toby mcCosker - Real Estate Strategies To Build Your Empire Assembling Your Real Estate Portfolio: Strategies To Build Wealth 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. Flipping houses 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). Growing your real estate portfolio with long-term rental property 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: Your tenants finance the property you will own in the end, free and clear. You gain from long-term property appreciation if (or when) you decide to sell (or refinance and extract equity for other projects) in the future. Now, this is not guaranteed, but historically, real estate – especially in booming areas – has been growing in value. Generating income from a long-term rental property is usually subject to more beneficial tax treatment, compared to, say, house flipping discussed above. Not only do you get to offset rental income with carrying costs (because you incur them in generating business income), but you also typically get to amortize the cost of your property to expense each year for tax purposes, thus offsetting it even more (obviously, tax laws differ from country to country, so make sure you check yours before making any decisions). In countries with progressive tax brackets (i.e. – where you pay a higher percentage in taxes the more income you earn), you get to minimize annual tax impact (whereas with strategies that provide a windfall payment – such as, again, flipping, you will have to pay tax on the full amount in one year). Lease option contract / Rent-to-own 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 longerterm, 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 predetermined 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.
Investing in land 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. Passive real estate investments 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? Investing in a REIT 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. 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.
Investing in second mortgages 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 remortgaging 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 repossession 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. Vendor take back 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.