By Alexander Bermudez
How many times have you heard the statement, “ If only I had bought property, back when it was so cheap”? Even the most successful real estate investors have been known to mutter these words from time to time. Suffice to say, the best time to buy has always been in the past, short of that, and providing the property can achieve the economic objectives of the investor, now is as good a time as any to start investing in real estate.
The population of the world is continually expanding and with this, comes accelerated migration to areas with the greatest economic opportunities. As demand rises, prices of well-situated real estate will trend upwards, triggering a surge in development until equilibrium is achieved, thus the market cycle. However in mature markets or areas constrained by geography, new development (supply) is stunted, creating an imbalance. Rents and capital appreciation, in constrained markets will invariably outperform the broader markets, due to the increasing demand and limited supply.
That being said, it is far more prudent for prospective buyers to focus their analysis on free cash flow rather than speculating on future appreciation. As with all real estate investments, ‘cash flow’ is the true asset being acquired.
Cash flow is expressed as ‘net operating income’ (NOI), which is gross scheduled income minus vacancy allowance and expenses. The NOI formula has no provision for mortgage costs and thus eliminates the impact of fluctuating interest rates, while comparing the relative profitability of various real estate investment opportunities.
Assume two buildings, each with a ‘gross scheduled income’ of $100,000. The vacancy allowance for each building is $5,000. One building however, has annual expenses of $30,000 (NOI of $65,500) while the other building has annual expenses of $45,000 (NOI of $50,500). Presuming no other differences between the two buildings exist, prudent investors will inevitably opt for the property with the greater NOI.
A word of caution; investment real estate in well established, affluent or ‘low risk’ neighborhoods will exhibit noticeably lower ‘net operating income’ (NOI), when compared to similar properties in marginal, less affluent or ‘high risk’ neighborhoods. This is particularly important if an investor intends to personally manage the property, as affluent neighborhoods will be far less demanding on one’s time, relative to properties in less favorable areas.
Yields will also vary according to the age of the improvements; an older building with a higher risk of incurring unexpected maintenance costs, due to obsolescence will tend to exhibit a better yield relative to new construction. This is the nature of all investing; as the rewards increase so does the risk.
Investors will have to carefully balance their aspiration for yield against the shortcomings of lesser neighborhoods. When equilibrium is reached that satisfies both the risk tolerance and the yield expectations of the buyer, a transaction will likely ensue.
By Alexander Bermudez
Now that we have discovered the miracle of compounding property values, it may be a good time to discuss the inherent shortfalls of real estate. Remember all investments harbor risk, in the case of real estate; the lack of liquidity is its Achilles Heel. Liquidity is a term that refers to an asset's ability to be sold (liquidated), in a short period of time and with minimum loss of value.
Although one of the best asset classes available to individuals with long term investment horizons, real estate can take months, if not years to sell. In a slow market, pricing may be unpredictable and adding insult to injury the transaction costs are high. In a poor market leverage only exacerbates the problem, by increasing the volatility of the asset. Needles to say, you don't want to be forced to sell an illiquid asset under adverse conditions. Thankfully there are steps we can take to reduce the risk, without significantly diluting return expectations, thus engineering a more efficient investment.
Short-term reserves of cash or cash equivalence, while unlikely to rival the investment performance of leveraged real estate, provides a hedge against the inherent lack of liquidity. The amount of accessible cash will largely depend on your fixed liabilities and your risk tolerance, but three to six months of expenses, set aside for unforeseen costs, would substantially reduce the likelihood of default or distressed sale. However a word of caution, while cash reserves are highly recommended, excessive cash positions do present a substantial opportunity cost.
In addition to short-term reserves, insurance, hedges against the possibility of catastrophic events. Banks will always insist you insure any real estate, they hold mortgages on. However in this litigious climate we all live in, additional liability insurance is highly recommended. Statistically speaking, landlords are amongst the most commonly sued. Not only will insurance companies bear the financial burden of any legitimate claim against you, but also they will likely use their vast legal resources, in an effort to preserve their own capital, to defend you against any frivolous lawsuits. A good insurance broker should be able to show you a host of different insurance products, specific to your real estate needs..
Property Management, regardless if you delegate the job or not, is of paramount importance to the long-term performance of real estate. Attractive well-kept buildings not only command premium rent, but also attract good long-term tenants, substantially reducing vacancies. As a landlord, empty apartments are amongst the largest of expenses, due to lost rent and all the costs associated with re-leasing the unit. Avoiding vacancies through good management will preserve the cash flow of the investment.
As with all investments, low levels of uncertainty tend to have lower yields, conversely high levels of uncertainty tend to have higher yields. However, tremendous long-term returns can be achieved with real estate, through good management and successful hedging, with minimal downside risk to the investor. The key is to remember, that in real estate you will only get a good price, if you do not need the money.
By Alexander Bermudez
In this increasingly material world we live in, many people find themselves living beyond their means, and the prospect of investing takes a back seat to consumption. Ironically wealth is so coveted by our society, many people, not disciplined enough to invest, take the easy road and consume, often more than they make, in an effort to appear wealthy.
Our culture seems to promote this behavior, how many times have you heard the term, “rich man’s car”? A car may be expensive, however this does not make the man who drives it rich, surely any car a rich man drives regardless of price, quality or condition is a “rich man’s car”, after all, it is the man who defines the car.
Not content with the facade of keeping up with the Joneses, many high net worth individuals resist the temptation of conspicuous consumption, in favor of investing. As any investor worth his salt will tell you “the sooner you start to invest, the greater the benefit of compound appreciation will be”.
To illustrate the point we will use a hypothetical building for sale today priced at $1,000,000. Let us say you put a down payment of $350,000 and financed the balance of $650,000. We estimate the value of the property will increase by 7% annually; by this measure it will double its value in ten years.
After ten years your building is now worth $2,000,000. You decide to refinanced leaving $700,000 of equity and employ the cash out proceeds of $650,000 and a mortgage of $1,150,000 to buy another building for $1,800,000. You now control a total of $3,800,000 of real estate, the original building now worth $2,000,000, and your new acquisition valued at $1,800,000. Your equity at this time is $1,350,000.
Another ten years have passed and your real estate portfolio is now worth $7.6 Million. You refinance for the second time leaving you with 2.7 Million in equity in the first two buildings, and employ the cash out proceeds of $2.45 Million and a mortgage of $4.55 Million to buy another building for $7 Million. You now control a total of $14.6 Million of real estate, the new $7 million purchase plus the prior 2 buildings worth $7.6 million, and your equity is now $5,150,000
Ten more years pass and you are still a firm believer in the buy and hold strategy, your real estate portfolio is now worth 29.2 Million and your net equity is $19.75 Million. You have $9.45 Million in mortgage obligations, which your tenants are paying off for you.
We now can see how compounding $350,000 over a thirty-year period can result in $19,750,000. But if you only have 20 years to compound, your equity drops to $5,150,000. Those lost ten investment years cost you $14,600,000!
As you can see the opportunity cost of deferring your investment strategy is exorbitant. So forget the Joneses, live below your means and save for a down payment! If you wait, there will be less time for your money to compound, and the consequences will be very costly. Remember the loss comes off the thick end of the investment wedge, when the greatest amount of money is compounding.
Classic Apartments is a privately held real estate management firm based in Burbank, California. Classic Apartments specializes in the acquisition, management & rehabilitation of apartment buildings.
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