Defensive Real Estate Investing
DEFENSIVE
REAL ESTATE
INVESTING
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DEFENSIVE
REAL ESTATE
INVESTING
10 Principles for Succeeding
Whether Your Market is Up or Down
William Bronchick, Esq.
With Gary R. Licata
PUBLISHING
New York
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This publication is designed to provide accurate and authoritative information in
regard to the subject matter covered. It is sold with the understanding that the publisher
is not engaged in rendering legal, accounting, or other professional service. If
legal advice or other expert assistance is required, the services of a competent professional
person should be sought.
Editorial Director: Jennifer Farthing
Development Editor: Joshua Martino
Production Editor: Julio Espin
Typesetting: Black Diamond Graphics
Cover Design: Rod Hernandez
© 2007 by William Bronchick, Gary Licata
Published by Kaplan Publishing
A Division of Kaplan Inc.
All rights reserved. The text of this publication, or any part thereof, may not be reproduced
in any manner whatsoever without written permission from the publisher.
Printed in the United States of America
May 2007
07 08 09 10 9 8 7 6 5 4 3 2 1
ISBN 13: 978-1-4277-5463-9
ISBN 10: 1-4277-5463-2
Kaplan Publishing books are available at special quantity discounts to use for sales
promotions, employee premiums, or educational purposes. Please email our Special
Sales Department to order or for more information at kaplanpublishing@kaplan.com,
or write to Kaplan Publishing, 888 7th Avenue, 22nd Floor, New York, NY 10106.
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Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
CHAPTER 1: Don’t Try to Get Rich Quick . . . . . . . . . . . . . . . . . . . . . . 1
Getting Rich in Real Estate Isn’t Easy or Instant . . . . . . . . . . . . . . . . . . . . . . . . 1
Start with Realistic Goals and Expectations. . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Developing Skills Takes Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Success Requires Education plus Action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Key Points to Remember . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
CHAPTER 2: You Can Profit in Any Market, But You Must
Know Your Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
What Determines the Market? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Analyzing Your Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
What’s Right for You? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Key Points to Remember . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
CHAPTER 3: Learn How to Valuate a Property. . . . . . . . . . . . . . . . . . 29
The Art and Science of Valuating a Property . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Key Points to Remember . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
CHAPTER 4: Determine Your Profit before You Buy . . . . . . . . . . . . . 45
The Past Doesn’t Equal the Future . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Find Motivated Sellers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
How to Analyze a Potential Deal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
CLEAR System of Analyzing Deals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Balance Your Business with Your Personal Goals . . . . . . . . . . . . . . . . . . . . . . 58
Key Points to Remember . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
CHAPTER 5: Always Invest in “Safe” Deals . . . . . . . . . . . . . . . . . . . . . 61
Invest in Deals, Not Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Stick with Metropolitan Areas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Buy the WOB in the MOB Near the Blob. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Fixer-Uppers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
Condominiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
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Multifamily Housing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Properties to Avoid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Key Points to Remember . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
CHAPTER 6: Manage Your Cash Flow. . . . . . . . . . . . . . . . . . . . . . . . . 81
The Importance of Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
How Much Should You Keep in Reserve? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
Cash Flow Applies to Fixer-Uppers and Flips Too! . . . . . . . . . . . . . . . . . . . . . 85
Cash Flow versus Cash Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
How Cash Flow Affects Your Decisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
Generate Both Cash Flow and Cash Reserves . . . . . . . . . . . . . . . . . . . . . . . . . 87
Key Points to Remember . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
CHAPTER 7: Have Multiple Exit Strategies . . . . . . . . . . . . . . . . . . . . . 93
Choices, Choices, Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Exit Strategies and Financing Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
What to Do When Plan A Won’t Work. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Buy It Right. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Key Points to Remember . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
CHAPTER 8: You’ve Earned It, Now Learn How to Keep It. . . . . . . 111
Know the Laws. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
Insurance—Your First Line of Defense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
Corporate Entities—Your Second Line of Defense . . . . . . . . . . . . . . . . . . . . 116
Doing Business with Partners. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Release Yourself from Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
Get Educated on Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
Key Points to Remember . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
CHAPTER 9: Avoid Common Investment Scams . . . . . . . . . . . . . . . 129
The “Too Good to Be True” Deal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
Letting Others “Borrow” Your Credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
Mortgage Elimination Scam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Syndication Scam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
Join the “Club” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
Learn What’s Not a Scam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
Don’t Involve Yourself in a Scam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
Key Points to Remember . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
vi Contents
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CHAPTER 10: Treat Real Estate Investing as a Business . . . . . . . . . . . 141
Should You Invest Full Time? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
Act Professionally and Look the Part . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
Tools of the Trade. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
Assessing Your Strengths and Weaknesses . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
Cash is King—But So Are Great Deals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
Setting Goals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Enlisting Your Team . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Hire Employees to Increase Your Effectiveness . . . . . . . . . . . . . . . . . . . . . . . 156
Learn Your Local Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Personal Traits of a Defensive Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Key Points to Remember . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
SUMMARY: The Ten Principles of Defensive Investing . . . . . . . . . . . . . . . . . 165
APPENDIX 1: Internet Resources for Market Data . . . . . . . . . . . . . . . . . . . . . . 167
APPENDIX 2: Sample Residential Appraisal Report. . . . . . . . . . . . . . . . . . . . . . 169
APPENDIX 3: Recommended Reading. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
APPENDIX 4: Resources for Tenant Screening . . . . . . . . . . . . . . . . . . . . . . . . . 195
APPENDIX 5: Sample Property Cash Flow Analysis. . . . . . . . . . . . . . . . . . . . . . 197
APPENDIX 6: Sample Property Disclosure Form. . . . . . . . . . . . . . . . . . . . . . . . 198
APPENDIX 7: Sample Independent Contractor Agreement. . . . . . . . . . . . . . . . 203
APPENDIX 8: Sample Joint Venture Agreement. . . . . . . . . . . . . . . . . . . . . . . . . 207
APPENDIX 9: Sample General Release of Liability Form . . . . . . . . . . . . . . . . . . 211
APPENDIX 10: IRS Publication 537 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
APPENDIX 11: Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
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Preface
Instead of the Latest “Secret Formula,” Learn Proven Steps
to Success
The recent “real estate boom” has led to an equally great boom in
the number of books published on the subject of how to make money
in the real estate market. Everywhere you turn—whether it’s print, tel-
evision, or the Internet—people are talking about real estate. Is it going
up or down? Do you get in now, later, or is it too late? There are many
resources: some good, some bad, some original, and some just a rehash
of old ideas. Occasionally, though, an author writes a special book that
really sets him or her apart from the pack. That such writer is William
“Bill” Bronchick.
Bill Bronchick is an accomplished author, speaker, commentator,
and real estate investor. This book, Defensive Real Estate Investing,is
a culmination of his years of practical experience and the experiences
of other investors we know. For those of us who view real estate in-
vesting as a profession, Bill has produced a book that anyone can use,
whether you’re a novice or seasoned professional.
Defensive Real Estate Investing is an in-depth look at the chal-
lenges of succeeding in both the short term and long term as a real es-
tate investor. Novice investors are often looking for a “magic
bullet”—an idealistic, hopeful way to make a quick buck. These im-
petuous investors soon realize that their approaches to investing don’t
work consistently and they’re off in search of the next “secret formula”
that will make it all work.
At some point, novice investors (and even some experienced in-
vestors) come to the frustrating conclusion that real estate investing is
harder than they thought. If this is the case, why do so many people
believe you can get rich quickly by investing in real estate? Given this
conundrum, is it possible that success in real estate investing is limited
to the lucky or privileged few?
Bill says, “Success in real estate is for just about everyone.” It does-
n’t matter whether you have an hourly job in a fast-food restaurant or
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x Preface
you’re the CEO of a large corporation. You must, however, follow cer-
tain steps to be successful. If you take shortcuts, you run the risk of fail-
ure. Instead of offering a magic bullet or secret formula, Defensive
Real Estate Investing provides you with concrete steps to success.
Successful Investors Are Made, Not Born
To be a successful investor, you must acquire the correct real estate
investor mindset, learn sound money management skills, and most im-
portant, develop a “can do” attitude with an appropriate plan of action.
Bill has developed several brilliant acronyms that make it easy to
learn and remember these steps to success, like the “Buy the WOB in
the MOB near the Blob” and the CLEAR method of analyzing a deal to
determine if it is a great deal. (You’ll learn about these concepts later
in this book.)
Remember, to succeed, you must first learn to think like a suc-
cessful real estate investor. After you read this book, you’ll have gained
the real estate investor’s mindset and you will have a set of guidelines
to use and review. Success in real estate investing looks easy and it can
be—but only for those who know how.
This book is both for serious beginners who are studying real estate
investing and for experienced investors who need to go back to the ba-
sics to polish their techniques and improve their profits.
I’ve known Bill Bronchick for more than ten years. Together, we
offer more than 40 years of combined real estate experience. It’s been
a privilege collaborating on this book. In fact, through him, I’ve re-
learned real estate investing techniques that have helped me become a
more profitable investor.
My recommendation therefore is to enjoy Defensive Real Estate In-
vesting to develop the proper real estate success mindset, learn sound
money management skills, and develop your “can do” attitude and plan
of action. I invite you to read, enjoy, and learn from our experiences.
—Gary R. Licata
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Introduction
The Key to Success is Using Ten Principles of Defensive Investing
Countless people are attempting to become real estate moguls in
today’s market. All of them, in one way or another, strive to be suc-
cessful. Gary Licata and I know from our past 40 years of combined ex-
perience that, unfortunately, the vast majority of these people will fail.
Despite their best efforts, many of them won’t be able quit their day
job or, if they do, they may not be able to sustain a steady income
stream by being a real estate investor. Many of them will go to from one
seminar to another, read book after book, and eventually quit the busi-
ness altogether out of frustration, failure, or impatience. You may know
someone like this or you may be that someone. Is there an answer to
this dilemma? Yes, and you’ll find the answer in this book, Defensive
Real Estate Investing.
Real estate markets go up and down, and every investor, whether
novice or experienced, must learn the principles of successful invest-
ing to survive. While the title Defensive Real Estate Investing suggests
that this book is intended for those investing in falling housing mar-
kets, the principles apply to every market. This book conveys ten uni-
versal principles that have stood—and will continue to stand—the test
of time. Regardless of where the market is heading, ten principles of
defensive investing will work for you every time, in any market.
The Ten Principles—Proven and Reliable
These ten principles are not magic bullets; they’re tried and tested
concepts that are proven and reliable. We use these methods in our
own real estate investing careers. In addition, we’ve met thousands of
investors who have succeeded and failed. We’ve elicited a common
thread from their successes and failures for this book.
Take one of our clients, Sharon. A few years ago, she and her hus-
band wanted to make a move out of their stressful business. Doing
fairly well, they had managed to save a few hundred thousand dollars.
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xii Introduction
However, they were nearing retirement age and didn’t have enough
money in their retirement savings to retire comfortably.
Sharon enrolled in one of our coaching programs. She learned the
successful principles of the real estate investing business, and in less
than three years, has purchased 17 properties with a net worth of over
one million dollars! Her success was typical of someone who has a
sound investing strategy, not just because she had a few hundred thou-
sand dollars to invest. Many people start out with a decent nest egg and
lose it because they don’t have a plan or squander it in low-yield in-
vestments that take too many years to accumulate the sufficient funds
for a healthy retirement.
You may be thinking, “I don’t have several hundred thousand dol-
lars. How can I get started and be assured of similar success?” You sim-
ply don’t need a lot of money to get started. In fact, most people we
meet have less than $20,000 when they start their real estate investing
careers. In fact, the more cash you start out with, the more you have to
lose, and thus the more “defensive” you have to be in your approach.
“Defensive,” among other things, means being thoughtful, conser-
vative, and not-too-risky in your approach. It means knowing where
you are in the real estate cycle, whether you are in an up or down mar-
ket; you don’t want to sell too early or buy too late. It also means know-
ing how to preserve your cash flow, analyze a deal from all angles, and
run your investments like a business.
If you use the techniques outlined in this book you can be inde-
pendently wealthy in fewer than ten years. Keep in mind that real es-
tate investing isn’t a “get-rich-quick” scheme. It takes time, diligence,
persistence, and good planning. Above all, it takes using intelligent in-
vesting principles.
If you apply what you read in this book, you can be a successful real
estate investor, no matter where you’re starting. When we speak at one
of our seminars, it gives us great pleasure to look at the faces in the
crowd and wonder who will be the next success story. This book shares
the message of intelligent investing. We hope it will have an impact that
will set you in the right direction. We’ve written this book as a resource
you can use daily. Please don’t read it only once and put it away.
Each chapter in this book directs you towards one of the ten prin-
ciples of defensive investing.
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In Chapter 1, you learn what it takes to be a real estate investor: the
virtue of patience. We provide real-life examples that guide you through
the investing process and help you develop the necessary skills to be a
successful real estate investor. Getting rich is a matter of degree. How
rich do you want to be, where do you start, and how do you reach your
goals? We help you answer these questions in Chapter 1.
Chapter 2 discusses in detail the real estate market, how to deter-
mine the market you’re in, and how can you use that information to
profit. Discussions include median versus average prices and what this
means to you. In addition, you learn whether market timing is a good
or bad idea.
Chapter 3 is the essence of the investing world—that is, learning
how to determine the true value a house and sell it for a profit. We de-
tail what it takes to rehab a property, identify which repairs add value,
and determine which improvements and repairs to avoid because they
won’t increase your return on investment. You’ll also learn which real
factors determine value and how they can help you buy a house at the
right price.
Chapter 4 is probably the most important chapter in this book.
You’ll discover how to make your profit when you buy (versus making
a profit when you sell). If you don’t understand what we mean, be sure
to read every word of this book more than once!
Chapter 5 provides insight into where to invest. Do you invest in
your own backyard or in another part of the country? Is location more
important than price or vice versa? We provide specific examples of
the types of projects that are worth taking on and show you how to an-
alyze a deal. You’ll also recognize the certain types of properties that
are more profitable than others—and which properties you should
avoid at all costs.
Chapter 6 discusses the critical topic of cash flow versus cash re-
serves. We detail sources of cash and formulas for analyzing cash flow.
Moreover, if you aren’t starting with much cash, we teach you how to
generate a cash reserve.
Chapter 7 prepares you for exit strategies. The reality is that not all
deals work the way you anticipate so it’s important to have multiple
plans of action and a backup plan.
Chapter 8 gives you details about legal and tax aspects of real es-
tate. You’ll learn simple techniques to keep the profit you earn.
Introduction xiii
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Chapter 9 reveals common real estate investment scams and traps
you must avoid, the common myth about “nothing down,” getting cash
back at closing, and other “get-rich-quick” schemes. You’ll identify
these schemes and determine how to protect yourself from unscrupu-
lous investors. We also show you what to look for when researching an
investment club.
In Chapter 10, we provide specific examples of how to treat real es-
tate investing as a business. That includes how to set up your company
and your office, set goals, bring in partners, hire employees, and take
the steps necessary to be a professional real estate investor. You’ll as-
sess your strengths and weaknesses and bring together the important
members of your real estate success team.
The Real Secret to Successful Investing
The secret is there’s no secret. Nevertheless, we can offer a solid
piece of advice based on our years of experience: Take investing one
step at a time.
That means plan carefully, don’t overdo it, and build up slowly so
you don’t get off track. If you were planning to run a marathon, you
wouldn’t just show up for the race, would you? Of course not; you’d
prepare and take it one step at a time. You’d consult with experts, plan
your training schedule, work on your stamina, eat well, cross train,
stretch before and after each run, and build up to the big race.
Writing this book has been a labor of love based on our personal
experiences, failures, and successes. We enjoyed collaborating on the
ideas for this book. We want to share our experience with you to pre-
vent you from making mistakes. Most of all, we want to help make the
investing process easier and more profitable for you.
After we speak in public, we often ask each other, “Who’s going to
be the next successful investor from this group?” Will it be you? If you
apply the ten principles of defensive investing, you’ll change your
mindset about real estate investing forever.
Remember, success is a process, not a place. We hope you enjoy the
process and can benefit from our help to get you to the top—wherever
that is for you.
—Bill Bronchick and Gary Licata
xiv Introduction
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CHAPTER
1
Don’t Try to
Get Rich Quick
“The things that will destroy America are… the love of soft
living, and the get-rich-quick theory of life.”
—Theodore Roosevelt
As we discussed in the introduction, investors should be defensive
in their approach to real estate investing, whether the market is up or
down, good or bad.
To build wealth quickly, the assumption is that one must accept
more risk. This assumption is generally correct, but lowering risk
means more than just doing things more slowly; it means thinking
things through before you take action. The ten principles in this book
determine exactly how you can do that in your real estate business.
Getting Rich in Real Estate Isn’t Easy or Instant
Generally speaking, people want something for nothing. This
statement may sound cynical, but ask yourself these questions and an-
swer honestly:
• Would you rather work more time or less?
• Would you rather have more income or less?
1
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• If we can show you how to make more and work less, would
you be interested in hearing how?
Doesn’t the last question sound like a typical late-night infomercial?
This is why advertisers are so good at exploiting human nature!
If getting rich in real estate were easy, everyone would be doing it.
It’s not easy. Many aspiring investors are lured into the world of real es-
tate investing because they see other people doing it and want to taste
a better life. Unfortunately, it isn’t realistic to expect instant wealth
without first investing considerable time and effort. While many peo-
ple have gotten rich quickly in real estate in recent years, more often
than not, it was pure luck. Most investors who succeed in real estate
do so in the long term—through hard work and patience. Those who
try to “crack the code” and shortcut the system are often disappointed.
Another common mistake impatient investors often make: They
learn a few tricks and think success will instantly follow. Another com-
mon mistake is seeing the instant success of someone else and believ-
ing you’ll have the same results. In reality, this rarely (if ever) happens.
These people may have had a good plan, but face failure because they
didn’t give the required effort necessary to achieve the goal. It takes a
lot of work to achieve long-term success in real estate, which is why so
few accomplish it on a grand scale.
Many people start out in real estate investing with great fervor, only
to become discouraged after a few months when they don’t attain in-
stant fortune. They discover they can’t get rich quickly and easily so
they move on to the next investing scheme.
Surprising as this may sound, real estate has a lot in common with
weight loss. In real estate, as in the weight loss industry, everyone talks
about it and many try it, but few experience real long-term success! Both
industries offer thousands of “get rich quick” and “get slim quick” gim-
micks, making billions of dollars in sales in the “getting people to try.”
If you’ve tried to lose weight, you know it isn’t easy. In fact, it’s a
serious challenge. Yet the basic concept is simple: eat less, exercise
more. Even with this approach, most people give up after a few weeks
because they don’t have the discipline or the patience to work consis-
tently at a well-defined plan.
Does this mean that all the weight loss plans you see on television are
a scam? No, most of them will work if you follow their plan. Likewise,
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1 / Don’t Try to Get Rich Quick 3
most of the techniques advertised on real estate investing infomercials
do work if you work. Admittedly, like weight loss commercials, the re-
sults take longer for some people than for others. The problem is that too
many people are impatient and either give up or, worse, engage in risky
or speculative real estate deals that end up bankrupting them.
