Real Estate Investing, with Tony John

April 9, 2008

Experts

Filed under: Attitude — Tags: , , , — Tony John @ 12:37 pm

While you are preparing to purchase a property, be prepared for ‘experts’ to try to talk you out of doing things.

I can give you a wealth of examples, but here are a few:

1. Valuers

When I purchased our shops a few years ago for $400,000, a valuer friend asked me “if it’s a good deal, why hasn’t someone else bought it?’. Today, it has put probably $150,000 directly in my pocket (after paying interest), and is worth over $900,000.
Interestingly, with that logic, you could never buy a good deal.

2. Lawyers
When we purchased a residential property for $240,000, I had to add my wife’s name on the title, to help us get finance. The bank insisted that she independently see a lawyer, before she signed a particular document.
When my wife came out from seeing the lawyer, she was worried. She nearly pulled out of the deal. The lawyer had explained how dangerous it was to be responsible for a debt. All sorts of dreadful scenarios were concocted, all leading to heartache and poverty.

We decided to buy anyway, and within four years, we sold the property for $680,000. Glad we weren’t talked out of it by that doom and gloom lawyer.

3. Bankers
With our latest property, I contracted to buy a 1.4 million office, subject to obtaining finance. I emailed my long-term banker: could he help us get finance?
He quickly replied, “you can’t get finance for this property. But don’t worry! I’ll write you a letter which will get you out of the deal”

The implication being that I was some sort of idiot to get myself in that position, but he would kindly help me out of my predicament.

We found another bank, bought the property, and it is now worth 1.6 million.

4. Real Estate Agents
We had the real estate agent who did not pass our offer onto the vendor. He told me “the vendor is not going to be interested in that offer” After a week, I called the vendor direct (which was a bit naughty) and asked him if he was interested in my offer. He was shocked that he didn’t know about our offer. He rang the agent, yelled at him, then the agent yelled at me. It was messy there for a day or two, but the vendor accepted our offer.

5. More lawyers
The latest commercial property I mentioned above: we had terrible trouble getting finance, and we didn’t settle on the due date. We were charged penalty interest of $18,000. For various reasons, we felt this amount of penalty interest was unfair.
On the day we were finally ready to settle, we protested the penalty interest. The vendor said “well, you pay it, or we won’t sell it to you, and we’ll put it back on the market tomorrow. Your choice”.
Our lawyer did not want us to settle, and suggested we walk away from the deal, rather than get slugged like this.
But we ate it up, went ahead with the purchase, and as already mentioned, the following month it was valued at 1.6 million. So we paid $18,000 to make $200,000. Bigger picture.

6. Accountants
Have I mentioned that I am interested in aircraft? Well, I am building some hangars at the moment. When I mentioned this to my accountant, he said “you’re not likely to make money doing that. I mean, people may as well build their own. Why would they buy one from you?” In fact, there are many good reasons why people will buy from me, rather than build their own. My accountant has never built a hangar.

So, when your expert gives you advice, you may want to ask yourself: “is this expert obscenely wealthy?” If not, then do they know everything about the topic of building wealth? Unlikely. So feel free to take their advice with a grain of salt.

Please note that I’m not telling you to assume everyone else is an idiot and ignore them. You can learn a lot from listening to other people. I’m just saying that ultimately, you have to make your own decision.


Add to Del.icio.us

April 7, 2008

Fear

Filed under: Attitude — Tony John @ 2:23 pm

I’ve never purchased a property without fear.

People are different. Maybe you are fearless. But I am not. Every time I make a purchase, I have a lot of doubts.

  • Am I doing the right thing?
  • Am I being ripped off?
  • If this is a good buy, why hasn’t someone else bought it?
  • Will I be able to pay the interest?
  • What if I lose a tenant?
  • Do I need this much debt? Wouldn’t I sleep easier if I don’t have this extra worry?

I think it’s healthy to have doubts, and to ask yourself some tough questions. These are all sensible questions to ask. If you’re not asking them, then you’re probably being reckless.

When you answer these (and more) questions honestly, you may end up discarding some properties. I had to do this recently. I got quite excited by a deal, but then when I asked some tough questions (and my business partner asked some even tougher questions), I decided not to go through with the purchase. The deal was good, but I wasn’t convinced it was the best thing to be doing with my money. So I said ‘no’.

But if you answer all these questions, and still, the deal looks good, then what? I’ve seen a lot of people who still won’t act. They get gripped by fear, and don’t act. They say things like “I’m still thinking about it” but really, if they are honest, they are afraid to act. Eventually, soemone else will come along and do the deal, then they say “oh too bad, I was quite interested in that, I guess I missed out.”

In fact, not acting is a deliberate act. It’s a cover for “I’m too frightened”, or “It looks like a good deal, but I don’t trust my judgement”, or similar. It’s a way of saying ‘no’ to a deal without having to find a good reason to say ‘no’. It’s a way of pretending to be in the game without actually being in the game. Essentially, it’s a lie.

There’s nothing wrong with saying ‘no’ to a deal. But saying ‘no’ is a very different thing to simply not acting. While it has the same end result, saying ‘no’ is more positive act, and avoids our human tendancy to kid ourselves.

There are a lot of frightening things about purchasing property. It involves large sums of money. There are the negotiations with the vendor. Emotions can run high. There are lots of official documents to sign. There are mortgages with horrible consequences if you don’t pay the interest.

Literally every property I’ve bought, I’ve asked ‘why am I doing this?’ at some point during the process. When things get complicated, or don’t go the way I want, I’ve been gripped by doubt and concerns. Somehow, at least up to now, it doesn’t seem to get much easier, even as I buy more property.

But afterwards, I’m always glad. When the rent is flowing in, I’m happy. When my equity goes up, I’m happy. In hindsight, investing in real estate has always been a very good use of my time, energy and money.

Perhaps getting past all the fear is a big enough barrier to stop most people becoming serious property investors.

How do you press on, despite your fear? Well, you’ll have to figure it out for yourself, but I’ll tell you what works for me:

1. Excitement
I revisit the numbers which excited me in the first place.
I put together a spreadsheet showing how much income I get now, and how much I’ll get after the purchase. How much equity I have now, and how much I’ll have afterwards. If it’s a good deal, these numbers are exciting to me. I examine this spreadsheet frequently during the process, to remind me, and excite me, about why I’m bothering to do this.

2. Risk Mitigation
I look at: if things went wrong, what would be the worst case? Surprisingly, it’s often not as bad as you think.
Example: I once offered an unconditional $40,000 deposit on a deal, without knowing if I could get finance. This was scary - in the worst case, if I couldn’t raise finance, and I would lose $40,000. Would that hurt? Yes, absolutely. Would I continue to live, eat and breathe? Yes, I’d still be alive, and I would still have some money. So the worst case, though bad, wasn’t the end of the world. The sky wasn’t going to fall on my head.

I look at what can go wrong and try to minimize the risk. I get a sense of peace once I feel like I know all the things that might go wrong, and what the consequence will be. If I can handle things going wrong, then I’m usually happy to proceed.

I try to recognize if I’m being hopeful. If my solution to dealing with a risk is to hope it doesn’t happen, then I’m not dealing with that risk properly. This is a warning sign to me.

If there is an outcome which I can’t accept, but I’m crossing my fingers that it won’t happen, then I have a genuine reason to fear, and it’s too dangerous to proceed.

3. Sense of Perspective
If you can, try to put your fear in some sort of perspective. It helps me to consider the bad things that can happen in the world. That might sound odd to you, but it works for me. I read a book about World War 1 recently, and I think about the horror of the British Army losing 20,000 men killed, most younger than me, in a single day on the Somme. I think about what all those men faced. Compared to them, my concerns are of very little significance. Gee, I could lose money. So what? I’ll still be alive. My dogs will still love me.
This line of thinking genuinely helps me to take action despite my fears.

Feel free to substitute some event which touches you.

4. Support
Whether it’s my wife, or a business partnership, I find it helps having other people involved in the adventure, who also care about the outcome. I doubt I would have done the deals I’ve done on my own.

Do I sound like some sort of motivational life-coach? I don’t mean to. But if you’re not growing your portfolio as fast as you would like, consider whether fear is one of the factors holding you back.


Add to Del.icio.us

February 20, 2008

Commercial Real Estate Course - Part 5

Filed under: Education — Tony John @ 3:15 am

In 2005 I wrote an introductory course on commercial real estate investment. This 5-part course was received via email in daily installments. Here is the final part.

Commercial Real Estate: How To Invest Like The Rich
Part 5: How Can YOU Get Started?

There’s such a difference between understanding something and living it. So, how do you start being a commercial real estate investor?

5.1 The Importance Of Prompt Action
I once spent a great weekend with about 400 people in a real estate course. The presenter kept drilling home the point: “You’ve got to get excited about it! You’ve got to open the paper, find interesting properties, and get on the phone. Start making calls!”

The course ended on a Sunday night. Afterwards, I flew home to the other side of the country, and looked at the local paper that evening. I had made an offer on a property by Tuesday morning. Within three months, I had purchased two properties (one residential, and one commercial - my first).

I would love to know what percentage of people at the course went home and actually put all their new knowledge into action. I suspect that it’s pretty low. A lot of people like to arm themselves with all the facts, all the knowledge, but then STILL DON’T ACT!

I tell you - I learnt a lot at that real estate course, but it was only the basics. You get to a certain point where the best way to learn is by doing it yourself. That is where the real lessons start.

I can’t stress how important it is to act on your new knowledge. Otherwise, it all becomes a memory, and you gradually talk yourself out of taking any action (or worse, allow other people to talk you out of it!)

5.2 Things That Will Stop You
When I began investing in commercial property, there were a lot of people around me who tried to talk me out of it.

My family, my friends, even some of my fellow investors, could all see ‘problems’ with the deals I found. The most common things I heard? “Why would you buy that?”, “You have to be careful”, “Do you know what you’re doing?”, and “That sounds risky”.

The thing is, I had very little personal experience to support my beliefs. I mean, everyone has to start somewhere. I was sure that the deals were good, but I couldn’t prove it. It really took courage to go against what well-intentioned people around me were advising.

Now, after investing in commercial property for a while, it is much easier. I haven’t gone bankrupt, I have money flowing into my accounts, and I continue to buy commercial property. Now, friends and family are more likely to say things like “well, you seem to know what you’re doing,” which is big difference, when you think about it!

But it’s really interesting to see how the human minds work. A lot of people just aren’t prepared to take action. Their reasons may change, but their actions don’t.

Take the shops I talked about back in Part 3. I’ve got a friend who, back then, said “There’s got to be something wrong with them. I wouldn’t buy those. There’s got to be a catch.”

Now, years later, when it’s easy to see that the shops turned out to be great deal, he says “Well, if I could find a property as good as those shops, of course I’d buy it. But you have to be lucky to find those. That’s why I havn’t bought anything yet.”

