and to know the timing of your investment market. Ideally, you want to sell somewhere leading up to the peak of the market. Remember that a property can continue to appreciate for a short period of time past the market peak. However, properties do take longer to sell and may begin to come down in value shortly thereafter. Selling Options ■ ■ ■ ■

Assign the contract during construction Sell when construction is complete Lease and then sell Lease option

Assign the Contract During Construction Let’s take a look at your different selling options. The first in order of timing is to assign your purchase contract during the construction period. A contract assignment is when you transfer your purchase contract to another buyer, usually for a fee. Most developers will not permit you to do this. They don’t want you assigning contracts at the same time they are trying to sell their units, because you will be competing against them. However, in some cases this is an option. Participating in a group Investing Tour often helps you negotiate contract assignment. When you assign your contract, the new buyer pays you a fee and then closes on the property when construction is complete. The fee that you collect is your profit on the investment (after deducting your deposit cost). If the developers permit a contract assignment, they will likely require you to be responsible should your new buyer fail to close. In most cases, the developer will control the assignment process. The developer will usually charge a fee to allow an assignment, along with the commission. This is customary. The developer might only allow resales (assignments) through its own sales center. In this way, the developer controls the inventory on the market and also the pricing, and retains control over the marketing. This eliminates having for sale signs by several real estate companies, or “for sale by owner.” This upholds the value with the development for all. Consistency is key to selling and marketing a development. It is good for you, as a

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seller, and for the developer to sell out an entire development. Usually a developer will not allow assignments until groundbreaking or until construction financing is in place. The developers will want to make sure they have sold enough units of their own inventory before they allow resales. Take, for example, a waterfront high-rise condominium in an emerging market, a warm southern state favored by Baby Boomers for retirement and second homes. We assume that you participate in an Investing Tour to maximize your investment potential. The build cycle for this building is two years from the date of contract signing. On this particular deal, Investing Tours can secure a 10 percent reduction off public pricing and negotiate a 10 percent deposit. You select a two-bedroom, two-bath unit for $355,500 (the price when it’s released to public two weeks after the tour is $395,000). Your deposit of $35,550 is due at the time you sign the contract. During the initial part of the market upswing, we will assume appreciation rates of 10 percent per year. So at the end of the first year your unit has appreciated to $434,500. At that point you decide to assign the contract by putting your unit on the market. And let’s say you decide to “leave some money on the table” to facilitate a quicker sale. Let’s say you sell your unit for $419,000. What will your profit be? Based on a selling price of $419,000, you might pay between $25,140 and $29,330 in Realtor commissions. This is 6 to 7 percent, which is what we see as typical for developers who allow assignments. Most of this goes to the Realtor, and usually a portion will go to the developer for the assignment fee. This is only an estimate, and it will vary in each situation. The pre-tax net profit to you after deducting the remainder of your purchase price and initial deposit is $34,170 (assuming the 7 percent commission). Because you never took ownership of this property, you have to pay the short-term capital gains tax rate, which is the ordinary income tax rate. Let’s say you are married with a combined income level above $63,700 but below $123,700, which puts you in the 25 percent tax bracket. Your federal tax on this property would be $8,543, giving you a post-tax net profit of $25,627. In the one-year period, this is a 72 percent return on your money, a very handsome return considering you never owned the property. Even though this is a good return, this is not usually our intended exit strategy method. It’s always more challenging to sell a property quickly than it is to sell a property over a longer period of time. Even

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though the developer is getting paid a sales commission to resell your unit, rarely is this a developer’s top priority. Of course the Realtor on-site wants to sell out the development, but which unit is unimportant, as they are all paying equal commission. Remember, many times the units that were sold first were the best units, and might likely be the ones that will sell again quickly. There might be pressure from the developers to sell their units first. You never know. With this being the case, we always have realistic expectations, which usually include intending to hold the property long-term. This allows us to facilitate a profitable and realistic exit strategy. Going longer-term with the exit strategy also creates a more profitable transaction. Assigning a contract might be quick money, but rarely is it big money. Always remember, you must be prepared to close on every single property that you add to your portfolio. This doesn’t mean you will close, but you must be prepared to close. Why is this? What if you can’t assign your contract? Do you know what happens? You have to close on the property. What happens if you can’t close? You forfeit your deposit. That is a huge loss. It’s also a very good idea to be prepared to go long-term on every single property you add. This way you will always be safe.