The bottom line is that if you set realistic expectations, apply our
principles, have a good plan, and work hard, you’ll succeed.
Start with Realistic Goals and Expectations
Thinking big is great, but we cringe when we hear someone say, “I
want to make a million dollars in real estate in my first year.” Everyone
loves a dreamer, but there’s a fine line between dreams and delusions!
Someone who earns $50,000 a year and has no prior experience in real
estate probably wouldn’t make that kind of money by next Christmas.
What kinds of expectations are realistic for a beginner? The best ap-
proach is to set short-term, intermediate, and long-term goals. Be sure
your goals are realistic, specific, and attainable. For example, your goals
may look like this:
• Fifteen-year goal: Retire with $10,000 in passive income per
month, inflation-adjusted. This may require between $3 and $4
million in free-and-clear rental real estate.
• Five-year goal: Acquire between $3 and $4 million in real estate
in steadily appreciating areas. Buy, fix, and flip five properties per
year at an average profit of $20,000 to replace current income.
• One-year goal: Buy, fix, and flip two properties and acquire
three rental properties to keep.
• Six-month goal: Buy one rental property and one fixer-upper.
Be as specific as possible and take time to do the math. For exam-
ple, if your goal is to retire within 15 years, how much income will
you need to attain that goal? If you need $10,000 per month, will that
require owning and collecting rent on five houses? Ten houses? Will
you be managing that property? If you pay a manager, how will that
affect your bottom line? If you need $10,000 in today’s money, what
will that amount be worth adjusted for inflation? The more diligently
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you put the pen to paper—or the fingers to the keyboard—the better
prepared you’ll be.
To avoid setting yourself up for certain disappointment and possi-
ble financial disaster, you must forget the dream of becoming an
overnight millionaire. Instead, focus on the slow-and-steady route, aim-
ing to accumulate wealth one small step at a time, one deal at a time.
(We’ll discuss setting goals in more detail in Chapter 10.)
Most important, be defensive in your approach. Think things
through. Be conservative and cautious while always considering the
risks. Real estate generally goes up and down in natural market cycles
about every seven to ten years from top to bottom to top (or from bot-
tom to top to bottom, whichever way you view it). Could property val-
ues decline after you buy them instead of increase? Could you end up
at the bottom of a cycle when you plan to retire, and how will this af-
fect your decisions? Could inflation be more than you expect? Could
your kids’ college cost more than you anticipated?
When you develop your goals, spend plenty of time. Be sure to look
at the positive and also anything that could negatively impact your
goals. Imagine that you’re preparing this plan for your boss—what
would he or she think about it? What aspects would you need to clar-
ify and present in more detail if you had to “sell” it to someone else?
4 DEFENSIVE REAL ESTATE INVESTING
A True Story: Focus on
Quality, Not Quantity
Steve bought 140 investment properties in his first three years of in-
vesting. Each house he purchased had less than 10 percent in equity. He
hoped that appreciating values would be his payoff. Unfortunately, the real
estate market in his city leveled off and he ended up with multiple vacan-
cies, negative cash flow, and financial distress. Steve would have been bet-
ter buying one-third as many properties with more equity while focusing on
quality deals rather than quantity.
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Developing Skills Takes Time
When you invest in real estate, risk is directly proportional to edu-
cation. Compare this to the stock market where even the most edu-
cated professionals still can’t invest and achieve great returns with any
degree of certainty.
On the other hand, real estate has a higher learning curve than the
stock market, which means you must be willing to invest more time
and resources to get results. Real estate is more like running a business
than managing an investment, so it takes more time to learn. If you’re
hoping for success in real estate (or any challenging field), you must be
prepared to invest time to develop the necessary skills and expertise.
Too many aspiring investors assume they can jump into the fray and
learn as they go. Certainly many people do this, but the stakes are high;
there’s plenty of money to be made in real estate, but there’s plenty to
be lost! More often than not, foolish investors jump into investing with-
out knowing the rules and end up paying an expensive lesson.
At any given time, in virtually every major city across the nation, nu-
merous real estate seminars are offered to guide you through the learn-
ing curve. Seminars run the gamut from affordable to expensive and
from useless to very helpful (and everywhere in between). We recom-
mend that you attend a few reasonably priced seminars; you’ll likely
learn at least a few helpful tips. In addition, this gives you the oppor-
tunity to meet other investors in your area.
How do you know if a real estate seminar is worthwhile? Here are a
few facts to consider when determining whether to invest in a seminar.
• Price—Be cautious of seminars at either extreme of the price
spectrum. If the seminar is free, it’s usually because the pro-
moter plans to make a profit by selling his products to the at-
tendees. If you attend free seminars, be prepared for a sales
pitch for books, CDs, coaching, or other seminars. By contrast,
expensive seminars sometimes leave investors feeling as if they
didn’t receive sufficient material to justify the high cost.
• Class size—Free or low-priced seminars generally require large
audiences to make the event cost-effective for the promoters.
This means it’ll be difficult to ask questions or receive individ-
ual instruction.
1 / Don’t Try to Get Rich Quick 5
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• The expert’s teaching ability—Some experts are knowl-
edgeable in their field, but they simply don’t have the teaching
skills necessary to convey information in an interesting and
easy-to-understand manner. Unfortunately, it’s difficult to judge
a speaker’s teaching ability beforehand unless you can get feed-
back from others who have previously attended one of the
speaker’s events.
• Refund policy—All legitimate seminars should offer some
type of refund policy. Always ask about the refund policy before
registering for any events.
• Your commitment level—Until you’re completely certain
that you wish to pursue the real estate business seriously, avoid
spending an excessive amount of money on seminars or coach-
ing programs. It’s wiser to attend a few low-priced seminars
first while you’re deciding whether you’re really committed to
this field.
Many investors go to one extreme or the other—they jump into real
estate investing without an education or they spend tens of thousands
of dollars on education and don’t ever buy a property! Neither outcome
is desirable, but certainly there needs to be a balance. Our advice: Learn
a little, take action, then learn more and apply it. Education is a lifelong
process. Chances are, the more you learn, the more you’ll earn.
Success Requires Education plus Action
Some people are critical of the real estate seminar business because
it attracts so many people to real estate investing, yet few people make
the grade in real estate, even with the right education. Success takes
more than education; it takes massive action in the direction of your
goals. If you don’t plan to apply new information, then getting an edu-
cation and spending money on seminars and books is a waste. Never-
theless, given the two extremes, you can lose a lot more money by
making a mistake than by attending seminars and doing nothing. So in-
vest in your education, or you’ll learn an expensive lesson with the first
mistake you make. We call that going to a “real-life seminar.”
6 DEFENSIVE REAL ESTATE INVESTING
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In today’s information age, there’s no excuse for making a mistake
that someone else has made and can teach you to avoid.
The more you learn, the less daunting real estate investing will be-
come for you. Being defensive means taking time to anticipate poten-
tial pitfalls and, most important, being aware many pitfalls exist that
you didn’t even think of. The only thing more dangerous than igno-
rance is the ignorance of what you are ignorant about! (Think about
that last sentence for a moment.)
1 / Don’t Try to Get Rich Quick 7
Mentoring and
Coaching Programs
Ideally, finding an experienced mentor who can guide you through the
process of real estate investing is infinitely important. However, few people
offer mentoring for free and, even so, such a person may be a poor teacher
or mentor. Currently popular are coaching and mentoring programs from
“gurus” who charge as much as $25,000 or more. If you’re willing to pay a
high price for this type of program, ask the seminar leaders the following
questions before you sign up:
1. Who will be teaching me—you (the guru) or someone else?
2. How quickly will you respond to questions?
3. Are you currently active in real estate investing?
4. How many students are in the program? Will you give me their
names and contact information?
The Internet is a great place to find reviews from people who’ve partici-
pated in coaching programs, but keep in mind that most of the opinions you
get from people about anything on the Internet are negative. It’s human na-
ture for people who are dissatisfied to voice their opinions, particularly those
who don’t succeed and want to find someone else to blame for their failures.
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Key Points to Remember
The most important concepts addressed in this chapter are:
• There is no magic bullet or secret to overnight real estate success.
• You must have patience to accumulate wealth.
• Take the time to plot an action plan—and stick to it.
• Get an education before attempting your first deal.
• Learning isn’t enough; you must take action to achieve results.
8 DEFENSIVE REAL ESTATE INVESTING
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CHAPTER
9
You Can Profit in Any
Market, but You Must
Know Your Market
“Give me six hours to chop down a tree and I’ll spend the first
four sharpening the axe.”
—Abraham Lincoln
The most common myth in real estate: You can only make profits
when the real estate market is rising. While it’s true that more people
make money in rising markets than falling markets, the reason is often
luck, not good market timing. Armed with the right knowledge, you
can profit in any real estate market.
First, however, you need to apply the second principle—know
your market—so you can plan your investing strategy to fit that mar-
ket. The defensive investor cannot operate in the dark with improper
assumptions about where the market has been and is going. Different
strategies apply to different market conditions, so it’s critical to first as-
sess the investor’s target market thoroughly.
2
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What Determines the Market?
Most people think of the real estate market as something that’s
measured like the stock market—bearish or bullish. In real estate, the
common expressions for a bull market are “up,” “strong,” “good,” “hot,”
and “seller’s.” A bearish market is described as “soft,” “bad,” “down,” or
“buyer’s.” On a daily basis, you’ll hear the media use these expressions
to describe the real estate market based on facts and figures, most of
which are confusing to the average investor. Let’s discuss each of the
categories for the numbers you may be hearing and see how they affect
the market and, more importantly, your investing strategies.
Market Categories
New home sales. Sales of new-construction homes is an indicator
used by many market economists to measure the strength or weakness
of the housing market. This data comes from homebuilders in the form
of scheduled permits for new home builds and orders for new homes
from consumers. This data is somewhat relevant to your investing plan
because it can show how strong the demand is for new homes. How-
ever, keep in mind that in some places—such as inner cities where
there is no available land—developers aren’t building new homes in
mass quantities. Likewise, in suburban areas where land is plentiful,
there is endless room and an oversupply results.
Note that most of the homebuilders in the United States are large
companies that operate in many different markets. These companies
work on large volumes and may continue building houses in markets
where they are breaking even or possibly losing money, simply because
they’ve committed to building permits and plans. Therefore, while large
builders are still making new homes in a particular market, they’re often
looking at long-range plans, not short-term financial decisions. This can
create a false sense of market strength, not to mention an oversupply
problem that can affect the rest of the local housing market.
A good way to tell if a builder in your market is doing well is to look
at its supply of housing. A typical supply for builders is about six
months of homes, that is, if they stopped building, they’d run out of ex-
isting inventory in six months. Having more than six months on hand
is a sign of oversupply. The reverse is also true. Plus, if builders are sell-
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2 / You Can Profit in Any Market, but You Must Know Your Market 11
ing lots without homes on them, this generally means they own too
much land, another sign of a soft market for new homes in that area.
Be sure to compare apples to apples. When you analyze home-
building and sales data, it’s important to compare single-family homes
with single-family homes. Condominiums and multifamily homes have
different buyers, so it’s possible to have a strong demand for one and
not the other. This is why data for single-family homes, condominiums,
and multifamily homes is often broken down in sources that report on
real estate.
Our Advice: Look for Investment
Projects Near New Developments
One side effect of building new housing is having a place for new
homeowners to shop. Massive new home developments are often built in
places where there is no shopping, so inevitably a strong retail market will
follow. We suggest that you look for opportunities to invest in projects that
“feed” off new residential housing developments.
Home resales. The resale of existing homes is another indicator of
your local real estate market, particularly in areas where there isn’t a
large supply of new homes. This data comes from the REALTORS® as-
sociations such as the National Association of REALTORS® (NAR).
Note that the price of home resales is more important than simply the
number of homes sold. Also, home resales may be stated as, “sales of
homes down 15 percent.” This simply means the number of homes
sold has decreased, not the price. A decrease or increase of the num-
ber of homes sold is only part of the equation. Data for home resales
can be found at www.realtor.com.
Mortgage applications. Applications for new mortgage loans
show data that is ancillary to the sale of new and existing homes. Of
course, some of this is refinancing, which is driven by the rising effi-
chapter02_FINAL.qxp 3/15/07 3:42 PM Page 11
ciency and falling cost of loan processing and in large part driven by
low interest rates. Statistical data for mortgage loan applications can
be found at the National Association of Mortgage Brokers’ Web site at
www.namb.org.
Rental vacancy rates. Rental vacancies are relevant to the values
for multifamily housing, and they can be a good sign of what’s hap-
pening in the single-family homebuying arena. When interest rates are
low, homebuying goes up on the low-end of the price scale, simply be-
cause it’s cheaper to make mortgage payments than rent payments.
This trend leads to higher vacancy rates in an area and, thus, lower
rents. Why? Because in this market, managers and owners lower their
rents to make properties more attractive to the few renters that are
available. Likewise, when interest rates and home prices rise, renting
becomes a cheaper option. This causes a drop in the demand for sin-
gle-family housing and an increase in the demand for rental units and
homes. Daily interest rate data can be found at www.bankrate.com.
Cost of materials. The increase in the cost of certain building ma-
terials can affect housing prices. For example, a rise in the cost of tim-
ber can affect the cost of housing nationwide.
It’s worth noting that often these statistics are based on nationwide
facts and figures. The nationwide statistics aren’t as important to you if
you’re only buying in your local market. (In most cases, this is your
own backyard or a particular “emerging” market.) The stock market
uses indexes to determine the market as a whole, but is this really im-
portant if you only own two stocks? Likewise, does it matter how many
homes sold nationwide when you only buy homes in Cleveland? In
short, you need to focus primarily on local trends rather than national
trends. (The two exceptions to this rule are interest rates and income
taxes, discussed next.)
Interest rates. Nationwide and even global factors such as the Fed-
eral Reserve rate, worldwide markets, and competing investments
such as stocks and bonds control interest rates on mortgage loans.
When interest rates fall, housing becomes cheaper across the nation
because homeowners’ monthly payments are lower. However, the flip
side of the equation is that when interest rates rise (particularly for bor-
12 DEFENSIVE REAL ESTATE INVESTING
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rowers who are getting adjustable-rate loans), the mortgage default rate
will increase, causing a boost in the number of properties available for
sale as foreclosures. Foreclosures are generally sold cheaper than other
houses, which can drive down prices. If lenders are dealing with too
many defaulted loans, they may tighten their practices, making it
harder for people to borrow money, particularly those with poor credit
and low income as well as those who want very large mortgages
(called “jumbo” loans in the business).
Income taxes. Federal income tax rates, particularly on investment
properties, can have sweeping changes on the real estate market na-
tionwide. A prime example was the Tax Reform Act of 1987, which
changed depreciation rules on investment properties and was a major
catalyst to the downfall of real estate in many parts of the country. A
similar change to the tax laws in the future (e.g., a change in whether
property owners can deduct interest payments) can significantly affect
the profitability of real estate for investors. A drastic change could drive
investors away from real estate, causing a drop in the number of buy-
ers, thus a drop in demand, and a resulting drop in prices.
Analyzing Your Market
Use the MAD Method
There are many complicated ways to analyze the market conditions
in your local area, enough to confuse and boggle the novice investor’s
mind. However, you can keep things simple by using our “MAD”
method. This means paying attention to three important factors and
noting whether they’re going up or down:
• M—Median housing prices
• A—Active listings on the market
• D—Days on the market
By paying attention to these three simple factors, you’ll get a good
snapshot of the state of your local market.
2 / You Can Profit in Any Market, but You Must Know Your Market 13
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Median housing prices. The median home price is the exact mid-
dle of the scale, meaning that half the houses sold for less and half sold
for more. Compare this with the mean or average, which takes the total
number of dollar sales and divides it by the number of homes sold.
14 DEFENSIVE REAL ESTATE INVESTING
What Does Median Price Mean?
Let’s say you had seven properties in a neighborhood and they sold for
the following amounts:
• $87,000
• $110,000
• $112,000
• $115,000
• $118, 000
• $120,000
• $122,000
The median price of these properties is $115,000. The mean or average
price is $112,000, which is logically closer to splitting the difference be-
tween the high and low sales.
Generally, the median price is considered a more reliable indicator of the
state of the market than the mean price. Why? Because if more homes on the
extreme high end or low end of the spectrum sell (as in this example), it can
throw off the whole equation and provide a misleading figure. Therefore,
using the median price is a better yardstick to measure your local market.
If median house prices in your area are rising, this can be a good in-
dicator that your market is on the way up. If prices are rising, you can
ride the appreciation of the properties. In this kind of market, you
won’t have to buy houses as cheaply, depending on your exit strategy
(discussed in Chapter 7). However, if they have been rising for several
years and the rise in price is slowing, it can be a sign that your market
is flattening or getting ready for a fall. That requires you to be more de-
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fensive in your buying—that is, you would buy properties at a lower
price and assume no market appreciation (or possibly anticipate falling
prices in the short term). Also, keep in mind that many areas are sea-
sonal, so housing prices may be higher in the spring and summer than
in winter (or vice versa in ski resort areas, for example).
2 / You Can Profit in Any Market, but You Must Know Your Market 15
Our Advice: Use Housing Tracker
to Find Median Prices
Web sites such as Housing Tracker (www.housingtracker.net) can help
you keep abreast of the latest median prices of homes in your market. You
can also use this Web site to compare past prices and other markets.
It’s important to keep in mind that even if a real estate market is
reaching a peak in prices within a particular area, this doesn’t neces-
sarily mean it will collapse. The fact that real estate values in a specific
city have climbed at twice the rate of inflation last year and only half
the rate of inflation this year doesn’t mean the bottom is falling out be-
cause markets inevitably rise and fall in price.
A temporary excess of demand over supply causes a rise in prices,
but supply almost always catches up. When it does, prices level off;
sometimes they drop for a period and then rise again, with the next
peak being higher than the last peak due to inflation. However, just be-
cause a boom in housing prices exists, a bust doesn’t necessarily fol-
low. A likely scenario may be a “cooling off” where prices remain flat,
appreciating just above average inflation.
Keep in mind that just because your city’s average real estate values
or home sales may have declined, it doesn’t mean this was true for the
entire city. Unfortunately, people see headlines like “Median Real Estate
Prices Falling” and they panic. You need to look specifically in the
price range and location of houses you’re buying. For example, the
mass overbuilding of new $750,000 homes in your market may not af-
fect the older $200,000 homes that you’re buying. On the other hand,
chapter02_FINAL.qxp 3/15/07 3:42 PM Page 15
it’s certainly possible that a particular development or sector within a
market (such as high-priced condominiums) could fall in a market in
which median prices are otherwise stable or rising. In short, know
your market on multiple levels—national, local, and microlocal.
