Real estate investing in troubled times.

Posted by: David Larson in Untagged  on Feb 4, 2009

The Stock Market is in shambles, the residential real estate market has not been this bad in my lifetime, and the commercial real estate market was doing well up until the credit crunch stopped development and acquisitions dead in the tracks.  Property values are down 40% and more from a few years ago.  What is a prudent investor going to do?  Buy!  In the next 18 months I believe we will see opportunities in the real estate market that are once in a lifetime opportunities.  But first let's examine what has happened in the past and what we need to look for going forward.

In the past we real estate agents have either been naïve or flat lying to the public.  "Location, Location, Location, the three most important things in Real Estate", lie!  "The house just down the street sold for $210,000, I think you can get this one for $195,000, this is a great investment", lie!   What matters in any investment is does it achieve the goals the investor sets for themselves at a tolerable risk.

Investing in real estate has two components, financial and emotional.  The emotional component, other than that gut intuitive stop sign, needs to be put on the back burner.  The financial decision should be an easy one after all the pertinent information has been collected and analyzed.   The first step in the financial process is to honestly assess your current financial picture and define the goals you would like the investment to achieve.  There are 4 financial benefits that real estate offers, any one of them may be a priority to one person and create grave economic challenges for another person.  The 4 financial benefits are;

• 1. Depreciation, the IRS allows you to depreciate a residential property over a 27.5 year period and most commercial properties over a 40 year time period. The depreciation does not include the land which must be factored out of the property value. The benefit of depreciation is not equal to all people. Some people may not make enough money and some may make too much to have this benefit work for them. Unfortunately this depreciation must be recaptured at sale unless you elect to do a 1031 like kind exchange, or die and have the basis steeped up. Both of these issues are beyond the scope of this letter but will be addressed latter. Let's just say that depreciation can be of great benefit to an individual and it would be best to contact a CPA to determine how it might benefit you.

• 2. Appreciation, if you are old enough to have gone through a number of market cycles you will know this can be a fool's game. Properties always go up in value right? Appreciation can come in two ways, first with the market cycles, or forced as in improving the property physically, with better management or better financing structure.

One very bright spot I do see in the current market in regards to appreciation is entitled land.  We have seen land prices fall through the floor.  There is little to no development going on and the owners of land that have been putting improvements to eventually sell lots or have gotten governmental approvals to build lots and infrastructure are suffering from lack of buyers and in many cases these properties are going back to the lending institutions.  In the current market there is a glut of product and no buyers.  The opportunity here is to pick the best of these developments, pay pennies on the dollars, and hold them until the market comes back.  The challenge here is the cost for entering this market is high, and returns on investments may be 5-10 years out.

• 3. My favorite financial benefit, cash flow. Investment property should spin off periodic cash flows. The typical seller of real estate or their agent will tell you that their property cash flows if you put enough money down. This is not positive cash flow as you should receive a return on your down payment. The key to understanding a property's cash flow is doing the proper due diligence to understand what the income of the property should be. Subtract from this income, maintenance fees, reserves, taxes, water, sewer, licensing, advertising, cable, internet, electricity, gas, financing fees, etc, etc, etc. The challenge here is most sellers will not tell you the true expenses and most buyers and agents do not take the time to get a complete understanding of the cash in and cash out. Emotionally they buy the property before the homework is finished. That being said with the proper due diligence cash flow properties can be found.

Having been in the real estate business for a number of years I can say something with great certainty, "I cannot predict what will happen tomorrow, or tell you the timing of real estate cycles".  If a property has good positive stable cash flow we do not care if the sales market is down, we just hold the property and enjoy the monthly check that comes in.  If the property increases in value dramatically due to a cyclical market, we look at whether we should sell, and if we sold can we reinvest in a better performing property or pay the taxes and pocket the cash.   Unlike the properties where we are expecting an increase in value from appreciation,  properties that cash flow work for us in an up or down market.

• 4. Mortgage paydown is the last financial benefit. If you have a few gray hairs like me you might have noticed that the last 10 years has gone by in the blink of an eye. Most real estate loans are amortized. That means that every month a little percentage of your payment goes to paying down the principal amount of your loan and over time the loan is paid off. The older the loan the larger the percentage that is being paid down, which goes against refinancing to get a slightly lower interest rate. Mortgage paydown is the turtle; slow and steady against the rabbit of appreciation.

All this being said, were is the real estate opportunity today?  I believe there is opportunity in two diverse property types and I see an incredible window of opportunity in both of these in the next 18 months.  The first of these is lower end residential rentals held for cash flow.  In the height of the market buyers were jumping at any property they could find with the belief that prices would continue to rise and someone would come along a while latter and pay them more for the property (this is called the greater fool theory, expecting someone dumber than yourself to pay more than you did).   These buyers are now in trouble and the institutions that loaned them money are also in trouble and in some cases are going to be the owners of the properties by foreclosure.  In some cases hard to find financing may be available from the original lender to preserve their balance sheet.  Buyers beware!  Not all foreclosure properties are bargains, but some of these foreclosure properties are good buys, will cash flow to provide a steady income.  The lower end is more stable than the upper end in retreating economies people will move down but moves up may not happen.  The lower end properties also have a greater rental rate in proportion to their purchase price.  They may be harder to manage and you will have to hire management unless you posses the right skills and disposition take on the job yourself. 

The second opportunity is purchasing entitled land, improved lots or master planned projects.  The price of these can be high and the money invested will have to be left in the investment for an indeterminate time, perhaps a 5 year period.  One method of ownership that works for this type of property might be partnerships in which a group of people come up with the cash to purchase the property.  Leverage is not a good thing on this type of property as monthly payments on an investment that may go 5 years or longer would be tedious.  Reserves will also be needed in consideration for taxes.  I do however believe that this type of property, correctly bought, will give the largest return in real estate in the next 10 years.

How can you participate?  We are currently talking with Banks looking for cash flowing properties they have taken back in foreclosure.  We are looking for partners on these transactions as we believe there will be enough good inventories that our current members will not be able to handle all the available properties.  We are also looking for partners to invest cash in larger entitled land projects.  Currently we are looking at a few different projects, one prime property we believe we can be purchase for $.14 on the dollar.  If any of this seems of interest to you, or you have any questions, please email or call for an appointment.

Good Hunting!

David Larson 775 786-1616

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