Now, what he’s telling himself is not actually true. These deals do come along, regularly. But when they do, he’s gripped by doubt and fear. In hindsight, when he’s missed the deal, he can see it was great. But put a great deal in front of him, and he can’t see it. Doubt and fear arise, and all he can see are the things that might go wrong.

Do you know anyone like this?

Are you like this?

If so, are you interested in breaking through this?

5.3 Learn To Talk The Talk
One of the most valuable things I can tell you is that you should learn how to ‘talk the talk’. This is not so you can sound like a big shot, it’s so you can converse with a seller and ask the right questions, and understand the replies.

My wife is a doctor. When we sit down and watch a medical show such as “ER” on TV, I’m always struck by how she understands much more of what’s going on than I do. She hears a doctor speak, and it makes sense. She picks up a lot of details that I don’t even notice. It’s because she’s trained in the field, she knows the jargon, so she can process the information as it comes in.

It’s the same with commercial property. As you get more and more familiar with it, you get better at spotting interesting details, that might go straight over other people’s heads. And spotting these might make the difference between seeing the bargain and completely missing it.

Gradually, you get to know the numbers. For example, if someone on the phone tells you the building rents for $15 per foot, it might not mean much to you. But if you know that all the similar buildings nearby are leased at $30 per foot, you might start to get excited about the chance to buy a property at half-price. That’s a possible bargain you wouldn’t be able to see if you were not familiar with the numbers. And you learn the numbers by making calls, and getting experience.

Here’s what I recommend you do in the next 24 hours: find the commercial section in your local paper, spot an interesting property, and get on the phone about it. See what the seller can tell you about it. Decide whether it sounds like a good deal, a bad deal, or a mediocre deal. I’m not asking you to go and see the property, I’m not asking you to make an offer. I’m asking you to take an action which will have you learn something new, leaving you more experienced than you are right now.

You see, something magic happens when you phone up about a property. You start hearing details that did not fit into the ad. The seller has a new job on the other side of the country, and is getting desperate; the seller is willing to lease back the building; the seller will do $20,000 of work on the building as part of the settlement; the seller is willing to help finance the property; the seller will defer settlement for 18 months; you start to get a feel about whether there’s a deal to be done. Your creative juices start flowing.

You’ll find that commercial property can actually be exciting!

5.4 Where To Now?
This is the fifth and final part of the course.

I certainly don’t expect everyone who has followed along for the last five parts to rush out and buy a commercial property by next Tuesday.

I once spent a fascinating evening talking to a guy who concentrated on doing property ‘wraps’. He told me that each week he put in more than 100 offers on residential properties, and usually bought several properties each month, way under market price.

While I could see that he made a lot of money using this approach, I decided that I was not interested in investing that way. Apart from the fact that estate agents got completely sick of him and his constant low-ball offers, it was practically a full-time job for him, and I did not want an approach which took that much time. So it was not for me.

Similarly, commercial real estate investment may or may not be for you.

But you should now be at a position where you can either say:

  • “OK, I see how commercial real estate works - but it’s not for me”, or
  • “OK, I get it, I’m excited - let’s get started!”

5.5 The Importance Of Education
If you’re serious about investing in commercial real estate, I recommend education, education, education. After all, a commercial property is a big purchase, so it is worth making the effort to educate yourself. I’m not talking about ‘analysis paralysis’, where you learn more and more and act less and less. But arming yourself with knowledge about commercial real estate is a smart thing to do.

I believe the best way to learn something, apart from doing it yourself, is to listen to and observe other people who have done it, or who are doing it. If I consider the people who have taught me the most, they are active and seriously wealthy commercial property investors. In general, they have come from ordinary families, and their fortunes are entirely self-made. That is what makes them so inspiring to me.

Actually, I believe the absolute best way to learn is to do it yourself. But in a serious venture like commercial real estate investment, it’s good to learn as much as you can before getting started.

5.6 It’s Important to Control Your Own Destiny
I want to tell you about an older couple I know. They retired a couple of years ago. They both worked really, really hard all their lives. They were very careful with their money - they have lived modestly, within their means, and they have carefully saved money all through their working lives.

In the last couple of years of their working life, they enlisted the help of a financial planner, to help them manage their money into retirement. Naturally, all of their savings quickly went into the Stockmarket.

Within two years, their savings were cut in half. Unfortunately, their financial planner put their money in some IT stocks, just before the IT bubble burst. Also, he put a lot of their money into “blue chip” stocks. But one of these had an accounting scandal, and halved in value overnight. And another blue chip stock put out a profit warning, and lost significant value. In fact, if you saw the list of the stocks they were in, it was a list of what not to own in the late 90s. Of course, that’s with hindsight - their financial planner was no fortune teller.

Half of their savings represented many years of working hard and saving carefully. And they lost that within about two years.

They recently nearly missed an important family funeral, because they simply couldn’t afford to travel to it. The rest of the family had to pitch together to help them attend.

As their financial planner told them: over the long run, the stock market generally goes up - any financial planner can tell you to ’stick with it for the long run.’ But that doesn’t help them in this case. The husband has developed some health problems, and needs expensive care. They’ve had to pull a lot of their remaining funds out of the market. With their money out of the market, they can’t recover the massive losses they took. They are going to live out their remaining years with very little money. In fact, the wife now bursts into tears whenever they talk about finances. And that’s after an entire lifetime of hard work, responsible saving, and using professional advice. It makes me feel very sad, and not a little outraged. How can good, responsible, hard-working people end up in this situation? It doesn’t seem fair.

I really want to encourage you to take full control of your financial future, so that for your family’s sake, you are not able to be completely sunk by outside forces. I believe commercial real estate is a very safe, secure investment - it’s what I’m banking on.

5.7 Stick a fork in me, I’m done
Well, we’ve covered a lot of information in this 5-part course. I really hope you’ve got some valuable information which will help you look at commercial property in a new light.

If you’ve followed along, congratulations! Remember, what we’ve covered so far is just the starting point of a journey which never really finishes. But you have to start somewhere, right?

I hope that you are inspired to build wealth in commercial real estate, and your financial future is improved because of it.

Until next time, then, remember: EDUCATION, AND TAKE ACTION!

Good luck!


Add to Del.icio.us

February 18, 2008

Commercial Real Estate Course - Part 4

Filed under: Education — Tony John @ 12:56 am

In 2005 I wrote an introductory course on commercial real estate investment. This 5-part course was received via email in daily installments. Here is Part 4.

Commercial Real Estate: How To Invest Like The Rich
Part 4: Cashflow or Capital Growth?
Some people think you have to invest either for capital growth, or cashflow. As though you can’t get both, so you have to choose.

With a lot of properties, particularly residential, this is largely true. If I look at my own residential properties, I have certainly got much larger capital growth on the low-yielding properties, than the high-yielding ones. Although I would point out that if you buy particularly well, you can get both.

One of the things I particularly like about commercial property is that it’s possible to get both.

4.1 Why Is Cashflow So Important?
Imagine you own a house, and it literally doubles in value overnight. Next morning, you walk into the kitchen for breakfast, a far wealthier person. But what actually has changed? Do you have nicer food in the fridge? Is there more money in your bank account? In your wallet?

Can you make your mortgage payment more easily?

While there’s no doubt that you are more wealthy, it’s purely on paper. You may well feel happier, but I’m asserting that it makes absolutely no tangible (ie real, physical, measurable) difference, until you ‘cash it out’, either by:

  • selling the house, or
  • refinancing the house

Until you get the cash in your account, your new wealth is purely on paper.

There are a lot of people out there (especially older, retired people who own their own home) who are sitting on enormous wealth but feel poor.

And no wonder - because unless you have the available cash to spend, you may as well be. If you can’t afford your groceries, you are living the life of a poor person - even if you own a nice house!

That belief drives my approach.

I use cashflow to experience wealth now, in the present. Not in 10 years, or 20 years, but this month. I have money pouring into my account every month, which is available for me to use as I see fit.

I don’t want to be sinking money into some big pit, hoping for a big payoff in the future. I’ve got my government-mandated retirement fund for that!

I want cash returns now.

There’s another very important reason I want cashflow: to pay my interest bill! As I said way back in part 1, my personal salary cannot pay for the properties I own. This salary limitation is what prevents most property investors from continually growing their portfolio. They invest in cash-losing properties, chasing capital growth, but there are only so many of these that they can afford to pay for each month!

Now, some people get uncomfortable about this. “What if you lose your tenant?” they ask. Well, if I just had one tenant, this would be risky. But the more properties, the more different tenants, the less important any individual tenant becomes. I could lose any tenant tomorrow, and still meet all my interest payments. Excess cashflow gives additional safety, when things go wrong. Excessive cashflow has me sleep well at night.

4.2 Why Is Capital Growth So Critical?
Now, after raving on about cashflow, you might think that I don’t care so much about capital growth.

In fact, I care about it a great deal. Capital growth is critical for me to keep growing my portfolio at the rate I want.

I use capital growth to “jack up” my cashflow. Look at the following example.

My bank will generally lend me 70% of the value of commercial properties. To keep the numbers neat, pick some example numbers. Imagine I own $1,000,000 of commercial property, and the bank has lent me 70%, that is $700,000. I have $300,000 equity.

Now, imagine I want to buy another $500,000 commercial property. The bank will lend me 70% ($350,000), but that still means I need to come up with $150,000.

Where does that money come from? How do I buy this new property?

Well, there are lots of possibilities of where that $150,000 could come from. But ignoring anything too creative, let’s just consider that I have to come up with $150,000 that I don’t have. I decide that I want to get it out of the existing portfolio.

Then there are two possible ways to do it:

  • Cashflow: I save up $150,000 from my existing rental income
  • Capital Growth: My property grows 15% (from 1 to 1.15 million).

Of course, I can use a combination of these sources.

It would take me too long to save up the $150,000 from excess rental cashflow. Especially when I was planning to use a lot of that cashflow to fund my lifestyle.

But 15% capital growth is not too hard to get. Therefore, I use capital growth to fund future purchases, making sure that each purchase brings in additional cashflow, to make my position safer.

I’ve found that holding some well-selected residential properties can also be a good way to get capital growth. But my approach is different from a lot of other people’s. When the property goes up in value, I refinance it. But rather than take out all that tax-free money and putting it in my pocket, I put most of it back into another property - usually a commercial property. Sure, I pocket a bit of it - that’s my reward for investing wisely. But most of it goes as equity to fund my next commercial property.

The new commercial property gives me:

  • another boost in cashflow.
  • an additional property which will appreciate, and give further capital gains.

When I get the additional capital gain, then I refinance again. In this way, I can keep ‘jacking up’ my portfolio, funding it via capital growth. Residential property is not strictly necessary for this strategy, but I find it fun to own some. Maybe I’ve got too much time on my hands.

