By Alexander Bermudez 

How many times have you heard the statement, “ If only I had bought property, back when it was so cheap”? Even the most successful real estate investors have been known to mutter these words from time to time. Suffice to say, the best time to buy has always been in the past, short of that, and providing the property can achieve the economic objectives of the investor, now is as good a time as any to start investing in real estate.

The population of the world is continually expanding and with this, comes accelerated migration to areas with the greatest economic opportunities. As demand rises, prices of well-situated real estate will trend upwards, triggering a surge in development until equilibrium is achieved, thus the market cycle. However in mature markets or areas constrained by geography, new development (supply) is stunted, creating an imbalance. Rents and capital appreciation, in constrained markets will invariably outperform the broader markets, due to the increasing demand and limited supply.

 That being said, it is far more prudent for prospective buyers to focus their analysis on free cash flow rather than speculating on future appreciation. As with all real estate investments, ‘cash flow’ is the true asset being acquired.

Cash flow is expressed as ‘net operating income’ (NOI), which is gross scheduled income minus vacancy allowance and expenses. The NOI formula has no provision for mortgage costs and thus eliminates the impact of fluctuating interest rates, while comparing the relative profitability of various real estate investment opportunities.

Assume two buildings, each with a ‘gross scheduled income’ of $100,000. The vacancy allowance for each building is $5,000. One building however, has annual expenses of $30,000 (NOI of $65,500) while the other building has annual expenses of $45,000 (NOI of $50,500). Presuming no other differences between the two buildings exist, prudent investors will inevitably opt for the property with the greater NOI.

A word of caution; investment real estate in well established, affluent or ‘low risk’ neighborhoods will exhibit noticeably lower ‘net operating income’ (NOI), when compared to similar properties in marginal, less affluent or ‘high risk’ neighborhoods. This is particularly important if an investor intends to personally manage the property, as affluent neighborhoods will be far less demanding on one’s time, relative to properties in less favorable areas.

Yields will also vary according to the age of the improvements; an older building with a higher risk of incurring unexpected maintenance costs, due to obsolescence will tend to exhibit a better yield relative to new construction. This is the nature of all investing; as the rewards increase so does the risk.

Investors will have to carefully balance their aspiration for yield against the shortcomings of lesser neighborhoods. When equilibrium is reached that satisfies both the risk tolerance and the yield expectations of the buyer, a transaction will likely ensue.

By Alexander Bermudez

Now that we have discovered the miracle of compounding property values, it may be a good time to discuss the inherent shortfalls of real estate.   Remember all investments harbor risk, in the case of real estate; the lack of liquidity is its Achilles Heel.   Liquidity is a term that refers to an asset's ability to be sold (liquidated), in a short period of time and with minimum loss of value.

Although one of the best asset classes available to individuals with long term investment horizons, real estate can take months, if not years to sell.  In a slow market, pricing may be unpredictable and adding insult to injury the transaction costs are high.  In a poor market leverage only exacerbates the problem, by increasing the volatility of the asset.  Needles to say, you don't want to be forced to sell an illiquid asset under adverse conditions.  Thankfully there are steps we can take to reduce the risk, without significantly diluting return expectations, thus engineering a more efficient investment.

Short-term reserves of cash or cash equivalence, while unlikely to rival the investment performance of leveraged real estate, provides a hedge against the inherent lack of liquidity. The amount of accessible cash will largely depend on your fixed liabilities and your risk tolerance, but three to six months of expenses, set aside for unforeseen costs, would substantially reduce the likelihood of default or distressed sale.  However a word of caution, while cash reserves are highly recommended, excessive cash positions do present a substantial opportunity cost.

In addition to short-term reserves, insurance, hedges against the possibility of catastrophic events.  Banks will always insist you insure any real estate, they hold mortgages on.  However in this litigious climate we all live in, additional liability insurance is highly recommended. Statistically speaking, landlords are amongst the most commonly sued.  Not only will insurance companies bear the financial burden of any legitimate claim against you, but also they will likely use their vast legal resources, in an effort to preserve their own capital, to defend you against any frivolous lawsuits.  A good insurance broker should be able to show you a host of different insurance products, specific to your real estate needs..