Housing prices alone may not be an accurate indicator of the local
market. Sellers often give buyers concessions at closing rather than
drop the price, which can skew the math. For example, a concession
may include paying some of the buyer’s loan fees or allowing a credit
16 DEFENSIVE REAL ESTATE INVESTING
What Causes a Real Estate Bust?
The “bubble” theorists claim that if housing prices rise too rapidly, a
bust or sudden drop is likely to follow. However, the bubble theory is full of
hot air, according to a report published by the Federal Deposit Insurance
Corporation (FDIC) in 2005. A 25-year study of nationwide housing prices
shows that only 17 percent of local markets “busted” (experienced a 15 per-
cent decline in five years) after a boom period (experienced a 30 percent in-
crease in three years). The vast majority of “busted” markets could be
explained by local economic conditions that resulted in mass unemploy-
ment or a mass population decrease in that city. In other words, once hys-
teria subsides, most real estate markets tend to flatten or fizzle after a boom,
rather than crash (absent other contributing factors such as a recession in
the local economy).
To invest defensively, keep an eye out for local or national events or is-
sues that could potentially kill a market, such as:
• rising interest rates,
• drastic tax or zoning law changes,
• a major local employer leaving town or downsizing,
• a local industry (such as oil or high tech) that is substantially af-
fected by world events, and
• environmental issues such as lack of water supply, pollution, or
public health issues (e.g., “cancer clusters”).
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for items that are in need of repair. In the case of new homes, housing
prices don’t always reflect builder concessions, such as favorable fi-
nancing or upgrades.
In addition, housing prices don’t reflect the amount of money sell-
ers spend to renovate the property before the sale. In a seller’s market,
homes will sell quickly regardless of their condition. In a buyer’s mar-
ket, sellers may spend as much as 10 percent of the price of the home
doing renovations before placing it on the market. Thus, for example,
if the price of a house rose 5 percent in the last year, it’s really a net
loss of 5 percent for that area. You need to look not only at numbers,
but also at the houses for sale. Go to open houses and talk with real es-
tate brokers in a particular area to get a reality check of what’s really
going on.
Active listings on the market. This is the second factor to track in
our MAD method of determining the state of your local market. The
changes in the number of properties available for sale provide a good
sign of the state of the local market. The basic economics of supply and
demand determine whether the local housing market is rising or
falling. When demand exceeds supply, prices rise—and the real estate
market is said to be rising. When supply exceeds demand, prices fall—
and the real estate market is said to be falling.
Most residential properties for sale are listed on the Multiple Listing
Service (MLS). The number of active listings on the MLS today com-
pared to six or 12 months ago (adjusting for seasonal changes) can tell
you if the market in your area is rising or falling. A good real estate bro-
ker can provide you with the numbers for listings by searching the
local MLS.
In addition, you can check your local building department for the
number of permits for new buildings to see if more development is
coming. Being active in local politics can give you the inside track on
upcoming projects that builders are involved in to get housing devel-
opments approved. Also, it never hurts to make friends with people
who are in ancillary businesses such as the subcontractors who supply
goods and services to home builders. They often can provide prospec-
tive and “inside” information that the statistics won’t show.
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Days on the market. This is the third factor to track in the MAD
method. It will help you determine the state of your local market, after
median housing prices and active listings on the market. This factor is
the average number of days it takes to sell a house in the relevant price
range. For example, a market in which a house sells for $250,000 in
three weeks is quite different from a market in which the same house
sells in six months (the latter is known as a soft market). In a soft mar-
ket, sellers can drop prices, give concessions, or wait longer for their
houses to sell. The vast majority of homes are owner-occupied, so
18 DEFENSIVE REAL ESTATE INVESTING
Economic Factors
Behind the Math
Instead of focusing on price and inventory trends, take time to study
the local economic factors that cause trends. Weather, cost of living, taxes,
and overall “livability” can all play a factor in driving population statistics,
but jobs are generally the main factor. If the job market is good, it will drive
people to move into a particular area. If it’s poor, people will move away.
If housing supply is limited, find out why. Is it because of unanticipated
demand or because of geographic limitations, such as lack of land or zoning
restrictions? In some parts of the country, water supply, highway infrastruc-
ture, or political factors limit growth.
Keep in mind also that nationwide migration of the existing population
will play a big factor as baby boomers retire.
Boomers may move to retirement-friendly areas and many will pur-
chase second homes and condominiums in resort communities. This in-
creases demand without increasing population. In addition, immigration
from Mexico and other countries may affect housing prices, especially in
border states where people come to work and live. Finally, “wildcard” fac-
tors such as terrorism, hurricanes, earthquakes, and weather may drive peo-
ple in and out of certain parts of the country.
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there’s generally not a negative impact to sellers who can’t sell their
houses because they can continue to live in them unless sellers are in
dire need to move because of a foreclosure, job transfer, or other firm
deadline they’re likely to hold out for more time to get their prices. If
sellers have enough equity in their homes, they can refinance their
loans and take their homes off the market.
You can find the average days on market for a particular-priced
home by asking a real estate broker to search through the MLS. Make
sure you’re comparing apples to apples—that is, the average days on
the market for houses in the same area and in the same price range. If
the broker has access to the right information on the MLS, you can
compare renovated versus nonrenovated homes to get a more detailed
analysis. The more information you have, the more accurate your as-
sumptions about the market will be and the more solid your resulting
investing plan will be.
2 / You Can Profit in Any Market, but You Must Know Your Market 19
Our Advice: Watch for
This Listing Trick
Because an old listing can spell trouble for a seller who doesn’t want to
appear too motivated, real estate brokers often cancel listings, wait a few
weeks, and then relist a property that hasn’t sold. Make sure you take this
possibility into account when you’re analyzing days on the market data.
Work Your “Farm” Area
Real estate brokers generally have particular neighborhoods in
which they work, rather than an entire city. Brokers refer to this as a
“farm” area. You’d be wise to adapt a similar approach to your business.
The goal is to become an expert on one specific farm area, roughly
3,000 to 5,000 homes. In some locations, this will be easy because the
homes are divided into subdivisions or developments.
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You’d be wise to learn the neighborhood inside and out and be-
come familiar with every detail about it.
Values. Become familiar with the high and low range of the neigh-
borhood. If all the homes are similar and were built in the same time
period, this task should be quite easy. You should be able to rattle off
value estimates almost instantly upon hearing a few pertinent details
about a particular property in your farm area, such as the style and size
of the home. In older neighborhoods (usually 50 years or older), a par-
ticular geographical area may have a wide variety of homes, making it
difficult to determine values. Novice investors should avoid these areas
until they have more experience.
Schools. Schools, particularly elementary and middle schools, are
an important factor for people with families who are considering mov-
ing to an area. Get to know the local schools and determine which are
the most desirable.
Zoning and homeowners’ association restrictions. Learn the re-
strictions on building and remodeling as well any homeowners’ asso-
ciation (HOA) rules or covenants for the neighborhood that may affect
its salability. For example, there may be a covenant restricting how
many unrelated people can live in a home within that neighborhood.
Local shopping and developments. A new road, highway, or com-
mercial development nearby can affect property values in a positive or
negative way. For example, a new shopping center or highway nearby
may improve values or be so close as to create undesirable traffic and
noise. Get to know what’s in the works by following local news and at-
tending local city council and HOA meetings or by visiting the local
zoning and planning department.
Failed communities. Many new developments that rely on a golf
course, ski resort, shopping mall, or other attractions for value can
tank quickly if the attraction closes, is becoming run down, or isn’t as
great as it was predicted to be. Be especially careful of the risk if the at-
traction hasn’t yet been completed, such as a new country club.
20 DEFENSIVE REAL ESTATE INVESTING
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Different Markets, Different Strategies
Once you learn how to analyze where your market is and the di-
rection it’s probably going, then you can plan your investment attack.
Certain strategies work well in a rising market, others work better
in a flat or falling market. Many strategies will work in any market, as
long as you know your market and adjust your investing accordingly.
Here are some of your options.
Flipping works in every market. Frustrated investors often com-
plain that specific real estate techniques such as flipping (buying low
and selling quickly for a profit) won’t work in their market. We call this
the “not in my market” myth. The reality is this: Flipping works in any
market, depending on how you do it. For investors who buy dilapidated
properties, rehab them, and sell them quickly, the market appreciation
or decline isn’t relevant to profit because the holding period is typically
only a few months. If your plan is to flip houses, you only need to know
what the resale value is for that type of house in that neighborhood and
approximately how long it will take to sell (days on market).
2 / You Can Profit in Any Market, but You Must Know Your Market 21
Our Advice:
Always Use Common Sense
While statistics, calculations, and economic factors are relevant, so is
common sense. Look around. Observe what’s really happening in your farm
area right now. Talk to your local real estate brokers, investors, and lenders
for a better picture of the local market. Don’t focus solely on broad nation-
wide, statewide, or even citywide statistics. Be concerned with the median
prices in the particular neighborhoods in which you buy houses; the aver-
age time on the market; the changes in sales prices, inventory, sales con-
cessions, and days on market from last year to this year.
You need more than a snapshot of your farm area—you need thor-
ough, up-to-date insight on the housing situation in your farm area.
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If you’re in a hot market, you can sell properties faster or, if you
keep them, you can ride inflation—that is, realize gains from inflation
over the years. Flipping in a hot market means you won’t find as many
incredible bargain properties, but you’ll be able to get top dollar on any
resale. If you time it right, the property may appreciate in the few
months you’ve owned it.
22 DEFENSIVE REAL ESTATE INVESTING
Our Advice: Keep in Touch
with Sellers in Denial
Buyers and investors are often more receptive to noticing the signs of a
weak market than sellers may be. Sellers have a tendency to stay in a state
of denial for a while, refusing to believe the market is taking a turn for the
worse. They’ll convince themselves that any slowdown is a temporary fluke
or won’t affect an “irresistible” property like theirs. Such a seller will be re-
luctant to consider a low offer. In this case, it’s best to move on to the next
deal rather than wasting time trying to get a reluctant seller to “see the
light.” Nevertheless, keep this seller in the back of your mind and check back
after a few weeks or months. By that time, the seller may have accepted the
reality of the market and might be more agreeable to discussing your offer.
Market timing. Without a doubt, price inflation is the easiest way
to make money in real estate because you don’t need to struggle to find
a super bargain; you only need to hold on to the property long enough
to ride the market. Markets generally go up and down in price cycles,
about every seven to ten years from bottom to top to bottom again,
with the next top being higher than the last. There are two problems
with using this approach:
1. Your local market may move inconsistently with your retire-
ment plans—your retirement age may end up in the middle of
a bad market trough and you won’t be able to sell or rent your
properties for what you anticipated.
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2. You may be wrong about the top or bottom of the market. Be
sure to apply the market factors we discuss in this chapter to
any market in which you choose to invest.
While there is no crystal ball, educated investors can make some
good investments in places other than their own backyards if they’re
armed with the right information. (You’ll find a list of sources for this
data in Appendix 1.) However, keep in mind that market timing by it-
self isn’t enough. You must learn how to make an investment within a
particular market that makes sense.
The following chapters provide more guidance and formulas to
help you make prudent investment decisions—whether your market is
rising or falling in the short term.
Long-term investing works in any market. If you buy and hold
property for the long term (15 years or more), you’re not likely to lose.
Real estate values go up and down in cycles, but they generally go up
in the long run, with few exceptions. (The same is generally true of the
stock market in the long run, but there’s one problem: You have no
guarantee that a company in which you invest will be in business in 15
years!) Therefore, if you try to time the market in the short term and
make a mistake, you may end up doing just fine if you hold on to your
investments long enough. Historically, median real estate prices out-
perform inflation over the long haul. At the risk of beating a dead
horse: Be a defensive investor. That means have a solid plan as well as
a good backup plan with an exit strategy if the first plan doesn’t work.
(Chapter 7 discusses multiple exit strategies in more detail.)
The Great Debate: Flipping versus Holding
Some investors focus on flipping—that is, turning properties over
quickly, rather than keeping them long term. In some cases, holding
property generates more long-term wealth for you than flipping. There-
fore, you may consider flipping some properties and holding others.
On the other hand, you may consider using the flipping strategy
awhile, and then begin holding properties later. The big question is,
“When should you hold versus when should you flip?”
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The advantages of flipping. The main advantage of flipping is that
you get your cash out immediately rather than later. For many people,
the certainty of getting a paycheck right away is highly appealing. Flip-
ping takes the real estate market per se out of the equation. If you buy
a property correctly, whether the market is rising or falling is almost ir-
relevant, except for how long it will take you to resell the property. (Of
course, if you buy cheap in a soft market, you can afford to hold a prop-
erty longer.)
Flipping is generally good for your cash flow, which is important in
any business. If you purchase houses and acquire too much equity and
not enough cash, you may get into a cash crunch if you don’t have ad-
ditional income. (We’ll discuss the importance of cash flow more in
Chapter 6.)
Don’t forget that you can flip houses as a part-time or full-time busi-
ness. You can do as much or as little as you want and you can also af-
ford to take a break from your flipping business. In short, once you
empty your inventory, you’re not tied to your business; you can take
long vacations or up and move to another city and start over.
The disadvantages of flipping. The main disadvantage of flipping
is that it’s “hands-on” income: Once you stop flipping, you stop mak-
ing money. If you’re young and like to work for a few months and then
take a few months off, the flipping strategy can work for you. However,
at some point, you’ll realize that if you keep spending the profits, you
won’t accumulate wealth.
In addition, if you flip, you lose the benefit of market appreciation.
While market timing is a risky venture, a good market timer can gain
wealth quickly with little effort by buying properties at the right time
in emerging markets (developments, cities, or parts of the country that
are ripe for economic growth and new jobs, thus new home building).
On the other hand, if you buy a property in the wrong place at the
wrong time, particularly for the wrong price, you can end up with a
property you can’t get rid of quickly enough. You could also get in over
your head in a rehab project and have to bail, risking the loss of thou-
sands of dollars.
Finally, if you don’t spend all your income on living expenses, what
will you do with it? A diversified portfolio is a good idea—you could
24 DEFENSIVE REAL ESTATE INVESTING
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put some of this cash in bonds, money markets, or mutual funds—but
you might earn a better return by leaving your profits in real estate
rather than taking them out.
The advantages of holding. Property holders can generate true
wealth over the long term. Historically, property values appreciate at a
rate greater than the rate of inflation in the United States. If you buy in
the right neighborhoods, your annual appreciation may reach double
digits. You can use properties with equity as collateral. You can pro-
vide rental income for your retirement years, and you can pass prop-
erty down to the next generation. Once your rental properties are
owned “free and clear,” you have passive income from rents paid that
gives you an income even when you’re not working.
The disadvantages of holding. The main disadvantage to holding
on to property is that your assets aren’t liquid. Unlike stocks or bonds,
real estate isn’t easily converted to cash. When selling real estate, you
have to locate a buyer and then pay transaction-related costs.
If you must sell when the market is down, you won’t get the best
price. If you have tenants in your property under a lease, you can’t sim-
ply kick them out without notice. You have to wait until the lease ex-
pires, pay the tenant to leave early, or hope to find a buyer who doesn’t
mind having someone living in the property. Moreover, of course, the fu-
ture is always uncertain. While real estate may have appreciated in a par-
ticular area an average of 10 percent over the past 20 years, it doesn’t
mean it will do so in the future.
If you hold properties, you also risk running into negative cash
flow. There may be times when your properties are vacant or need re-
pairs. That’s when you have to dip into your savings to feed the prover-
bial “alligator at your door.”
What’s Right for You?
The important question isn’t whether flipping is better or worse
than holding, but which strategy is right for you. To discover the an-
swer for yourself, ask these questions:
• Do I need additional income now or in the future?
2 / You Can Profit in Any Market, but You Must Know Your Market 25
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• Am I in a high-income tax bracket that would be adversely af-
fected by more income now?
• Does my local real estate market present opportunities to ac-
quire bargains, yet still command high rents that would cover
my expenses if I need to hold on to the properties?
• Do I have other income or savings that I could tap into in case
my rental properties become vacant or need major repairs?
• Do I have the time and patience to deal with tenants and land-
lord issues?
• Is the local real estate market rising or falling at this time?
• Does bringing in income now or later fit into my short-term and
long-term financial goals?
Most investors start out flipping houses, and then gradually work
into managing rental houses or becoming involved in larger, more com-
plex real estate projects. Some people don’t have the temperament to
deal with tenants and the headaches that come with rental properties.
Some look for side income by flipping. Others want to quit their jobs
and make flipping houses their full-time business.
As you can see, many investors were once in your shoes making
these decisions. Be sure to consider all options, including a mixture of
flipping and holding properties. Reevaluate your financial goals on a
regular basis and adjust your real estate strategies to support these
goals. Moreover, of course, make sure your strategy is appropriate for
your local market.
Being defensive may mean adjusting your strategies on a regular
basis, as well as re-evaluating your goals to work within market condi-
tions. Sometimes the market works for you and sometimes it may be in
conflict, but smart investors know how to make any market work to
their advantage.
26 DEFENSIVE REAL ESTATE INVESTING
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Key Points to Remember
The most important concepts addressed in this chapter are:
• Focus on one limited farm area and learn everything you can
about that market.
• If you use the right approach, any type of market can offer great
opportunities.
• Use our MAD approach to determine market conditions.
• Market timing alone isn’t likely to work—you need to apply the
principles of successful investing to any market.
• Consider a mix of flipping and holding properties.
• Whatever strategy you choose, be sure it supports your long-
term investing and financial goals.
2 / You Can Profit in Any Market, but You Must Know Your Market 27
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CHAPTER
29
Learn How to
Valuate a Property
“Country clubs and cemeteries are the biggest waste of prime
real estate.”
—Rodney Dangerfield, from the movie Caddyshack
How do you know if you have found a good deal? You can’t deter-
mine whether you have a good deal unless you know what the prop-
erty is currently worth. In the stock market, the current day’s trading
price will give you an idea and you can compare that to the earnings
report of the company. In real estate, the current valuation isn’t so cut
and dry. The third principle of defensive investing is learning to valu-
ate a property.
Most novice investors are either ignorant or downright delusional
when it comes to property values. A defensive investor does extensive
research, verifies all assumptions, and is extremely conservative when
estimating property values.
The Art and Science of Valuating a Property
To valuate a property, some people look at appraisals, others look
at the tax assessor’s value, and others say that a house is worth what
3
chapter03_FINAL.qxp 3/15/07 3:44 PM Page 29
someone will pay for it. Further confusing the issue, we can look at the
income the property generates or the insurance replacement value. In
some cases, the land is worth more than the house itself and any im-
provements are ignored.
All these factors have importance when you valuate a property so
we’ll discuss how to apply each factor and in which circumstances.
Keep in mind that valuation is more of an art than a science, but by
using a few formulas and practicing them, you can learn to valuate any
property correctly.
30 DEFENSIVE REAL ESTATE INVESTING
Warning! Don’t Ask the Person
Who Has a Stake in the Property
The worst way to find out a home’s value is to ask someone who has an
interest in the deal. For example, asking the listing real estate broker for ad-
vice on what the property is worth is like asking your barber, “How’s my hair-
cut?” In both cases, they’ll tell you what they think you want to hear. A bad
deal burns many novice investors because they trusted someone for advice
and that person was biased by the potential profit of the deal.