Sell When Construction Is Complete: (Using a Realtor or FSBO) The second option for selling is to sell once construction is complete. With this method, you wait until construction is complete, close on the property, and then re-list the property for sale. You might use this method in the following way: After closing on the property, you might wish to list it for sale and for lease at the same time. This allows you to attempt to sell the property immediately. If the numbers are acceptable, you might wish to do that. You can also try to list your property before construction is completed, to give yourself some additional marketing time. Realize, however, that some MLS organizations have rules against listing a property that you do not own. Check with a local broker or the local MLS in that area to determine their policy. Even if you can’t list the property before you’ve closed, you can list it the moment you do. And you can put two listings in the MLS at the same time—one for sale and one for lease (at least in most

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areas of the country). We have done this many times, and whichever option gets fulfilled first is the one we would take. More often then not, we end up renting the property, which allows us to gain additional market appreciation. But there is no harm in listing the property for sale at the same time. You might get lucky! The numbers would look something like this, assuming you do not secure a mortgage: Selling price would be $477,950. Less Realtor commissions, original deposit, and original purchase price, that yields a gross profit of $58,223. The tax rate is the same as assignment, short-term capital gains at 25 percent, resulting in $14,556 in taxes and a post-tax profit of $43,667.

Lease and Then Sell The third selling option in new construction investing is to lease the property and then sell. The point of this strategy is to maximize your appreciation capture, selling near the peak of the market and reducing your taxable impact. History clearly shows that when a market gets closer to the peak of the cycle, appreciation rates accelerate. When you follow this strategy, you will need to secure a mortgage and you will need to place tenants in the property. We discussed mortgages in Chapter 15. For the sake of this example, we will assume that the mortgage is a 3/1 interest-only ARM on a second-home purchase with an interest rate of 7 percent. The mortgage origination fee and closing costs when you buy will be an estimated 3 percent of the purchase price, or $10,665. The interest-only monthly payment would be $1,866.38. You would also need to pay property taxes, insurance, and condo association dues. All three of these can vary greatly by location, so we can only estimate these costs. We will say that the monthly property taxes will be $350, insurance will be $267, and condo association dues will be $495. This brings the total monthly payment up to $2,978.38. We also need to take into account property management. Unless you actually live in the same market, you will need property management. Placing and managing tenants on your own will cost you far more in time, money, and stress than using a property manager. Even if you live in the same area, you might quickly find that it is much easier and less of a headache to have a property manager handle your property. Property managers collect anywhere from 7 to 12 percent of gross rents as their payment. In this case we will say 10 percent, which

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is typical for a single-family unit. The market rent for a two-bedroom waterfront condo in this example is $2,400, making the property manager’s monthly fee $240. Adding the property management fee to the total monthly payment and deducting the monthly rent results in a negative cash flow of $818.38 per month during year one. Based on the market cycles, we would say that the market peak happens after two years of renting, and the property would be sold at that time. In the second year, the market rent becomes $2,450, increasing the property manager’s fee to $245 per month, but decreasing the negative monthly cash flow to $773.38. By selling when the market is near its peak, the demand is still great and the property should sell quickly. Because the appreciation rates accelerate closer to the peak of the market cycle, we will use a 12 percent rate of appreciation for the first year as a rental and 15 percent appreciation for the second year as a rental. Thus the value after two additional years of appreciation is $615,599.60. To help keep the numbers simple, we will round off to $615,600. The cost to sell will be $36,936 in Realtor commissions, plus some possible closing costs. This will give you a large pre-tax profit evenafter the negative cash flow. We recommend that when there will be negative cash flow in a unit, you plan for it up front. Put aside the amount of money needed for the length of time you are planning to hold the unit. We talked more about this in detail in Chapter 14. Justin and Wendy’s Advice: Be safe and not sorry—plan ahead for negative cash flow properties in high appreciating markets. Put aside the cash in advance!

Because you purchased the property and held it for more than one year, you are now eligible for the long-term capital gains tax rate of 15 percent instead of short-term capital gains (ordinary income tax rates). This makes your federal taxes $27,209.68, with a post-tax net profit of $154,188. Your cash on cash return over four years is 282 percent, or 71 percent per year.

Lease Option The fourth option when selling is to sell the property on a lease option. We discussed this strategy in more detail in Chapter 7. Please also reference www.WendyPatton.com for additional information.

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This is similar to the lease and sell strategy; however, with the lease option you might be able to reduce your negative cash flow, which would reduce your out-of-pocket cost and increase your cash on cash return. Let’s see how this works. With a lease option tenant, you will collect an option fee when the lease is signed. This secures the purchase price, and is also applied against the purchase price when the tenant buys the property. Typically option fees range from 3 to 5 percent of the purchase price in a market on the upswing of the market cycle, we’ll say 4 percent in this example, making the option fee $20,080. This amount is nice to have, as you can use it to offset your negative cash flow. Additionally, with a lease option, typically there is a markup on the purchase price; for this example we’ll use 5 percent. The time you close on the property is the time you would place a lease option tenant in the property. Thus the 5 percent markup is based on the value after two years of appreciation, in this case $501,847.50. We might make it sound better at $499,900. We’ll say that the tenant buyer has two years in which to exercise an option; however, after the end of the first year the option price will increase to cover some of the additional appreciation; we’ll make the increase 12 percent. To make an even comparison to the “lease and sell” strategy, we will assume that the tenant buyer doesn’t exercise the option to purchase until the end of the two-year period, making the resulting purchase price $562,240. In addition to collecting the option fee and increasing the purchase price, the rent on a lease option property is typically higher. In this case we’ll say the rent in year one is $2,700 and the rent in year two is $2,800. This results in a year one negative cash flow of $6,580.56 and a year two negative cash flow of $5,500.56. Remember however, that you collected a $20,080 option fee at the onset, which more than covers your negative cash flow, thus keeping you from paying any additional out-of-pocket costs. Let’s take a look at the profits on a lease option. Based on the option buyer’s purchase price of $562,240, your pre-tax profit would be $139,014.76. You would also qualify for the long-term capital gains rate on this property making your federal taxes $20,852.20, giving you a post-tax net profit of $118,162.48. Because you didn’t have to pay out of pocket for the negative cash flow, your cash on cash return goes up to 333 percent, or 83 percent each year.

