Investment Basics: Buy and Hold Money Makers

I have included an illustration today to show why real estate is such a good investment in the long term. Profits on real estate investments come in four forms: appreciation, amortization, cashflow, and taxation. For our purposes today we are going to address appreciation and amortization.

The Utah real estate market follows a stair-step appreciation curve over time on average. There are always local pockets of volatile prices but on the average real estate here appreciates quickly and then flattens out for a while before appreciating rapidly again.

Everyone knows how to make money with appreciation, thats why smart investors bought in 2004 and 2005. The lemming investors bought in late 2006 and 2007. Unfortunately for the lemming investors, they will have to wait to make a killing on appreciation. Hopefully they have amortized loans.

Here is our first chart for discussion:


This chart illustrates how people get rich in real estate. The late night gurus will tell you its about notes and quick profits. The true real estate investor knows that its all about time working on your side. In this example our property is a $200,000 3 Bed 2 Bath home. The red line in this chart represents your debt. This loan is amortized for 30-years and has a $0 balance at the end of its term. The black line is your property value. It follows a stair-step pattern modeled after our own market. 5 Years under 3% appreciation followed by 2 or 3 of 10%. Very similar to our own. The green line represents equity...or the difference between the black and red lines. Your main interest is the green line.

Lets pretend that this is your investment property. The first 5 years are going to be the toughest because there is little equity in the home. You have to sit on it just to make enough equity to sell it at a break even price. The reason this is the case is because you paid full price for this home and at the beginning of a down market. Expect it to take 3 or 4 years just to break even on a sale. Hopefully the rents compensate for the payments so you are sustaining yourself (this will be a separate issue we talk about later) At 7 years the market picks up again and you see some significant appreciation. You have made $100K in equity. Its been a hard slog but you are starting to see some returns. In just 8 more years you are at $200K in profits. Your rents have increased in the meantime so being a landlord seems a lot easier. After 30 years with appreciation and inflation working on your side, your meager home is now worth $700K free and clear. You keep almost all the rents! Now multiply this example by 5 or 6 homes. How nice does retirement look now?

Here is a preferred variation on the model that mitigates risk and provides greater returns and safer positions. This is the model that I find most appealing:




Rather than buying a $200K home at full price, lets pretend you bought a $240K home that was a distressed for $200K. Not only do you get the benefit of immediate $40K equity but you also could sell the place immediately if you had to. A much safer position to be in. Your payments on your mortgage are the same so your amortization pays off at the same rate but now you have a home that is worth more and will appreciate to larger dollar amounts than our previous example. Rather than being $700K. This home will be $850K in 30 years.

NOTE: These large dollar figures for 30 years from now may be hard to grasp but consider that today's prices are almost 3 times what they were in 1975. My parents paid $40K for their first home. That home today is worth around $150K.

Finally lets consider what interest only loans do to your situation:


This chart is a bit inaccurate because lenders will rarely give an interest only loan for more than 5-years. If you look at just the first 5 years the equity increase is insignificant. On top of that, at that time you are forced into a sale or refinance which will consume equity. You could risk making the payments when the ARM adjusts if you bought the property low enough but its risky. If you paid full price for the property you will be in hot water. For this reason, I don't believe ARMS are a good idea for long term investments. Only use an ARM if you buy the home 75% or less than market price. You can now understand why so many OWNER OCCUPANTS who went down this road are in real trouble.

If you have any questions or comments about this let me know.

DOM Rising

Does it feel like its taking longer for homes to sell than a year ago? Your intuition is right.

Days on Market has been climbing for over a year. I expect us to top out again around 80-85 days for the average sale just as in 2000-2001. I can live with it taking three months to sell a properly priced home. Its the improperly priced ones that worry me. Since they don't sell they don't show up on this chart.

Prepare for the Seller Financing Market

News came out today that Fannie Mae may slow down its purchases of mortgages from originators. This is a big headline that is getting very little attention today. Fannie Mae and Freddie Mac are the part of the home loan pipeline that has been the saving grace of the marketplace. FHA and VA loans have been keeping the market moving along since the demise of Subprime, Stated and many other Alt-A loans.

This news, if it comes to fruition, means that lending will go through another cycle of contraction and interest rates will likely increase. This in turn will bring about the need to understand and use seller financing to make real estate transactions work. Stay tuned for another post with a breakdown of the kinds of seller financing and the advantages and risks of each type.

Picture of the Day

You know its time to fire your roofer when.....