4.3 How Do I Get Capital Growth With Commercial Property?
The conventional wisdom goes:

  • high cashflow properties have low capital growth
  • low cashflow properties have high capital growth

This means, when you go to invest, you must decide: am I investing for cashflow, or capital growth?

I also hear people say:

  • commercial property gives you cashflow
  • residential property gives you capital growth

This is too simplistic. It’s not generally true at all.

Certainly I have seen some spectacular growth in residential properties. But you can get excellent capital growth on commercial property - something a lot of people don’t realize.

Some great ways to get capital growth are:

  • buying under value.
  • increasing the cashflow from the property.

4.3.1 Buying Under Value
I gave an example of buying under value last time in part 3. This can give you a big capital growth on day 1.

4.3.2 Increasing the Cashflow
There are various ways to increase cashflow from a commercial property. Most commonly, you increase the cashflow by increasing the rent, or finding a new tenant, or subdividing the property into smaller, lettable areas, renting each at a higher rate.

Usually, your lease only allows you to increase the rent a small amount (a few percent), which, provided the Cap Rate stays constant, gives only modest growth. I have some commercial properties whose rent-reviews are tied to the nation’s overall economic growth, which gives me a growth of only a few percent per year in the current low-inflation environment.

But you can make a lot of money by purchasing properties whose rents are below market, then raising the rent to market level at the next review. If you double the rent of a commercial building, you may have doubled its value. It’s pretty rare for residential properties to get this kind of growth. So don’t let people tell you that commercial property doesn’t give any capital growth.

4.4 Stick a fork in me, I’m done
Now I’ve explained how I look at capital growth and cashflow.

As you’ve seen, cashflow if very important to me. It’s like air - I need it to survive. Cashflow is how I pay the bank. It’s how I pay myself. It’s how I pay for unexpected costs. It stops me getting into trouble. It provides a safety buffer.

But I don’t ignore capital growth. But the way I treat capital growth is different to many investors I speak to, so I need to emphasize:

I don’t use capital growth to ‘cash out’ and put in my pocket directly. I use it to purchase additional cashflow-positive property, to increase my cashflow.
Capital growth jacks up cashflow. Cashflow is king. Capital growth is secondary. I get it, I take some of it, and I convert the rest to more cashflow.

In part 5, the final part of this course, we start talking about YOU. How do YOU get started in commercial property. What actions do YOU need to take now? See you then…


Add to Del.icio.us

February 15, 2008

Commercial Real Estate Course - Part 3

Filed under: Education — Tony John @ 2:27 am

In 2005 I wrote an introductory course on commercial real estate investment. This 5-part course was received via email in daily installments. Here is Part 3.

Commercial Real Estate: How To Invest Like The Rich
Part 3: The Day I Made $100,000
It’s hard to talk about returns without mentioning the word “risk”. When people ask me “where can I get the highest returns?” I answer: “In a casino”. But that’s not for me. I’m a naturally careful person, and I like to keep my risks to a minimum.

People complain to me that making money in property is slow. Sure, it builds wealth, but you have to wait for property values to go up. So a lot of people run around looking for things which work quicker. I see them invest (or gamble) in other, riskier things, looking for that quick return. But you know what? If you buy well, building wealth in property is not slow. In fact, I don’t know of anything that beats it, in terms of high returns and low risk.

Let me give you an example.

I was looking to buy a high-yielding income stream, in the form of a commercial property. I talked to an agent who was based in a town that depended almost purely on mining. Let me tell you more about this town.

It was hot, dusty, and no-one wanted to live there for pleasure. People only lived there for the work. Now, resource prices depend heavily on the world economy. Prices go up, and prices go down. Mines open, and mines close. A town like this depended heavily on the mines. The town was used to booms, and it was used to quiet periods. It was not exactly stable.

However, it was the major town in the area. It had a major port, through which all the resources would pass on their way out. Although it was at the effect of resources, it was much more stable than all the smaller towns around it. In quiet times, the smaller towns would almost disappear - but this town would just go a bit quiet for a few years. It’s been doing that for the last half-century.

3.1 Cap rate is related to risk
The reason I was looking in this town is not because I like heat, or dust, or instability.

The reason I was looking in this town is because it offered high returns.

Why did it offer high returns? Because of the instability I’ve talked about. If you bought a property here, and it went empty during a quiet time, you might have to carry it vacant for years. And it would be hard to sell. I don’t want to be stuck with a property which loses me money each month.

Going back to Cap Rate, which we talked about in part 2: one of the main things that affects Cap Rate is the level of risk, giving this rule of thumb:

The higher the risk, the higher the Cap Rate should be

Let’s look at this statement. Say I want to buy a $100,000 property. I’m looking at two shops, deciding which to buy:

  • Shop A is in the middle of a busy city. The city has been steadily growing for decades, and retail space is scarce. If I lose my tenant, there will be a long line of people wanting to rent my shop.
  • Shop B is on a quiet street in a small town that is heavily dependent on one industry. The industry has ups and downs. If I lose my tenant, the shop could be vacant for 12 months.

The shops both rent for $10,000 per year. All other things being equal, which would I buy?

Hopefully you said Shop A. After all, if they give me the same return, wouldn’t I go for the one which seems safer? Of course.

OK, let’s make it more interesting. What if:

  • Shop A rents for $5,000 per year
  • Shop B rents for $20,000 per year

Now we’ve got a real choice to make. Do we go for the lower rent with greater stability? Or do we go for the sky-high rent, but take the greater risk?

It depends on your own situation, and your own goals, but this does illustrate the relationship between Cap Rate and Risk.

Remember from last lesson, that

            ANNUAL INCOME
CAP RATE =  --------------
            PURCHASE PRICE

In this example, Shop A is being valued using a Cap Rate of 5%:

                   ANNUAL INCOME      $5,000
Shop A CAP RATE =  --------------  =  -------- = 5%
                   PURCHASE PRICE     $100,000

Shop B is being valued using a Cap Rate of 20%:

                   ANNUAL INCOME      $20,000
Shop B CAP RATE =  --------------  =  -------- = 20%
                   PURCHASE PRICE     $100,000

So, because of its apparent risk, Shop B is being valued with a higher Cap Rate, meaning that a buyer would want a higher return, to be compensated for the greater risk.

Going back to my situation, this explains why I was looking to buy in this higher-risk town. I’m relatively young, I don’t have children, I’m still establishing myself. I figure if there’s ever a time to have a higher risk profile, it’s now. So I was looking for a higher return, and was prepared to accept higher risk. That’s why I was looking for property in a mining town. Notice that I still wanted to limit my risk - I was still looking in the big regional centre, not the smaller surrounding towns.

I don’t want to go into a big discussion about risk vs reward here. But the trend I’ve observed looking at other more established investors is that they tend to lower their risk profile over time. Initially, they maximize their borrowing, their profit, and their risk, to grow quickly. Once they’re wealthy enough, there’s no need to do deals with the risk they once considered quite acceptable. They lower their borrowing ratios, and they might look for lower returns, if it means getting really solid properties with a great location. They do this even if it means slightly lowering their profit on each deal.

I don’t advise you to go into risky deals. But if you’re interested in commercial property, you have to be able to deal with a certain level of risk. My best advice is to get educated as quickly as you can. Once you know the risks, you can decide whether the expected returns are worthwhile. The most dangerous risks are the ones you’re not even aware of.

3.2 What is a Fair Market Value?
Let’s go back to the story.

We phoned the agent in a mining town. We talked about what we wanted. We were looking for something which would give at least a 10% return, at a time when interest rates were about 5%.

Less than a week later, the agent rang us up and said ‘I might have something for you’.

I got out my pen and paper, and said ‘go ahead’.

He said: ‘There’s a sale that has fallen through. There’s a really nice pair of shops on the main street which are for sale. They rent pretty high, they’ve got good long leases, and I think they could be perfect for you.’

He gave me some more information:
‘Each shop rents for $700 per week. They have 5 year leases. The tenant also pays all outgoings.’

I pulled out my calculator did some quick sums. Two shops, that’s $1,400 per week. Over a 52 week year, that makes $72,800. And there are practically no other costs, because the tenant pays everything: insurance, rates, water, power, taxes, everything.

I came to the point: ‘What are they asking?’

‘Well, they’re asking $400,000. They just want to get out. They’ve done well out of the place, and that’s how much they need to build their dream house on the coast. They just want an easy sale, they don’t want a hassle, and they don’t want another sale that falls through.’

By now my feet had started dancing a jig under my desk - I hoped it was not to loud.

‘I might be interested. Can I get back to you tomorrow?’

‘Sure, get back to me tomorrow, but don’t take any longer because this will sell quickly,’ he said.

3.2.1 I Knew It Was Worth More Than They Were Asking
Now, I didn’t know exactly what the prevailing Cap Rate was in this mining town. But, this property was yielding 18.2% (72,800/400,000), and I knew the Cap Rate would be lower than that.

Did you get that?

They had priced the property as though the Cap rate was 18.2%. But I felt that the cap rate should have been lower than that. The result is, I felt the property was being sold under market value.

To cut a long story short, I decided to purchase the property, using a bank to get finance. The bank needed a valuation done.

The valuer said that prevailing Cap Rates for this sort of property, in this town, were 12%-15%. This was great news!

Using a 12% Cap Rate, the property value was:

                  ANNUAL INCOME     72,800
PURCHASE PRICE =  -------------  =  ------ = $606,667
                  CAP RATE          0.12

Using a conservative 15% Cap Rate, the property value was:

                  ANNUAL INCOME     72,800
PURCHASE PRICE =  -------------  =  ------ = $485,333
                  CAP RATE          0.15

So I knew the valuer (and therefore, the bank) would consider the property worth somewhere between $485,000 and $607,000.

The valuer came back with a value of $500,000.
Yet I was buying it for $400,000.

The day I bought that property, I made $100,000.

3.3 Stick a fork in me, I’m done
Now, if you think I was a bad guy, and that I ripped off the sellers, I can’t help you. You should get out of the property game.

Here’s how I look at it:

  • The sellers were really happy to sell the property for the price they did. They made a lot of money. It allowed them to retire and build their dream home.
  • No-one else was offering them more
  • I paid as much as I was willing to pay for it.
  • I took the risk. The town could have gone quiet, and left me with a vacant property.

This is truly a case of win-win, in my opinion. Some people think that there is no such thing as win-win. They think: for someone to win, someone else must lose. I’m the opposite - I believe that if someone loses, nobody wins.

Now there are many reasons why it is good to buy a commercial property significantly under market value.

The most important, is that it means I can get my money back out quickly, so I can purchase another property. The whole point (apart from the stream of cash a property like this provides) is that I can keep my Loan-Value-Ratio (LVR) low enough to buy another property.

I talk about this a bit more in part 4.