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Summary of Exit Strategies: (The Power of Long Term vs. Short Term) Now that we have examined the four exit strategies, let’s compare the results to determine the pros and cons of each. With the contract assignment option, the turnaround was quick at one year, with a low profit—$25,627. No mortgage was required. Taxes were high, at over $8,543. The cash on cash return was 72 percent. The contract assignment is quick money, but it’s not big money. We have not taken into account the amount of time spent finding the emerging market and then finding the deal within the market. If your funds are sitting and waiting during this time, it will substantially reduce your cash on cash return for the quick turnaround of contract assignment. For example, if it took six months to identify the market, find the deal, and secure the property, and then you did the contract assignment one year after you secured the deal (for a total of 18 months) your cash on cash return drops to 48 percent. (The post-tax profit was $25,627. Divide that by the deposit of $35,550 ⫽ 72 percent. Divide 72 percent by 1.5 years ⫽ 48 percent.) That is still a very healthy return. However, on the longer-hold strategies, this additional time has less of an impact, as you’ll see in a moment. The “sell when construction is complete” strategy yields a nice dollar return, but is still, comparatively, small money at $43,667, especially given that an emerging market sees the greatest rates of appreciation later in the upswing. The investor is passing on much larger profits. The “lease and then sell” strategy yielded the highest dollar return at close to $154,000. The hold period was four years and a mortgage was required. Although this strategy provides the highest dollar return, it does require more money out of pocket to cover the negative cash flow from renting at a loss for two years. The annual cash on cash return was 71 percent, when factoring in the additional six months for locating and securing the deal, it drops only to 63 percent. There is greater tax savings from holding longer term. Because the tax rate dropped to 15 percent, the total taxes paid were only $27,000. This option is certainly the most attractive. It does require almost $20,000 in additional funds to cover the negative cash flow. This might not be feasible for everyone. This is why the lease option strategy can be an excellent alternative. This strategy still provides substantial profit at $118,000, but does not require additional payment to cover the negative cash

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flow—the option fee covers it. Because of that, the annual cash on cash return was higher at 83 percent. Factoring in the extra six months for location and deal finding, the annual cash on cash return drops only to 74 percent. Like the “lease and sell” strategy, this option does require a mortgage. It also provides tax savings with the long-term capital gains rate. The taxes were just short of $21,000. In all of these examples, we included the cost of a real estate commission. The commissions might have seemed quite high, ranging from $26,000 to almost $37,000. That extra cost can take a large portion of profit, which prompts some investors to try selling on their own. A good Realtor often earns a commission in the time saved in the negotiation process, in proper pricing, and in the many other things that Realtors do behind the scenes. Selling on your own isn’t always feasible, and it isn’t always wise. If you live a long distance away from the property, trying to sell on your own is virtually impossible. Showing and marketing a property from a long distance simply isn’t viable. If you live close to your investment, you need to consider the value of your time. You can sell your property on your own; however, it may require numerous showings and a lot of effort on your part. Many homeowners who try to sell on their own are often very surprised by the amount of time and effort they must dedicate to the task. Second, you need to make sure that you have the most current value on your investment. In a market where property values are rising quickly, it is a big mistake to try to set a price based on tax assessments or even on the sales history you see in the local newspaper. An inaccurate price can easily cost you as much or more than a Realtor’s commission. Third, the Realtor’s Multiple Listing Service is the single greatest marketing and sales tool in existence for residential real estate. By trying to sell on your own, you are crippling your marketing efforts and will likely increase your time on market, which increases your holding costs and decreases your profits. If you do sell your investment exceptionally quickly on your own, there is a very real chance that you severely underpriced the property. And Fourth, if you have no experience selling a home, it can be very easy to make mistakes in the sales contracts. Poorly written or deceptively written contracts not only can cost tremendous amounts of money, but also create enormous legal problems. All of this being said, it does not mean you cannot sell on your own. However, if you are going to try, you should do your research

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and exercise caution. Also, bear in mind that the 6 percent commission rate we used in the examples is not a number that is set in stone. Commissions are negotiable, especially in hot markets. A 1 percent reduction in the commission could save you thousands of dollars.

