Our friend and long time Rock Star, Teymur Mammadov, told us a while back that he was going to begin writing articles for his site, The Ultimate Alpha Project.
We've heard this type of talk before, but little did we know that not only would Teymur begin, but that his stuff would be so good.
The focus of The Ultimate Alpha Project is to share strategies for optimizing your life: health, relationships, money...and building yourself into a real life super-hero.
When Teymur asked us to take a peak at a new real estate article we decided that we had to share it with you.
He speaks from experience, is well researched, very thorough and an all around great guy. In this article Teymur breaks out nine different real estate strategies you can use to build your portfolio. Even experienced investors will enjoy his neatly organized and thoughtful summary.
Let's get to it, take it away Teymur...
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In Part I, we briefly discussed the benefits of investing in real estate in general and hopefully, you were convinced that this is one of the absolute best types of investment available. In Part II, we are going to look at a few different strategies of building your real estate portfolio. Each strategy requires a lot of time to cover in detail, so it will only be an overview.
There are many ways and many strategies you can use to invest in real estate. Let’s look at some of the most popular ones that you can use.
Flips (or flipping) are a way to realize a quick gain from creating additional value in a property. Typically, people think of it as buying a property in a dilapidated state, renovating, and quickly selling it. However, there are no hard and fast rules – as long as you create additional value with the intent of realizing it on sale, your starting point can be anything (you can buy a perfectly fine home for $2m, but as long as you redesign and renovate it and later sell it for $4m – this is still considered flipping).
Despite various TV shows that glamourize the process and make it seem very easy, flipping houses involves a lot of risk and is often not for novice investors and, probably, not the most recommended introduction to real estate investing.
The goal with flipping houses is to make a quick gain based on forced appreciation, which is the difference between what you paid to acquire the property plus all costs of renovating it and bringing it back to market (contractors, designers, engineers, building materials, sales agents, advertisers – and don’t forget the value of your own time) and what you ultimately sell it for.
Any variable that changes during the process can affect your investment gain or, worse – result in a loss. There are many mistakes that novice house flipping enthusiasts can make – underestimating costs, overestimating final sales price, having emotions involved in business decisions, selecting incorrect materials, having no real strategy, etc. But even if you’ve done everything under your control, market prices can change pretty quickly. That is why house flipping is usually a quick endeavour, lasting no longer than several months – anything longer and you face a greater risk of the housing market adjustment, which can quickly erode your return on investment or easily turn it into a loss.
The benefits of flipping houses are all around the potential of making a lot of money in a short time (if you know what you are doing). Remember, though, that in most countries the whole amount of your gain on sale is going to be considered your business income. This means you might be hit hard with income tax when you sell your property. Conversely, if the primary goal of making money from a property was not through re-sale (as in when you buy a property and hold it to generate rental income), you would only be hit with capital gains tax on sale. You can partially mitigate this if you move into and live in the property while renovating it to sell (primary residences are exempt from capital gains tax in most countries).
Long-term rental is the bread and butter of real estate investing. It is the most sustainable strategy and probably generates the most money as a long-term investment, if you are willing and able to stick with it long-term.
The strategy with a long-term rental is simple – buy a property, renovate if needed, then hold on to it and rent it out for the rest of your life, continuing to maintain it in a good state. Financing and carrying costs (mortgage, taxes, insurance, maintenance) should be covered by your tenants’ rent payments and, ideally, you should have a bit of money left from each payment collected after all costs are covered, to create additional cash flow for yourself, which is a part of your overall return on investment.
There are many benefits with this strategy:
Are there risks and disadvantages with long-term rentals? Of course! The biggest one is vacancy – you have carrying costs for your investment property regardless of whether anyone lives there. But if it’s vacant – there is no rental income to cover these costs and generate that extra cash flow for you. Vacancy is not the only reason you would not receive your rent – another one is simply a non-paying tenant. Most countries have a formal eviction process to counter that, but since it may take months, in the meantime you risk losing time and, potentially, money in the form of lost rent and extra administrative expenses.
New landlords also seem to dread the risk of dealing with tenant vandalism – intentional or otherwise. Anybody trying to build their initial real estate portfolio almost inevitably hears horror stories about tenants, who unexpectedly move out and take everything with them (including toilets, door knobs and light fixtures), clog the sewer causing floods, punch holes in the walls or throw some crazy party that leaves a trail of destruction.
Cases like that, though, can be managed by two things:
Nothing is guaranteed but with proper strategies, and with having all the right systems in place, your risks are minimized.
Long-term rentals could take many forms:
In each of these cases, investment strategy, initial investment, and the ultimate return on investment will be different. The typical strategy for growing a real estate portfolio for a typical investor usually involves starting with single-family houses, moving on to small multi-unit properties, then, maybe larger multi-unit buildings and/or commercial real estate. Analyzing advantages and disadvantages of each is beyond the scope of this article, but we might return to these topics in the future.