Also in part 4, I will give my take on the difference between investing for capital gain, and investing for cashflow. In the above example, the $100,000 is only on paper. It is not yet money in my pocket. As I’ll explain in part 4 - cashflow is extremely important. It is your lifeblood.

By the time I finish that, you will be ready for part 5, where the rubber hits the road. It will be time to see how YOU can start doing this.

3.4 UPDATE - 5 years later

Now, in 2008, that mining town has boomed. It’s because of worldwide demand for resources. I didn’t predict this - I just got lucky. Over the years, the rent has hardly changed. It’s now around $80,000 per year. But because the property is now more desirable, and considered much less risky, the valuer used an 8.8% cap rate for my last valuation. This gave a valuation over $900,000. ($80000/0.088)


Add to Del.icio.us

February 13, 2008

Commercial Real Estate Course - Part 2

Filed under: Education — Tony John @ 2:03 am

In 2005 I wrote an introductory course on commercial real estate investment. This 5-part course was received via email in daily installments. Here is Part 2.

Commercial Real Estate: How To Invest Like The Rich
Part 2: Capitalization Rate

WARNING: In this part, I will show a formula. A physicist called Steven Hawking once said that each mathematical equation you insert in a text will halve your readership. You may have to work through this part twice.

My promise is that it will be worth the effort.

Understanding capitalization rate gives you a way to quickly tell whether a deal is:

  • an exceptional deal
  • a mediocre deal
  • a dog

The other incentive I’ll give you is that I promise the following part, part 3, will be much lighter. In part 3, I will show you how I used my understanding of capitalization rate to make $100,000 in a single day!

2.1 The Money-making Machine
You walk into a quiet old shop. In the darkest, dustiest corner, you see a little machine, looking a bit like a pump. It probably hasn’t been cleaned for years. It might be a piece of junk. It doesn’t look like something that would be valuable.

Out of curiosity, you ask the owner what it is. He smiles, and says:
“Most people don’t notice that thing. That there is a money-making machine.”

You nearly walk out of the shop right there, but you’re in no hurry, so you let the owner continue.

He starts it up and gives a demonstration. Sure enough, despite some noisy rattling and clanking, dollar bills start flying out of the nozzle.

Picking one up and examining it, it looks real.

The owner shows you a certificate from the government, indicating that this machine complies with all requirements, and that any dollar bill it produces is legal tender. He shows you sworn statements from valuers, saying the same thing. It truly is a money-making machine.

He shows you his records, which show that, after the costs of operating and maintaining the machine are taken into account, it makes a profit of $10,000 each year.

He tells you that the machine is guaranteed for life. And it is for sale.

By now you’re excited by this machine. You ask him how much he is selling it for.

The owner looks at you for a while, smiles and says:
“Make an offer.”

2.2 How much is an income stream worth?
The above story may sound ridiculous. But I want you to know, it’s not far from the truth. They don’t look like I described, but open your real estate section each weekend, and it’s full of money-making machines. You just have to start to see them for what they truly are.

Forget about the details: how much parking it has; what type of carpet it has; whether it needs paint; what business is carried out inside it. What would that property be worth if you looked at it purely as an income stream?

So, I come back to the question, if someone offered you an income stream of $10,000 per year, for the rest of your life, how much would you pay for it?

I don’t want you to get caught up in details, like the time-value of money or whether the money is yours or the banks, or anything else. Assume the income stream goes up in line with inflation. This is not a trick question. I’m just asking you, ignoring other factors, how much would you pay for this income stream?

Would you pay $50,000 for it?
Would you pay $100,000 for it?
Would you pay $200,000 for it?

Now, I don’t really mind what answer you came up with.

At the moment, I just want you to see that there is a direct relationship between what you would pay for it, and the return it would give you. If you paid:

  • $50,000, you would get a 20% return on your money each year (10,000/ 50,000 = 0.20)
  • $100,000, you would get a 10% return on your money each year (10,000/100,000 = 0.10)
  • $200,000, you would get a 5% return on your money each year (10,000/200,000 = 0.05)

The return, also called the yield, changes depending on the purchase price.

The less you pay, the higher (better) the yield.

We’re half-way there.

2.3 Capitalization Rate
We’ve seen how the purchase price directly affects the yield you would get from the income stream.

Put another way, the amount you would be willing to pay for the income stream is directly related to what sort of yield you want to get. If you wanted a:

  • 5% yield, you would pay $200,000 for a $10,000 per year income.
  • 10% yield, you would pay $100,000 for a $10,000 per year income.
  • 20% yield, you would pay $50,000 for a $10,000 per year income.

Well, this brings us to the capitalization rate. There are various definitions of capitalization rate (or Cap Rate, as I will call it from now). Here is one:
“The rate of interest which is considered a reasonable return on the investment.”

Remember I said there would be a formula? Well here it is:

            ANNUAL INCOME
CAP RATE =  --------------
            PURCHASE PRICE

In real terms, it gives a way to value an income stream according to the return you want. Another version of the same formula, which I find more useful, is:

                  ANNUAL INCOME
PURCHASE PRICE =  -------------
                  CAP RATE

This formula allows me to take an income stream, specify what cap rate I want, and come up with an amount I would pay.

So, going back to the $10,000 income stream. If you were prepared to accept a:

  • 5% yield, you would value the stream using a 5% cap rate, giving a purchase price of (10,000)/(0.05) = $200,000
  • 10% yield, you would value the stream using a 10% cap rate, giving a purchase price of (10,000)/(0.10) = $100,000
  • 20% yield, you would value the stream using a 20% cap rate, giving a purchase price of (10,000)/(0.20) = $50,000

And that is how the capitalization rate works.

2.4 So, how much would I offer?
Well, if you’ve absorbed everything up to here, you’ll know that I can come up with a purchase price as long as I can define what cap rate I think is appropriate.

Now, you’re probably wondering, how do I come up with a cap rate? Well, that is the million-dollar question. I briefly touch on this in part 3.

Well, to figure out a cap rate, let’s look at some alternatives I could do with my money.

a) Put it in the bank
Interest rates are always changing, but last time I looked, my bank will pay me 5.45% on my money. I figure my bank is pretty safe. So I want to get at least 5.45% from buying the money-making machine, otherwise I may as well just put my money in the bank.

b) Invest in a mutual fund
My mutual fund is telling me that they’re averaging a 7% return over the last 5 years. But there’s no guarantee of future performance. I figure my money-making machine is safer than my mutual fund.

Let’s say I want a higher return than my mutual fund’s average. I am willing to accept an 8% yield. That way, I have a return which is both higher and safer than my mutual fund.

This means I would be willing to purchase this income stream for

                  ANNUAL INCOME     10,000
PURCHASE PRICE =  -------------  =  ------ = $125,000
                  CAP RATE          0.08

Notice that the higher the cap rate I choose, the cheaper I get the income stream. So why not choose a higher cap rate? Why not choose 25%? Why not choose 100%?

The answer is that the seller has to agree on the purchase price, which is exactly the same as agreeing on a cap rate, even if the seller doesn’t know what a cap rate is.

2.5 Bonus Question to Consider
Why would anyone sell a money-making machine?

2.6 Stick a fork in me, I’m done
So ends part 2 of my 5-part mini-course. You have just seen how a magic number called the cap rate can be used to place a value on a stream of income.

You’ve also seen how this can be a useful basis for working out the value of a commercial property.

What’s next? Well, that’s enough of the dry theory for now! With residential real estate, we’d already be talking about the details - painting, fixing the toilet, ripping up the carpet. Here I’m talking about a strange number called Cap Rate!

I mean, what’s going on? Forget commercial real estate - it’s too hard. And it’s probably for people who are already rich!

If that’s what you’re thinking, I apologize. It’s just that sometimes you need to cover the basics before you get to the interesting stuff. You see - you haven’t been wasting your time. Understanding the Cap Rate can really help you to unearth hidden bargains and make a lot of money.

So next, in part 3, I’m going to give a real-life example - an actual deal I did. I’ll give real numbers, and show how I used knowledge of the Cap Rate to make $100,000 in a single day.

Now, I’m not telling a story like that just to blow my own horn - in fact, I’m worried about mentioning actual amounts, because I don’t want people to think ‘oh I could never do that!’ The fact is, you could.

Later in this course (part 5, to be exact), I’m going to talk about how YOU get started. That’s where the rubber hits the road.

But for now, well done on hanging in there. This has been a tough lesson. Part 3 will show you why we bother learning all this stuff. So, catch you next time.


Add to Del.icio.us

February 12, 2008

Commercial Real Estate Course - Part 1

Filed under: Education — Tony John @ 3:02 am

In 2005 I wrote an introductory course on commercial real estate investment. This 5-part course was received via email in daily installments. On re-reading this course, I can see that my thinking has shifted slightly over the last few years. For example, in this course I explain that I like to hold both residential and commercial real estate, whereas today I prefer to hold a pure commercial portfolio. Having said that, I still stand by the contents of this course. Many readers have written to me that they found this course to be a useful starting point with commercial real estate investment. Let’s begin! Here is Part 1.

Commercial Real Estate: How To Invest Like The Rich
Part 1: Why Commercial Property?

There’s a lot of money to be made when you invest in commercial real estate. I believe it is the key to creating streams of cash which automatically flow into your bank account, month after month.

Yet, if you’re like most real estate investors I know (including those of you who are not investing right now, but plan to in the future), you’re looking exclusively at residential housing, and are not considering commercial real estate for yourself.

Later, I will show you just how much money you can make with commercial real estate. But for now, let’s look at:

  • why most people don’t invest in commercial real estate
  • why YOU should!

1.1 Why don’t people invest in commercial real estate?
I strongly believe that we learn from people around us - our family, our friends, our colleagues, and so on. Truth is, not very many people invest in commercial real estate. This means that the rest of us just don’t get exposed to it.

1.1.1 Pre-conceived Notions
Because we’re not exposed to it, we are stuck with pre-conceived notions about commercial real estate, which prevent us from ever considering the possibility of owning it. Some of these notions (or superstitions) are:

  • commercial real estate is only for rich people
  • commercial real estate is risky
  • commercial real estate is boring (who wants to own a shed, when you can own an apartment with a water view?)
  • commercial real estate is complicated

Well, this course will clear up any misconceptions you might have.

1.1.2 Lack of Familiarity
Like I say, we’re just not familiar with commercial real estate. Most of us grew up in a house or an apartment. We know what they are, we are comfortable with them. But we don’t feel the same familiarity with a commercial property.

But in fact, you’re already way more familiar with commercial real estate than you think. Every time you walk into a shop, a mall, an office, or a warehouse, you’re walking into a commercial property.

I promise you, you are going to start noticing commercial property more and more after you finish this 5-part course. You’ll notice when they’re for sale, you’ll notice when they’re for lease, and you’ll find yourself driving past shops and industrial buildings, and wondering who owns them.