Other Tax Strategies When we consider our exit strategy in new-construction investing, we also need to take tax strategies into account. We recommend talking with your tax advisor when planning any of your tax strategies. In these examples, some strategies are taxed at the short-term capital gains rate, which is combined with employment income. If you make enough profit on your properties, in addition to your regular employment income, you could move to a higher tax bracket. This would increase the tax you pay both on your real estate investments and also on your regular employment income. This is definitely something to consider when you are planning your exit strategy. 1031 Exchanges

In these examples, the highest amount of tax paid was $27,000, which is a substantial amount of money to give up in taxes. There are legal ways to reduce the taxable impact of selling your real estate investments. One way is the 1031 exchange. The details are beyond the scope of this book, but we will examine how they can save you thousands of dollars in tax payments and also make you tens of thousands, if not hundreds of thousands, of dollars in additional profits! A 1031 exchange is a tax deferment. You take the profits of an investment property you sell and roll them into one or more other real estate investments. By doing this, you do not pay any taxes from the sale of the first property at that time. You can take the profits you make from the sale of your first investment and roll them into more real estate investment properties. How does this benefit you? Obviously, it can save you from having to pay up to $27,000 in taxes from our examples, but also imagine the additional buying power you have on more real estate if you can invest that $27,000 instead of paying it to the government. The power of growth from this is exponential. Each time you perform a 1031 exchange, it gives you that much more buying power from the tax savings. To learn more about 1031 exchanges go to www.lnvestingTours.com and read the article on 1031 exchanges.

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Self-Directed IRA

Another very powerful technique for eliminating your taxes when selling your real estate investments is the self-directed IRA. Using a Roth IRA, which is funded with post-tax dollars, to buy real estate allows you to increase your IRA at a terrific rate tax-free. To use your Roth IRA to buy real estate, it must be a self-directed IRA. We recommend Equity Trust, www.trustetc.com. In a self-directed IRA you control your IRA funds, choosing the investments. Because the IRA is a Roth IRA, any profit made from your real estate investing goes back into the IRA without any taxes paid at the closing or when withdrawn from the IRA. When you are eligible to start taking disbursements from this IRA, you take them tax free. Like the 1031 exchange, this allows you to reinvest all of your profits into more deals, instead of paying tens of thousands of dollars in taxes on each real estate investment. To get an idea of how powerful either of these techniques can be, let’s imagine that you take the $27,000 in tax savings from your first real estate investment and invest it into another property. After four years, that $27,000 investment yields a tax-free or tax-deferred profit of $80,000. Combining the original $27,000 and the $80,000 profit, you invest in two more properties. After four years, those deals give you a profit of $130,000 each. Combining those profits with the original investment money of $27,000 and $80,000 in profit off the second deal, you’ve made $367,000 in eight years. If you take the $367,000 and invest it in six more deals for four years, you could realize a total profit of more than $1.1 million. That is the power of exponential growth. In only 12 years, you can make over $1 million off of the $27,000 that was originally going to be paid as taxes! Gulf Opportunity Zone Act – GO Zone

The final tax strategy we will discuss is the Gulf Opportunity Zone Act of 2005, or GO Zone Act. The GO Zone Act was enacted after Hurricane Katrina to spur rebuilding efforts. If you invest in real estate in areas that qualify, you can receive a 50 percent first-year bonus depreciation deduction (normal depreciation on residential real estate is spaced out over 27½ years). In the examples we used above, that would amount to a deduction of more than $160,000 in the first year of ownership. This would not apply if you did a contract assignment or sold as soon as construction was complete,

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because the property must be held as a rental. As an additional bonus, if this deduction generates a loss against its rental income, this loss can be carried back five years or carried forward up to 20 years against other taxes. You must place the residential real estate into service by December 31, 2008 for your investment to qualify, unless the property is located in Hancock, Harrison, Jackson, Pearl River, or Stone Counties, Mississippi. Those counties have been extended until December 31, 2010. The GO Zone Act is a huge tax savings benefit, one of the biggest in our nation’s history. The exact rules of the GO Zone Act are a bit complex, so it would be wise to seek the help of a qualified CPA. We also have an article on the GO Zone on our Web site, www. InvestingTours.com. Wendy & Justin’s Advice: No matter what exit strategy you choose, it is best to know how you will get out before you get in!

In the final chapter we will cover investing in a foundation of reality—the things that can happen during your investment process.