From Worst to First: The Magic Formula

So, how do you take a dumpy neighborhood and make it nice? The formula my wife and I conjured up has worked tremendously well for us. So much so, that most people just shake their heads and say "I couldn't do that. I don't know how you did it." I have heard that way too many times and it really bugs me. Anyone can do what we have done. It just requires a clear vision of what you are going to do, a budget, and fortitude. The truth is, my wife and I stumbled upon a formula that is not new. The Housing Geeks at the Harvard Joint Center for Housing Studies have probed this issue in depth. Here is what our Ivy League Scholastic Achievers have to present to us (color and additional labels added by me):This chart explains everything about fixing run down neighborhoods. The secret? Capital improvements in property with the resulting skilled tenants that pay higher dollars for them. The Q* line is the line where skilled tenants will pay more for a property than unskilled tenants. There is a certain quality of home where this change in rent dynamics happens. Inversely, if the home is lower quality, the skilled tenants willingness and bid to rent the property drops off tremendously while the unskilled tenants willingness and bid to rent remains high.

This chart perfectly describes the dynamics going on between high-income and low-income housing. At a certain point, regardless of the niceness of the home, unskilled tenants cannot afford to pay more for a property. Their income is tapped out at a certain level, no matter how nice the home. The skilled tenant has more income and therefore can afford a significantly higher rent for the nicer homes.

This process also shows how you can have substantial changes in quality of neighborhoods in very short distances. The lines passing through the Q* inflection point between these two groups are pretty steep. Therefore, the change in quality of neighborhood can be pretty abrupt from location to location.

A good example of this is the before and after snapshots of my fourplex. I inherited tenants in the fourplex when it was purchased. The upstairs tenant was a stripper by trade with multiple evictions, felonies, and a drug habit. She paid $550 a month for a 3 bed 1 bath Unit. The problem was that she was in jail so much she could barely make the rent if at all. The down stairs tenants were drug users with a knack for painting graffitti on the walls. They paid $500 for a 2 bed 1 bath basement unit. After the $35K that it took to resurrect the building, the 3 bedroom was rented to an accountant and a surgical technician for $610 per month. The basement unit was rented to college students for $495. Fortunately the building was purchased for such a price that it made sense to make these repairs.

Prior to the repairs, skilled tenants would not even look at the property. The property landed at the very left end of the chart. By fixing it up, the property moved to nearly the inflection point. Again, the numbers on this particular project made it worth the while. By renting to skilled tenants, management has been significantly easier.

If you are thinking about fixing up homes in Ogden, plan on spending 10% to 20% of your purchase price on capital improvements. Buy the place right, and you will be rewarded handsomely.

FrontRunner Experience

I had a meeting in downtown SLC today so I decided to give the FrontRunner a whirl. I wanted to see how the system works and gage the time and money advantages over driving the car.

I started from home at 7:05am. Rather than "Park-n-Ride" I thought I would walk instead. The FrontRunner Hub is only 5 blocks form my home.



The walk through the neighborhood was gingerly. The streets are pretty empty this time in the morning.






Here is a photo of The Junction from 23rd and Adams. My entire walk to the Hub was along 23rd St. Construction is still bustling with more retail and residential in the works.





The hub is at 23rd and Wall Ave. This is a photo of that intersection.








The ticket kiosk next to the loading pad.









The loading pad.

The Salt Lake Hub.





So the trip to my destination via foot, FrontRunner, and Trax took me 1 Hour and 45 minutes. A little longer than I was hoping. I could have shaved about 15 minutes off that time if I had driven to the Ogden hub from my house instead of walking there. The ticket for FrontRunner cost me $11 round trip. Trax in Downtown SLC is free. The trains are all timed very close to one another so there wasn't much waiting. Lets chart this and compare it to my normal vehicle trip and see if it was worth it.


Train
Time 1:45
Gas Cost or Fare $11
Wear and Tear $0
Parking $0
TOTAL $11

Car
Time :45
Gas Cost or Fare $25.20
Wear and Tear $20
Parking $5
TOTAL $50.20

I estimated that wear and tear on a vehicle was about $.20 per mile. My car gets 15 miles per gallon (yes, its an SUV) and gas is about $4.20 right now. Parking is also going to cost in SLC. There is no escaping it. Given this scenario, I estimate I saved about $40 for my hour of inconvenience. The time would have been more productive had I brought a laptop. The train does have WiFi so the time could potentially be highly productive. In all, I would recommend FrontRunner's use. I certainly will be using it again.