The Equity Delusion: Collecting Houses V...

Anyone who knows me knows that my years in real estate investing have taken a number of twists and turns. I've had some great big wins and some painful losses (just like any other investor with more than a couple of years notched on their belt).

These experiences have been an important part of my path to success. And they have taught me some powerful lessons – lessons that have shaped and reshaped the choices I make and the way I think – about investing, about what makes a truly good deal, about what’s worth the fight and what’s not, about cash today vs. cash flow, and so on.

And frankly, I get a great deal of fulfillment out of helping newer investors find their own path in real estate investing, while hopefully shortening their own learning curve a bit from sharing some of the key lessons I've learned along the way.

The Equity Delusion

I recently met with a nice young couple. While they have regular jobs, they had flipped a couple houses and had a portfolio of 3 rental houses as well. They had asked me to look at what they were doing and see what I thought.

I was happy to do so but cautioned them that if I did I would be honest about what I thought.

Now I've flipped many houses over the years, and I still do. I love getting bigger chunks of cash just as much as the next guy. But the older and more experienced I've gotten, the more interested I've been in replacing the income I make from rehabbing with cash flow.

I’m going to write more on this later, but the bottom line is you have to work until your investments make the money you need to live on. That’s what retirement actually means – assets pay for lifestyle.

Anyway, this couple had 3 houses but little equity. There was some equity but the price depreciation of the last few years had them down to very little. They had put down 20% per house, and had good fixed rate loans.

But there was no positive cash flow.

In fact, since they had not yet experienced major replacements such as roof or heat/air, I could tell that in the long run the cash flow would move towards negative.

So, the bottom line was they had tens of thousands invested and made nothing off it. They were just collecting houses, hoping for good out of them one day.

Just like me when I started, they were counting on 3 things:

the houses would go up in value,
the tenants would pay off their loans,
and the tax advantages would help their bottom line.

And in many respects these things can and do work out. But I don’t think they are enough on their own.

The Way I See Things

I used to see real estate through similarly rose colored glasses. Many do. But personally my experiences have really shaped and evolved my thinking on rental property over the years.

For one, I am much more debt adverse. I would rather partner with someone and own a portion of a rental with no debt than own the whole house with debt.
Second, I won’t buy anything that doesn't produce cash flow today. Waiting 15 or 30 years for cash flow is just too long a plan for me.
And 3^rd I look now at the CAP rate the houses produces, just as if it were a commercial property.

CAP rate is a term which basically means the rate of return if you pay all cash. It’s a really easy formula…

Cap Rate = Annual Net Operating Income (NOI) / Cost

So if a house rents for $1000/month, but average $600 per month after taxes, insurance, management, vacancy, repairs, and reserves for replacing major items – then it truly makes $7,200 per year. So, if you have invested $90,000 in this house you make an 8% return, or it produces a 8 CAP rate. It may be worth $140,000, but it only makes 8% based on the 90K invested.

An Unfortunate Mistake Many Borrowers Make

Borrowing at a rate higher than the CAP rate is a recipe for disaster.

Don’t borrow at 7% to buy something that makes 5%. Granted, this problem is less likely with today’s low rates, but it was easy to do back when rates were 8% or more (Ask me how I know!) and at some point rates will inevitably be swinging back up again.

Many houses that appear to be good investments in that they are easy to rent, in nice areas, and are well built. But they actually have low returns if you run the real numbers. Low CAP rates.

I see far too many Investors get excited because they have 100K in a house worth $130K and it looks nice and rents well. But it has a CAP rate of 5.

Who wants to spend 30 years paying off an income producing property that makes 5%? But the investor is fooled by his low payment and what appears to be positive cash flow. He hasn't owned enough houses to understand what the real rate of return is.

Again, I speak from experience. 5 or 10 years down the road, when the house needs a 10,000 upgrade that ends up devouring years of supposed cash flow, you’ll know exactly what I’m talking about.

Why Are You Really Investing?

The point of investing in general to me is to produce cash flow. Equity has very little meaning to me. I have to work for my family to live. But if I can own enough income producing assets to pay for my family’s lifestyle, then I am now free from having to work.

It’s really just that simple. If I buy a rental with no cash flow and a 30 year loan, I am saying I am willing to work for 30 more years. Not true. At least not for me.

My Personal Investing Rules

After many years of trying it different ways, here’s where many, many deals and years of experience have brought me:

I now actively buy property to build cash flow
I buy only properties that produce at least a 10% CAP (I prefer 15 or better)
No debt financing (instead I’ll use cash, partners, creative financing, my IRA, etc.)
I never manage properties myself but always hire management so it can be a true passive investment.

If my methodology resonates with you and you want to follow a similar path, here are some basic action steps you can begin taking:

Look for deals that will produce a high CAP rate after management fees
Either save to buy them or find partners to put up the cash. If you find a property that produces a 15 CAP and find a partner that is happy with a 10% return, you can keep 5% for yourself with no money invested.
Learn how to use self-directed IRA’s, both yours and others, to put together partnerships with people who will want to invest with you again and again.

I’ll be going into self-directed IRA and financial freedom investing more in the future. Remember – financial freedom is when your assets pay for your lifestyle. That doesn't mean you have to stop working or can’t raise the lifestyle, but the pressure is off. If you if knew your basic needs would be met, the bills paid, weather you worked or not, then you could cherry pick only deals or projects that you actually wanted to be involved in. You wouldn't HAVE to do deals. As I said – freedom.