Investing in Real Estate

Real estate is the big one. It is considered the “single biggest investment an individual makes” and that’s often true. People invest far more into their homes than they do into any other types of assets, rightly or wrongly.

Why is that the case? Is there something special about real estate as an asset class? Yes and no. Like other assets (stocks, bonds etc.) its prone to market bubbles, price volatility, speculation, bear markets, bull markets and so on.

What is unique is that it’s a real physical asset that has a limited supply (determined by available land, number of homes, rate of construction etc.) and demand that’s determined by demographic/income trends in a localized area. It also gives the benefit of control, you can change the layout of the property, renovate and make it more valuable. You can not do this if you invest in a company (unless you buy a controlling stake!).

Another unique aspect is that there are huge government incentives for people to buy homes compared with literally anything else. Governments insure your mortgage, enable low down payments, offer no capital gains taxes for selling your primary residence and offer other deductions while you’re a homeowner. This structure enables banks to offer mortgages at low interest rates compared to other debt products. If you go to a bank and try to get $100,000 to start a business, or to invest in stocks you will have a hard time. But if you go to that same bank looking for a $400,000 mortgage to buy a house, suddenly they are happy to give it to you. This means that for this one asset class society is giving us significant access to capital.

There are three ways to make money in real estate. Ideally, you should opt to be a “Randy Renter” or “Ally Arbitrage” for your first few properties! They earn higher and safer returns compared to “Sally Speculator”.

Randy Renter — Buys a good property that will generate positive rental cash flow from day one. Randy might do minor renovations from time to time, but he plans to hold on for many years regardless of the changes in its market value. Even if the value of housing faced a recession lasting years, he would still be earning a healthy return on his investment from the consistent cash flows it generates.

Randy’s key metric is the “Cash on Cash” return which is the net income from his rentals vs the money he invested in the property (down payment + initial renovations). When searching for properties Randy ensures that potential rents are larger than his operating costs and that he is earning at least 15% per year on his invested cash. Randy’s total return could be much higher as small increases in property value will be added on top of the 15% per year. But as mentioned, this is just icing on the cake for Randy.

Ally Arbitrage — She is a shark. She looks for beat up under valued properties to fix up and either sell for a profit or hold as a rental. She locks in a gain in value from day one, then gets income. Ally is willing to do the hard work. Ally makes the highest returns, but has to work harder upfront compared with Randy Renter. Ally is a boss.

Ally’s key metric is “Total Cash Return on Investment — Total Cash ROI”, she will generally be more focused with the value of the home after renovations are done since her work is what raises its value (not the market!). For example, in an area with $400,000 homes there is one for sale for $340,000 because it is in poor condition. Ally can spend $10,000-$30,000 renovating it up to the standards of its neighbors over her first few months of ownership to make it worth the $400,000 that’s common for the neighborhood. Once that’s done, she can choose to sell it locking in the difference between the cost of the home + renovations and the new market price, or she can rent it out. At which point she will focus more on her annual “Cash on Cash ROI”, but will have earned a much higher Total Cash ROI due to the upfront appreciation compared to Randy.

Sally Speculator — Sally tries to buy the “nicest” house she possibly can. She will not rent out spare space, nor will she fix up or renovate it (not that there’s much to do anyway since she bought a newer well done place). Because of this she is at the complete mercy of the market prices for her house. If values rise she will make some profit, but, if they stay flat or go down she could quickly find herself in a situation where she is playing more for her mortgage than what the home is worth (negative equity!).

Get a mortgage broker: Ideally an independent one that will search for mortgages from many different banks. They will get you pre approved for a mortgage amount depending on your income, savings, debts and planned down payment. The higher your income/savings and the lower your debts (especially credit card debts) the higher your approval figure will be. Once you know your max amount and have pre approval its time to start aggressively searching for deals.

Get a Real Estate Agent: They are critical since they have a network of agents to find houses for sales (including ones not publicly listed yet!) and can get you into quick showings/open houses to see potential properties for yourself. They will also guide you through the technicalities of the whole process.

Searching for homes: While you may browse through hundreds of listings online, its important to see the ones you are most interested in, in person to get a sense of the work needed to be done or changes needed to be made. Houses can be move in ready, quick fixes, in need of renovations, or in need of major construction.

If you are a Randy Renter you will look for move in ready or quick fixes needing small repairs, new appliances, fresh paint, a good cleaning etc. If you are an Ally Arbitrager you will be looking for homes that need significant renovations (such as new kitchens, new bathrooms, internal layout changes etc.). Ally Arbitrager’s need to beware of structural issues or water/mold damage effecting the foundation, roof, floors, or frame of the house. Those problems can be extremely expensive to fix and do not add value to the property (unlike remodeling a kitchen which can significantly increase a homes value).

