How to avoid BAD Real Estate Investment deals
We set out to purchase real estate as an investment to build and hold wealth.
Real estate is an incredible asset class where fortunes can be made for sure! (I have a personal mentor who sold his real estate company for $1.4bn… not bad huh?!) HOWEVER, if you don’t structure an investment deal correctly from the start, you could own a dog of an investment for years until the day comes that you can finally exit the property. This same mentor once told me the best deal he ever did was the one he walked away from and didn’t do. Read that last sentence again. It’s a powerful lesson.
It’s important to state that there are countless ways to structure a deal. You are only limited by your creativity!
To me, this is the really really fun part! Why?! Because you can create additional value from just an idea. There are so many endless ways to structure things! It’s definitely the part of dealmaking that gets my energy flowing and creativity switched on 🙂
Here’s a real-life example of how I just recently did this on a land deal I put together and purchased. We acquired exclusive use and access to an additional 1.5 acres of land in the West Michigan area for just $10.00 in consideration monies via an easement agreement. It cost me nothing but a few hours of my attorney’s time who helped me navigate and implement the “idea” I had into the deal. So let’s run some quick numbers and you’ll see why I love this stuff so much:
1.5 acres of raw land value = $15,000
Attorney costs on deal = $1,482
Easement Agreement consideration = $10
$15,000 – $1,492 (expenses) = $13,508 Forced Equity
$13,508 / 5 hours = $2,701.60/hr value of my idea!
I probably have about 5 hours into emails and phone calls on this. So if you take the $13,508 in forced equity I created and divided that by the hours I have into it, I earned $2,701.60/hour of my time on just this one small aspect of the deal. Not bad huh.
If you buy an investment property the right way, the property will be a positive source of cash flows PLUS equity growth on your balance sheet. The equity growth (capital gains at sale) can be a very, very significant upside.
So let’s break these down right here:
#1 – Cash Flow –
You want an investment property that PAYS YOU, not the other way around. You want the property to cash flow from the start. Any upside you create should be yours, not the sellers. Don’t let sellers or their realtors b.s. you here. We buy on actual historical financials; NOT on a brokers “pro forma” set of pipe-dream projections. The property needs to be self-supporting and sustaining on its own from the start. Otherwise, you’ll find yourself in a very uncomfortable position bleeding cash.
If you overpay for the asset (property in this case), the debt service will eat what would have been your cash flow. Imagine, if you can barely cover your mortgage payment from the start, what do you think is going to happen when something breaks??? That’s when your investment property goes from what should’ve of been an asset, to a cash draining liability. All because you overpaid and/or over-leveraged the deal.
#2 – Equity Growth –
Equity is simply the difference between what you own (asset value) and what you owe (liabilities). Here’s the best part… you’re only limited by your creativity to accelerate that equity growth! This is the really, really fun part because as seen above from my example, there are so many ways you can create real value ($$$) here! Here’s a few:
First is Debt Amortization.
Quite simply, it’s your mortgage being paid down by your tenants renting your property. That’s why it’s important to be on your “A” game when managing tenants. If they don’t pay, they can’t stay. Your investment is not a charity. You can structure the best deal in the world but if you don’t manage it well, it will become it’s own sort of a beast. You don’t want that. Make sure your management team is solid and you get along well. A great management team can be one of the best additions to your investment team of advisors and can be an asset to your investing.
Second is Forced Equity by Income Growth.
Forced equity is accomplished by increasing the asset value above and beyond the capital required to make the improvement. The Gain has to be greater than the Cost. You can go a step further and calculate your return on the improvement and compare against alternative improvements/uses of capital.
How do you increase the value on a residential rental property? Quite simply, you grow the income stream by adding improvements (in the form of features or upgrades) that your current or future residents are willing to pay for. If they’re not willing to pay more for it, you very well may be over-improving the asset and wasting capital.
Third is forced equity by expense reduction.
You can do the same as with income growth, but even quicker by cutting expenses! Unlike rental income growth which takes time to ramp up, the benefits of cutting an expense are almost instantaneous. Every dollar saved is another dollar in your bank account. Additionally, every dollar in expense savings increases your assets market value! Divide the expense savings by the current cap rate.
Expense Reductions / Current Cap Rate = Forced Equity Growth
For example, $2,000 in savings in a market with let’s say a 7% cap rate (capitalization rate), comes out $28,571 in INCREASED equity. That’s real money when you sell the property or pull cash out.
To Sum it Up
When you purchase an investment property correctly, you can create a LOT of money that goes into your pockets and on to your balance sheet! Not only that, if you stick to the fundamentals you will have a solid performing asset that can withstand the turbulence of market cycles. But that’s a whole other topic I’ll share my insights into soon 🙂
Until then, happy investing!
-Justin Bajema, CPM®