September 19, 2013 - A Trader's Approach to Residential Real Estate Investing: Part Two by Dr. Van Tharp Trading Education Institute
In part two of this series we are going to discuss real estate market conditions, several real estate investing methods, including the method I've used successfully for years, and how you might find similar opportunities. If you missed Part One, click here.
Real Estate Market Types
Market conditions in real estate are noticeably and tremendously important, yet they are rarely used with discipline, even by institutions and "professionals."
They are noticeable because we see them every day and the data is generally very easy to find on the Internet. While there are a few different kinds of data that are useful, you could determine the market type easily by using permit data, since it is the most useful and the most prevalent.
Here is a simple set of rules, partly implied by Will Rogers, when it comes to real estate market conditions:
If single family housing permits are going up, then buy, borrow or lend.
If family housing permits are going down, then don't buy, don't borrow, and don't lend.
If people want to buy from you, you hit a predetermined target, or permits go down, then sell.
Typical Method for Real Estate Investing
The easiest and most liquid way to invest in real estate is through public securities such as REITs, ETFs, homebuilder stocks and shares of related companies like banks, other mortgage lenders and construction suppliers.
The next most common method is buying homes, whether to fix and flip or to rent and potentially sell. We could include here-buying tax certificates, foreclosures or other distressed properties. While some people invest through partnerships, most operate with the mindset of a self-employed person. Lots of "gurus" market programs that teach these kinds of strategies.
A newer twist on this method is buying properties with all equity and no leverage. Companies (or funds) that practice this method tend to have the mindset of a business owner, with those who finance the method having an investor mindset.
The investor must make sure, however, that the operation is run with a business owner mindset and performance discipline, rather than finding out the group just has a nice marketing pitch. I don't know if any of these funds are really using market conditions to drive their strategies in a disciplined way,1 so you'll need to find that out for yourself if you are interested in these investments.
These days, there is a lot of competition for residential property investments because there are so many individuals and funds chasing them.
My Preferred Method
At the risk of creating a lot more competition for my own method, let me talk about what I do. Find private homebuilders you like, preferably locally. Lend them money for models, spec homes, pre-sold homes and finished lots; set whatever limits are comfortable for you. Sometimes the investment structure is an equity position rather than a loan. If you have an equity position, you have the option to borrow funds and leverage that position.
Let's review two potential deals, a construction loan on a spec3 home and an equity position on a model home.
Spec Construction Loan
Assume a new home will have a $300,000 value, 80% construction and finished lot costs, and that you are financing 100% of those costs, or $240,000. Say it takes four months to build and sell the home. On average, you tend to have 60% of your funds advanced, with 90%-100% advanced by the time it is sold and you get your money back. Let's say you charge a 1% fee, a 6% annual interest rate, and 10% of the sales price over $240,000 as a "kicker." What is your return? You get 6% annual interest rate, but the annualized effect of the fee and the kicker really improve the return. The fee provides 3 1/3% (1%/60% x 12/6) and the kicker provides another 3% [($300,000 - $240,000) x 10%/60% x 12/6]. The total annualized return, then, is 12 1/3%.
Not bad for 3-6 month money, eh?
Using the same figures, let's say this home will be a sales model. In this case, the builder wants to improve his balance sheet and you want a good return over a longer time. For this type of situation, we might want to modify the structure a bit.
First, set up a limited liability company. Your LLC buys the finished lot from the builder for $60,000 and gets a construction/permanent loan from a bank for $180,000. The builder agrees to build the house, furnish it, and rent it from your LLC, then sell it and split the profits 50/50. The bank lends at 2% fees and costs, 7% annual interest rate, interest only payments for 5 years. The builder rents it for $2,500 per month once it is complete and sells it three years later for $330,000.
In this case, you have invested $63,6004, and have personally guaranteed a $180,000 loan, which includes an interest reserve for six months. You get $30,000 rent per year for 2 ½ years ($17,400 after interest) and 50% of the profit when it is sold. Assuming 5% selling expenses, there is $73,500 of profit and your share is $36,750. This yields about 10.1% annual return on your funds. Compared with the yield on three-year bonds, that's not too shabby, is it?
Deeper Into My Method
While I approach this method with the mindset of an investor, I also integrate the mindset of a business owner - that of one which invests in assets used by homebuilders. There is a financing need and a reasonable risk/reward structure for every asset homebuilders use: land, lots under development, finished lots, pre-sold homes under construction, spec homes, model homes, furnishings, equipment and vehicles. There is even a way to finance software.
Not only must you understand and choose the structure, return and repayment requirements for yourself, you must understand the same elements of the deal from the homebuilder's perspective and help them see how these affect their business. For example, you'll need to think through -
How much of your investment should be in the form of a loan versus preferred equity versus common equity.
What is a reasonable return? (for now, that seems to be about 8%-18% per annum)
How much time do you want to be invested in an asset? (usually this ranges from three months to three years)
How much leverage will you choose to employ?
How much personal recourse should you provide to those who lend to you, and how much should you require from those to whom you lend?
How much communication will you need with the builder and in what form?
How will you monitor your investment, your builder, and the market?
Next, you must understand contingencies, plan for them and commit to executing on those plans when the time comes. Encourage or require this of your deal structure and builder as much as possible also. The examples above all assume normal conditions but what happens if things go a little worse than expected? A lot worse? How about the absolute worst case scenario? What will the builder do? What will you do? How do you define "worse" and "worst"? On the other hand, what if things go really, really well?
Then, you must develop your position sizing plan. How much of your total assets will you invest in this "system"? How much will you place with any one builder? In any one deal? How will that change if market conditions worsen? Improve? How will you monitor those market conditions?
Probably the most significant aspect of real estate investing is your commitment and discipline to your position sizing strategy when market conditions falter. For example, if permits in an area drop for four months in a row or have dropped in six of the last nine months, I don't invest in any new deals. Following these rules, however, causes me to miss deals and it has even caused me to lose relationships because I won't consistently invest in new deals. When conditions worsen, what will you and your builder do with existing deals? Consider that beforehand rather than at the onset or in the middle of the next decline.
Obviously, you want relationships with good businesspeople who build good products in good places. You're going to have to learn to define what "good" means, and what the signs of "bad" are. Here are the kind of builders I have found make good candidates for my investing:
Look for local families who have built near you for years. While they may not need an investment from you, they can see that they take on lower risk with your funding. Many of these families have a "self-employed" mindset so you might get a lower return, but it will probably be a more stable investment.
There are a few builders around who have had the "business owner' mindset for a while, including some of the families I mentioned above. Business owner builders are distinguished by strong processes in land, design, sales and production. Also, they tend to have regular, simple and meaningful management reporting.
These are the types of homebuilders I want to work with, no matter where they are located because they will provide the best returns and lowest risks. Overall, low-key people in construction who run a good operation are the kind of people with whom I like to associate.
Opportunities and people in real estate are all around us ready for buying, selling, renting, lending, managing, and building. Perhaps some of those people and opportunities fit you.
1. Just because I don't know of any doesn't mean there aren't some. I don't follow this industry or "space" much.
2. You can leverage loans you make, too, but that is more complex and requires a relationship with a bank that is comfortable with that business.
3. A spec home is one that is started without having a sale contract in place with a homebuyer.
4. Includes $3,600 for loan fees & costs.
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