1.1.3 Lack of Information
When I go into my local bookshop and go to the investment section, I see a mountain of good, bad, and indifferent books dealing with residential real estate. But there is almost nothing available out there on commercial real estate.

The last time I actually found a book about commercial real estate, I immediately bought it, without even looking inside. But when I took it home, I was very disappointed. It was written by a man who had NEVER purchased or owned a commercial property. His ‘research’ consisted of talking to a few people who had done it. In his conclusion, he said that he was now ‘planning to buy something’.

In one section, he listed a whole lot of ‘rules’ for buying commercial real estate. If I had read his book first, I never would have bought anything! I think I broke all his major rules with the first property I bought. Yet I’m still alive, and making money!

Some expert, huh? The same man had written a book about the stock market. I found myself wondering if he had ever bought any stocks!

So, you have to be careful who you listen to. There aren’t many knowledgeable people talking about commercial real estate. A lot of the people who really know about it are too busy to write about it!

1.1.4 Expensive
A second reason that we’re not familiar with it is that commercial real estate can get expensive very quickly. Now I want to clear up any concern you might have about this straight away.

There’s a big belief out there that commercial real estate is only for the rich. Well, it’s just not true. If I look in my local paper, I find a lot of commercial properties under $100,000. I find some storage sheds for less than $15,000! Given that you should be able to borrow 70% of the purchase price, and there are some creative ways to come up with the other 30%, the entry cost into commercial real estate may be much lower than you think!

I started, and still operate near this lower end of the market. The average value of my commercial properties is around $500,000.

There are people, companies, groups, trusts who regularly purchase properties for $5 million, $10 million, $50 million, and higher. I am not in that category yet. I love Donald Trump - I always find him really interesting to listen to, and also I think he’s a funny guy, whether he means to be or not. I really admire him. But I’m not sure that when he talks about real estate, the average investor can listen without tuning out, and having their eyes glaze over. He talks about deals which are so big that the average investor just shuts down their brain.

So there are not many people at the lower end who are taking the time to talk about what they’re learning, and what they’re doing.

1.1.5 Requires Mental Leap
That’s where I come in. Like most property investors, I started off investing purely in residential real estate, because it was all I knew about. After educating myself some more, I switched (and I believe it took a mental leap) to commercial real estate. Now I invest in both. I find it really useful to hold a mixed portfolio. I talk more about how why I hold both residential and commercial in part 4 (hint: it’s to maximize how quickly I can buy my next property).

1.2 Why should YOU invest in commercial real estate?
There are a number of reasons I think it’s worth considering commercial real estate.
1.2.1 Higher Cashflow
In general, commercial real estate provides higher cashflow.
For example, based on their current valuations, across my portfolio:

  • my residential properties yield an average of 6.1%.
  • my commercial properties yield an average of 11.5%.

Clearly, my commercial properties return more cash, for the given capital value. Now, the actual returns I’m getting are much higher than that, because I purchased them at lower prices, plus I’m using mortgages to give me more leverage. But I talk about that later in the course.

This is true in general. While actual amounts will vary, commercial real estate generally provides a greater rental for the same purchase price than residential.

That’s more money in your pocket!

1.2.2 Longer Leases
Usually, my residential tenants can leave within a week or two of giving notice, leaving me with an empty property, and the task of finding a new tenant.
Not so with commercial real estate - I’ve locked those guys in for years!

1.2.3 Tenant Pays Costs
For my residential properties, I have to pay a lot of additional costs:

  • water
  • insurance
  • rates & taxes
  • maintenance

One of my houses even has a poorly constructed pool. I just got a bill for $7,000! That wiped out most of the income I was due to receive from rent for the entire year. I am regularly paying plumbers, electricians, handymen, to fix all sorts of problems.

With my commercial properties, the leases specify that the tenant pays all outgoings.
Every time I get a bill, I just put it on the fax, straight to the tenant. The only bill I personally pay is the insurance (I don’t want to risk the tenant forgetting to pay it). But I make sure I pass the expense directly onto the tenant.

Also, the tenant has a much greater incentive to keep the property in good shape. If the painting looks poor, a door falls off its hinge, usually the tenant rushes out and fixes it without even telling me. Why? Because:

  1. the lease specifies that it is the tenant’s job
  2. the tenant is trying to run a successful business, which often includes attracting clients and customers. Having attractive premises is more important to the tenant than to me!

1.2.4 Stronger Legal Position For Landlord
Residential tenants are usually covered by government laws, which cover how long they can avoid paying rent before you can take action. Often, these laws have been written to prevent nasty, greedy landlords from taking advantage of poor battling tenants. After all, you’re dealing with people’s lives.

With commercial properties, your tenant is more often a company, although you may have personal guarantees from individuals involved. Commercial Leases are usually drafted in a way that protects landlords. With my shops, for example, if my tenant falls two weeks behind in rent, I can lock them out of the building, and start selling the contents of the shop! Try doing that with a residential tenant! That would be called stealing.

I can charge penalty interest if rent is otherwise late. If I have to take legal action (eg writing a letter) to recover money, then tenant has to pay my costs. The leases are structured so that the tenant has a huge incentive to stay up-to-date with all his obligations. I recently had a tenant who had to re-mortgage his house so he could continue to pay what he was contracted to pay me.

This might sound nasty, but it’s not. The tenant has entered into a legal contract with me. It is their job to pay what they owe me. It’s nothing personal.

I sleep better at night having a thick lease in my filing cabinet which protects me from tenants who would avoid paying rent.

1.2.5 Easier To Purchase Significantly Undervalue
I give a great example of this in part 3 of this course, where I bought a property for $100,000 less than market value. And the seller was completely happy!

My personal approach is that I always want the seller to be happy with the price I pay. I don’t want to leave them feeling ripped off, or like I’ve stolen from them. I’ve found with residential properties, the seller likes to haggle over every single dollar. On the other hand, with commercial real estate, often the seller has very different concerns. They might not even bother to haggle about tens of thousands of dollars. This may sound unbelievable, but it’s true.

1.2.6 Play A Bigger Game
I found that looking at commercial real estate has changed my relationship to money.

When I used to invest exclusively in residential real estate, at the back of my mind I used to consider whether I, personally, could pay the mortgage.

Now, with commercial real estate, I owe bigger amounts. Each year, my interest bill to the bank is much higher than my personal salary! That means that there is absolutely no way I could pay the interest on these properties myself. I absolutely depend on the rental income each property generates.

When I first had more debt than my salary could pay, something ‘clicked’ in my head. I suddenly realized that there were no more limits to the size of property I could own. I began to realize that I could hold any size property, so long as it reliably generated more income than it cost to hold it.

My game changed from ‘how much property can I afford’ to ‘how much can I get the bank to lend me?’ If you’re not used to debt, and are not comfortable with this idea, don’t start worrying yet. As this course continues, I will keep speaking about it, and you might find yourself getting used to the idea. In fact, you’ll see how the more properties you own, the safer your position becomes.

1.3 Stick a fork in me, I’m done
That’s the end of part 1 of my 5-part mini-course. I have just shown you why I think commercial real estate is worth considering, even if nobody you know is talking about it.

When you start investing in commercial property, it is certainly a different game. But if you’re reading this, you’re up to it.

Next I will talk about a magic little thing called capitalization rate. This little number is the key to finding telling good deals from mediocre deals.


Add to Del.icio.us

February 6, 2008

Keeping Good Tenants

Filed under: Property Management — Tags: , — Tony John @ 1:45 am

Today’s post will conclude my series of posts about tenant quality.

Let’s say you’ve got a good tenant, by luck or good management. Now what?

By corollary, if getting a better tenant makes your property more valuable, getting a worse tenant makes your property less valuable. So, it’s worth looking after a good tenant.

How do you look after a good tenant? You’ve already got a lease which guides you and the tenant about what you can and can’t do. For me, looking after a tenant means being flexible, and caring about the tenant’s business.

Examples:

  • I had a tenant who had recently taken over a business (which had been running poorly), and was in the process of building it up again. She was finding the first few months tough, and a rent-review fell due. I could have raised her rent 5%, instead I raised it 2%. She was very grateful.
  • I allowed a tenant to have a pizza oven installed, which required a new hole in the ceiling and roof. This was on the condition that he repair it all at the end of the lease. The pizza oven helps the business.
  • Doing some cosmetic work to the grounds (garden), so the tenant’s business will look better.

None of these are required by the lease. I could say no to all of these things. But it pays to have a happy tenant, who is not whining or blaming you, the landlord, for problems in their business. It pays most of all to have a tenant who is reliable at paying rent.

What am I not willing to do for a tenant? Accept late rent or non-payment of rent. As soon as a tenant has problems paying rent, I want to talk with them. I want to find out whether it’s a one-off, or there’s a long-term problem. If there’s a long-term problem with the business, I don’t want them as a tenant!

Well, that’s enough about tenants for now. Starting tomorrow, I’m going to repost some articles I wrote some time ago - the original 5 parts of an introductory course on Commercial Real Estate Investment.


Add to Del.icio.us

February 5, 2008

Another Way a Change of Tenant Can Make You Money

Filed under: Property Management — Tags: , — Tony John @ 3:01 am

I was saying yesterday that one of my properties became more valuable when I changed tenant. It didn’t become more valuable in a way that a valuer would recognize. The new tenant wouldn’t affect the official value. But the property became more valuable to me, because my life suddenly got easier and more enjoyable. Even though it’s hard to quantify, don’t underestimate how important that is.

When I met with the new tenant, I saw another real benefit straight away, and this will ultimately make me money.

You see, this is the property with a lot of extra land, which I want to break off and sell.

When I first mentioned subdivision to the old (angry) tenant, he essentially said: “I hope you don’t plan to subdivide the land. You can’t. I’ve had the lease checked, and my lawyers have confirmed that you can’t do it. My lease covers the entire block, so you can’t subdivide it, and if you start taking any action towards subdivision, I’ll fight you.”

Now, we checked this clause with our lawyers when we purchased the property. They told us that the subdivision clause was clearly intended to allow subdivision, but was badly worded and ambiguous. Not great, but quite different to the tenant’s stance on the issue.

Anyway, with the new tenant, when I mentioned subdivision, her response was very different. “Please!” she said, “I’m not using any of that land, but it costs me thousands of dollars on mowing and general maintenance. The sooner you can subdivide it, the better. I only want to manage the small piece of land my that the building is on.”

I don’t know exactly how much, or exactly when, but that difference in attitudes will make me money in the future - no doubt. Again, it doesn’t show up in an official valuation, but it’s worth a lot to me.


Add to Del.icio.us

February 4, 2008

Tenant Quality: How a Property Can Become More Valuable Without Increasing in Value

Filed under: Property Management — Tags: — Tony John @ 5:29 am

I’m continuing the topic of tenant quality today. I’ve been describing how I was extremely happy to get a new tenant for one of my properties.