Property Management, regardless if you delegate the job or not, is of paramount importance to the long-term performance of real estate.  Attractive well-kept buildings not only command premium rent, but also attract good long-term tenants, substantially reducing vacancies.  As a landlord, empty apartments are amongst the largest of expenses, due to lost rent and all the costs associated with re-leasing the unit.  Avoiding vacancies through good management will preserve the cash flow of the investment.

As with all investments, low levels of uncertainty tend to have lower yields, conversely high levels of uncertainty tend to have higher yields.  However, tremendous long-term returns can be achieved with real estate, through good management and successful hedging, with minimal downside risk to the investor.  The key is to remember, that in real estate you will only get a good price, if you do not need the money. 

By Alexander Bermudez

In this increasingly material world we live in, many people find themselves living beyond their means, and the prospect of investing takes a back seat to consumption. Ironically wealth is so coveted by our society, many people, not disciplined enough to invest, take the easy road and consume, often more than they make, in an effort to appear wealthy.

Our culture seems to promote this behavior, how many times have you heard the term, “rich man’s car”? A car may be expensive, however this does not make the man who drives it rich, surely any car a rich man drives regardless of price, quality or condition is a “rich man’s car”, after all, it is the man who defines the car.

Not content with the facade of keeping up with the Joneses, many high net worth individuals resist the temptation of conspicuous consumption, in favor of investing. As any investor worth his salt will tell you “the sooner you start to invest, the greater the benefit of compound appreciation will be”.

To illustrate the point we will use a hypothetical building for sale today priced at $1,000,000. Let us say you put a down payment of $350,000 and financed the balance of $650,000. We estimate the value of the property will increase by 7% annually; by this measure it will double its value in ten years.

After ten years your building is now worth $2,000,000. You decide to refinanced leaving $700,000 of equity and employ the cash out proceeds of $650,000 and a mortgage of $1,150,000 to buy another building for $1,800,000. You now control a total of $3,800,000 of real estate, the original building now worth $2,000,000, and your new acquisition valued at $1,800,000. Your equity at this time is $1,350,000.

Another ten years have passed and your real estate portfolio is now worth $7.6 Million. You refinance for the second time leaving you with 2.7 Million in equity in the first two buildings, and employ the cash out proceeds of $2.45 Million and a mortgage of $4.55 Million to buy another building for $7 Million. You now control a total of $14.6 Million of real estate, the new $7 million purchase plus the prior 2 buildings worth $7.6 million, and your equity is now $5,150,000

Ten more years pass and you are still a firm believer in the buy and hold strategy, your real estate portfolio is now worth 29.2 Million and your net equity is $19.75 Million. You have $9.45 Million in mortgage obligations, which your tenants are paying off for you.

We now can see how compounding $350,000 over a thirty-year period can result in $19,750,000. But if you only have 20 years to compound, your equity drops to $5,150,000. Those lost ten investment years cost you $14,600,000!

As you can see the opportunity cost of deferring your investment strategy is exorbitant. So forget the Joneses, live below your means and save for a down payment! If you wait, there will be less time for your money to compound, and the consequences will be very costly. Remember the loss comes off the thick end of the investment wedge, when the greatest amount of money is compounding.

What is the one thing you are most concerned about regarding the current real estate market?

Anonymous

Dear Anonymous,

The problems we face in Real Estate today, were spurred out of a global, low yield environment, due to the lowering of interest rates by the Fed and other central Banks around the world, after the tech "bubble" crash and 9/11.

This phenomenon stimulated massive investment in real estate, through the use of cheap capital. Unfortunately consumer debt also increased substantially, leaving Americans for the first time in history, with a negative savings rate. This is of grave concern, as it leaves Americans with little or no financial cushion, for the hard times upon us.

Investment Banks yearning for higher returns, responded to the historically low yield environment, by vastly increasing their holdings in the, high yielding sub prime market. (In essence creating the credit crises the Fed is wrestling with today). As more capital flowed into the Real Estate market, prices moved up triggering a wave of development and speculation, which has left us with a housing surplus.