Common Methods to Estimate Property Value
Generally speaking, a good appraiser can pinpoint a home’s value
within 1 to 2 percent. As an experienced investor, we recommend you
shoot for the same accuracy rate.
Appraisers typically use the following three ways to estimate a
property’s value:
• Comparable sales approach
• Replacement cost approach
• Income approach
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3 / You Can Learn How to Valuate a Property 31
Comparable sales approach. This is the most common method to
valuate single-family homes and condominiums. The comparable sales
approach (also known as using comps) involves comparing a specific
property to other similar properties in the area that have sold recently.
Ideally, all the properties you consider should be roughly the same
size and style. They should have the same number of bedrooms, bath-
rooms, and other rooms, and it’s important that they’re in the same
neighborhood. Comparable sales are considered a very good indicator
of the market because the market is always changing. Comps reflect
these changes (More details about using comps are explained later in
this chapter.).
Replacement cost approach. Using this method of valuating a
property, you add the value of the land, the age of the building, and the
cost to reconstruct the building. It’s important to go by today’s costs,
not original construction costs, because it would most likely be more
expensive to construct the building at current prices. The goal is to fig-
ure out what it would cost today to replace the building if a fire, natu-
ral disaster, or other unexpected event destroyed it.
The cost replacement approach is not as accurate as comps be-
cause of the variations of land values. For example, a “shack” on the
beach that can be replaced for a few hundred thousand does not take
into account the value of the land.
Income approach. The income approach is particularly useful
when you’re valuating commercial property and multifamily rental
property with more than four units. The valuation of income proper-
ties is based on its capitalization or cap rate, which is the value of prop-
erty compared to the income it brings in. Cap rates are a measure often
used on income properties to make comparisons to other income
properties. When using this approach, you base your figures on the
building’s actual current revenue.
It’s important not to be misled by a seller’s representation that he’s
renting the property for less than market because he doesn’t want ten-
ant turnover. In addition, don’t go by “full occupancy” estimates ei-
ther—vacancies are a real factor determined by the market and the
condition of the property. While using the income approach does
make sense for income properties, it’s generally not as accurate as the
chapter03_FINAL.qxp 3/15/07 3:44 PM Page 31
comparable sales approach for single-family units because owners, not
tenants, occupy most single-family properties. Thus, the comparable
sale for an owner-occupant is more accurate than a sale to an investor
who will rent the property. For two-unit, three-unit, and four-unit prop-
erties, it’s best to look at both comparables sales and income. For lend-
ing purposes, the comp standard is generally used for four units or less.
Comparable Sales Method
The comparable sales method is the most commonly used—and the
most accurate method—to determine the value of single-family homes,
condominiums, and small rental buildings (two to four units). There-
fore, the rest of this chapter describes how you can implement this for-
mula in your investing activities. Much of the legwork noted here is
what a professional appraiser would do. (We’ve provided a sample ap-
praisal report in Appendix 2.)
When doing comparables sales, make sure you compare actual
sales, not listings. Remember, a listing price is an asking price. Novice
investors often look at listing prices to determine what a house is
worth, but this isn’t as accurate as looking at properties that have sold
within the last six to 12 months.
Listing prices become relevant, however, if they’re substantially dif-
ferent from the sold prices because it may indicate a trend (for exam-
ple, a rapidly appreciating or declining market). Furthermore, when
you look at sold prices, compare them to the original asking prices.
This will give you an idea of where the marketing is heading.
Real estate brokers are notorious for choosing the highest priced
listings and sales, then using them as your comparables. Not all bro-
kers who do this are dishonest, but brokers are trained to be opti-
mistic. Appraisers are more conservative and realistic about the
amount for which the home will sell. Still, it can be helpful to take a
peek at newer listings as a market barometer; if the new listings are
substantially lower than existing home sales, for example, this may in-
dicate a falling market.
In addition, you can have high-tech help when it comes to deter-
mining a home’s value. Start by researching information about sold prop-
erties on your local government Web sites for your target area. Many tax
assessors’ offices and county courthouses have searchable online data-
32 DEFENSIVE REAL ESTATE INVESTING
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bases where you can view the prices for properties within a specific
area. They usually list some information about the properties, including
square footage. Subscriber Web sites such as www.dataquick.com and
www.electronicappraiser.com can give you detailed information, par-
ticularly in areas where online data is scarce.
Free Web sites such as www.zillow.com that offer property data
are available, but the information is less detailed than for the paid Web
sites. For example, the seller’s name may be missing, which could be
relevant if the seller was a bank (as in the case of a foreclosure sale). If
that’s the case, it can’t be considered a comparable sale because this
property was sold in distress.
Be careful using Web sites that offer a computer-generated valuation.
These are automated valuation models (AVMs), which are statistical
models of many comparable sales of reportedly similar comparables.
Many times they’re not similar, but they’re generally accurate within 10
percent. Remember, we advised you to become an expert in your farm
area. If you’re becoming an expert in your area, 10 percent isn’t good
enough. AVMs are useful for preliminary research and for getting a
rough idea of value, but they aren’t nearly as accurate as using your own
eyes, driving by properties, and applying experience and common
sense to create your own comps.
The most useful computer database for getting information about
comps is the local Multiple Listing Service. This database shows the
number of days on market and includes notes that indicate whether
the property was updated, whether the seller offered concessions, and
so on. This additional data is generally not available through other
sources and most MLS systems aren’t accessible to the general public,
so having a real estate broker help you will be crucial.
Be forewarned: Comps provided by a broker who is listing the
property may not be the best indicator of value. Agents carefully select
the comps, providing the ones that best suit their own purposes.
While many factors come into play when you’re evaluating a resi-
dential property’s value by comps, the three key factors are location,
size of the home, and the number of bedrooms and bathrooms. Obvi-
ously, you’ll need to look at many other aspects before you can pin-
point the exact value of a property, but these are the “big three.” You
should be able to look at comparable sales involving properties with
3 / You Can Learn How to Valuate a Property 33
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the same three factors and get a good idea of the value of properties
you may invest in.
Location, location. This factor is extremely important when you’re
comparing sold properties. A professional appraiser typically looks at
houses in the same subdivision and so should you. In the case of a sub-
division where the houses are all similar and built in the same time pe-
riod, you only need to compare similar houses with similar styles to get
an accurate valuation. If there’s a wide mix of properties in the subdi-
vision, you may need to go outside of it to get comparable sales, but be
careful with “dividing lines.” Geographic dividing lines such as differ-
ent sides of the river, the park, or a main highway may put the prop-
erty in another school district and may not give you accurate comps.
34 DEFENSIVE REAL ESTATE INVESTING
Look Within a One-Mile Radius
Appraisers and loan underwriters generally look at comparables sales
within one mile of the subject property. However, in populated cities, one
mile may be too far. In rural areas, one mile may be too close.
Within a subdivision, you’ll find variations in lots that affect privacy,
road noise, or sunlight. These lot variations won’t affect the valuation unless
an extreme difference exists. For example, if a row of houses backs up to a
major road, this may drop the value of the house as much as 10 percent. If a
row of houses backs up to power lines or a garbage dump, the discount may
be even more substantial. On the other hand, a great view may affect the lot
substantially—in a positive way, of course. A location on a golf course, lake,
ocean, or simply having a spectacular view may push values up by 25 per-
cent. Take note of the assessed land value versus the improvements, then
note what the average lot premium or discount amounts to. You can check
the lot premium in new home developments by asking the builder. In older
areas, the home sales records of similar houses in the neighborhood will be
reflected in the prices of houses sold that are the same model, but have dif-
ferent lots. Amateur investors often make the mistake of comparing houses
that are across the street from each other, overlooking the fact that the lots
have significant variations.
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3 / You Can Learn How to Valuate a Property 35
What Is Assessed Value?
County tax assessors value property for tax purposes. This is called the as-
sessed value. This figure usually has some bearing on market value, but don’t
rely on its real market value. Instead, look at the assessed value as it compares
to the selling prices on the comparable properties as a reference point.
In some parts of the country, assessed value is a formula based on real
value so the amount is more reliable. In either event, only use the assessed
value as a benchmark. For example, if the assessed value of homes in your
farm area is generally 90 percent of market value and your subject property
is listed for double the assessed value, something may be wrong!
Square footage. When determining a home’s value be sure to eval-
uate the home’s square footage. Note that appraisers typically look at
homes that are within 20 percent more or less in square footage as
comparables. Doing the same shouldn’t be a problem for you and your
farm area. Generally (especially within a subdivision), most homes fall
within a fairly limited size range. Granted, nearly every neighborhood
has one or two homeowners who try to outdo their neighbors by
building a behemoth that towers over all the other homes—and a few
tiny homes may dot the neighborhood—but the majority will fall in the
middle of the spectrum, often at several size increments. Therefore,
you should be able to develop a good gauge for the selling price of
homes in those particular sizes.
Not all square footage
is created equal
Most people think that if a house has 1,000 square feet and is worth
$100,000, then the 1,100-square-foot house next door would be worth
$110,000. Wrong; the extra 10 percent in square footage equals only a few
chapter03_FINAL.qxp 3/15/07 3:44 PM Page 35
Below-ground space. While finished basements can add value, the
amount of value is less than it is for above-ground living areas. In addi-
tion, this greatly varies depending on different regions of the country.
In humid areas, below-ground living space isn’t as valuable to home-
owners as in dryer areas of the country. Thus, the American National
Standards Institute (ANSI) uses above-ground construction as the na-
tional standard for comparing values.
Sometimes homeowners refinish basements (or add other space)
without obtaining proper building permits from the county. Be sure to
check public records to see if the finished square footage represented
by the seller matches the county’s file.
36 DEFENSIVE REAL ESTATE INVESTING
Bill’s Advice: Know
the Local Laws
A client rented an illegal basement apartment to a woman who had
stopped paying rent. We filed for an eviction in court for nonpayment of
rent, but the judge dismissed the case. He said my client wasn’t legally per-
mitted to collect rent in the first place! In some parts of the country, added
or renovated space requires a certificate of occupancy from the local build-
ing department before you can close on the sale of the home. In other
areas, this sort of thing is overlooked. In short, get to know what’s custom-
ary in your area.
percentage points in value. If these two houses offer the same location,
style, and number of bedrooms and baths, the 10 percent additional square
footage won’t change the valuation much because there is a fixed cost on a
house based on the value of the land, cost of construction, sewer, subdivi-
sion plans, and more. An extra few hundred feet of space involves very little
cost—only wood, nails, carpet, and possibly some minor electrical and
plumbing costs.
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Bedrooms and baths. To determine a home’s value using comps,
also look at the quality and number of bedrooms and bathrooms. After
studying the farm area awhile, you’ll become familiar with the price
levels for the most common bedroom and bathroom combinations:
• two bedrooms and one bathroom (“two-one”),
• two bedrooms and two bathrooms (“two-two”),
• three bedrooms and one bathroom (“three-one”), and
• three bedrooms and two bathrooms (“three-two”).
When comparing bathrooms make sure you understand the differ-
ent types of bathrooms and compare them correctly. A full bathroom
includes a shower, bath, toilet, and sink. A three-quarter bath has a toi-
let and a sink plus a shower but no tub. A half bath has a toilet and sink
but no tub or shower. A three-quarter and full bath have roughly the
same value, particularly if another bathroom in the house has a tub. A
half bath has less value unless there are enough other bathrooms in the
house. In addition, a five-piece bath (separate shower and tub) gener-
ally doesn’t add more value than a regular full bathroom with a combi-
nation shower and tub.
Other factors that affect the value of the home. There are other
factors to consider that will affect the value of a home, but generally
you’d give these less weight than the location, size, and number of bed-
rooms and bathrooms.
Some houses have one-car or two-car garages, some have carports,
and others have neither. The garage factors in some value, depending
on the rest of the neighborhood. For example, if the neighborhood
comps all have two-car garages, this can affect value as much as 10 per-
cent on the subject property if it only has a one-car garage or no garage.
However, if the houses are all small and there’s a mix of garage options,
the garage won’t be as big an issue. Likewise, a four-car garage in a
three-car garage neighborhood probably won’t count for much either.
One exception is with condominium developments. Parking spots or
garages are generally sold with condominiums and can have substantial
value, particularly in large cities where parking is limited to the street.
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In most cases, a swimming pool won’t affect the value of a prop-
erty. In fact, in most regions of the country, a pool may actually dimin-
ish the value because it’s considered a safety issue and may take up
precious backyard space. In hot regions like Arizona or southern
Florida, though, a small dipping pool is a nice feature. However, it still
won’t affect the value to a large degree.
A House Is Its Own Best “Comp”
An appraisal is a certification by a licensed professional that a house
is worth a certain amount based on comparable sales. It is, however, an
opinion of value based on one person’s analysis and experience. The
actual “market value” is the amount a buyer is willing to pay and for
which a seller is willing to sell under normal circumstances.
Investors often misunderstand the phrase market value.Here’s a
good way to understand this: Imagine that a home has been on the mar-
ket for several months. Typically, homes in this particular market sell
within a few weeks; if the seller doesn’t receive a single offer, then you
have to assume the property is overpriced. Several factors may con-
tribute to the problem, including the condition, location, and layout of
the house. However, all of these factor into the asking price. In short, if
the house is priced right for its location, condition, and features, it will
sell within the same time frame as other houses in the neighborhood.
Many times the real estate broker takes a listing at a higher price than
“market” with full knowledge that the home is listed too high. Some-
times brokers do this to win the listing over competing brokers by telling
sellers what they want to hear. Like the barber who says, “It’s a great hair-
cut,” they’ll say, “I’ll get you a higher price.” Most often, having an asking
price that is higher than market is the seller’s fault (rather than the bro-
ker’s) because the seller has unrealistic expectations about the prop-
erty’s value. However, you can’t always blame sellers. They get their
information from other brokers, the sales prices of other homes in the
neighborhood, information and misinformation from neighbors, and the
most recent appraisal. Therefore, your job as an investor is to sift through
the information and determine the real value of the property.
In the real estate business, the subject property is often its own
best “comp.” This means that the final sales price agreed upon by the
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buyer and seller is generally the property’s true market value. It does-
n’t matter what the real estate broker, appraiser, neighbor, or mortgage
broker have said. The actual selling price will often determine the
property’s value.
A common trap for novice investors is the so-called “bargain” prop-
erty. For example, a house is appraised at $200,000 and available for
only $150,000. Certainly, there are cases in which a property is avail-
able for a real discount of 25 percent, particularly if the property is in
disrepair or the seller is extremely motivated as in the case of a divorce
or foreclosure.
Absent motivating circumstances, however, if the property in ques-
tion sells for $150,000, the comp has been established for this house.
The value of the property is what it sold for, regardless of what the ap-
praisal shows. Many houses are listed on the MLS as “priced below ap-
praisal” and, in fact, sit for months without selling. If a property was
listed on the MLS at $150,000 for six months when the average num-
ber of days on market in that price range is 96 days, does the $200,000
appraisal mean anything? Obviously not!
A word to the wise: When you’re doing comparable sales, look at
the sales history of the property itself. Knowing if it was previously
listed, relisted, or sold helps a great deal in determining a property’s
true value. Don’t buy a house you think is worth $200,000 just because
it’s appraised for $200,000. Do your due diligence.
Estimate Repairs Accurately and Carefully
One area in which both new and experienced investors often run
into trouble is estimating the costs of repairs and how this affects the
current and potential value of a property. Looks can be deceiving.
What appears to be a minor problem can often end up costing a lot to
fix. Even if you don’t plan on doing any of the work, you still need to
know how the current condition of the property affects its market
value. Obviously, two identical houses side by side are not worth the
same amount if one needs substantial repairs.
Be sure to follow these rules:
• Do the math correctly.
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• Don’t do the work yourself.
• Estimate high on repairs.
Do the math correctly. If a house is listed for $180,000 and needs
$20,000 in repairs, it should be worth $200,000 when fixed up, cor-
rect? Theoretically the answer is “yes,” but then why bother with the
headache and risk of a rehab? You should look at the least to double
your money on the rehab, thus you should pay $160,000 (or less) for
the house. The bottom line is that you need to know the current “as is”
value as well as the “after-repaired value.” The as-is value of a house
should be a lot less than its value after it’s repaired, less repair costs,
because a house that needs $20,000 in work lacks market appeal and
attracts fewer buyers. In other words, you want to discount the prop-
erty more than the dollar value of repairs needed.
40 DEFENSIVE REAL ESTATE INVESTING
Our Advice: Get Appraisals for
“Before” and “After” Values
When you purchase a property using institutional financing, the lender
requires a professional appraisal. Ask the appraiser for two values: an “as is”
value and an estimated value after certain repairs are completed. Be pre-
pared to give the appraiser a written list of repairs you intend to make on
the property.
It’s important to do research that will give you a basic idea of the
cost of common home repair projects. At the very least, spend time
browsing home repair stores to become familiar with the costs of
building supplies. Call a few contractors or “handymen” to estimate
labors costs.
Don’t do the work yourself. Many novice investors evaluate the
cost of the labor by assuming they’ll do some or all of it themselves.
This is generally a mistake for several reasons. First, your time is more
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valuable than a contractor’s time, so it’s best to hire out the help. If you
get a particular “Zen” from plumbing, that’s great, but replacing toilets
isn’t the best use of your time.
Second, most investors are unskilled or lack the necessary time to
devote to rehab projects; this causes frustration with an extended rehab
project. Finally, what if you’re injured or have a family emergency and
can’t complete what you started? Always assume you’ll hire people in
the trades to help and figure this cost into your purchase price.
Estimate high on repairs. Novice investors often delude them-
selves about the necessary rehab costs. The following story illustrates
how investors should approach estimating a rehab project.
Legend has it that Tiger Woods was playing golf in a tournament
with the late Payne Stewart, another great golfer. They were tied at
even par. On one particular hole, they both hit their drives down the
fairway and their balls landed about 100 yards from the green. Payne’s
ball was just a few inches behind Tiger’s, so he would take the next
shot. Payne asked his caddy how far he was from the hole. “One hun-
dred yards,” his caddy replied, handing him a club. Payne hit the ball,
which landed ten feet from the hole. Tiger turned to his caddy and
asked, “How far?” His caddy replied, “Ninety-seven yards,” and then
handed Tiger a club. Tiger hit his ball six inches from the hole. Payne
turned to his caddy and angrily demanded, “Why did you give me a
round number and Tiger’s caddy gave him exact yardage?” Payne’s
caddy replied, “Because you’re not as good as Tiger Woods.”
The lesson here is that most investors are not good enough at esti-
mating repairs to guess exact numbers. Instead, it’s best to think in in-
crements of $5,000 or $10,000, always rounding high. For example, an
investor who’s talented at estimating repair costs may come up with
the figure of $7,200 to rehab a property. A “guestimating” investor may
come up with a similar number, but should round it up to $10,000 to
play it safe.