I feel this way because the previous tenant was, well, difficult, to put it politely. Oh, he ran the business profitably and always paid rent on time. You would think that made him the perfect tenant. But he wasn’t. He was unpleasant to deal with.

Now, business is business, and you might think that values such as being pleasant don’t count for much. But it can count a lot. See, you can get things done easier, quicker, and cheaper when you have a cooperative tenant. It’s hard to get anything done in an atmosphere of dislike, distrust, or where there’s a willingness to involve lawyers at the first opportunity.

The problems with this tenant started a long time before I came on the scene. By the time I purchased the property, there was an escalating fight in progress between the tenant and the previous owner. In summary:

  • the lease said that the tenant had to paint the building. The tenant refused. When the tenant refused, the owner started sending the legal notices. The tenant went to his own lawyer, and soon enough expensive legal letters flew back and forth.
  • a few months later, the building still was not painted. The lease said that when the owner incurs legal costs, enforcing the lease, then the tenant must pay them (commercial leases generally favour the landlord like this). So, the tenant got a bill for all the legal costs. The tenant refused to pay these costs. Things were getting nasty, and all over a coat of paint. The legal costs had become much higher than the cost of painting, but that’s how silly people can get when they’re angry.
  • towards the end, every time the owners wanted to inspect the building, the tenant refused to let them on the property. Ultimately, the owners had to get police to escort them onto the property, so they could safely inspect the property without interference from the tenant.
  • there were other similar issues, about carpets, general maintenance, and so on. Nothing went smoothly. There was no goodwill on either side. Everything ended up in a fight.

Sure, eventually, with enough legal procedures, the tenant would either have to comply with the lease, or be evicted. But the cost for the owners, both financial and in terms of peace-of-mind, was huge. In fact, I’m sure this is why they put the property on the market. By the time we came along, they were very keen to sell. This property was supposed to be an investment which looked after the owners in retirement. But they were not enjoying retirement. They were stressed, and simply tired of the whole thing. They wanted out. So I bought it.

One of the problems with this property is that by the time I purchased it, the tenant was no longer on speaking terms with the property manager. There was a poisonous relationship, which was no good to anyone. So I decided I would manage this property myself. I have some training in customer service, so I felt I would be able to resolve conflict better than the previous owners. Well, my skills were tested to the limit! Sure enough, within a month, the tenant was on the phone, furious over some matter. The matter itself was a fairly minor misunderstanding, which, with most people, would be resolved in about one minute. But not this guy. He was what I would call disproportionately angry. He reminded me of those people you read about who in a road rage attack will kill someone over changing lanes without indicating. With my training, I was able to resolve the problem in a way that satisfied him, and he ended up apologizing for getting so angry. So we kept our working relationship, but things weren’t easy.

Fortunately for me, soon afterwards, that tenant decided to sell the business. Most people assumed that he enjoyed fights, since he would get into them so often, but I guess the fighting must have been causing stress for him as well.

He sold his business to one of his employees. This was a perfect opportunity to make a fresh start. In my book, it was worth flying for two hours each way just to meet them for fifteen minutes. Business is based on relationships, and I think it makes an enormous difference to actually meet the people you’re talking to.

The meeting went well. Just about everything the new tenant said was music to my ears. For example, she told me: “I’m Italian, and was brought up to look after something, whether it belongs to you or not. Now there are some improvements I’d like to make to your property, that I want to talk to you about. I want to repaint this room, install new powerpoints here, …”

What a breath of fresh air! Here is someone who is not looking for a fight. Instead, they want to have a good relationship, based on mutual respect and goodwill.

This doesn’t show up on any balance sheet. If I was getting the property valued, I would expect the value to come in the same, with either tenant. But it’s worth a lot more to me now, because I don’t have to spend my time, money, and energy on fighting.

And guess what? Because she’s so much nicer to deal with, the business is doing a lot better since she took over. Customers are flooding back - almost more than she can handle. She’s making more money, and can more easily pay the rent. Everybody wins.

I’m happy when the world works out this way.


Add to Del.icio.us

January 29, 2008

Tenant Quality Affects YOUR Life

Filed under: Lifestyle, Property Management — Tags: , — Tony John @ 1:05 am

I previously explained how the quality of your tenant can affect your property value. This happens when a valuer (and presumably, the market), can see that you have a better, more secure, more reliable tenant, and decides that the property is worth paying more for. People will pay more to get a lower risk. That’s why we have a different capitalization rates in different areas.

Why do we care about this? Because a higher valuation gives you greater equity, which makes it easier to buy your next property. I keep drumming that in, because it’s so important to keep remembering why we care about this.

But you know what? Tenant quality is even more important than that. There are intangible benefits to having a good tenant. These benefits may not be reflected in a valuation report. They may not affect the value of your property to the outside world. But they sure make a difference to your life.

I’ve had two commercial properties with struggling tenants. Both of them fell behind in their rent payments.

On a human level, these stories are very sad. Nobody wants to fall behind in their payments. These tenants are not bums, they are trying to be responsible members of the business community. They bought the business with high hopes of making good money. But now they are making a loss, for whatever reason. When you meet them, you can see the signs of stress and shame in their face.

At a business level, the situation is a disaster that can not be allowed to continue. I rely on their rents to pay interest to the bank. If they don’t pay, I risk becoming the same as them, unable to meet my financial obligations to the bank.

Both times, I found myself worrying. Worrying whether they would pay rent. Worrying whether I could pay my interest bill. Worrying if I would need to find a new tenant, and whether I could afford an empty building. A struggling tenant affected my peace-of-mind.

In the end, both tenants ended up selling their businesses, and moving on in life. One paid me back completely what he owed, the other paid me back 30 cents in the dollar.

Luckily, the new owners of both businesses are thriving. The new tenants have never missed a rent payment, are profitable, and are happy.

The benefit to me is that I know that I will be paid each month. I don’t lie awake, wondering what will happen if they don’t pay rent. This is a huge benefit to me. Having a tenant that you worry about is a real drain, mentally. Replacing a struggling tenant with a good operator, who you can rely on, makes a big difference to the quality of your life.


Add to Del.icio.us

January 25, 2008

Tenant Quality Affects Property Value

Filed under: Property Management — Tags: , , , , — Tony John @ 6:27 am

I was looking through one of my Valuation Reports the other day, and found a nice quote which demonstrates how valuers evaluate commercial real estate.

“Well located suburban properties, securely leased to national tenants, with modern building improvements, represent prime property investments and sell on yields of between 6.5% and 8.0%. These properties are in very strong demand with an oversupply of buyers and an undersupply of stock for sale.

Properties that do not possess all of these attributes but have reasonable lease covenants of say 5 years, are selling on returns of 8.5% to 9.5%, depending upon location and building quality. There has been generally good demand for these investment properties.”

Now, your mileage will vary - the numbers themselves will change from region to region. But the key is this: a better quality tenant will give you a more valuable property.

You see, it’s all about risk.

With a big, national company, your tenant has a strong financial backing, which means you can have a lot of confidence in your income.

With a smaller tenant, no matter how well-intentioned or business-smart they are, there is inherently more risk. One big lawsuit, one marital split, one fraudulent employee, or some unexpected occurrence, and their business (consequently, your income) is under threat.

People are willing to pay more for a lower risk.

Back to my valuation report. The valuer went on to value my property using a capitalization rate of 8.75%. This reflected the fact that my property had a single, independent operator.

Now, I’ve got a chance to re-lease the building, and I’m going after a national tenant.

Here’s the math, assuming the valuer chooses the mid-point of the respective ranges:

Let’s say my property brings in $50,000 per year in rent.

With a lower-quality tenant, my property gets valued with a capitalization rate of 9%, giving it a value of $556,000.

With a national tenant, my property gets valued with a capitalization rate of 7.25%, giving it a value of $690,000.

So, switching from a standard, independent tenant, to a strong national tenant will make me $134,000. Even if the rent doesn’t change at all. That’s a massive difference! Makes it worth acquiring a good tenant, doesn’t it?

Some people are surprised by this. It’s the same land. It’s the same building. Surely the value can’t just change like that? What you have to remember is that a buyer doesn’t just buy the land and building. They also acquire the tenant and the lease. That’s why the value of a commercial property can change so significantly overnight.

Tenant Quality Affects Property Value!


Add to Del.icio.us

Tenant Quality

Filed under: Property Management — Tags: , , — Tony John @ 6:19 am

I flew across to one of my properties this week, and met the new tenant for the first time. The new tenant struck me as a delightful person: enthusiastic, motivated, smart, and respectful. It made me think about tenant quality. But before I start this topic, I’m going to repost a relevant article from my old site…


Add to Del.icio.us

January 21, 2008

There’s Always Something Else

Filed under: Attitude — Tags: , , , — Tony John @ 2:03 am

I had a phone call today from a man representing a sports arbitrage company. His company had sent me a brochure a week earlier, and this was a follow-up.

What is sports arbitrage, you might be asking? I certainly had no idea. Arbitrage is where you take advantage of pricing differences in different markets, buying in one and selling in another, to make a profit. Ideally, the transactions happen at the same time, making a risk-free profit. Sports arbitrage is doing it by placing bets on sporting events.

It was interesting to talk to him. He asked me which sport I followed. After I named a few sports which were out-of-season or for some other reason unsuitable, he steered me towards the Australian Open Tennis, which is on as I write this. I was surprised by this; surely he needn’t have bothered finding a sport I cared about - the whole point is that you don’t have to understand the sport or the contestants, you simply look for suitable odds. He could have picked a cock-fight in some remote Vietnamese village, for all I cared.

Anyway, he found a tennis match in progress, found two suitable sets of odds in different parts of the world, and showed how he could take $1000, place a bet in each market, then end up with either $1067 or $1064, depending on the outcome (a 6.7% or 6.4% return)

Easy money, hey? Only it’s not completely straight-forward. You need access to hundreds of online betting agencies, to find the mismatching odds. You can be sure that there will be other people or companies searching for exactly the same thing. because there’s a profit to be made. Then there are technical issues with losing some money on exchange rate conversions, making sure the bets are accepted at the same time, before odds change, not to mention the upper limits to how much bookkeepers will take before changing their odds, or refusing to take more bets. Plus his company took the first 5% profit for each transaction, so the actual returns promised were pretty small.

At the end of his explanation, he invited me to hand over $8000 and start an account with them. They would take care of everything else. This is where I said no, and we ended our call.

At least arbitrage is in theory risk-free. Some investment systems I find comical. One company was trying to sell me horse-gambling software. If I diligently typed in horse data - results, odds, and so on, from all the different venues, for weeks on end, it would tell me what bets to place. I remember explaining to the sales person: “I like commercial property, because I like the safety of a legally-enforceable lease”. She countered with “but this is as safe as commercial property”. I wondered what my bank would say if I tried put up my house as a 30% deposit, and borrow 70% to bet on horse-racing, explaining that it was just as safe as commercial property, and should therefore attract the same LVR.

