Those ancient Mayans had one messed-up clock
Every day, people miss out on great investments because they don’t know how to quantify risk vs. return. You need written investment criteria. Here’s a sample.
If you don’t have the energy to click the link, it’s mostly a series of questions that read something like this:
What type of investment is it?
Real estate.
This is a straightforward question with a clear answer. Knowing what classification the investment falls into tells you how liquid it is and how much its value might fluctuate. If the investment were a stock it’d be easy to sell, though not necessarily for a premium. A plot of dirt, improved or raw, has tangible value. But selling it, even in a seller’s market, can burn a lot of hours.
If I bite, how will this affect my allocation?
Negligible.
You don’t necessarily want your eggs in a million baskets, nor in one, but you do need to know how many they’re in. And if the breakdown among the baskets gets out of proportion, you want to know that, too. Say your portfolio starts out with 33% in growth stocks, 33% in long-term notes and 33% in real estate. Six months later, if the percentages have changed to 5, 34 and 61, you’ll want to rearrange to keep things in balance (or ride the 61% component if so inclined.)
But what if this transaction did affect allocation? What would you do to balance the imbalance? You could sell an asset, buy other assets, or decide you’re going to live with a different breakdown.
What do you estimate the return will be?
4½–8%, plus however much the property appreciates, which we estimate will be nothing for the next 3-5 years.
We keep score when building wealth. Amazingly, some people haven’t figured this out yet or refuse to acknowledge it. If you think investing has an emotional component, and that either being a nice person or playing hunches is part of the game, please stop reading Control Your Cash and find something less demanding. Seriously. See, we said “please”. Didn’t hurt your feelings or anything. You should be happy.
What exactly is the investment?
A 2nd floor, 1-bedroom/1-bath 770 ft2 condo in an above-average part of town. The condo’s listed at $50,000 and approved for a short sale*.
Meanwhile, nearby condos rent for $650-750 a month. Estimated annual expenses read like this. (This is something called an annual property operating data worksheet. Download it at your leisure.)
The above question is self-explanatory, right? And its relevance should be self-evident. If it isn’t, return to kindergarten and start over. We’ll be waiting.
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Anyhow, this investment allows for multiple variables that affect ROI (that’s return on investment, in case you forgot.) Variables include things like rents, and whether you can buy the property as owner-occupied, which means you should be able to get a cheaper loan with lower closing costs. Here’s what we mean:
There are two primary ways to buy this condo as an investment if you have neither the cash up front nor excellent credit. Find a partner, or incorporate.
1. Find a partner (a joint venture.)
An investor lends you $50,000 interest-free to complete the sale. You buy the house and live in it.
Nothing’s free, of course. Under this form of owner occupancy, you pay the investor 70% of the house’s net operating income (i.e., the rent.) Another 10% of the rent goes into a reserve maintenance account – out of which you pay for things like appliance repair. Which you shouldn’t need to if you have a home warranty. But there’ll always be some unexpected expense that a warranty won’t cover: stucco repair, interior paint, etc.
What about the remaining 20% of the rent? That’s yours to keep. Yes, under this arrangement you pay only 80% of fair-market rent. On the other hand, doing it this way you can’t write off your expenses on your tax return.
Who would work out a scheme like this? Lots of people. It’s a perfect vehicle for a father who wants to help his kid buy a home and still earn a return.
Or
2. Form a limited liability company (details here, here, here, and here.)
You and the person who’s lending you money are partners in the LLC, which becomes the official and legal owner of the property. Once you create the LLC and it takes ownership of the property, it’s the sole owner: nobody and nothing else. It’s not as if you own x% of the property and your partner owns 100-x%. The LLC owns it all. You own a particular share of the LLC, but that’s a different issue.
Each LLC has an operating agreement that lays out the details of the deal: such as who gets to write expenses off, how you’ll split profits when you sell the property, and specific duties for each partner. The LLC also protects you from unlimited liability in case a tenant or a visitor decides to sue. They can sue for $1 trillion if they want, and even have a case, but they can’t get more than your investment in the LLC.
With this example, the investor again lends you $50,000 interest-free. You find a tenant, charge her the going rate and again keep 10% in a maintenance account.
This scheme works for partners with disparate skills – e.g. one partner with the time and expertise to find the property (in this example, you) and the other with most of the money.
What’s the downside?
Property values could drop even further, meaning you might need years just to break even. If the property doesn’t rent immediately, your return will decline.
The renter might damage the property. This is why you qualify prospective tenants and collect a security deposit. If you really want to avoid headaches, spend 10% of the rent on a property manager. If you value your time at all, hiring a property manager will pay for itself quickly.
You and your partner might disagree on how to manage the place and, when it comes time, how to sell it. You solve this with an operating agreement, one that looks something like this:
That’s pretty much it. Just make sure that every conceivable subject of potential dispute finds its way into the operating agreement, and that you register your LLC in a state that’s business-friendly. That usually means Delaware or Nevada. Or failing that, your home state. (You can live and operate in, say, North Dakota but register in Maine if you want. It’s totally legal.) Just don’t register in California, and never New York: their LLCs don’t protect you enough.
The old pessimistic saw says you have to have money to make money. That’s not true if you leverage someone else’s.
*Selling a house short means begging the lender’s representatives to take less than they originally agreed to, on the theory that a wounded bird in the hand is worth more than a potentially rabid pair in the bush. Details here.
**This post is featured in the 1/4/11 edition of the real estate investing carnival**
**This post is also featured in the Carnival of the Road to Financial Independence**