Today, in many markets across the country, there is an abundance of high-end new construction sitting vacant, awaiting absorption into the market. This has pushed down prices, as the capital markets have dried up. Stricter loan requirements have been reintroduced, however at this point, with a national negative savings rate, it is not clear how many people will have the necessary down payment saved up.

Again in response, the Fed has lowered interest rates and Congress is exploring a variety of bail out packages, for distressed homeowners. It is hoped that the measures taken, will prevent the Real Estate bubble from deflating in a disorderly fashion. However I fear inflation, due to the weak US Dollar, (a byproduct of low interest rates), is a far grater problem than the Real Estate cycle.

The trade deficit amplifies the effects of inflation and the weak dollar, as everything we import, will become more expensive. However this could incentives consumers to stop buying and start saving... only time will tell. Additionally our exports have been steadily increasing over the last quarter, improving our trade imbalance and the deficit.

All this said I believe we will come out of this stronger and better for it, as we have always done in the past.

To conclude, the two things that concern me most, although not directly related to the Real Estate market, are the lack of personal savings and the presence of stealth inflation.

I believe that the Real Estate market is going through its natural cycle.  

Alexander Bermudez

If you are a real estate investor, what kind of cap rate do you look for?

Anonymous

Dear Anonymous,

"Capitalization Rates" much like "Gross Rent Multipliers" are useful as a preliminary measure of any given building's ability to create cash-flow, relative to other available properties. Different markets will have different Cap Rates, the better the neighborhood, the lower the Cap Rate and vice-versa.

One could look at recent sales of comparable buildings, to ascertain what a typical Cap Rate would be, for a particular sub market. In doing so, an investor could calculate how much he or she, is paying for each dollar of income, relative to other investment properties in the same sub market.

Cap Rates however do not take the expense of financing into account, thus they do not give a comprehensive financial picture. The presence of leverage can drastically change "Cash-Flow" and "Capital Appreciation", as a measure of return, relative to the down-payment.

Return on Invested Capital, I believe is a far more useful measure of a building's investment value.  

Alexander Bermudez

We have seen how raising oil prices have affected the auto industry, how do you foresee the high prices of oil affecting the real estate industry?

Anonymous

No other city in the world has embraced the automobile as enthusiastically as Los Angeles and its satellite communities. The perpetuation of 'suburban sprawl' and the extensive freeway system, are products of an economy based on cheap petroleum. Because of this, the ramifications of sky high gasoline prices will be particularly impact-full on real estate and future development within LA county.

As gasoline prices continue to climb, alternative transportation will become increasingly attractive to many commuters; this would lead to further development of LA's mass transit rail system, in an effort to satisfy the growing demand. Invariably developers will respond, as they have already in Pasadena, by building high density, mixed use, multifamily projects within walking distance from Metro Rail stations. Naturally, property within walking distance of such public transport and other neighborhood amenities, will became more valuable as the price of oil continues to climb.

Additionally 'urban sprawl' will likely slow, in favor of re-gentrification and high population density within the 'Central Business District' (CBD). For this to happen in any meaningful way, large public and private investments will have to be made in infrastructure, such as schools, housing and a host of other neighborhood amenities, no longer found not only in downtown Los Angeles, but in many other CBDs around the country.

Thankfully, in Los Angeles this process is well on its way. Over the last few years many developers such as the South Group, KOR, Linear City, and countless others have worked tirelessly to bring thousands of units online. Unfortunately market saturation has been very slow, due to the deteriorating real estate cycle, however it is likely as gasoline climbs, real estate close to the 'Central Business District' will become an attractive alternative to many suburbanites, who no longer benefit from living in a more affordable submarket, two hours drive away.

Satellite communities until recently, had been considered a less expensive alternative to living in the city. However there have always been drawbacks prospective buyers had to consider, most notably the time wasted due to the long commutes to work. Many satellite communities in Los Angeles bear another burden, as one moves further east, away from the coast line and closer to the high desert, the temperature rises significantly.