When flipping houses, you generate return on investment through forced appreciation. When buying and renting them out long-term – you generate it mostly through gradual increase in equity with time (as you pay out your mortgage loan) and a margin earned on carrying costs (cash flow). The first strategy is quick, but risky; the second strategy is longer-term, but is less dependent on housing prices and is usually better in terms of after-tax returns.
What if there was a way to get the best of both worlds? It turns out – there is one. It is called a lease-option contract, lease option agreement, a rent-to-own, lease purchase agreement – or any of several other names such arrangement gets.
So what is rent-to-own? With all the different names, what it is, essentially, is an arrangement that allows your tenant to rent a property from you, with a simultaneous option (but not an obligation) to purchase that property in the nearest future at a pre-determined price (usually paying slightly higher than market rent in the meantime, because of that embedded beneficial option).
A typical arrangement with lease purchase contracts is that a portion of the higher monthly rent also counts toward the future purchase price (sort of like an instalment payment).
Adding lease option contracts to your real estate portfolio allows you to force appreciation of the property by embedding it into a sale price (fixed at the beginning of the lease), while getting better cash flow due to higher rent, which you are still going to receive for a few years.
In most cases (at least it is a good idea to do so), to have the option to purchase a potential tenant would have to make a non-refundable downpayment (usually, only a small fraction of the property’s sale price), which would also count towards future purchase price and which further reduces the risk to you as a landlord (vacancy suddenly becomes a much more manageable risk).
Rent-to-own arrangements generally offer a better overall return on investment, compared to traditional rents, while not carrying any risks of flipping.
What kind of tenant would want to do a rent-to-own, you ask? Typically, these are tenants who want to buy their own home at some point in the nearest future, but either lack the funds currently, or cannot quality for traditional financing (due to credit issues or otherwise). Such tenants would be forced to rent either way (after all, they need a place to live), but with a rent-to-own deal they are now able to save up for that future home purchase, while straightening out any credit issues they might have and buying themselves more time.
Rent-to-own deals carry the same risk as straight rent arrangements, but because of a (potentially sizeable) cushion a landlord has (extra non-refundable downpayment and higher monthly rent), these risks are mitigated to a much larger degree and often even outweigh the added risk of dealing with tenants with a potential history of non-payments (which is how they get into credit problems most often)
Some people who have patience and a lot of available funds prefer to invest in real estate that naturally appreciates with time even if they don’t generate any rental income in the meantime. One – and probably the most popular form of – such asset is land.
The strategy to generate a return from investing in land usually involves buying an underdeveloped plot in a remote area, away from regular urban (or even nearest suburban) locations that is not currently in high demand, with a vision (or a hope) that eventually that area will get developed as cities grow and the population catches up.
Land is a limited resource – you only have so much of it on planet Earth, but the world’s population is constantly growing. This is especially true in developed countries that have an inflow of immigrants and/or positive birth rates – the growing population needs to find places to live. Sure, one solution that is often found in big cities is to go up and start building skyscrapers, but that is rather a response to growing land prices and not the solution to stop them.
Even when people buy houses in areas that are developed but not quite popular, they are really buying the land to hold on to – especially if the area is so unpopular and so remote that counting on rental income may not be a good strategy.
It is true that, usually, purchasing a house also involves investing in land that goes with it, so from that perspective – most real estate investors are implicitly investors in land. But generating income from investing in land plots purchased specifically with the expectation of further development is very different. The way people make money on those plots is by holding it for 30, 40, sometimes even passing it from generation to generation for 100 years – and selling it to a developer in a distant future. Most people have heard the story about Manhattan being sold for $24 – you can only imagine how much the whole Manhattan land is worth now (back in 1991 it was estimated to be worth $2.7 trillion). That’s the ultimate example of land appreciation – but even more modest and more modern real-life examples have shown us that a plot of land purchased for $200,000 may be easily worth $15,000,000 in 50 years. 50 years is a very long time to wait for a payout. But the 7500% appreciation is not too shabby either – that’s why you have to have the patience and the funds to invest and forget about for a long while.
Keep in mind that most of the time, investing in land plots does not generate any significant income (you might be able to rent it out as agriculture land, if there is demand) and they will probably need at least some attention and result in some (albeit usually smaller) property taxes – so until the very last day when you sell it is a losing proposition.
Is your income guaranteed? Not at all. These investments are largely speculative (although, some may argue this is a calculated risk) and you cannot predict how much, or even if, land values will rise in several decades. If you keep investing in land that nobody wants, there is still some chance that nobody will want it even in 50 years.
For that reason, investing in land is rarely a real estate investment strategy suitable for a novice. Leave this for a later stage in growing your real estate investment portfolio.