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CHAPTER

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W

e are very optimistic people. Our optimism is also a certain type of optimism: it is based firmly on a foundation of reality. We like to discuss challenges that can develop. If you understand what these challenges are, you will be prepared to address them when they come. A successful real estate investor is a problem solver. And if you get skillful at solving problems, the reward will be enormous profits in the end. We should discuss some things that might or might not happen to you while investing. If they do happen, you will be more prepared and better able to handle the situation. Optimism is fine, but you also should have a realistic picture. The point of this chapter isn’t to scare you away. It’s to prepare you for possible situations so you won’t be scared away. When real estate investing is done right, it is profitable, even with its challenges. We actually enjoy studying problems. Everything in life contains problems. Every type of investing contains problems. But problems also have solutions, and these solutions can empower you. As we discussed in Chapter 18, developers have pretty much one goal in mind: get their projects off the ground and completed. This is how they get paid and make their living.

Goal for the Developer Build new real estate development. Basic steps for the developer: 1. Find & lock up (usually called optioning) or purchase of the land outright 215

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2. Evaluate initial financing for the project 3. Hire engineers and architects to design buildings or subdivisions 4. Get city/township approvals (usually a multiple stage process) 5. Get state or other approvals 6. Find a marketing arm or Realtors for the project 7. Market the project 8. Get final construction financing 9. Get insurance 10. Pull permits 11. Build the project 12. Manage the project 13. Get the Certificate of Occupancy 14. Phase out the project 15. Resolve miscellaneous items As you can see by this list, detailed in Chapter 18, there are many steps and many details in between each step. In new-construction development, many things can cause a delay in a project. For many builders and projects, a delay almost becomes the norm. Unfortunately, we see delays more often than we see on-time delivery of a project. This however, can be very positive for the real estate investor if you are: ■

In an emerging market and it is appreciating (and)

■

You have a true pre-construction contract, and you do not have a construction to permanent financing type of loan where you are accruing interest or even paying interest during the construction period. (See Chapter 15 to learn more about construc tion to permanent or perm financing loans.) They are not “bad” by themselves, we just don’t like them for this reason. If your monthly payments are more than the market appreciation per month, the delay begins to cut into the profit and cash reserves. This is why we prefer projects where someone else is carrying the construction financing.

So why do developers get behind? There are many reasons. Let’s discuss just a few of them in this chapter.

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Contractors Get Behind The contractors hired by the developer make money only when they have jobs lined up. As such, it is not uncommon for them to overbook when work is plentiful. Additionally, when a market is beginning to emerge, there are fewer workers in the area, probably caused by a shortage of work in the past. The sudden rise in demand of an emerging market can result in a labor deficiency. This problem is certainly not unique to new construction. If you have done any other type of real estate investing, you are probably already familiar with contractor delays. If you are a rehabber especially, or own any type of real estate, you are already aware of the types of delays contractors can have on your projects. Now, take those delays you have and multiply them 100 or 300 times. That is what a developer has to deal with on a large development.

Architects Change Plans When architects review a development or building design, many times they recommend changes. Sometimes the city’s architects recommend changes. This usually leads to longer delays, as the changes must be made, and then they must apply to get on the next city or township agenda to review those changes. Also, the developer may decide on a better use for part of the structure as the project unfolds and request that the architects incorporate the changes. All of these changes must be approved by the township or possibly other approval processes (lenders, and so on). Any change in plans cause delays.

City Delays Approvals of Plans or Requests Changes To obtain approval from the local municipality, developers typically must jump through many hoops and an assortment of people in the municipality must approve different parts of a plan. Also, once construction has begun, inspectors may require changes, or there may be delays in getting the inspectors to the site to do the approvals. We find that especially in emerging markets, the inspectors tend to be behind on inspections. They are busy with many building permits. It can cause a backlog in the community.

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Specific-to-Area Changes (Wetlands, Airspace) A specific site may cause issues or changes. Building near local airports or military bases can require making certain accommodations in terms of land use. Building on wetlands or finding that an endangered or threatened species lives on the land can cause problems. Sometimes people who live next to the intended project don’t want the land developed, so they will try to throw up roadblocks.

Natural Disasters Hurricanes, earthquakes, tornadoes, wind storms, ice storms, and thunderstorms are a part of life. Some of the most desirable places to live are also prone to natural disasters. In spite of these natural disasters, people want to live in these areas and home prices continue to rise. Look at California! Earthquakes are accepted as a fact of life and California boasts some of the highest home prices in the entire country.

Financing Delay in Final Contract Because developers often must pre-sell certain numbers of units to receive financing and start construction, delays in sales or slow sales can inhibit financing. Loan approvals also can be delayed for other reasons due to internal requirements of the financing company.

Changes in Contracts Any time a developer makes a change in a contract, an attorney will review it. Other delays or changes can sometimes make changes to the contracts necessary.

Delay in Completion Dates All of these issues can result in delays to the completion date. Remember, however, that if you selected the right type of project and financing, delays are often to your advantage!

Worst Case Sometimes projects get canceled. If a developer cannot sell enough units to obtain financing or cannot obtain the necessary rezoning or other municipal requirements, they cannot build.