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42 DEFENSIVE REAL ESTATE INVESTING
Bill’s Advice: Be Very
Conservative on Old Houses
If you’re looking to purchase older homes, consider the “Hoffa Factor,”
that is, the odds that when you open up the walls, you might find Jimmy
Hoffa buried there!
Joking aside, rehabbing old houses frequently comes with surprises that
you don’t discover until you start taking things apart. Therefore, we suggest
that novice investors estimate as high as 50 percent more on repair budgets for
older homes.
Ideally, you already have a trusted contractor on your side. Good
contractors have the experience and expertise to provide a quick, ac-
curate estimate of needed repairs. Even so, always estimate high on re-
pair costs and cost of materials. Our experience has consistently
shown us that two things are inevitable when rehabbing a property:
• It always costs more than you think it will.
• It always takes longer than you think it will.
As with market conditions and property values, be defensive. Esti-
mate conservatively on repairs and you will be pleasantly surprised if
it costs less.
It’s essential to know how to valuate a house quickly and accurately
because you can’t determine whether you have a good deal unless you
know what the property is currently worth. Being defensive means being
as dead-on accurate as you can with the realistic value of a home in its
present condition and what it will be worth after repairs or renovations.
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Key Points to Remember
The most important concepts addressed in this chapter are:
• Comparable sales are generally the best way to assess a home’s
value.
• Knowing the costs of repairs is essential when determining a
house’s value.
• Always be conservative and estimate high on repairs.
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CHAPTER
45
Determine Your Profit
Before You Buy
“Look before you leap.”
—Confucius
In this chapter, you’ll learn the cardinal rule of real estate: You
don’t make your money when you sell; you make your money when
you buy. This means that, as an investor, you shouldn’t buy houses
with the assumption that you’ll figure out how to make a profit later.
Instead, you need to ensure that you get a good deal—better yet, a
great deal—when you buy a house so you see your profit up front. This
chapter addresses determining your profit before you buy.
The Past Doesn’t Equal the Future
Many people make the mistake of counting on earning a profit be-
cause of something that might happen after they buy, such as the prop-
erty appreciating in value. While it’s true that most properties generally
do go up in value over time, this isn’t always the case, especially in the
short run. Unforeseen events may depress property values in the area.
Beware that many investment gurus use this emphasis on apprecia-
tion as a tactic when they’re trying to persuade prospective clients to
accept their advice about investing. They’ll often use a pitch along this
line: “If you had used this strategy of ours ten years ago, you would
4
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have realized a 100 percent return on your money.” Hindsight is always
20/20 and every economist is a genius when looking back.
When you’re investing in real estate, never presume that a property
will increase in value. Don’t be controlled by the blind hope—based
on the fact that the property’s value rose in the past—that it will con-
tinue to appreciate if you hold it for another few years.
Over the long run, the real estate market always seems to correct an
investor’s mistakes. Values go up and down in cycles in the short run,
but over 20 or 30 years, the market tends to go up at a steady, conser-
vative pace. History has shown that real estate has almost always out-
paced inflation over the long term. However, if you’re looking at the
short term and counting on a three- to five-year strategy because real es-
tate values went up over the past few years, you may be taking an un-
necessary risk. A more defensive strategy is to make your profit from the
start by getting the proper discount when you purchase a property.
Comparing real estate investing with the stock market. To grasp
the idea of up-front profits and their importance in a real estate deal,
it’s helpful to compare real estate and the stock market. When you buy
a stock below value, you assume that it’s undervalued. Thus, for you to
realize a profit, your stock must go up in value.
With real estate, the concept of value is different. Value is regarded
as what a property will sell for today. For example, if similar houses are
selling for $100,000 in a neighborhood, buying a property for $50,000
is a bargain because you can realize a profit by selling it quickly at its
current value: $100,000.
In real estate, a particular investment is a deal in one of four cases:
1. You can buy it below it's current market value
2. There is some upside potential, such as a change of use, better
management or additions and improvements that can be made
to the property
3. It will provide sufficient income in relation to the purchase price
4. Future market appreciation.
The latter two cases are very similar to the stock market in that they
are driven by earnings per dollar invested or future speculation, both
of which are market-driven. The first two cases are generally based on
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seller distress or mismanagement, neither of which have much to do
with the local real estate market.
In the stock market, a business may have a good plan but lacks cap-
ital; therefore, an investor can supply the necessary capital in ex-
change for future profits. In real estate, a seller’s distress can mean
profits for a buyer. Certainly market timing opportunities exist in real
estate, but regardless of the market, one thing is constant: Individuals
are often in distress.
Reasons for their stress might include:
• Divorce
• Job loss
• Foreclosure
• Death
• Lack of interest in the property
Thus, even if you think there are no deals in your town because it’s
a seller’s market or there’s no growth opportunity, someone always fits
in one of the categories. Someone always exists who will sell you a
property for less than fair market value. These people are called moti-
vated sellers.
Find Motivated Sellers
The key to getting great real estate deals in any market is finding
motivated sellers. After all, only those who absolutely need to sell are
going to price their homes well below market value or accept unusual
financing arrangements.
Generally, motivated sellers are facing some kind of crisis or hard-
ship such as divorce, unemployment, or financial instability. In these
cases, the property and the expenses of owning that property are one
of many problems these people must deal with. Therefore, they’re usu-
ally eager to get rid of their properties.
Here is your dream scenario: A property owner says, “That’s it, I
want out. I can’t take it anymore. I’ve got to sell right now. I’ve just got
to get rid of this house.”
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How do you find these motivated sellers? Fortunately, that isn’t dif-
ficult to do these days because many motivated sellers exist out there.
Start by scanning the classified ads for “For Sale by Owner” properties.
Look for key words that signal distressed sellers such as “must sell” and
“needs work.” Basically, look for anything that implies desperation or
urgency on the seller’s part.
You can also take a proactive approach by advertising that you’re
looking for properties. It’s important to emphasize that you’ll pay
quickly for homes. The lure of fast money will help you reel in dis-
tressed sellers.
When it comes to finding distressed homeowners, a little detective
work also comes in useful. Search public notices and courthouse
records for owners who are delinquent on their property taxes or are
in some stage of the foreclosure process. There’s a good chance these
people are having money problems and may be eager to sell their
homes before a foreclosure is complete.
How to Analyze a Potential Deal
When you find a motivated seller, consider whether that person’s
property is a good deal or not. Before you can do this, determine your
plan for this property. Too many novice investors just assume, “Every-
thing in this area has gone up, so I ought to invest.” In other words, be-
fore you buy a property, construct a viable plan including an exit
strategy. (You’ll learn more about exit strategies in Chapter 7.) The key
point here is this: Never go into a deal without knowing exactly how
to exit it. The lower the purchase price relative to the current market,
the higher your profit potential will be.
A “Good Deal” Can Vary from Place to Place
When it comes to determining a good deal, no cut-and-dry formula
works for every market. In some areas, you can pay 90 percent of mar-
ket value and still make a substantial profit, especially when demand is
high. In other places, you may need to obtain a property for 70 percent
of market value or less to be confident that you’ll do well. Once you be-
come familiar with an area and have completed a few deals, you’ll get
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a feel for the market and know exactly what kind of discount is neces-
sary to consider buying a property and calling it “a good deal.”
Unfortunately, this means that you’ll be less likely to spot a good
deal when you first start out. Therefore, if you’re a novice investor, we
suggest you accept the fact that you’ll miss out on a few good deals by
taking a defensive stance. Being too aggressive can lead to borderline
deals—deals that don’t provide much profit. It’s better to let a few
deals slip through your fingers rather than take a chance on properties
that end up costing you money.
Knowledge Is Power
The keys to analyzing a good deal are knowledge and education.In
real estate investment, a strong correlation exists between knowledge
and risk. The more knowledge you have about properties, markets,
mortgages, financing, neighborhoods, local rent rates, repair costs, and
so forth, the less you risk losing on a deal.
CLEAR System of Analyzing Deals
A great way to determine whether a deal is good is to use our
CLEAR system. CLEAR stands for:
• Cash flow
• Leverage
• Equity
• Appreciation
• Risk
Let’s analyze each of these concepts.
Cash Flow
Cash flow is an important consideration when you evaluate a po-
tential deal. Your first priority is to determine whether a property will
provide you with positive cash flow. This depends on a number of fac-
tors such as the state of the local rental market, the amount of financ-
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ing, and the interest rate you’ll be paying. Be sure to compare the cash
flow potential of a particular property against that of other properties
you’re considering.
It’s important to do “real math” on income properties. What do we
mean by this? Let’s look at “fool’s math” for income properties. Novice
investors generally do the following math for rental properties:
Monthly rent $1,000
Monthly mortgage payment $ 800
Monthly profit $ 200
However, when you apply for a loan, most lenders will discount the
rental income on your existing properties by 25 percent because there
are other costs (see below) involved in operating a rental property.
Therefore, using the above figures, you’d be in the hole by $50 a month
(that is, $1,000 – $250 vacancy – $800 mortgage payment). Our expe-
rience shows that a 25 percent discount is generally correct. Rental
properties involve much more than “rent versus mortgage payments”
because expenses include:
•Taxes
• Hazard insurance
• Vacancy
• Repairs
• Management (there’s a cost, even if you manage it yourself)
• Evictions and legal fees
• Maintenance
• Utilities
• Advertising
With multiunit residential rental buildings, these expenses can be
as much as 50 percent of the rental property’s income. Of course,
they’ll vary depending on local vacancy rates, the type of neighbor-
hood (for example, there may be more vandalism, repairs, and
turnover in low-income areas), and the age and condition of the prop-
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4 / Determine Your Profit Before You Buy 51
erty when you bought it. As with repairs, always estimate high on ex-
penses. (Refer to the sample expenses in Property Cash Flow Analysis
form in Appendix 3 to get a better idea of the real math involved.)
Several traditional income formulas for real estate are applied to in-
come properties, although less commonly to single-family rentals. We
suggest you take time to become familiar with these common formulas
and use them to compare income properties.
Gross operating income. Gross operating income refers to the
scheduled income of the property minus allowable vacancy. If the
property is currently vacant or rented below market, you could use the
potential income amount, using conservative figures. Don’t compare
rents to a building much nicer or in a better location, but rather a prop-
erty that is similar to yours. You can send a “spy” (friend) to check out
the property and act as a potential tenant, or check online Web sites
like www.rentclicks.com.
Operating expenses. Operating expenses include just about every-
thing else except paying mortgage debt. This includes maintenance,
management, insurance, taxes, and all the other expenses listed in the
Property Cash Flow Analysis form in Appendix 3.
Net operating income. Net operating income is gross operating in-
come less operating expenses, as explained earlier.
Capitalization rate. Capitalization rate (also called the cap rate) is
the net operating income divided by the value of the property. This
doesn’t take into account the financing and is a measure of a property’s
value compared to income it will provide. For example, if you own a
property worth $100,000 that has a net operating income of $10,000
a year, your cap rate is 10 percent. If you own it free and clear without
a mortgage, you have more cash flow than if you paid a mortgage each
month, but doing that only changes your cash flow, not your cap rate.
Cash on cash return. Cash on cash return is the annual rate of re-
turn you’re getting based on the cash you invest. This number will be
higher the less you pay for the property and the less money you have
invested in the deal. As an example, let’s use the same $100,000 prop-
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erty that has a net operating income of $10,000 a year. If you invested
$10,000 down on this property and have a $90,000 mortgage with an
annual payment of $9,000, your cash flow annual is $1,000 and your
cash on cash return is 10 percent. If you put $40,000 down and have
a $50,000 mortgage, your cash flow would increase, but your cash on
cash return would go down.
These are just formulas; they don’t take into account anything other
than the income of the property. However, they provide useful bench-
marks for comparing one property against another for income potential.
Leverage
Next in our CLEAR system for determining a good deal (after cash
flow) is leverage. Because of inflation, a dollar today will generally be
worth less in the future. Thus, while real estate values may increase, an
all-cash purchase may not be economically feasible because you could
use your cash in more effective ways. As you can see from the previous
cash on cash return example, more cash invested into a deal may in-
crease cash flow, but may not maximize the return on your capital.
52 DEFENSIVE REAL ESTATE INVESTING
Understanding the
Concept of Leverage
Leverage is the concept of using borrowed money to make a return on
an investment. Let’s say you buy a house using all your cash for $100,000. If
the property increases in value 10 percent over 12 months, it is now worth
$110,000. As a result, your return on investment (ROI) is 10 percent annually.
(In actuality, you would net less because you would incur costs when you
sell the property.)
However, if you purchase a property using $10,000 of your own cash and
$90,000 in borrowed money, a 10 percent increase in value would still result
in $10,000 of increased equity, but your return on cash is 100 percent
($10,000 investment yielding $20,000 in equity). Of course, the borrowed
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4 / Determine Your Profit Before You Buy 53
money isn’t cost-free; you incur loan costs and interest payments when you
take on a loan. However, you could also rent the property in the meantime,
which would offset the interest expense of the loan.
Please note that ROI is not the same as cash on cash. As you can see in
the examples, appreciation on the investment was considered in the equa-
tion. Cash on cash return is simply the cash you get each year versus the
cash you have invested. The return on investment (ROI) calculation consid-
ers the total profit including appreciation.
Taking the concept of leverage a step further, you could purchase
ten properties with 10 percent down and 90 percent financing. If you
could rent these properties for breakeven cash flow (that is, actual ex-
penses and mortgage payments not exceeding actual income), you
would have built up a large nest egg in 20 years when you pay off the
properties. Balance that with what you could make by investing the
cash flow on one free-and-clear property for 20 years; you would have
maximum cash flow each year, but your total portfolio would not in-
crease nearly as much.
Why is leverage important when you invest? Because the less cash
you put down on each property, the more properties you can buy.
Many investors ask us, “If leverage is so important, what about the
‘no money down’ deals?” Many people like to buy real estate with no
money down because it’s the ultimate form of leverage. In addition,
this may also be their only option if they have no cash available at the
moment. Keep in mind, though, that there’s nothing special about buy-
ing a property with no money down; the deal must also make sense in
terms of profitability at some point.
On the other hand, if you can purchase the property at a substan-
tially below-market price and with no money down, you have the per-
fect combination for a good deal. This is buying 100 percent
loan-to-purchase (LTP), not 100 percent loan-to-value (LTV). Figure 4.1
illustrates the difference between LTP and LTV. Investors should strive
for high LTP and low LTV.
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FIGURE 4.1 LTP versus LTV
Price Value Loan LTV LTP
$100,000 $100,000 $100,000 100 percent 100 percent
$ 80,000 $100,000 $ 80,000 80 percent 100 percent
If you can buy below market and close to 100 percent loan-to-pur-
chase (LTP) with breakeven or positive cash flow, you’ll go to real es-
tate investor heaven!
The problem with buying a property at a below-market price is that
lenders tend to “penalize” investors with their loan regulations. Fannie
Mae (FNMA) conforming loan guidelines usually require you to put up
20 percent of your own cash as a down payment. The 20 percent rule
applies even if the purchase price is half of the property’s appraised
value. Thus, the loan-to-value (LTV) rules are based on appraised value
or purchase price, whichever is less.
54 DEFENSIVE REAL ESTATE INVESTING
Seasoning May Be Necessary
When You Refinance a Property
Refinancing is generally based on loan-to-value (LTV), not loan-to-pur-
chase (LTP). Thus, if you can buy a property below market using cash (using
a source such as your home equity line of credit), you can refinance the prop-
erty based on its appraised value and be close to 100 percent loan-to-value
on the property with little or no money in the deal. To refinance based on the
property’s value (assuming it’s higher than the recent purchase price) a
lender generally requires six months or more of ownership. This is called sea-
soning. Some lenders will refinance a property without seasoning if you have
excellent credit.
Leveraging real estate deals is great if the properties go up in value
because the rate of return on your money goes up exponentially. How-
ever, if the properties go down in value and you have a lot of debt on
them, the result will be negative cash flow.
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4 / Determine Your Profit Before You Buy 55
Is negative cash flow necessarily a bad thing? Well, yes and no. If you
have other sources of income and are looking for long-term apprecia-
tion, you can consider negative cash flow the equivalent of payments
into a retirement plan that will eventually pay off. This leads to a dis-
cussion on equity, the next concept in the CLEAR system after cash flow
and leverage.
Equity
Remember, our goal with the CLEAR system is to determine if pur-
chasing a specific property is a good deal. Therefore, you need to de-
termine how much (if any) equity the property has. You can find
equity in many forms, including a foreclosure or other distress situation
in which a property has a discounted price, a fixer-upper offering lots
of potential, or a poorly managed income property. You can also create
equity by rezoning a property—changing its use from commercial to
residential or vice versa. For example, buying a house on a main street
may not be appealing, but if the area gets rezoned for commercial use,
this house can be converted into an office or a retail storefront and
prove to be a good investment.
With financing involved, equity can take the form of a paydown on
debt. For example, a rental property with income can be used to pay
down financing, known as amortization. Each mortgage payment is
part principal, part interest. As you collect rent and make mortgage
payments, the principal payment increases your equity in the property,
even if the value does not increase.
Appreciation
The fourth concept in our CLEAR system is to determine the prop-
erty’s probable appreciation. Jumping into the right neighborhoods at
the perfect time can result in appreciation and profit. However, it can
be tricky to time this exactly right.
Depending completely on appreciation for your profit is risky. In-
stead, buying for moderately long-term (ten to 20 years) appreciation
is safer and easier. Study the long-term neighborhood and citywide
trends to choose areas that will hold their values and grow at an aver-
age 5 to 7 percent annual rate.
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Risk
The final concept in the CLEAR system to assess the risk involved
in a particular property investment. Unfortunately, many investors
don’t spend nearly enough time considering risk. Virtually every real
estate deal involves at least some element of risk, no matter how “safe”
it may seem. Because real estate purchases most often involve debt, an
initial investment of cash can turn into a huge liability if an investment
turns bad. There are also potential legal liabilities involved in real es-
tate, which are discussed in Chapter 8.
We suggest you always have a Plan B in case your initial plan goes
awry. Know the answer to this question: If you buy a property for
short-term appreciation and it doesn’t appreciate in value, can you rent
it for positive cash flow until the market rebounds?
Also take financing into account when you’re considering risk.
Many novice investors buy properties with adjustable rate loans as-
suming that they’ll sell the property for a profit before the loan pay-
ments increase. If you do that, consider this question: If you buy a
property with an adjustable rate loan and the rates go up, will this put
you out of business? If you have a few vacancies, can you handle the
negative cash flow or will it break the bank? In other words, expect the
best but prepare for the worst.
56 DEFENSIVE REAL ESTATE INVESTING
Calculate Appreciation
as Net of Inflation
Note that appreciation should be calculated net of inflation. For exam-
ple, if inflation is 3 percent annually, a 5 percent increase in property values
translates into a 2 percent gain. In inflationary terms, this is described as
“nominal” (numbers) versus “real” (inflation-adjusted) or “net” value.
You can find information on annual inflation at the U.S. Department of
Labor Statistics at www.bls.gov.