Commuters from these communities, will not only have to cope with two hour drives to work at the expense of personal quality time, and expensive electricity bills, due to perpetual air-conditioning, but now have the added burden of skyrocketing gas prices. Because of this it is probable we will see a slow migration out of the satellite communities, unless local officials can create job opportunities, by attracting large high paying employers to those areas. 

Short of this I believe the high price of oil, will over time, force our cities to contract into more efficient denser communities, much like we see in Europe.

Alexander Bermudez

How Can I Start Flipping houses?

Anonymous

Dear Anonymous,

I strongly believe in adding value to real estate, through rehabilitation and redevelopment. This simple idea has been the foundation of my investment strategy over the past several years. However it is important to note, our firm focuses on the rehabilitation of small, 6 to 12 unit apartment buildings and we have, for the most part, held on to our properties in order to capitalize on the resulting cash-flow.

This strategy, while being lucrative is of course quite different to 'Flipping' in the context of your question, but the experience my team and I have acquired over the years, in addition to my market knowledge as a Realtor, has led us to explore, on many occasions, the opportunities flipping real estate could present to us.

Having said that and after much heated debate, we have elected not to participate for the time being, as it has become quite clear that buying property, with the intent of rehabilitating it for resale, in the deteriorating Los Angeles market, would likely present limited returns relative to the risks we would expect to undertake.

Of course all real estate is local and the market conditions in North Carolina may be quite different to what I am seeing in Los Angeles. However your question in and of itself, implies somewhat limited experience on the subject of 'flipping' houses. If indeed this is the case, I would encourage you to take a more passive role to begin with, perhaps partnering with someone with more experience but limited capital. Not only would you learn from such a partnership but diluting the economic risk, may be a wise choice at this time.

Additionally I would recommend you read as much as possible on the subject of real estate. There are many excellent books out there containing a wealth of good information. Lately I have found myself reading graduate-level textbooks, on the subject of real estate economics and development. I bring this up because as inspiring as the 'Rich Dad' books and the like are, you will likely become disinterested by the lack of in-depth practical knowledge. Below are a couple of titles, I have read lately, that may be of interest to you.

Commercial Real Estate Analysis and Investments

Real Estate Development: Principles and Process

Real Estate Market Analysis: A Case Study Approach

On a final note, I want to let you know how admirable I think what you are aspiring to do is, not only from an entrepreneurial point of view but also because of the positive effects redevelopment inevitably has, on otherwise blighted communities.

Alexander Bermudez

I am writing an article on the dangers of trying to time the real estate market or the pros and cons of a first time homebuyer buying a home now.

Anonymous

Dear Anonymous,

Buying at the absolute bottom in the Stock Market, a highly liquid, publicly quoted, market is difficult, to say the least. "Private Real Estate", a fundamentally illiquid market comprised of emotionally charged buyers and sellers, with limited pricing data, makes timing the bottom next to impossible.

If one is interested in attempting to time the market, I assume it is for investment or more precisely, speculative reasons. This brings up another important point; a home is not an investment.

Historically house prices have followed the Consumer Price Index (CPI) quite closely over the last hundred years, hardly an attractive return on your money. Buying a house, is a life style choice, (and a good one at that), invariably, your quality of life will improve but unfortunately you now will have transaction costs, property taxes and maintenance to budget for.

Rather than fixating on finding the bottom of the market, it is far more prudent, to buy a house that adequately fulfills your needs, at a price you can comfortably afford. This balance between utility and cost will give you your individual entry point into the market, based on your particular expectations and financial means.

On the subject of income property, the price is not as important as the "Return on Invested Capital"; after all, this is why they call it an INCOME Property.

Investors must ascertain what their investment expectations are and then find a suitable investment vehicle that satisfies their expectations.

"Free Cash-flow" and thus Return On Investment (ROI), will improve as prices of apartment buildings and other income generating properties decline and the entry point would be predetermined, by the investment expectations of the investor. In other words, when the fundamentals of a particular property line up, with the return expectations of the investor.