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Fortunately, deposits are held in escrow accounts. If a project cannot be built, your money would be refunded to you. Some developers will hold your money in an interest-bearing escrow account, especially if the project will take several years. (You should always read your contract closely to determine if your deposit will be held in an escrow account. Also, if it is placed in an interest-bearing account, be sure that it indicates to whom that interest belongs.) Delays can be frustrating and stressful if you let them be. They are usually much more stressful if you bought into the wrong kind of project or at the wrong time in a market cycle. If you bought smart, however, delays are to your advantage. The smart buyer looks at a delay as extra money from the additional appreciation, without having to pay out of pocket or tie up credit. The following is an article written by Wendy for participants of Investing Tours. It addresses scams and pre-construction deals that literally are too good to be true.

Pre-Construction Investing – put your money down now! Get returns for 200 percent on your money next year! Developer will pay your payments for four years! Have you heard that before? As I have been seeing so much “hype” with e-mail blasts recently, from many different sources, about different pre-construction opportunities that are available through the Internet, I felt it was my duty to send this to you. It concerns me deeply to see some of the advertising that is used to attract people to these deals. One e-mail that I saw recently said “$50,000– 100,000 below market value, and builder will pay your payments for two years,” guaranteed equity, and also a market with at least 20 percent appreciation. Wow, I can’t believe anyone can guarantee something like that. Will it be in writing? Will they stand behind it with their own cash? Something must be said about development and how things work for developers. If the market is really strong in an area, the builder concessions and pricing are very tight. Why would builders give $50,000–$100,000 in discounts if they could sell units all day long? Don’t you think they would keep most of that profit for themselves?

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Think about that for a moment! Why would they pay your payments for four years if the market was so good, and give a huge discount? They would not think of offering that, nor would they need to. In residential real estate, in a “seller’s market,” do sellers knock their price down $20,000–30,000 just because, or are they getting 100 percent or at least very close to their asking price? Developers have a margin for profit and price their projects based on those margins, for the most part. Usually when you start to see large concessions from developers, you must be concerned. They are trying to “dump” or get rid of their inventory. We at Investing Tours, Inc. work very hard to get our investors a discount. Sometimes we can negotiate 5 to 10 percent below public pricing. These substantial discounts are for a large group of buyers to buy on a tour within three days. Why 5 to 10 percent versus $50,000 to $100,000? Because we are in an emerging market where the developers have many buyers and don’t need to negotiate much. These sort of “amazing deal” e-mails tend to “draw someone in.” Many times they are in markets that are not solid and are not emerging. Please check them out carefully. Be sure to do all of your due diligence. Don’t just get “drawn in” and make a buying decision based on that alone. If a deal ever sounds “too good to be true,” it probably is! Look toward a long-term wealth building plan and not just a short term “get rich quick” scheme. There are many good and honest ways to make money. Just make sure you are working with the right people and developers in your investing. We get a number of these “unbelievable deal” e-mails, and we see them posted on the Internet or being sold by others. There were many areas still seeing large volumes of construction as the boom tide was turning. Developers were stuck with inventory when sales were turning down. If a developer has sold 75 percent of a project during the construction period, but then the market turns before the other 25 percent is sold, what do you think will happen? A developer who lowers

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the price substantially is hurting 75 percent of his customers who already have bought. This does happen sometimes, much to the dismay of the property owners. How would you feel if you found out that the exact same condo you bought one year ago could be purchased for $50,000 less than what you paid? These problems can be avoided if you are a selective investor to begin with, and invest in the right product in the right market. Be conservative in terms of your cash outlay, always maintaining plentiful cash reserves. That way if the market does make a correction, you can always continue to hold the property until it rebounds. Two things really help to solve problems in the real estate business, time and money. Be prepared so that you can use these two powerful allies to your advantage. Wendy and Justin’s Advice: Understand problems so that you’re prepared to solve them in advance! This will allow you to always invest in a reality-based fashion!

Real estate investing is the best thing that has ever happened to either one of us. It is not our job; it is our passion! We also hope that you will discover the incredible journey of real estate investing, as we have.

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APPENDIX

A

T

he following are recommendations for websites and companies that can assist in new construction and emerging market investing. This list contains the websites mentioned in the book. www.InvestingTours.com Investing Tours, Inc. or call 800–913–7560—offering tours in emerging markets. www.CatalinaCapitalMortgage.com Catalina Capital Mortgage or call 954–537–7500—they offer mortgages in most states. www.ctcrem.com Coast to Coast Property Management or call 877–749–0055. www.WendyPatton.com Wendy’s website. It contains information on lease options and subject tos. www.PrepaidLegal.com/Hub/Mgott Pre-Paid Legal Services—Contact Michael Gott at 248–227–3943 for more information. www.InvestingTours.com/gozone.html An informative article about the GO Zone Act.