I know someone investing in rare artwork. He expects to make a good capital gain, and thought I might be interested. I told him that he may well be right, but that I need cashflow in the meantime. I’m not investing to get some lump some at the end. I’m investing to get cashflow now. My lifestyle depends on my investments paying me money now.

I also know people who honestly believe their best chance of getting rich is to win the lottery.

I don’t know if I attract these people, or everyone gets this: I had a consultant come around to offer me a crop of trees. I wouldn’t get to own any land, just a certain number of trees, which would be cut down in about 10 years time. I was amazed at the low return. Yes, you would double your money over 10 years, but that worked out to be a pretty low rate of return. After his presentation about trees, he moved onto a questionaire, including the question “what rate of return would you like to receive?”

I thought about this. I’ve talked about how I like to make a rapid capital gaid soon after purchasing. I like to make my deposit back in the first year, equating to a 100% return of the money I put in. I thought that sounded a bit high, so I scaled it down and said “Probably 50%”.

“OK, 15%,” he said, writing earnestly into his questionaire. “No, 50%” I said. I wasn’t trying to be boastful, but he stopped writing, and looked at me to check if I was serious. When he realized that I was, he was gone within five minutes, and never did the follow-up call that he promised.

As long as it doesn’t take up too much of my time, I enjoy hearing about opportunities. Even if I’m going to say no, I like to understand it first, so I know what I’m saying no to. When people or companies offer me ways to make money, I generally listen, because it’s interesting to hear different approaches. I see what I can learn from them, evaluate them critically, looking for flaws in systems. For example, when I asked Tree-man what happened if a storm or fire destroyed my trees, he said I would get my money back. Get my money back! I would be devastated if after 10 years I got back what I put in! Talk about going backwards.

There are so many opportunities to put your money into different things. Thus far, I’ve always come away concluding: “I prefer real estate.” To be fair, I’ve only been talking about the more unusual types of investment here. What about the stock market?

This past year, I’ve been bombarded by the media, telling me again and again how much money everyone is making in the stock market (at least until the sub-prime issue dented prices somewhat).This is OK. I would need to undergo a massive education process to do well in stocks. I don’t have the expertise. If I went in without the expertise, I would be gambling. Fundamentally, I don’t like gambling.

When you hear all these different things, it’s tempting to move around, from one investment type to another, looking for that big return. The grass does often look greener elsewhere. Alternatively, you might try to put your money into everything at the same time, trying to cash in on all market sectors,. Instead you spread your money too thin and dilute your profits.

At this point in time, and for the foreseeable future, I’m very happy with my choice to stay with real estate. If the media tells me that others are making fortunes elsewhere, good luck to them. When I worry about what other people are doing, that’s when life becomes less peaceful for me.

If you don’t have one already, the sooner you can develop a very clear strategy for wealth creation, one that you can stick with, the better.


Add to Del.icio.us

January 18, 2008

When Is It OK To Lose Money?

Filed under: Attitude, Buying — Tony John @ 2:03 am

I’ve got a property which is eating me alive at the moment.

Last year, I sold my only residential investment property. I didn’t want any more properties which cost me money each month. From now on, I told myself, I only want properties which make me money each month. This is one of the reasons I decided to focus on commercial property.

Yet soon afterwards, I broke my own rule.

I bought a commercial property (a child-care centre) for $885 000.
I borrowed 70%, that is $619 500.
I pay approximately 8.5% interest on it, that is around $53 000 per year, to cover the mortgage.
The child-care business is leased out for $31 000 per year.

This property costs me $22 000 per year to own. Ouch! Why did I do that?

I confess that each month, when I have to cough up the interest, I ask myself the same question. It’s not comfortable, owning this property.

But I’ll tell you the reason I did it. The property sits on a big block of land, zoned as ‘Town Center’, in a bustling coastal town. The child care centre occupies around 10-15% of the block. The rest of the block is vacant, and can be turned into at least 8 residential blocks. Blocks are selling for around $170 000 each at the moment.

This means that the 8 blocks should fetch 1.3-1.4 million. It might cost a few hundred thousand to do the subdivision, so all up I should end up with at least 1 million for the blocks. That will put more than $100 000 of profit into my pocket, and leave me with a ‘free’ commercial property paying me more than $30 000 per year for the rest of my life. That will be a good outcome.

It’s a great theory. The only catch is, it’s killing me until I am able to sell those blocks. Sometimes things in property happen slower than you want, and this is one of those cases. It’s almost a year that I’ve been holding this block, and the subdivision process is moving very slowly.

So, should I have bought this property, or was it a mistake? I’m not sure. It’s a learning experience. I don’t enjoy paying out money each month. But if things go as I expect, eventually I will be very glad that I did buy it.

As I’ve said before, even mistakes can make you money, as well as give you invaluable experience. Right now, it’s hurting me. I may not buy a property like this in future, because I don’t like paying so much interest (I prefer to have a tenant who pays it for me). But I don’t regret buying it. It has been worth it for the experience alone.


Add to Del.icio.us

January 15, 2008

Buy Smart and Hope

Filed under: Buying — Tony John @ 2:03 pm

Last time, I was writing about techniques to rapidly increase your real estate equity.

One favorite approach to real estate investing, if you want to rapidly gain equity, is to buy in an area which is about to go up. People go to great lengths, studying data, analyzing demographics, watching trends and weighing up all sorts of factors, to work out the areas which they think are about to explode. For convenience, I’ll label this approach ‘buy smart and hope’.

I call it smart because it acknowledges that a rapid increase in equity is A Good Thing, and it tries to maximize your chances to get it. I use the word ‘hope’ because there is no guarantee.

I want to suggest that this strategy is a poor-man’s version of what I spoke about last time: ‘buy below market value’. I’m not saying it’s a bad strategy. It’s far better than having no strategy. I’m saying buy smart and hope is clearly inferior to buy below market value. Why?

  • you don’t get your equity immediately. You have to wait.
  • you don’t get guaranteed equity. You hope that the market moves like you thought.

So, it’s slower, and it’s more risky. Therefore, it’s inferior, if your goal is rapid equity growth.

Think of it this way. If you had a choice between these two methods of making $100,000 equity:
(a) buy at property for fair market price of $400,000. Wait for value to increase to $500,000.
(b) Find a property worth $500,000. Buy it for $400,000.
Which would you choose? Where possible, I would choose (b). It’s faster, and safer.

I assert that we only buy smart and hope because we can’t see how to buy below market value. Because we can’t achieve the one, we settle for the next best thing.


Add to Del.icio.us

January 11, 2008

Fast Equity? Think Commercial

Filed under: Buying — Tags: , , , — Tony John @ 5:27 am

Not every real estate investor increases their wealth at the same speed. There are faster ways, and there are slower ways.

When it comes to increasing our wealth, we would all prefer fast growth over slow growth, so long as it doesn’t involve any extra risk. The faster the growth, the faster our equity increases, which means the sooner we can buy that next property, which in turn builds our wealth even faster.

If you just want average growth, you can buy at market price, and wait. Your property value will move with the market, and over time, you’ll (usually) see an increase. If you are lucky or smart and you buy in a better market, you’ll get faster growth, but you’re still fundamentally limited by that market.

For truly extraordinary growth, you need a property which increases in value faster than the market grows. There are two ways to do this:

1. Take action which increases the value of the property
For example, renovating a ‘fixer-upper’, subdividing a block, refurbishing, re-zoning, re-leasing, or redeveloping a property. These things can make the property more valuable than it was when you bought it, without relying on any shift in the market itself. If you increase the value by more than you spend doing it, you increase your equity.

2. Buy a property below market value
This creates instant equity the moment you purchase it.

Of course, there is no reason you can’t do both! But in this article, I want to concentrate on the second method: buying below market value. Buying property below market value is an extremely effective way to build rapid equity.

OK, so far, so obvious. Everyone knows that it is good to get stuff below market value. Even the guy who breaks into your house for your high-definition plasma TV knows this.

If you have any skeptical bone in your body (and if you’re investing in real estate, I hope you do), you’ll be saying: “of course buying below market value is desirable, but it’s easier said than done.”

That’s very true. So the question is, ‘how do I buy real estate below market value?’

A second question, which I think is important, but the guy who breaks into your house does not, is ‘how do I do it ethically?’

Don’t be alarmed, I’m not about to spend time talking about ethics. You’ve got your own standards, and I’m not going to preach mine to you.

But I will point out that I see a lot of stories in the media presenting real estate investors as ’sharks’, interested only in their own profit than at the expense of other people. And you might think this is the only way to buy real estate below market value. You’re probably thinking of things like:

  • buying foreclosures
  • making lowball offers to flush out the desperate seller, or the seller who is grossly out-of-touch with current market value.
  • finding senile old ladies and tricking them,
  • and so on.

Before you call the station to lodge a complaint, I know, I know - if you buy from a desperate seller, you’re actually helping them out of a tight spot. Furthermore, I’m definitely not saying that buying a foreclosure is the same as tricking a senile person.

I list these scenarios together because for you to make a rapid gain, someone else has to lose (or has already lost) in some way. If you look for this type of property, good luck to you. I’m saying that personally, I do not look for these types of property, and I know that there are other investors who do not want to deal with this segment of the market, but who are still interested in buying below market value.

What I look for is a piece of real estate where the asking price is well below market value. I don’t need to make a lowball offer if the price is very good already - the seller is delighted because they’ve got what they were asking for, and everyone ends up happy. To me, that is a great deal. Sounds too much like a Disney cartoon? Well, it happens!

I’m not just talking about 5% below market value, either. I’m talking 20% or more below market value. And I repeat, I’m not insulting anyone with lowball offers - I’m paying full asking price!

But why, you ask, would anyone be happy to sell below market value? How would you find such a property?

Well, my advice is to stop looking at residential real estate, and turn your eyes to commercial real estate. I’ve found deals like this on multiple occasions. Once is a fluke, twice is a pattern. In other words, these deals are out there, and will continue to be out there. It takes finding them.

Example 1
I’ve written elsewhere about the first commercial property I purchased, so I won’t go into great detail here. To summarize: the sale had fallen through, and the seller was disappointed, wanting to sell it quickly. They were set to retire to their dream house on the coast. They had already sold their businesses for a good price. Now they were just selling the building which housed those businesses. They already had enough money. What they needed was a quick sale, so they could start their retirement. Speed was more important than getting top dollar. The agent told me “They previously contracted to sell it for $400,000. They’ll sell it to you for the same price. It’s worth more than that.” Yes, he didn’t serve the seller very well by telling us that. Sure enough, straight after we bought it, we had it officially (and conservatively) valued at $500,000. That’s $100,000 of equity on day one.
Why was it undervalued? We had a keen seller who already had enough money, and a slack agent who wanted a quick commission.