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When you’re considering risk, also pay attention to possible tax law
changes. Rental properties can provide a good tax break for those who
qualify because of their depreciation factor. While real estate does in-
crease in value, the IRS allows a large deduction for the theoretical de-
preciation of the property improvements, which can often create a
loss, at least on paper. For some investors, a negative cash flow is a
large loss that offsets other income.
4 / Determine Your Profit Before You Buy 57
Bill’s Advice: Look at a
Wide Range of Risk Factors
When considering risk, also consider the headache and liability in-
volved in your investments.
At one time, I considered investing a few hundred thousand dollars in
properties in Kansas City, Missouri. An investor was liquidating a portfolio of
22 houses that he owned free and clear, and would owner-finance with a
sizeable down payment. The houses were worth about $30,000 each, and
each one rented for about $300 a month. On paper, it seemed like a great
deal because it would yield $6,600 a month in income. After careful consid-
eration, however, I passed on the deal to buy one single-family rental in
Boulder, Colorado, and one condominium in Denver, Colorado. They rented
for a total of about $2,500 a month.
Why didn’t I go for the deal in Missouri that seemed more lucrative?
First, the Kansas City properties were older than those in Colorado were and
located in poor neighborhoods. While the income was better for these 22
houses, so was the potential for crime, management hassles, liability, and re-
pairs. Remember, putting a roof on a $30,000 house in Kansas City costs the
same as putting a roof on a similar house that’s worth $200,000 in Boulder
or $500,000 in Boston.
Second, it’s much easier to manage two tenants than 22 tenants. Re-
gardless of the property values, dealing with more tenants and more prop-
erties means more headaches and more liability.
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58 DEFENSIVE REAL ESTATE INVESTING
However, as many investors learned in the 1980s, “what the gov-
ernment giveth, it can take away.” With the Tax Reform Act of 1986,
the U.S. Congress suddenly and drastically changed rules on deducting
losses on rental property. Before that time, many investors bought
properties that did not make financial sense, except for the tax write-
offs. When the laws changed, many investors simply walked away from
these properties, causing massive foreclosures that significantly hurt
the housing market. We hope that investors learned from this debacle
and won’t make the same mistake. In other words, don’t just buy a
property because it’s a good tax break because that risk factor could
change overnight.
Balance Your Business with Your Personal Goals
You must balance using the CLEAR system with your personal
goals. For some investors, cash flow isn’t as important as retirement in-
come or equity growth. For others, they need income right now to quit
their job and, thus, owning rentals may not provide enough income. If
you have a full-time job or business, rentals or rehabs may be too time
consuming. In short, do the math and consider all the implications of
your real estate investments.
Gary’s Advice: It’s Critical to
Follow Your CLEAR Plan
Over the many years I’ve been in this business, I have encountered nu-
merous successful investors and many others who struggle. I can boil down
the difference into one statement: The successful investors had a CLEAR
plan and followed it through.
I advise first-time investors to purchase one good house a year for ten
years using the CLEAR formula and hold them. At the end of ten years, they
would have a million dollars in net worth. This advice is as valid now as it
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Key Points to Remember
The most important concepts addressed in this chapter are:
• As an investor, you can never take profits for granted. Be sure to
analyze and go for the best deal at the onset of a transaction.
• The ability to locate (and deal with) motivated sellers is critical
to realizing profitable deals.
• The CLEAR system can be an efficient way to analyze a poten-
tial deal quickly.
4 / Determine Your Profit Before You Buy 59
was 30 years ago. I know this because investors who tried to buy the latest
hot property in the latest fad areas are now struggling to be successful.
It doesn’t matter what your plan is; what matters is that you approach
each property using the CLEAR formula. Keep in mind that it’s more about
quality than quantity.
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CHAPTER
61
Always Invest in
“Safe” Deals
“Take calculated risks. That is quite different from being rash.”
—George S. Patton
People who’ve always put their money in blue-chip stocks, bonds,
and money-market accounts commonly think of real estate as being an
inherently risky investment. While real estate can be risky, you can cer-
tainly limit that risk by educating yourself. Our experience shows that
certain types of investments in real estate can be inherently safer than
others, particularly where there is uncertainty in the future of the mar-
ket, whether it will go up or down.
After all, real estate is a survival game—anyone can make money in
rising markets, but those who survive the down markets retire wealthy.
Stick to this fifth principle—always invest in “safe” deals—and you’ll
survive long term in this business. Remember, there is no 100 percent
“safe” deal, but being thoughtful, conservative, and defensive will in-
crease your odds of long-term success in real estate investing whether
markets are up or down.
Invest in Deals, Not Markets
Too many novice investors try to time the market and ride the
waves of market appreciation. Certainly buying and selling at the per-
5
chapter05_FINAL.qxp 3/15/07 3:46 PM Page 61
fect time (when the market peaks, for example) is the easiest and most
lucrative way to invest in real estate. It’s also the most risky because
few people have enough foresight to figure out where the top and bot-
tom of the market are.
Instead of trying to guess the bottom and top of a market, stick to
particular deals that make sense. In any market, by applying our CLEAR
formula from the previous chapter you can find particular bargains in
solid neighborhoods that make sense.
Buying houses at great bargains is easy when the market is soft and
sellers are flexible. Even if you’re in a hot market, you can still find
homeowners who want to sell below market for reasons other than
money, including the stress of a divorce, a death in the family, a job
transfer, or other life changes. At times like these, people can be highly
motivated to sell their houses quickly. If you’re in a flat or falling mar-
ket, you can either invest elsewhere or stay in your farm area and buy
extremely cheap. Even if you seek emerging markets around the coun-
try, you can still end up with a bad deal that won’t make you money.
In short, each deal must stand on its own.
The late Will Rogers said, “Buy when others are selling and sell
when people are buying.” This may work for stocks because you can
get in and out of a deal in a short time. However, in real estate, you
can’t expect to time the market in terms of days. Unless you’re in a mar-
ket where bidding wars occur and prices go up in a matter of days,
plan your strategies in terms of months and possibly years.
Stick with Metropolitan Areas
As mentioned earlier, housing markets are driven by people and
people tend to go where there are jobs. The more people who live in
an area, the easier it is to sell or rent a property, so stick with major
areas that have a large, diverse population. As a rule, stay away from re-
sort areas or smaller towns that have one major employer. (You may re-
call what happened to Flint, Michigan, in the 1980s when General
Motors laid off a large part of its workforce, causing mass unemploy-
ment and long-term depression of the local housing market.)
College towns are usually an exception to this rule. They tend to do
well because of the built-in population that lives there temporarily year
after year. College rental properties tend to cost more, are seasonal,
62 DEFENSIVE REAL ESTATE INVESTING
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5 / Always Invest in “Safe” Deals 63
and are prone to high turnover and damage (remember the movie An-
imal House), but there’s no shortage of college and graduate school
enrollment across the nation.
Another good idea is to invest in towns that have the employer-
equivalent of Disney World or a local government (e.g., the school sys-
tem) that employs a significant percentage of the population. These
people aren’t moving anywhere soon.
Watch the latest trends when looking for metropolitan areas in
which to invest. The revival of urban neighborhoods is a growing na-
tional trend. Once considered the haven for the poor, laden with crime
and plagued by poor schools, these areas are coming back with a
vengeance. Art galleries and restaurants are replacing burnt-out build-
ings. Boarded-up housing is being refurbished into stylish town homes.
Many empty-nester baby boomers are selling their large, suburban
homes and moving downtown to experience a hip urban way of life.
Thus, proximity to the downtown areas in many cities has become
more desirable than sprawling, suburban, middle-class neighborhoods.
Every city has certain neighborhoods that are more desirable than
others are. These areas always seem to hold their property values in
down times and increase exponentially in good times. It may be be-
cause of proximity to downtown or the strength of a particular school
district, but pound for pound, properties in desirable areas are worth
more than houses in areas that don’t have the same features. You may
not find great bargains, but they’re always safer investment bets over
the long run than newer developments or super cheap areas.
Buy the WOB in the MOB Near the Blob
As a rule of thumb, the worst house on the block in a median-priced
neighborhood (or below) is generally a safe bet for investing. We call
this buying the WOB in the MOB near the Blob. Spelled out, this is:
• buy the WOB (Worst On the Block)
• in the MOB (Median price Or Below)
• near the Blob (see explanation below).
Now, let’s break this down, step by step.
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Worst on the Block (WOB)
The worst house on the block in a good neighborhood is always a
better investment than the nicest house in a lesser neighborhood for
two reasons. First, most people would rather live in a better neighbor-
hood than be king of a slum. They like to brag that they live in a par-
ticular neighborhood, even if it’s the cheapest house in it.
Second, there’s always more room to push the values on the low
end of the spectrum than on the high end. As we discussed earlier, ap-
praisers look at comparable sales within a particular neighborhood. If
your house is already the highest priced for the area, there’s not much
you can do to improve its value. However, if your house is priced on
the low end for the area, you can fix it up and stretch its value. Ap-
praisers are more comfortable stretching the price per square foot of a
cheap house than stretching the total price of a house that’s already at
the high end of the neighborhood. Remember: Market value is what
someone is willing to pay for a house. A nicer house will generally sell
for more per square foot than a bigger one that’s not as nice.
Median Price or Below (MOB)
As you may recall, the median price marks the “middle of the pack,”
with half of the housing in that area selling for less, half for more. The
below-median price range within a metropolitan area is generally a safe
investment because there’s a growing shortage of these houses.
New homebuilders have certain fixed costs involved in building
new subdivisions. These costs include paving roads, installing power
and sewer lines, and maintaining a large staff. While more expensive
homes can take longer to sell, in the long run, those builders make
more money because of the economies of scale. It only takes a few
extra two-by-fours to make a house that’s 3,000 square feet versus a
house that’s 2,000 square feet and the profit margin on the extra size
is all gravy to the builder.
Because of land restrictions and costs, most of the newer develop-
ments are being built farther and farther from the center of town. As
discussed earlier, the inner-city housing demand has increased; many
smaller houses are being knocked down, refurbished, or rebuilt. Thus,
64 DEFENSIVE REAL ESTATE INVESTING
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what we have is a shortage of affordable housing. With mass immigra-
tion into the United States, the demand for affordable houses within
proximity of the metropolitan areas will continue, particular for rental
properties. Investors who own housing in the MOB will find their
properties retaining value in the long run.
The “Blob”
Remember the movie The Blob? In this movie, a giant monster
oozed from place to place, taking everything and everyone in its path.
The same effect often happens in neighborhoods. If a particular area is
hot and desirable, it will eventually run out of room and the closest ge-
ographical neighborhood will generally be next. In some cases, hot
areas may greatly exceed the median price, thus possibly increasing the
investor’s risk because it’s not the desired median price or below. In-
vesting in more reasonably priced homes in close proximity to this de-
sirable Blob neighborhood may be a safer bet.
When considering the Blob effect, take into account neighborhood
dividing lines. In some cases, it’s simply a road. In others, it may be a
hard, impassable line, including a railroad track, major highway, or
body of water. Paris is a good example of a city with a strong dividing
line. If you’ve visited Paris, you’ve seen the neighborhoods on the Right
Bank and the Left Bank of the Seine River. It’s clear to see how the
neighborhoods on either side of the river differ.
All things being equal, the worst house on the block in the median-
price neighborhood or below near a hot and growing area is your
safest and best investment in any market. Certainly when prices are ris-
ing, a new condo by the beach or a 10 percent appreciation on a mil-
lion-dollar house seems like a good way to make a fast buck
Nevertheless, being a defensive investor means going with the lowest-
risk investment on a consistent basis, not shooting for the moon. Ask
any good football coach the key to consistently winning and it’s not the
“hail Mary” pass. It’s making first down over and over by moving the
ball down the field a few yards at a time.
5 / Always Invest in “Safe” Deals 65
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Fixer-Uppers
Fixer-uppers are almost always a safe bet if you buy them right. As
we mentioned earlier, fixer-uppers generally have less market appeal
than houses that are in good shape. This translates into less demand
and a lower purchase price. However, be extremely careful about what
kinds of projects you take on—not all fixer-uppers are worth the effort.
Despite what you see on the cable television shows, a fix-and-flip prop-
erty isn’t just about fixing things. It’s about knowing what things to fix,
how to estimate the repairs, and whether such an endeavor is even
worth the effort.
What Should You Fix?
While you should be systematic in your approach to rehabs, keep
in mind that every property is different. Location, age, potential value,
and the architectural style of a property all affect how to approach any
renovation. The condition of the property and the scope of the needed
repairs will also affect the rehab process.
Certain improvements will always give you the most bang for your
buck—namely, kitchens and bathrooms. Remodeling kitchens and
bathrooms and adding bathrooms will give you the most return on
your money. However, if you plan to keep the property as a rental,
66 DEFENSIVE REAL ESTATE INVESTING
Look Where a
New Starbucks Opens
Have you noticed that Starbucks coffee shops are popping up in “up
and coming” areas? Big companies like Starbucks do a lot of research before
they open a store that sells four-dollar cups of coffee. Why should you rein-
vent the wheel? Let the pros do your initial research. They’re probably more
experienced than you are! If you see a Starbucks going up in a transitioning
neighborhood, that may be your green light to go ahead and buy there.
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5 / Always Invest in “Safe” Deals 67
adding more livable space may get you more rent, depending on how
much existing space is in the house already. For example, if the house
is a small, two-bedroom ranch, converting the garage into one or two
bedrooms may be worthwhile if plenty of parking is available other
than in the garage.
Generally, decks, pools, patios, landscaping, and expensive floor-
ing don’t add much value. Certain “overkill improvements” don’t add
much value either. This includes spending more money than neces-
sary on appliances, roofing, heating, plumbing, and sprinkler sys-
tems. For example, if the house has an old roof, you must fix it, but
adding a roof with a 30-year warranty versus a ten-year warranty
won’t get you more money when you sell the house. Likewise, an en-
ergy-efficient appliance that costs you twice as much as a typical ap-
pliance isn’t going to bring you more money for the house. If
something is old or broken, fix it, but don’t overspend unless the
extra money visibly adds to the marketability of the house. In many
cases, if it looks clean, replacing an ugly or broken appliance with a
newer used one works fine. Kitchen cabinets can often be painted
over or refaced instead of replaced entirely. Moreover, if you do
choose to replace the cabinets, spend a little extra on the handles for
an extra designer’s touch.
Appraisal versus Appeal
It’s important to understand the difference between improvements
that will affect the appraisal value versus the marketability or “appeal”
of the property. For example, using granite slab countertops versus
Formica will not significantly affect the appraisal of the property. The
issue for the appraisal is whether the kitchen was remodeled or not.
Granite slab may cost you $3,000, but add only $1,000 to the appraisal.
Therefore, why would any investor add such an extravagance if the
property won’t appraise for more? The answer is “appeal.”
While appraisers look unemotionally at facts like a house’s square
footage, buyers are emotional people who can get hooked by a classy-
looking kitchen countertop. If a buyer loves your house and is willing
to pay more for it, then it should appraise for the actual purchase price.
That’s why appraisers consider comparable sales of similar homes in
the neighborhood. Technically, they are required to consider the de-
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tails of the sale and are provided with a copy of the sales contract,
which includes the price and details of the sale.
Human nature being what it is, appraisers tend to appraise to the
contract price unless the price is completely out of line for the neigh-
borhood. This is why it’s crucial to remodel houses on the “inexpen-
sive” end of a neighborhood than on the high end. If the house you are
selling is on the high end and you attempt to push the price beyond
the highest comp, it gives the appraiser nothing to justify your price.
On the other hand, if your house is on the low end, there are other
sales to justify the price even if comparable houses are bigger than
yours is. Appraisers can record notes in their reports that your house
was better remodeled than similar houses in the neighborhood that
sold for less.
Keep in mind that if you’re getting an appraisal for a refinance, you
have no buyer in love with your kitchen to push up the house’s value.
Appraisers are human beings who are impressed with nice-looking
houses, but they won’t be swayed like a buyer who thinks about call-
ing this house “home” and wants a higher value to it.
68 DEFENSIVE REAL ESTATE INVESTING
Bill’s Advice: Be Cheap,
but Don’t Make Your
House Look Cheap
You can spend a minimal amount and still make a house look inviting.
We typically spend less than $15,000 on a complete renovation of a 1,200-
square-foot home, which is generally half what other investors spend. The
key is to spend the minimum on items that are expensive, and the maximum
on things that are inexpensive, but visible, as noted next.
Doors, electrical switch plates, faucets, door knobs, and light fix-
tures. Overspend on these hardware items because they will add “piz-
zazz” without affecting your total budget much. For example, a $100
light fixture will look incredibly nice in a basic house compared to a
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5 / Always Invest in “Safe” Deals 69
$30 fixture. Will $70 break your budget? Of course not! Use fancy $15
door handles instead of plain ones. After all, there are only about seven
doors in a small house. If your house has only one level, replace old
brown doors with new six-panel hollow-core doors. It shouldn’t cost
you more than $200 a door, including materials, labor, handles, and
paint. Instead of using cheap plastic switch plate covers, upgrade to
nice ones for about $60.
Upgrade the tile. If you are replacing the kitchen and bathroom
floors with new tiles, spend extra for really nice ones. If the total
square footage of the kitchen and bathrooms is 200 square feet, then
using $2 tiles versus $1 tiles will affect your budget by only $200.
Watch for hidden hazards. Be sure to go through an extensive in-
spection process before closing on a property. Sometimes what seems
like an easy rehab will turn out to be an environmental nightmare. For
example, water damage can lead to black mold, which threatens health
and can be expensive to get rid of. Lead-based paint, which was used
before 1978 but has been phased out, can be expensive to remove. As-
bestos is another hazard. If insulation made with asbestos is discovered
on ductwork over dirt, the dirt needs to be tested to see if it has been
contaminated by pieces flaking off, which usually happens. Radon is
common in certain parts of the country and houses should be in-
spected for this.
Finally, be aware of “meth” houses, that is, houses in which
methamphetamine was prepared or stored. Your county health de-
partment may have a list of houses that were identified as meth houses.
Once flagged as a meth house, a house must be completely renovated
by an OSHA-certified (U.S. Department of Labor Occupational Safety
and Health Organization) contractor, which is an expensive process.
How nice should the house be? Before you get involved in a fixer-
upper, assess the neighborhood carefully to determine the scope of
your repairs. Do you want your house to be consistent with those in
the neighborhood, or do you want to make it a little nicer? You can eas-
ily overdo this if you’re not careful, so don’t go overboard regarding
quality of materials, time spent on minor details, or unimportant prob-
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lems. Focus on repairs and improvements that add value and make
the property more marketable.
Beginning investors commonly spend time and money on unnec-
essary projects. As a result, these beginners are pressed to ask pre-
mium prices for their properties, wasting time and money as they wait
for their houses to sell. A rule of thumb is to tackle only projects that
will bring you at least double your money back in profit. For example,
if you spend $10,000 in repairs or improvements, you want to yield an
extra $20,000 or more in net profit when you sell.