Comparable Method: Is simple and widely used. It compares the prices of recent nearby sales to your property of interest. This number can be averaged out over several past transactions then be applied to a “price per square foot” basis. Typically, every major neighborhood will have its own average price that similar homes sell for (comparing a house to house, an apartment to apartment and so on). Your Real Estate Agent should be able to provide you with reports on all the sales in your target area to compare to current prices. Remember to always be mindful of layout, interior quality, number of bathrooms and minor locational differences. Ultimately, it’s a good check to know your getting a fair deal and to help set your final offer price. But it doesn’t give you a complete picture of your potential income or returns from ownership.

Net Operating Income & Cap rates: Net Operating Income (NOI) is the Gross Rent minus management expenses such as maintenance or property taxes but not deducting mortgage or income taxes. It enables easy comparison between different properties. When you look at a similar deal in your target area you take its NOI and divide by its purchase price to get the “Cap rate”. Your target area has an average cap rate that your agent can help you figure out. With that cap rate you can now apply it to new listings you are interested in buying. Simply take the estimated NOI of that property and divide it by the cap rate and you get a “fair value” estimate for the property.

For example, a house is listed for $400,000, its estimated NOI is $21,000 while cap rates in the area are 5%.

Fair Value = NOI/Cap Rate = $21,000/0.05 = $420,000

Any price around (especially below) that is a good one. We can enhance this simple analysis by using the tools to also estimate annual Cash on Cash and Total Cash Returns.

Cost Based Method: This is the least used method. Typically, it makes sense for developers or rural areas with no recent sales to compare to. It takes into account the cost of building a similar property from scratch (the cost of land and construction).

Why stop at one, if we have access to capital? This method turns one property into many.

Buy -> Renovate -> Rent Out -> Appraise -> Refinance -> Buy Another

If the home is appraised at a higher value than you bought it for you can refinance (get a new mortgage) from the bank that’s larger than your original. You will have more debt but you get to “pull out” your home equity as tax free cash! This could be as big or bigger than your original down payment to buy the first house. Next you use that fresh pile of cash to buy a second property. You can rinse and repeat this as long as you are employed, have good credit, rent out each new property and if the market is favorable (home prices rising, with steady or declining interest rates). The risks of this strategy are you take on more and more personal debt, usually, banks will resist lending to you after 2–4 properties unless you find an additional investor. Finally, if the market begins to fall and/or rates rise fast it could make continuing the process impossible.

For example, you put $25,000 down and spend another $10,000 renovating a townhouse you get for $300,000 (in a $340,000 neighborhood). You live in one room and rent out the other 3 covering your mortgage and earning a tidy profit. In one year, you get the home appraised for $360,000 (due to renovations and the market rising), meaning you now have $90,000 of equity in the home ($25,000 down + $60,000 appreciation +$5,000 of mortgage principle repaid). You go to your bank and refinance, meaning your remaining mortgage balance of $270,000 is repaid with a new $290,000 mortgage and you get to keep the $20,000 difference. Your monthly payment will rise slightly but you will have pulled out almost your entire down payment as tax free cash. This cash can then be used towards the down payment of a second income property. Rinse and repeat.

Like any investment there is “no free lunch” and it is possible to lose money in real estate. Markets can crash, interest rates could rise, your home could be destroyed (sure insurance will help but you wont make the profits you expected), renters might not pay, you might experience long vacancies, personal problems could lead to you having to sell too early and so on. There are a host of things that can happen, some you can control or mitigate and others that are out of your control.

Whenever leverage (in this case via mortgages) is involved there is potential for ruin. Leverage cuts both ways, a 5% down payment is 20 to 1 leverage meaning that a 1% gain in the value of the whole property = 20% return on your invested cash. This also means a 1% decline in prices results in a 20% loss for you. You can reduce this risk by putting more money down or by ensuring rental income covers the monthly payments.

As with all other decisions the choice to rent or to own has many trade offs and opportunity costs. If you can live in a place that has affordable rent AND you can earn a healthy return on your savings in other markets (like stocks, crypto etc.), then it may make more sense to keep renting especially if it would take most of your savings to put a down payment for a home. It could certainly be advantageous to do so over a short to medium time period. Renters also don’t have to worry about the real estate market, their mortgage debt, repairs and other issues homeowners deal with.

Within our tool there is a section to compare ownership and renting. Typically, over the long run it is far more advantageous to be an owner. The benefits of a levered investment that can produce both steady rental income and capital gains that are often tax advantaged overwhelmingly tips the scale in ownership’s favor.

Real estate is a powerful area to invest in for individuals. There is a potential to exponentially grow your holdings in a relatively short time compared to other types of investments and you are in full control.

As you build up your portfolio you can also apply these techniques to multi family housing, land, parking lots and commercial real estate. Best of luck!

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