The biggest risk in real estate is the lack of liquidity; it could take months if not years to sell a property. If a particular seller's cash flow does not allow him to wait for a more favorable market, the price of the asset will invariably come down due to the aggressive negotiations on the buyer's part. This phenomenon is far more lucrative to buyers than trying to buy at the bottom.  

Alexander Bermudez

There are a lot of hassles to owning rental property: late rent checks, maintenance expenses, insurance, vandalism, etc. Is it better to own REITs instead? There are six REITs that pay MONTHLY dividends, for consistent income, and have the same total return on investment as apartment buildings. Also, you never have to answer a phone call from a renter late at night.

Anonymous

Dear Anonymous,

Over the years, I have repeatedly considered buying REITs in an effort to diversify my existing real estate portfolio. However, to date I have not bought, due to the lower return's associated with REITs.

In many ways real estate is more about people, than bricks and mortar. Serving the needs of one's tenants must not be looked upon as a hassle, one must remember it is in-fact the tenants that, over time, pay down the mortgage on your behalf.

I encourage a healthy dialog with all my tenants; this over time has resulted in a portfolio of very well kept buildings, which in turn attract better quality tenants thus alleviating many problems in the future.

While it seams obvious, the most important aspect of buying an investment is the "Return on Invested Capital" in the form of free cash flow and capital appreciation. However lately in Los Angeles, many real estate investors have lost sight of this and focused solely on capital appreciation.

The Cash flow from the property is vital to the long term success of the investor. As long as the building is generating a healthy cash-flow, maintenance expenses, insurance, vandalism and everything else can be solved, quite painlessly, with a couple of phone calls.

I believe direct real estate ownership should be treated as a business rather than an investment. Invariably your properties will demand your time, this of course is one of the many advantages of investing in REITs, as they are professionally managed on your behalf.

REITs benefit from economies of scale and regional diversification. Barriers of entry are greatly reduced, thus REITs are far more accessible to many investors, unfortunately all at the expense of yield.

As with any investment, the investor must analyze the opportunities before him, and choose the one that best suits his expectations going forward.  

Alexander Bermudez

In balance, do most of the people that you deal with feel like the US Commercial Real Estate Market is a) softening to the point that better value opportunities are available, or b) has a long way to go before any real value opportunities are out there - therefore today's value opportunities will look like Fool's Gold when we eventually bottom out?

Anonymous

Dear Anonymous,

In Los Angeles, multifamily investment opportunities in reasonable neighborhoods are priced so high, that prospective buyers putting 35% to 40% down, would not likely enjoy any free cash-flow, and would have to rely solely on capital appreciation for financial gain. The same can be said for other classes of real estate, such as office and industrial properties in the same sub markets.

This market environment implies that buyers, have been willing to forego free cash flow and in some cases, accept negative cash-flow, in order to benefit from the real estate boom.

Admittedly this somewhat risky strategy has worked very well over the last decade, as many speculators successfully maneuvered in and out of the roaring real estate market. However as the market slows and capital appreciation grinds to a halt, investors will likely shift their focus to cash-flow, rather than capital appreciation. This shift will force sellers to lower their expectations, in order to sell their properties as income generating investments, with attractive returns.

Coinciding with this market shift in investor sentiment, interest rates will likely trend up from their current low. Not only will this put additional pressure on free cash-flow, resulting in significant price erosion to the asset class as a whole, but such a scenario will likely slow our economy. This will cause vacancy rates to rise, thus further eroding the attractiveness of real estate, relative to other asset classes.

Having said all this, the long term prospects for well located real estate, is very promising due to population growth. This will be especially true in areas with large employment opportunities. Because of this, there will be tremendous investment opportunities in real estate, when prices finally realign with fundamentals.

The value opportunities will occur, when investors are adequately rewarded with healthy positive cash flow, for holding real estate in a volatile market. However this will not likely mark the bottom of the real estate cycle, as the market will likely over correct.

It is impossible to know how close we are to the bottom of this real estate cycle, however, all the 'flip this house' style television shows will likely have to be canceled, due to a declining interest in real estate, before the market can bottom out.

Alexander Bermudez