Remember, “net profit” includes what you have after paying all of
your costs. Many novice investors mistakenly assume that buying a
house for $90,000 and investing $10,000 in repairs means the house
can be sold for $110,000 and bring in $10,000 in profit. This is not
quite true. Here are a few “hidden” costs to be aware of:
• Acquisition costs—When you purchase a property, you may
pay for various escrow fees, transfer tax (as high as 3 percent
70 DEFENSIVE REAL ESTATE INVESTING
Gary’s Advice: Look Out for
Fixer-Upper Cost Killers
Some minor but expensive hazards you may have to deal with include
single-strand aluminum electrical wire, polybutylene water supply pipe, ter-
mites, hidden water damage, and Masonite Woodruf roofing. Always hire a
qualified home inspector who has experience in these issues and other
building code issues before you buy a fixer-upper.
Make sure you hire a professional inspector to assist you with the in-
spection of the house until you become more experienced yourself. A pro-
fessional inspector charges between $300 and $500 for a thorough
inspection of a house from top to bottom. Choose an inspector who has ex-
perience with the particular neighborhood and model of house you are
considering purchasing.
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of the sales price in some areas), appraisal, inspection, and
lawyer fees.
• Loan costs—The cost of funding a loan to purchase the prop-
erty can be substantial for an investor. It could include points,
“processing” fees, prepaid interest, and lender escrows for
property taxes.
• Holding costs—The cost of carrying a property is more than
you think. Calculate at least six months of insurance, property
taxes, and utilities.
• Broker commissions—Statistically, 95 percent of all proper-
ties sell on the multiple listing service (MLS), which requires
using a real estate broker. You can use a flat-fee listing service
to save money, but you will likely have to pay a 3 percent com-
mission to the broker who brings you the buyer.
• Closing costs—When you resell the property, you will have
another set of escrow fees, title insurance, recording fees, and
other miscellaneous charges.
In short, estimate at least 10 percent of the total purchase price to
cover these charges, possibly more, depending where you invest. If
you are unsure, ask a local real estate broker for a good estimate.
5 / Always Invest in “Safe” Deals 71
Our Advice: Know the
Mathematics of Renovations
Many television home improvement shows and magazine articles cite
statistics about the dollar return on an investment for different home im-
provement projects. Generally, we find they are correct in terms of what
items are worth fixing and not. The confusing part is that they might say,
“For every $10,000 you spend on the bathroom, you will increase the value
of the property $8,000.” Remember, investing is a for-profit business, so
spending $10,000 to bring a return of $8,000—or even $10,000—simply
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Conversely, you never want to purchase the most expensive house
in a neighborhood—just the cleanest. Standard items should be con-
sistent with those in other nearby homes. For example, window air
conditioners may be the norm in one neighborhood, but central air
may be standard in another. That means you don’t need to install cen-
tral air conditioning in a window-unit neighborhood. Items such as
sprinkler systems, security alarms, and storm doors aren’t usually
worth the cost and effort to install. On the other hand, be generous on
the inexpensive items, such as ceiling fans, doorknobs, switch plates,
toilet seats, faucets, trim, bushes, and other cosmetic items that add ap-
peal without adding much total cost. New windows can sometimes be
worth the price you pay, particularly in parts of the country where
heating and cooling are big issues.
If you plan to buy a house for a rental, only spend money that will
make the house safe or command more rent. As previously discussed,
knowing the cost of the repairs is a crucial factor in the equation of how
to approach fixer-uppers. Whether you do a complete rehab and resell
it, do a light rehab and rent it, or resell the property “as is” to another
72 DEFENSIVE REAL ESTATE INVESTING
isn’t worth the effort. The key is to buy right, which means you must buy for
substantially less money than the repairs will cost you.
It’s crucial to understand that the renovation itself doesn’t make you a
profit; rather, it gets the home into “marketable” condition. The more repairs
a home needs, the less appealing it is, and therefore the fewer potential
buyers will be attracted to it. More than that, the market dictates that sell-
ers must drop their prices to attract more buyers who are mostly investors.
Most novice investors can handle cosmetic repairs like painting and carpet-
ing, but any major projects usually discourage all but the most experienced
rehabbers. That further drives down the “as is” market value of the house.
Therefore, instead of thinking, “What can I fix to improve the value of this
house?” it’s better to think, “How cheap can I acquire this miserable piece of
junk that nobody else wants?”
The key advice here is to make your money when you buy.Sound familiar?
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investor, understand how to evaluate repairs (e.g., the scope and cost
of the whole project) and how repairs will add value to the property.
Condominiums
Condominiums are traditionally the most volatile of real estate in-
vestments. Ask anyone who bought one in the 1970s or 1980s (your
humble authors are no exception) and they’ll show you the financial
scars on their backs.
Condos have made a strong comeback in recent years because of
the popularity of purchasing second homes, particularly in resort
areas. Whether this trend will continue is uncertain, but keep in mind
that condos are generally a tougher sell in most areas than single-fam-
ily homes. Moreover, because condominiums involve a homeowners’
association, you’ll have to deal with management issues, rules, and
costs that may be out of your control.
When buying a condo, consider your prospective tenant or buyer
when you resell. Is it priced so high that your pool of buyers is limited?
It may be in the median price range or below, but how many people
live in one-bedroom condos? Is the development so old that the HOA
(homeowners’ association) dues are high and will continue to rise as
the development ages and needs repairs?
For the most part, condos tend to fit into two categories: rentable
and livable. Cheap condos that rent well often don’t appreciate much
in value. Using our CLEAR formula in Chapter 4, you can get away with
buying a $50,000 condo and renting it for $500 a month forever. In 20
years, it may barely have appreciated above inflation. Yet a different
condo near downtown or the beach may rent for negative cash flow
and appreciate 10 to 15 percent a year.
In short, the normal formulas that apply to single-family homes
aren’t as consistent with condos, which is why defensive investors
need to approach buying condos with extreme caution.
5 / Always Invest in “Safe” Deals 73
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74 DEFENSIVE REAL ESTATE INVESTING
Multifamily Housing
Investing in multifamily housing can be a blessing or a nightmare,
depending on whether you’re cut out for management. While it’s pos-
sible to hire a management company, few are good at dealing with
small buildings. The cost per unit of multifamily housing is much lower
than single-family homes, but the management factor and liability is ex-
ponentially higher. Moreover, financing is more difficult for multiunits,
especially for buildings with more than four units that cost less than
$3,000,000 in total.
In short, the normal formulas that apply to single-family homes are
not the same with multiunit buildings, which is why defensive investors
need to approach them with more caution than single-family homes.
Properties to Avoid
The WOB in the MOB near the Blob is a good rule of thumb for safe
investments, but it is just that—a rule of thumb. Some investments may
be an exception or a calculated risk, but general rules like this provide
guidelines that both novice and experienced investors live by.
Likewise, pay attention to the rules of thumb for avoiding certain in-
vestments. Certainly exceptions exist, but the following tend to be more
speculative and riskier for novice investors. You can certainly make good
money at these, but it takes more experience and research. If you’re a
Our Advice: Look for
Limitations When Buying Condos
Be aware that some homeowners’ association rules restrict the rental of
units, so make sure you check the limitations before you purchase a condo
that you plan to rent out. In addition, many lenders have limitations on fi-
nancing condos, including a requirement that owners occupy a certain per-
centage of the units. Find out all these details before you buy.
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novice investor, we advise you to proceed with caution and be particu-
larly defensive in your approach to these types of investments.
New or Preconstruction Properties
Properties are often sold before they are built during the “precon-
struction” phase. Preconstruction properties, particularly condos, have
been popular in many markets over the last few years. Some specula-
tors have made a bundle buying up preconstruction condominiums in
hot markets, and then selling them for 25 to 50 percent profit upon
completion of the project, often a year later. Properly timed, a precon-
struction condo purchase can be lucrative if there is limited supply
(such as beachfront property) and a strong local market.
However, the basic premise of such activity violates one of our car-
dinal rules: Make your profit when you buy, not when you sell. If
you’re paying full price at what could be the top of a saturated market,
you may find yourself stuck buying an overpriced property or bailing
on a large earnest money deposit.
5 / Always Invest in “Safe” Deals 75
Bill’s Advice: Find Out Builder’s
Policy on Reservation Fees
Builders generally require a certain amount of the selling price (any-
where from 1 to 5 percent of the sales price) as a “reservation fee” before the
development is built. Most often reservation fees are refundable, but in
such cases the builder may reserve for himself the right to back out and re-
fund your fee.
It can be a Catch-22 because if you’re not committed, neither is the
builder, but if you are committed, you can lose money. The builder contract
generally requires an additional earnest money deposit of anywhere from 5
to 10 percent of the purchase price when the building reaches substantial
completion. Most often, this earnest money is not refundable.
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If you sign a contract to purchase a preconstruction property, make
sure the builder doesn’t prohibit you from flipping the property after
it’s complete. Also, have Plan B ready. For example, if you can’t sell the
property, can you complete the purchase and rent the property to ride
out a market cycle? Check the fine print to see what you’re committing
to and how much money you have to put up now and before the proj-
ect is completed.
Keep in mind also that construction projects often get delayed for a
variety of reasons, so make sure you’re dealing with a reputable builder.
Properties in Weather-Dependent Resort Areas
Investing in seasonal resort properties that depend on weather,
such as ski resorts and beach properties, can be risky if the weather
doesn’t cooperate. Most investors who profit from resort properties do
so by appreciation, but that requires good timing—and a little luck.
However, these tend to be risky ventures unless you don’t mind own-
ing a resort property as a second home and making payments out of
your own pocket during the hard times.
76 DEFENSIVE REAL ESTATE INVESTING
Bill’s Advice: The Math on
Vacation Homes Doesn’t
Usually Work
Too many people talk themselves into buying vacation homes as a
way to save money or as an investment. In fact, they are rarely a good idea.
For example, my family goes skiing an average of 12 weekends per year,
which is about every other weekend during the season. A two-night stay av-
erages $600 for the weekend, which ends up being $7,200 for the entire
season. The typical condo we rent (we find it at www.vrbo.com) costs about
$400,000 to buy. With 10 percent invested, a $360,000 mortgage costs
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Upper-Middle-Class Homes
Traditionally, the type of house that first loses value when a market
turns downward is the upper-middle-class home. If you purchase this
kind of house as a rental property, it can be difficult to rent for even
close to breakeven cash flow because of the limited market for renters
who can afford high rents. Generally, when the economy turns down-
ward, these homes get foreclosed and the occupants take one step
down when they need to rent or purchase a house. That’s where you
should be buying—in the MOB (median priced or below)—and not the
upper-middle-class homes.
Ironically, this trend doesn’t apply to very high-end homes, which
hold their value in soft markets. The super-expensive properties that
are second-home and even third-home playgrounds for the rich are fre-
quently owned free and clear. Therefore, these owners aren’t as vul-
nerable as upper-middle-class, white-collar workers who live in their
overleveraged homes as their primary residences.
Properties in Small, Rural Towns
Small rural towns that are far from major metropolitan areas and
lack a college or resort attraction aren’t the best bet for most investors.
Many of these towns have one major employer that could lay off a large
workforce or pack up and leave, crushing the town’s economy. In ad-
dition, the potential pool of buyers or renters is small.
5 / Always Invest in “Safe” Deals 77
about $2,400 a month, plus HOA dues, utilities, maintenance, taxes, insur-
ance, wear and tear, and cleaning fees. That totals well over $3,000 a month
or $36,000 a year. The condo would have to be rented every night from No-
vember 15th until April 15th to come close to breaking even in terms of
cash flow. This is nearly impossible; ski condos generally rent for long week-
ends and a few holiday weeks. It doesn’t take a complicated calculator to
figure out that the math doesn’t work unless the condo is in a rapidly ap-
preciating market and is rented every weekend—which means I wouldn’t
get to enjoy it!
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If you live in this type of town, you have two choices—invest else-
where or be extremely conservative in estimating vacancy rates or re-
sale time—and, of course, buy really cheap!
Mobile Homes
Mobile or “manufactured” homes can be risky, unless they’re on
their own parcel of land. If your home is in a park, you’re at the whim
of the park rules, which means your lot rent could increase or the lot
owners could change the standards and not allow renters. If you read
between the lines, owning a mobile park can be a safe bet; you collect
rent for the lots and you can also sell homes in your own park.
Be careful to distinguish between modular and manufactured
houses. A modular home is generally a prefabricated home that is built in
pieces, shipped to a destination, and constructed as a unit. Modular
homes are craned on-site and set on permanent foundations; once they’re
set in place they can’t be moved. These homes are generally classified the
same as regular “stick-built” homes for the purposes of financing.
Manufactured homes, which look similar, are built on frames and
tied down. They can, in theory, be transported to a new location, so
they’re generally treated like mobile homes and are harder to finance.
78 DEFENSIVE REAL ESTATE INVESTING
Gary’s Advice:
If It Quacks Like a Duck…
Many investors make the mistake of taking the word of a seller or real es-
tate broker that a house is a modular home when, in fact, it’s a manufactured
home. Here’s one easy way to tell the difference: By law, a manufactured
home must have a tag issued by the U.S. Department of Housing and Urban
Development (HUD) on it. The manufactured tag is located in two places: on
the outside of the home and under a sink in the kitchen.
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As you’re probably gathering from this chapter, we recommend
keeping your investment business simple if you want to succeed. Stick
to reasonably priced, single-family homes in good neighborhoods that
you can buy at a discount because they need a little work. Keep the
base of your investing portfolio in “the WOB in the MOB near the Blob”
category. Once you’ve mastered this, you can move on to the more ex-
otic investments.
Key Points to Remember
The most important concepts addressed in this chapter are:
• Invest in deals, not markets.
• Buy the WOB in the MOB near the Blob!
• Fixer-uppers can be a good bet—if you fix the right things.
• If you’re a novice investor, avoid risky deals.
5 / Always Invest in “Safe” Deals 79
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CHAPTER
81
Manage Your Cash Flow
“Cash is king.”
—Anonymous
Ask anyone who has spent a long time in real estate (or any other
business) about the secret to surviving and the response will probably
be these two words: cash flow. To remain a successful investor over the
long term, it’s imperative to master the art of managing your cash flow,
which is the sixth principle of defensive investing.
Many investors start out with little cash, and then what cash they
do have, they often sink into one property. They go broke in the
process because they don’t understand the importance of managing
their cash flow.
The Importance of Cash Flow
Many businesses fail in the first few year mainly due to poor cash
flow management.
According to a recent survey, the number-one thing small business
owners say they wish they’d have done differently was have more
startup money. Even experienced companies file bankruptcy, not be-
cause they don’t have a good business model but because they run out
of cash.
6
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Consumers, too, don’t often manage their cash flow effectively and
this can lead to foreclosures. True, the catalyst may have been an un-
expected layoff, a change in the economy, a divorce, or some other cri-
sis, but with sufficient cash reserves, consumers can overcome
virtually any problem.
The same principle applies to any business. Something can go
wrong or business can become slow because of a down cycle, but as
long as the business manages its cash flow, it will survive. Real estate
investing is no exception. The reason most investors fail is because
their plans and investment strategies don’t include effectively manag-
ing their cash flow.
For example, let’s say an investor (we’ll call him John) buys a house
as a rental property investment with no money down. If John has no
cash reserves, what happens if he experiences a 20 percent vacancy
rate—that is, he doesn’t rent the house for several months? What hap-
pens when there are repairs and unforeseen problems that may result
in the need for thousands of dollars in repairs or improvements? John
will have real problems if any of these events occur if his cash flow is
low or nonexistent.
82 DEFENSIVE REAL ESTATE INVESTING
Bill’s Advice: Unexpected
Repairs May Blindside You—and
Cause a Cash Crunch
Although I plan for repairs, vacancies, slow months, and a down market,
I’ve had more than my share of unexpected cash crunch issues.
For example, several times a local municipality made me repave a drive-
way, remove an abandoned car, or rebuild a fence. My insurance company
made me re-concrete a long walkway because of what they considered safety
issues. More than a dozen plumbing problems have caused major water dam-
age to my properties—damage that was less than my insurance deductible.
Every investor at some time gets blindsided by an unexpected repair
cost, so be conservative when establishing your cash reserves.
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6 / Manage Your Cash Flow 83
In essence, real estate investors are no different from average Amer-
icans who struggle to get by and live paycheck to paycheck, then sud-
denly get hit with an unexpected medical bill or car repair expense.
The bottom can fall out from underneath quickly, so you’d be wise to
set up a financial safety net.
How Much Should You Keep in Reserve?
There’s no magic formula you can use to determine how much you
should keep in reserve in the real estate business. When we rent prop-
erties, the four key factors to consider are strength of the local rental
market, eviction time line and cost, the age of the property, and the
type of neighborhood.
Strength of the Local Rental Market
The lower the vacancy rates in your area, the fewer reserves you’ll
need for vacancies. Your local newspaper or your city’s housing de-
partment may have articles or statistics on vacancy rates. You should,
at a minimum, have enough cash reserves to pay for one month of va-
cancy per unit, which is only an 8 percent vacancy rate.
Even in a good market, you’ll deal with problem tenants who may
stop paying rent and require an eviction. Good tenant screening will
help solve this problem. If you plan to rent properties, you should al-
ways, without exception, do a rigorous background check on tenants.
This includes reviewing credit reports, employment verification, refer-
ences, and calling current and previous landlords. (You’ll find a list of
resources for tenant screening in Appendix 4.)
Eviction Time Line and Cost
The length of time it takes to evict a tenant is relative to your cash
reserves. In pro-tenant states like New York and Massachusetts, it could
take months and thousands of dollars in legal fees to evict a tenant—
all while you’re paying the mortgage. In addition, in our experience,
collecting back rents or damages from tenants who’ve been evicted
can be futile.
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Age of the Property
With newer and recently renovated properties, you won’t need to an-
ticipate many repairs in the first few years. As noted earlier, we recom-
mend that you always hire a professional property inspector before you
buy. Inspectors will go through the property with a fine-tooth comb,
which helps ensure you’ll have no surprises later on. Another thing to
keep in mind is that many utility companies offer a fixed monthly pay-
ment option so you don’t experience payment swings each season if
you’re paying for heating, water, or other utilities as the landlord.
84 DEFENSIVE REAL ESTATE INVESTING
Gary’s Advice: Homebuyer’s
Warranty Is a Good Bet
When you buy rental property, purchase a homebuyer’s warranty to
cover everything from the furnace and air conditioner to appliances. These
warranties are available from many reputable insurance companies and often
cost less than $500 a year.
I know of an investor who buys properties in South Carolina and lives in
California. He instructs his tenants to call a toll-free number when a repair
that’s covered by the insurance plan is required. I purchased a home war-
ranty for approximately $300 and later discovered that the home needed a
new furnace and hot water heater at a combined cost of nearly $2,400. Was
the warranty a good investment? You bet!
Type of Neighborhood
If you’re renting properties in low-income neighborhoods, you can
expect the turnover to be much higher than in high-income areas. In ad-
dition, multiunit buildings with small units and one-bedroom condos will
attract more single people who tend to move more often than families.