Other Websites: www.landcontractsystems.com Pete Scheepens’ website on investing using land contracts. www.census.gov/const/www/C40/table3.html A link to the U.S. Census Bureau where new home building permit data is tracked.

223

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www.homeloans.va.gov/pm.htm Veterans Administration foreclosed property listings. www.hsh.com HSH Associates Financial Publishers, a site that provides current and historical data for mortgage rates. www.hud.gov/homes Department of Housing and Urban Development foreclosure listings. www.realtor.org The National Association of Realtor’s website. www.treas.gov/auctions/irs/cat_Real7.htm List of property being sold by the IRS. www.trustetc.com Equity Trust Company, a leader in self-directed IRA accounts. www.usdoj.gov/marshals/assets/nsl.htm U.S. Marshal Service property auction. www.realtytrac.com A real estate foreclosure listing service.

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INDEX

Alta survey, 187 Amortization, 170–172 Amount of investment: example of, 139–140 incoming funds investingexpenses, 138–139 living expenses, 138 numerical analysis, 144–149 overview, 137–138 recruiting additional money, 140–144 recruiting partnerships, 141 Are You Missing the Real Estate Boom? (Lereah), 45 Assessed value, 175

Countercyclical investing: buying indicators, 58–59, 61 overview, 57–58, selling indicators, 60–61 Direct mail, and lease options, 75–76 Duplex, new construction investment of, 131, 132–133

Bandit signs, 97. See also “Subject to” technique Builder’s risk insurance, 191–192. See also Real estate investment, insurance “Buy and hold” strategy: calculating cash flow, 122–124 getting the right price, 121–122 going long-term, 124–125 numerical analysis (See Numerical analysis) Buying from builders: overview, 113–116 strategies for outright purchase, 116 lease option/purchase, 116–118 short sale, 118–120 Campbell, Robert M., 61 Catalina Capital Mortgage, 158–159, 223 Classified ads, and lease options, 73–75 CNNMoney.com, 67 Condo conversions, 51 Condotel/Resort, new construction investment of, 131–133, 177–179 Contract for deed (See Land contracts)

Emerging markets: amenities and, 49 baby boomers and, 42–44 buying, 59–61 closing costs and, 46 countercyclical investing in (See Countercyclical investing) days on market and, 56 defaults and foreclosures, 55–56 echo boomers and, 44 entering, 57–59 example of , 39–42 existing home sales, 53–54 financing (See Financing new construction) geography of, 38 immigrants and, 44–45 indicators of, 37 interest rates and, 45, 56–57, 156 location and, 48–49 migration patterns and, 47 months supply data, 54–55 new construction (See New construction) population growth and, 53 real estate as household wealth, 46–47 retirees and, 47 schools and, 49 selling, 60–61 stock market performance and, 47–48 timing and, 38–42 web site assistance, 223–224 Equitable title, 82

225

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226 Exit strategies: assign contract during construction, 204–205 lease then sell, 207–208 lease option (See Lease options) overview, 203–204, 211–212 for new construction (See New construction, tax strategies) long-term vs. short-term, 210–211 sell when construction is complete, 205–207 Financing new construction: construction financing builder financed, 151–153 buyer financed construction-only loan, 151, 152, 154–155 buyer financed construction-toperm loan, 151, 152, 153–154 steps of, 190–191 end loan financing adjustable rate mortgage, 155–156 fixed-rate mortgage, 155 interest-only mortgage, 156 negative amortization loan, 156–157 group buying (See Group investment) lenders and, 158–159 overview, 151, 157–159 See also OPC, OPH, OPI, OPM Foreclosures: kinds of auctions, 104–106, 109 bank-owned properties, 106–108 pre-foreclosure, 104 redemption period, 106 liens, 105–106 See also HUD auctions; Probate; VA auctions; Vacant properties Former boom markets: Baby Boomer demand in, 69 employment in, 69 foreclosures in, 67 insurance rates in, 69 market indicators, 68 migration pattern in, 68–69 overview, 63–65 population growth of, 68–69 prices in, 65–66

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range of affordability in, 66–68 unique properties in, 65 “For Sale By Owner” (FSBOs). See “Subject to” technique, FSBOs Gates, Bill, 12–13 General liability, 192. See also Real estate investment, insurance Getty, J. Paul, 57 GO Zone Act (Gulf Opportunity Zone Act of 2005), 177, 213–214, 223 Golden rule of real estate investing, 31 Group investment: example of, 200–202 vs. individual investment, 195–197 process for, 197–200 Hackeling, Michael, 42 HELOCs (home equity line of credits), 162, 167–168 HOA (home owner association), 177–178, 194 How to Use OPM to Fuel Your Real Estate Investing, 141 HUD (Department of Housing and Urban Development), 109, 193–194 Investing in Real Estate with Lease Options and “Subject To” Deals (Patton), 101 Kiyosaki, Robert, 161 Land contracts: advanced strategies, 88–89 buying with, 83–85 finding sellers, 85–86 myths, 90–91 overview, 81–83 selling with, 86–88 Land installment sales (See Land contracts) Law enforcement seizures, 108 Lease options (sandwich lease options): as acquisition strategy, 71 as exit strategy, 208–209 example of, 77–78 and high-end homes, 78 process of, 72 76–77, 79