Most people don’t want to answer tenant calls in the middle of the night and deal with emergency flood in the basement, a pest problem, or anything of that nature. These fears keep a lot of people away from real estate investing.
If, when putting together your real estate portfolio, you follow time-tested systems and follow a certain set of rules – your investments would not need too much of your time. Mine certainly don’t. Of course, you would be naïve to think that you will never have to do anything – it just doesn’t work this way (although, you can fully delegate pretty much every task you would have as a landlord to a property management company or multiple contractors and other providers of professional services).
But what if even that tiny bit of work is too much? What if the stress of having to deal with the human factor (and, as a landlord, throughout your real estate career you might need to wear many hats – social worker, mediator, financial advisor, business person, plumber, carpenter, negotiator, etc.) was just too unbearable?
There are relatively passive real estate investment options that separate you as a landlord from any tenant-related issues. Let’s look at a few...
Investing in a REIT (Real Estate Investment Trust) is like investing in mutual funds – the (usually) publicly traded units represent share ownership in a total pool of investments a REIT has. Because of the economies of scale, better negotiating power and larger available capital, a REIT might give you access to types of real estate that you may not have access to individually. Some REITs are set up with a mandate to invest in a specific type of real estate (say, medical buildings or apartment buildings only), some are more diversified and have a nice mix of different types of properties and even finance land development. In any case, they basically employ similar real estate investment strategies (buy/build and rent), but operate on a much larger scale.
If you want to invest in real estate, but dread even the slightest amount of work associated with it – this might be your entry into the world of real estate investment. It is not exactly the same as building your personal real estate portfolio, but it allows you to passively participate in real estate market with minimal risks.
Speaking of the risks related to REITs – because most REITs are publicly traded, the price of a unit is subject to market fluctuations, triggered by typical economic forces, market sentiment, bad piece of news around the whole industry, or something similar.
Here is the thing, however – I have observed a lot of very solid REITs with very good real estate portfolios fluctuate in value unexpectedly, even though they continued to pump out consistent (and relatively high) distributions (these are like dividends paid on a stock). A REIT distributes the majority of its earnings (to maintain its beneficial corporate tax status), so return on investment (ROI) with them is typically higher than dividends on regular stocks.
If you invest in REITs speculatively, hoping that you will realize a large gain when they go up in value – this is no different from any stock-market investment. But if you count on consistent earnings from your initial investment – the same way you would do if you invested in real estate directly with a plan to rent it out – market fluctuations in unit price should not bother you too much. Choose the one (or many) with a proven track record, but of course, any REITs can go belly up as a result of bad management decisions, so there may be time when you just have to get out.
Compared to building your own real estate portfolio and investing directly – because you now get lower risk due to diversification and, allegedly, expertise of the Trust managers, and because this requires less time – your returns are also, typically, lower than what they could have been if you plunged into being a landlord yourself. That said, a well picked REIT can be a very good addition to your investment portfolio.
If you thought only banks can offer mortgages – you were wrong. You can do the same. All a mortgage is (in simple terms) is a loan that is secured against a property. The lender registers a lien against the property that prevents the owner from selling it (or re-mortgaging it) without first going through the mortgagee (lender). If the loan is not repaid, the mortgagee has the right to re-possess the property and sell it (or keep it). Accordingly, mortgages registered against a property have a priority – first, second, etc. This defines the order in which the parties involved are paid in case the property is sold.
Ultimately, the first mortgagee gets paid first, etc. But any mortgagee in line can initiate re-possession in case of owner’s default. If there are two mortgages against the property and the owner of the property is current on his payments to the first mortgagee, but defaults on the payments to the second mortgagee, the second mortgagee can re-possess the property and liquidate it. In this case, the proceeds (and any additional fees and administrative charges) would go to the first mortgagee first and the remainder would go to the second mortgagee.
Typically most first mortgages are provided by large financial institutions – both because the amounts involved are usually out of reach for many investors and because these institutions have established infrastructures that allow them to set everything up.
But when it comes to (usually) smaller second or subsequent mortgages, the amounts involved are usually much smaller. Sometimes owners need to borrow against the equity remaining in their property and the first mortgagee – for whatever reason – cannot provide these funds.
Second mortgages are gives similar benefits to borrowers as any secured borrowing facility that provides funds collateralized by the remaining equity in a property. These can come in the form of High Equity Line of Credit (HELOC), credit cards (usually with much lower rates) with a credit limit tied to the remaining equity or any other form. With these two above, the additional lending is usually provided by the same party that registered the first mortgage.
Second mortgages may or may not be provided by the same lender, but they usually aren’t. Top-tier lenders may have regulatory rules or policy constraints that do not allow them to invest in riskier second mortgages, because their total exposure compared to the appraised value of a property (the Loan-To-Value ratio) may get too large (the higher the LTV, the higher the risk that if something goes wrong and the bank would need to repossess a property to sell it, it would not recover all the funds, given all extra administrative costs involved).