Example 2
Then there was the oil company who were offloading all their ’second-tier’ service stations. Mine was the last of their inventory, and by the time I came along, they just wanted it gone. They had already reached their sales target. Paid $400,000 and immediately had it valued at $480,000.
Why was it undervalued? The company wanted a quick, easy sale more than it wanted to achieve a top price.

Example 3
Then there was the government department which was selling one of its offices for less than $100,000. I passed up the deal, because there was some uncertainty about the lease. When the extra information came through, I realised the property was worth more than $200,000, but by then, some bolder soul had already bought it.
Why was it undervalued? A policy change meant that a government department suddenly sold all its offices, preferring to rent in future. I suspect that because the department was selling so many properties simultaneously, it did not have its full attention on this particular (and minor) office. I also suspect the government department lacked the in-house expertise to price the property correctly.

Example 4
Another example: my latest commercial property purchase was a floor in a nine-story city office building. Several years ago, a company had bought the entire building for $8 million. They had then fully refurbished the building, were now selling it at a healthy profit. I bought my floor for $1.4 million. Overall, they sold the entire building for around $16 million.

Less than an hour after I bought the property, the agent who sold it to me said “$1.4 was a good price. If you like, I could sell it for you immediately for $1.6 million.” That was two months ago. I’ve since spoken to a valuer who believes it is more likely worth around 2.0 million, but that’s also because I’ve since re-tenanted my floor.

Why was it undervalued? The seller had contracted to buy a much larger office building for over $30 million, which would be very profitable for it. But they needed to sell this current building fast, to ensure they had finance for the next deal. By the time I came along, they were very keen to offload this floor to me. I suspect we had a secondary factor of a minor real estate company who were out of their depth, and who underestimated market value.

I could list more examples than this, but you take my point. It’s as though people are giving me hundreds of thousands of dollars. Yet they’re happy to sell. There are two main factors at work here:

1. Sellers require a quick, easy sale.
These sellers are not financially distressed, desperate, sad, or mentally unsound. For their own reasons, they place more importance on a quick, easy sale, than on maximizing their sale price.

2. Bad Selling Agents.
They may be agents who, to secure their commission, are deliberately, willfully bad. Alternatively, they may be well-intentioned agents who, for whatever reason, have set a price which I believe is under market value. It takes good knowledge of a market to spot an incorrectly priced property. Incidentally, it also takes a lot of courage to proceed to purchase an undervalued property, without talking yourself out of the deal.

Maybe I’m not looking in the right places, but I don’t find deals anywhere near this good in residential real estate. There’s a different selling mindset. I’ve found that the residential seller will haggle over every dollar. Their house is a big asset, and they’re sure going to make damn sure they achieve top dollar. See the grumpy old man who has been so carefully manicuring his lawn and pruning his roses for the last 60 years. If I offer him 75% of his asking price, he’ll stab me in the chest with his secateurs, and rightly so; this is his retirement nest-egg!

However, I’ve seen these bargains a number of times in commercial real estate, and I hear again and again from other commercial investors who find exactly the same thing. This is one of the many things I like about commercial real estate. So bear in mind if you’re looking to build equity quickly: there are bargains out there in commercial real estate.

Finally, some comments, which I need to add for completeness, and to hose you down if you’ve become too excited.

I don’t want to leave you with the impression that every commercial property is a bargain, with every seller throwing away money. It still takes something to find these properties. I spent months looking for that last property, and made at least twenty enquiries, after dismissing hundreds of properties through browsing the internet.

Secondly, I’m saying nothing about the long-term prospects for the property. After ten or twenty years, the top-quality property in the great location will have done much better than the shabby mediocre one in a run-down area. It won’t matter which one you purchased below market value.

The reason I look for under-valued properties at this early stage of my career is that they give me fast equity, so I can grow my portfolio relatively quickly, without waiting for market growth. At the moment I place more emphasis on this than on long-term growth prospects.


Add to Del.icio.us

January 9, 2008

Having a Job vs Being a Real Estate Investor

Filed under: Lifestyle — Tony John @ 7:05 am

Some people wonder what I do all day, as a real estate investor. Heck, even my own dear mother has trouble understanding what I do. I think it was easier for her when I had a simple job which everyone understands, so she could just say “my son is an engineer“, rather than “my son spends most of his time at home either looking after his daughter or doing real estate investing stuff.”

So what do I do each day? I find that with real estate, once you have a few properties, they each generate some ongoing work. The amount of work is usually fairly small and steady, but occasionally there will be a spike of work if a particular property has ‘issues’.

Let’s take yesterday.

I had to deal briefly with five properties.

1. I had a tenant whose airconditioner got fried by a recent power strike. He wanted me to authorise a repair. For most properties, I use a property manager for this stuff. But as an experiment, I’ve been managing this property myself, so I can weigh up the benefits of a property manager.

2. I arranged to meet with a business partner about a block we want to subdivide. This subdivision is proving to be difficult, and we need to get a plan for hurrying it up.

3. There’s another property we’re getting a new lease drawn up for. I had to check the progress with my lawyer.

4. Another property hadn’t paid as much rent as I expected. I had to call the manager and find out why.

5. I met with another business partner about a block of sheds we are planning to build.

Some of this work is planned in advance, and other pieces are not planned, but are instead a reaction to some event such as a phone call. The first four pieces of work were generated by existing properties. The final piece was working on my next real estate investment. I like to have something in the pipeline.

This is a reasonably typical day for me. All up, it was about half a day’s work. This is about as much as I like to work, because I like having time to do other stuff, including this blog.

None of the work is hard, complicated, or breathtakingly exciting. It’s not rocket science or brain surgery. It’s not even glamorous - people don’t crowd around me at parties when they discover what I do. But each activity is necessary to keep the portfolio ticking along, and growing. It’s not the minute-to-minute actions which are exciting - there’s nothing exciting about any particular letter, fax, email, or phone call. Some people even suggest that what I’m doing must be pretty boring.

But it’s the overall game which is exciting. I love building a portfolio, and I love the lifestyle that goes with it. This is what makes each phone call worthwhile. I love looking at spreadsheets, showing me how much my properties are worth, and how much money they give me each month. Growing these numbers over time is a game I love to play.

Then tomorrow, in the middle of the week, when most people I know are going to work, I’m taking the morning off with my business partner. We’ll go flying my plane, then talk about life, the universe, and future deals. Real Estate Investing has given me this flexibility. It would be extremely difficult to go back to a regular job now.


Add to Del.icio.us

January 8, 2008

Price of Mistakes

Filed under: Attitude, Residential, Selling — Tags: , , , — Tony John @ 12:34 am

I know this is supposed to be a blog about commercial property, and I’m getting there, I promise. But I’m going to continue about the sale of our residential property (hey, I’m on a roll). It does have general lessons which are relevant to commercial investing.

We bought with the plan of subdividing one block into four. But when we did detailed research, this turned out to be a bad plan. For all the reasons I explained yesterday, the retaining costs were astronomical, and we weren’t able to make money by subdivision. The main reason we bought the property turned out to be a bad one. What a disaster!

Our greatest fear had come true. Actually, it’s a collection of fears: the fear of making a mistake; the fear of doing something stupid; the fear of losing money; the fear that the naysayers, who told us that the sky will fall down, will be right (’I told you so’).

These fears are so powerful that they keep many out of property investment altogether. This is a shame.

Since I’ve been investing, I’ve done some dumb things. Some things I should have known were dumb. Other things, I couldn’t have known were dumb until I did them (Oscar Wilde: ‘Experience is the name every one gives to their mistakes’). I’ve learnt that when things go wrong, it’s not the end of the world. I’m still alive. I still have family and friends. Even when things go terribly wrong (like, when a tenant went broke owing us more than $40,000), it is not fatal.

Making a mistake with a property deal can be painful. But open any newspaper, any day of the week, and you will see that truly, there are worse things that can happen.

As it turned out, while we held our residential property, the market went ballistic, and we made more than ten times our money. Not a bad outcome for this property ‘disaster’.

So, do your research. Do as much as you can. But more importantly, have the courage to act and make mistakes. Otherwise, nothing will happen.

I was given a dictionary of quotations for Christmas, so if you’ll indulge me quoting General David Shoup: ‘The galleries are full of critics. They play no ball, they fight no fights. They make no mistakes because they attempt nothing. Down in the arena are the doers. They make mistakes because they try many things. The man who makes no mistakes lacks boldness and the spirit of adventure. He is the one who never tries anything. His is the brake on the wheel of progress. And yet it cannot be truly said he makes no mistakes, because his biggest mistake is the very fact that he tries nothing, does nothing, except criticize those who do things.’


Add to Del.icio.us

January 6, 2008

Another Reason to Sell a Property

Filed under: Residential, Selling — Tony John @ 11:46 pm

I’m reminded of a few other factors in our decision to sell the residential property.

It was an old house, on a rather large block. At the time of purchase, we were looking for a property where we could make a rapid capital growth, through what Dolf de Roos calls a ‘twist’. A twist is where you make some fast, relatively cheap changes to the property, to increase its value. In this way, you increase your value much quicker than if you simply wait for the market to go up. Our twist on this property was that we expected to be able to subdivide the block into three or four smaller blocks. After purchase, we sat on the property for several years. Finally, when we surveyed the block, and began to proceed with subdivision, we found problems.

Firstly, the block was very steep. This meant that a lot of retaining was required, to produce level, buildable blocks.

Secondly, the sewer line was mid-way through the block, in terms of elevation. This meant that one or two of the blocks would be below the sewer line. People don’t like sewerage flowing into their house, so this was a problem. We would have to significantly elevate the lower blocks to put them above the sewer line, which would require much higher retaining walls than anticipated.

Thirdly, the land at the bottom of the block was almost permanently soggy, thanks to a natural spring, so there were serious engineering questions about whether that much retaining was even possible.

In short, where we had done our numbers assuming there would be a $20k earthworks cost per block, our advice indicated it was more likely to be $100k per block! These new numbers forced us to change our plan. We decided not to subdivide. We needed a new plan.

I’ve heard people say that every day, you should be happy to buy each investment in your portfolio again at fair market price. If you wouldn’t be happy to buy it back, why do you own it? That makes sense if the market is perfectly efficient, and there are no selling or buying overheads. When there’s a cost involved with swapping investments, it’s not quite so simple, but the principle still applies: if an investment is not going as well as expected, question whether it’s worth holding on to.

Now, with our new information about retaining wall costs, the investment had changed. We bought with the intention of rapidly increasing its value through subdivision, but now we had learnt that this would not work. Instead, the only growth we got was a general market shift, while we scratched our heads watching. Admittedly it was a significant shift, but we no longer had any plan for how to gain a further (rapid) gain in value, which was one of our aims for each investment.

We felt that for a rapid capital gain, our money would be better elsewhere. Maybe it was time to sell this property.


Add to Del.icio.us

Newer Posts »

Powered by WordPress