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227

Index

locating, 72–76 title work, 76 Lereah, David, 45 Living Southern Style (Hackeling), 42 Millage rate, 174–175 The Millionaire Mind (Stanley), 49 MLS (Multiple Listing Service), and lease options, 72–73 Multiple streams of income approach, 110 National Association of Realtors (NAR), 43 New construction, 54, 127–129, 144 financing (See Financing new construction) hands-off approach, 129–130 property taxes, 173–175 tax strategies GO Zone Act, 213–214 self-directed IRA, 213 1031 exchanges, 212 types of, 130–133 warranty and maintenance fees, 177 web site assistance, 223–224 Numerical analysis: condotel costs, 178–179 home owner association fees, 177–178 insurance, 175 interest, 170–172 negative cash flow, 179–180 overview, 144–149, 169 principal, 170–172 property management fees, 176–177 property taxes, 173–175 return on investment, 180 vacancy allowance, 178 OPC (Other People’s Credit), 161, 165–166 OPH (Other People’s HELOCS), 161, 167–168 OPI (Other People’s IRAs), 161, 166–167 OPM (Other People’s Money), 161–165 Patton, Wendy, 101 Probate, 109

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Property management fees, 176–177 PUD (planned unit development), 185 Racketeer Influenced and Corrupt Organizations Act (RICO Act), 108 Ramsey, Dave, 139 RealtyTrac, 67 Real estate development: classification of, 183 process of, 183–184 steps for, 184, 215–216. See also Financing new construction approval of plans, 187–189 bonding, 193 certificate of occupancy, 193 delays, 192, 216–221 financing, 185–186, 190–191 HUD filing, 193–194 insurance, 191–192 management, 192 marketing, 189–190 optioning land, 185 purchasing land outright, 184 permits, 192 phasing, 193 surveys, 186–187 Real estate investment. See also Financing new construction: amount of (See Amount of investment) “buy and hold” strategy (See “Buy and hold” strategy) buying from builders (See Buying from builders) cash reserves, importance of, 21–22, 31–32 countercyclical (See Countercyclical investing) development (See Real estate development) emerging markets (See Emerging markets) exit strategies (See Exit strategies) financing (See Financing new construction) flawed thinking, 33 foreclosures (See Foreclosures) former boom markets (See Former boom markets) group buying (See Group buying) insurance, 175, 191–192

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228 Real estate investment (continued ) IRS seizures, 110 land contracts (See Land contracts) law enforcement seizures, 108 lease options (See Lease options) local vs. national, 11–12 local market influences, 48–53 understanding, 53–57 multiple streams of income approach, 110 national trends, 45–48 new construction (See New construction) numerical analysis (See Numerical analysis) obtaining the deed (See “Subject to” technique) Other People’s Resources (See OPC, OPH, OPI, OPM) outsourcing, 12–13, 29–31, 176–177 partnerships, 141 people trends, 42–45 probate, 109 property taxes, 173–175 risk management and (See Risk management) tax forfeiture, 108 timing, 33, 38–42, 203–204 vacant properties, 109 Resort/Condotel, new construction investment of, 131–133 Risk management: covering the rent, 21–22 demand vs. supply, 21 employment hubs, 21 fear, 17 brainstorming, 20–22 destruction of, 22–23 fear action threshold, 23–24 identifying, 18–20 flawed thinking, 33 insurance, 175, 191–192 process of, 26–33 property maintenance, 29–30, 176–177

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INDEX

reward analysis, 28–29 statistical probabilities, 25–26 sustainability of rents, 21–22 timing, 33, 38–42, 203–204 vacancies, 30–31, 178 ROI (return on investment). See Numerical analysis, return on investment Sandwich lease options. See Lease options Scheepens, Pete, 81, 85, 223 Single-family home, new construction investment of, 130–131, 132–133 Skeptics, 57 Stanley, Thomas, 49 “Subject to” strategy: buying at the right price, 94–95 “due on sale” clause, 96 finding deals direct mail, 97–98 “driving for dollars,” 98 FSBOs, 97 newspaper ads, 96–97 signage, 97 overview, 93–94 sample of, 101 Tax forfeiture, 108 Timing the Real Estate Market (Campbell), 61 The Total Money Makeover (Ramsey), 139 USA Today, 43 VA (Veterans Administration) auctions, 109 Vacant properties, 109 Warranty and maintenance fees, 177 Why We Want You to Be Rich (Kiyosaki), 161 Worker’s compensation, 192. See also Real estate investment, insurance

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