Second- and third-tier lenders, however, happily invest in second mortgages – yes they are riskier products, but, to compensate for that, the returns are also much higher than from first mortgages. Because second mortgages usually involve smaller amounts, you can get involved relatively easily – either as an individual, providing private funds, or by participation in a pool of investments through a company that deals with funding second mortgages.
Keep in mind that people who can get a HELOC or another form of credit secured by their property usually do so. Second mortgages remain the last resort for the most desperate (and usually the riskiest borrowers). From that perspective, the risk of losing money in these deals is higher. But – especially if you become a private lender – you can set whatever lending criteria you want for those deals. You may, for example, limit the total LTV exposure to 80% (a typical threshold for first mortgage lenders) – that way, if a borrower has paid down the first mortgage to the currentLTV of, say, 60%, he or she can still extract the remaining 20% of equity in the form of a second mortgage. Even if something goes wrong in this example and either the first mortgagee or you, as a second mortgagee, would have to re-possess and sell the property, you have this 20% buffer between the property’s value and total amount owed by the borrower, which is normally enough to cover administrative costs of executing this process.
Good real estate lawyers can usually help set up a second mortgage agreement and mortgage brokers can, sometimes, help you find borrowers looking for second mortgages.
A sub-case of investing in a second mortgage is a Vendor Take Back. This is a special case, as it is only applicable if you are selling a property, so it may not be a generic real estate investment strategy (you probably can’t build your real estate portfolio purely on VTBs). But if it is applicable in your case – it could be something you might look into.
A vendor take back (VTB) or a vendor take-back mortgage is an arrangement between the seller of the property (you) and the buyer, whereby the seller helps the buyer finance a part of the property, essentially lending the buyer some money and registering a secondary lien against the property. Typically, buyers are able to get at least part of the deal financed by the primary lender, but sometimes may be limited by what they are pre-approved for.
VTB mortgages are often offered by sellers at rates below market – most often than not just to make this option more attractive to the buyer and to facilitate the sale. This rate may also be attractive for sellers because it is typically higher than what they earn with traditional savings accounts with banks or “safe” investments.
In any case, if you are the seller, instead of ending up with a lump sum amount in your hands, you end up with the majority of what you were asking for (in a potentially quicker sale) and a future receivable that continues to generate revenue for you in the form of interest. VTB mortgages are typically short-term (6 months to 5 years).
There are capital management companies and venture funds that finance expensive property development projects, such as high-rise buildings, residential sub-divisions, or purpose-built commercial real estate (hospitals, storages, manufacturing facilities, etc.). They pool funds from individuals which are then used to finance such developments. There is usually a minimum investment required (and, sometimes, the allowed maximum). The returns may be paid out as a fixed percentage on the money invested or simply reflect whatever overall return on investment the project had, less administrative costs withheld by the company.
In any case, return on investment is usually noticeably higher than those offered by savings accounts, deposits, bonds or any other “safer” investments – this is because financing real estate development obviously does carry higher risk. But because the funds lent to the developer are ultimately secured by the real estate being developed (like a construction loan) it is not a totally speculative undertaking.
If you believe that real estate is a good investment, trust the company (do your research about its track record, developers it is working with, whether it is audited by an independent credible third party, etc.) and willing to sacrifice some returns for the convenience of a passive income, while still being exposed to the benefits of real estate investment – this might be something you may want to look into. Once again, these typically are not short-term projects and may last from 4 to 10 years.
A lot of times you can even use your registered retirement plans that get preferential tax treatment (RRSPs in Canada, 401(k) or IRA in the US, etc.) to invest into such projects. It is a great alternative to earning low returns in a mutual fund (and paying large management fees), so if your risk appetite allowed you to invest into stock market instruments – you should generally be OK with investing into something more tangible and slightly more secure like this.
There are many variables you may need to control when putting together your real estate investment portfolio. And there are many ways you can get a piece of the pie. Some of those are scalable, some are specific to only one or a couple of categories, but the bottom line is – if you were seeking an entry into the world of real estate investment and looking to build your real estate portfolio – you have many options. You can choose how involved you want to be, how much money you want to invest and what return on investment you are comfortable with given the level of associated risks.
In future articles we will explore more avenues and some creative ways of increasing your real estate returns even more. Once again, prior to making any decisions that may affect tax (and, ultimately, your final return on investment) – consult with a professional.
Until then – find the strategy you are most comfortable with and start exploring it further to being building wealth.
Looking for more articles from The Alpha Project? You can check out articles on everything from the role of bacteria in your life, to getting a six-pack, to healthy eating for kids over at www.TheUltimateAlphaProject.com.
Until next time ... Your Life! Your Terms!