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Cash Flow Applies to Fixer-Uppers and Flips Too!
Too often, inexperienced investors will buy houses, fix them up,
and decide to sell them. At this point, the investors have all their
money tied up in these houses. What happens if the houses on the mar-
ket for six months? The investors embark on a downward spiral, which
can lead to full-blown panic. Unfortunately, these investors can’t blame
anyone else for this situation; they should have planned for this possi-
bility and had the foresight to accumulate enough cash reserves to get
through this period. Lessons learned?
• Always price the property reasonably to move it quickly.
• Don’t overspend on repairs.
• Plan for it to take twice as long to sell as the average property
in the neighborhood.
Cash Flow versus Cash Reserve
Don’t look at your cash flow in a vacuum but look at it in relation-
ship with your overall financial strategy, the amount of cash you have
available, and your return on investment. For example, if you buy rental
houses for 100 percent cash, you probably won’t have a negative cash
flow, but you may not be maximizing leverage. On a similar note, the size
of your down payment will affect your cash flow on rental properties.
The following examples can shed some light on cash flow versus
cash reserve.
Cash flow example 1: Purchase a $100,000 property
with $20,000 down—Your $80,000 loan at 6 percent interest
(including taxes and insurance) is about $600 a month. As-
suming you can rent the property for $800 a month, you have
$200 a month cash flow or $2,400 a year. The cash flow is
good, but the $20,000 down payment may have wiped out
your cash reserve.
Cash flow example 2: Purchase a $100,000 property
with no money down—Your $100,000 loan at 8 percent (this
higher rate is common for zero-down loans) would make your
payments close to $900 a month. Again, let’s assume you can
6 / Manage Your Cash Flow 85
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rent the property for $800 a month. With zero down, you have
$100 a month negative cash flow—but you still have the
$20,000 in reserve.
Which is better? Well, it depends on your goals and the rest of your
financial picture.
Let’s say you intend to hold the property for ten years. In the first
example, you have $200 a month cash flow, but no cash reserve. In the
second example, you have $100 a month negative cash flow, but you
have $20,000 in reserve. Some people automatically assume that the
first example is safer, but is it really?
Think about it this way: In the first example, if your property be-
comes vacant for one month, you’d be out of pocket $600. Once you
rent the property, it would take three months to make up that $600. In
the second example, you have $20,000 in a cash cushion to make up
the deficit. With $20,000 in the bank, you could handle $1,200 a year
negative cash flow for 16 years. If the property is in an appreciating
market, you’d come out fine, even with negative cash flow.
Another factor in cash flow is the choice of loan. You could buy a
property with nothing down and an interest-only loan fixed at 5 per-
cent for three years. If your exit strategy was to sell within 36 months,
then why select a fixed-rate loan for 30 years?
The point here is that you shouldn’t automatically seek positive
cash flow as the only goal when choosing financing. Likewise, you
shouldn’t buy properties just for leverage and/or appreciation with
nothing down, experience a negative cash flow, and assume that short-
term market appreciation will be the only source of your profit.
Do you see how cash flow and cash reserve are important consid-
erations in your real estate investing plans and strategies? (See Appen-
dix 5 for a sample form that records cash flow.)
How Cash Flow Affects Your Decisions
By now, you’re getting the idea that to continue investing in real es-
tate over the long term, you need cash reserves. Buying real estate with
nothing down is easy. However, handling negative cash flow, repairs,
and other expenses once you purchase the property is the real test. In
fact, if you can make it through the bad times in real estate investing,
86 DEFENSIVE REAL ESTATE INVESTING
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6 / Manage Your Cash Flow 87
you’ll always come out on top. Lack of cash reserves—and the related
fear of vacancies—puts unnecessary pressure on landlord-investors to
do substandard repairs, accept unqualified tenants, and give in to ten-
ants’ demands. When these cash-strapped investors sell fix-and-flip
properties, this situation forces them to drop the price and leave too
much equity on the table because they can’t wait for the property to
sell to recoup their investment.
On the other hand, if you have the security of a sufficient cash re-
serve, you can act rationally and afford to play the waiting game, hold-
ing out for a higher sales price. You can also afford to wait for a
qualified tenant and even leave properties vacant rather than renting to
undesirable tenants. You can take care of necessary repairs and im-
provements on properties. In short, when you have cash in your
pocket, it’s a whole different ballgame than trying to operate with a
lack of cash.
The bottom line: You can buy real estate without money, but you
simply cannot survive in business without cash reserves. Thus, it’s im-
portant to consider accumulating cash reserves before you invest in
rental properties.
Generate Both Cash Flow and Cash Reserves
From a long-term perspective, rental properties can be a good
source of steady cash flow and equity buildup. As an investor, you can
buy a rental property and aim to break even, perhaps even provide
some cash flow, but with repairs and vacancies, this can be an up-and-
down process and most people won’t be able to retire on rentals until
these properties are paid off or have increased substantially in value.
Therefore, you need to plan other ways to generate cash flow or cash
reserves to protect your real estate investment business.
If you have a good-paying job, a spouse who works, another source
of income, or other cash reserves, rentals can be a good long-term in-
vestment play. If you don’t have any of these cash-generating
“weapons” in your arsenal, consider the following popular options to
generate some quick cash or build cash reserves.
Wholesale deals. A popular strategy is to do a lot of fix-and-flip
deals to generate cash and build a cash reserve. However, inexperi-
enced investors can get in over their heads quickly when a fixer-upper
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won’t sell. Some cable television shows make it seem that rehabbing is
easy, but it’s a lot harder to make a buck than it looks. Investors who are
new in the business, crunched for cash flow, or already involved in sev-
eral fix-up projects may consider wholesaling deals to another investor.
The wholesale usually involves flipping a fixer-upper property “as
is” to another investor who’ll do the lion’s share of the fixing. As the
wholesaler, you’ll only make a small profit ($5,000 to $10,000 per deal),
but there’s virtually no risk because, typically, you would accomplish
the transaction by using a double-closing or contract assignment.
Basically, a double-closing (or simultaneous escrow) means holding
two closings, back to back. The funds from the second closing are used
to fund the first closing. The double-closing is an effective way to buy
and flip properties without using your own funds. Despite rumors and
urban myths to the contrary, there’s nothing illegal about double-clos-
ings. However, many title companies and lenders won’t do double-clos-
ings because they fear potential fraud, but this is generally more of an
issue when flipping to owner-occupant buyers.
A contract assignment is an alternative transaction to a double-clos-
ing. Here, the buyer/investor assigns the purchase contract to another
investor who closes in his or her place. In the case of a contract as-
signment, there’s only one closing. A contract assignment is similar to
endorsing a check to a third party.
88 DEFENSIVE REAL ESTATE INVESTING
Bill’s Advice: Don’t Be Greedy
When figuring your profit on a wholesale deal, don’t expect too much.
Many novice (and some experienced, albeit foolish) investors expect more
profit than they deserve out of a deal. You must be realistic. If you want to
sell a property quickly to another investor who’ll do a lot of work and incur
some risk, you can’t expect to make as much as he or she will. While it’s pos-
sible to negotiate a great price and make a strong profit, remember that
most deals don’t have enough room for two investors to “make a killing.”
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6 / Manage Your Cash Flow 89
For a detailed discussion of the wholesaling process, refer to Flip-
ping Properties—Generate Instant Cash Profits in Real Estate, 2nd
Edition (Kaplan 2006).
Partner on Deals. If you don’t have the cash reserves, consider
partnering on a deal with someone who does. For example, a house in
an expensive area may rent for less than the mortgage payments, even
if you buy it at a tremendous discount in an appreciating market.
Bringing in a partner to cover the down payment requirement and to
feed the monthly negative cash flow could be profitable for both of
you if you split the profits when you resell the property.
Make sure you verify that this partner actually has the money and
consider forming a partnership or legal entity that has a bank account
where the money is deposited. (Chapter 8 discusses legal entities in
more detail.)
Bill’s Advice: Half of Something
Is Better Than All of Nothing
I know of a particular investor who had millions in equity. When the
local rental market went sour, he was stuck on negative cash flow on hun-
dreds of rental properties. His solution was to sell half of his equity, at a dis-
count, for cash to a partner. He used that cash as a reserve to feed the
negative cash flow the properties were demanding. As a result, he still has
plenty of equity and plans to sell the properties when the local market re-
bounds in price.
The lesson he learned is a good one that many investors would be wise to
follow: half of something is better than ALL of nothing is! If you can’t handle
negative cash flow, your equity won’t matter much when you lose your prop-
erties to foreclosure.
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Save Your Money. If your grandparents were like ours, they used to
scrimp and save every penny they could. Consider doing the same and
even wait awhile before investing until you have some cash in the bank.
If you have a good-paying job, we suggest setting up an automatic debit
of 10 percent or more of your income into a forced saving account.
Have Backup Sources of Funds. Having backup sources of funds
for emergencies doesn’t necessarily mean cash or other income. It can
be (at least in part) access to credit cards and credit lines. Many busi-
nesses have access to lines of credit for emergency purposes.
Many banks offer business credit lines up to $200,000, but these are
expensive to get. Often this will cost as much as $5,000, even if you
don’t use it. Don’t fret, though; you may already have more available
credit than you realize. Credit cards and other existing revolving debt
accounts can be quite useful in real estate investing. Most major credit
cards allow you to take cash advances or write checks to borrow on
the account. The transaction fees and interest rates are fairly high, but
you can access this money on 24 hours’ notice. In addition, you won’t
have to pay loan costs that are normally associated with a real estate
transaction such as title insurance, appraisals, pest inspections, sur-
veys, and so on. Often, you’re better off paying 18 percent interest or
more on a credit line for six months than paying 8 percent interest on
an institutional loan, which has up-front costs that would take you
years to recoup.
Promotional interest rates are often available on your credit cards,
but again, beware. These rates often skyrocket after several months.
Chances are if you have a good credit history, you’ll be able to raise
your credit limits on your existing cards. Creditors don’t need to know
you’ll be using your credit cards for the business of real estate invest-
ing. Ironically, these creditors would rather see you using credit-line in-
creases for typical consumer purchases that depreciate in value and
produce no income.
Keep in mind that you must approach high-interest debt cautiously.
Your personality type may not embrace the idea of owing tens of thou-
sands of dollars in revolving debt.
You can also benefit by using home improvement store cards with
no cash advance features. These cards are available through the major
lumberyards, hardware-store chains, and home-improvement stores.
90 DEFENSIVE REAL ESTATE INVESTING
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They allow you to finance your material costs that can involve many
thousands of dollars. The interest you pay for the use of this money is
generally deductible, so be careful to separate your business credit card
use from your personal credit card use.
A home equity line of credit (HELOC) can be an excellent financing
tool if you use it properly. Basically, a HELOC is a credit card secured
by a mortgage or deed of trust on your property. You only pay interest
on the amount you borrow on the HELOC. If you don’t use the line of
credit, you don’t have any monthly payments to make. You can access
the HELOC by writing checks provided by the lender. Note that, in
most cases, the HELOC will be a second lien on your property.
Key Points to Remember
Cash flow management is the bedrock of survival in any business,
with real estate being no exception. Defensive investors must be care-
ful not to run out of cash or they will be soon out of business.
The most important concepts addressed in this chapter are:
• Having little or no cash reserve is a surefire way to financial
disaster.
• Lack of cash flow can cause investors to make foolish, risky
decisions.
• Wholesaling properties can be a good way to generate cash flow.
• Line up sources of backup funds, such as credit cards and
credit lines.
6 / Manage Your Cash Flow 91
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CHAPTER
93
Have Multiple
Exit Strategies
“We must dare to think ‘unthinkable’ thoughts. We must learn to ex-
plore all the options and possibilities that confront us in a complex
and rapidly changing world.”
—J. William Fulbright
As mentioned earlier, we suggest you avoid entering a deal without
having a clearly defined exit strategy. Walking into a deal blindly is a
foolish move that will likely cost you dearly in the end. Many sorry in-
vestors have regretted jumping into deals without taking the time to
think them all the way through to the finish line. For an investor to sim-
ply rely solely on Plan A is a risky approach. You must also have a Plan
B and, ideally, a Plan C and D, as well. Our seventh defensive investing
principle is having more than one exit strategy.
As discussed in earlier chapters, market timing is difficult to pre-
dict, and many investors get into a market too late. This is fine if you
buy in areas where real estate appreciates over time and you actually
stick it out for the long run. In the stock market, there’s a concept
called, “dollar cost averaging,” which means if you keep buying con-
sistently, you will make out long term because some of your purchases
will be at the bottom of the market and some at the top. However, be-
7
chapter07_FINAL.qxp 3/15/07 3:47 PM Page 93
cause the market will always go higher in the long run, all of your pur-
chases will average out.
We believe the same concept applies to real estate—if you can sur-
vive in the long run. We don’t suggest that you throw caution to the
wind and just buy blindly. To the contrary, we advocate being defen-
sive—that is, plan carefully, consider the risk, know your market before
you buy, and have a backup plan if your assumptions turn out to be in-
correct. In fact, defensive investors have several backup plans if the
first one doesn’t work out.
Choices, Choices, Choices
No single exit strategy is inherently better than any other is. The
best choice for you in a given situation varies depending on numerous
factors including your long-term plans, the local market, your cash-
flow situation, and the condition of the property.
Let’s discuss a variety of real estate investment strategies that could
be your Plan A. Later in this chapter, we’ll discuss appropriate backup
plans you can turn to when Plan A doesn’t work.
The Fix-and-Flip
In the rehab deal, an investor intends to buy a property in need of
repair, fix it up, and then sell it to an owner-occupant. This property
will likely be listed on the Multiple Listing Service and involve a real es-
tate agent. Investors call this selling retail.
Always figure on paying a real estate commission when you sell
property retail. The standard commission in most parts of the country
is about 6 percent. Many novices make the mistake of thinking they
can cut out the broker’s commission and sell property on their own.
However, more than 95 percent of all retail properties (new homes ex-
cluded) sell on the MLS so don’t assume you can beat the odds.
The Wholesale Flip
As you learned in the previous chapter, you can flip a rehab prop-
erty “as is” to another investor. With this exit strategy, keep in mind
that there must be enough profit to go around here. Don’t try to work
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7 / Have Multiple Exit Strategies 95
on the “greater fool” theory—that is, a novice investor who knows less
than you, buys it thinking he can make a profit. This is hardly a way to
make a living, is unpredictable, and will not leave you feeling good
about yourself at the end of the day.
The Partial Rehab
In strong markets, you can flip properties directly to the retail sec-
tor with little or no rehab work involved. This an excellent exit strat-
egy in strong markets because if the property is in decent shape, you
may only need to do basic redecorating to prepare it for resale.
Even when the property needs more work, you can often make es-
sential improvements quickly and then sell it as a minor fixer-upper.
This is often referred to as a partial rehab or a flip/fix combo. In this
situation, a thorough cleaning and some painting may be sufficient to
get this property ready for sale. You can complete those tasks within a
few days so you’ll be able to offer this type of property for sale quickly.
Bill’s Advice: Consider Using a
Flat-Fee Listing Broker
If you have extra time on your hands, you can go with a flat-fee listing
broker. Most properties involve two brokers: the listing broker and the sell-
ing broker (a.k.a. the buyer’s broker) who split the commission when the
property sells. For a $200,000 house, a 6 percent commission is $12,000. A
flat-fee listing broker will charge you $500 or less to list the property on the
MLS. You’ll still need to pay the selling broker’s commission (about $6,000 in
this example), but you’ll save a lot of money—about $5,500 in this example.
However, you’ll have to conduct your own open houses, show the property,
and prepare contracts yourself. If you’re uncomfortable with the paperwork
and legal details, hiring a good real estate attorney is a lot cheaper than a
listing broker!
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The Rental
You can buy and hold a property as a rental, or you can buy, fix, and
hold a property as a rental. With this strategy, you must be familiar with
the rental market in your area (particularly in your farm area), the ap-
propriate expenses, and the rental laws. Keep in mind that rentals re-
quire time management so you should be able to devote the
appropriate time. Hiring a property manager for one single-family
home is economically unfeasible and usually unnecessary. Property
management isn’t easy and you should learn how to do it properly. An
old saying goes like this: “What you don’t know about landlording,
your tenants will teach you.” We highly recommend these books:
• Goodwin, Daniel et al. The Landlord’s Handbook, 3rd ed. Ka-
plan Publishing (2003).
• Robinson, Leigh. Landlording: A Handymanual for Scrupu-
lous Landlords and Landladies Who Do It Themselves, 10th
ed., Express Publishing (2006).
•Taylor,Jeffrey.The Landlord’s Kit: A Complete Set of Ready-to-
Use Forms, Letters, and Notices to Increase Profits, Take Con-
trol, and Eliminate the Hassle. Kaplan Publishing (2002).
The Lease/Option Strategy
Another popular exit strategy option is to rehab a property, refi-
nance it, and then lease it to your renters using a lease with an option
to buy. Lease/option is a popular format because it allows the seller to
get top dollar for the property without paying a broker’s fee while
covering mortgage payments on the property until the tenant exer-
cises his option to purchase. Generally speaking, you can get a higher
price for a property if you offer creative terms (e.g., give a partial rent
credit to tenants against the purchase price of the property, which al-
lows them to generate equity if they can’t afford a down payment at
the time). If tenants do exercise their option to purchase after 12
months, you’ll fare better with your tax situation than if you had
flipped the property quickly.
96 DEFENSIVE REAL ESTATE INVESTING
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Owner Financing
As the investor and seller in an owner-financed sale, you’d take all
or part of the purchase price in the installment payments after closing
instead of taking all cash. Remember, “all cash” doesn’t necessarily
mean the buyer is using 100 percent cash to purchase the property; it
may mean the buyer gets a loan. Both result in the seller receiving all
cash for the purchase price.
Three top benefits of doing an owner-carry installment sale rather
than a cash sale are:
1. Highest price—As the seller, you can insist on and receive the
highest price when offering flexible owner-finance terms. In
many cases, you can receive more than the fair market value of
the property by offering these “soft” terms. People are always
willing to pay a premium for nonqualifying financing.
7 / Have Multiple Exit Strategies 97
Bill’s Advice: Take Time to
Learn the Pros and Cons of
the Lease/Option Strategy
If you hold a property for 12 months or more, the gain on the sale is con-
sidered a long-term capital gain and taxed at a lower rate than if you sell the
property within 12 months. (We’ll discuss taxes in more detail in Chapter 8.)
However, a lease/option transaction does involve inherent risk. If ten-
ants choose not to exercise their option to buy, you’re left with the prop-
erty. The market may have taken a downswing since you first obtained the
property, meaning you’ll either need to lower your asking price or hold on
to the property awhile. In addition, if tenants put down a substantial de-
posit or did repairs and improvements, they may be able to claim an “equi-
table interest” in the property, making eviction more difficult. Good
paperwork is essential to making any lease/option strategy go smoothly.
For more details, check out the “Big Profits with Lease/Options” system,
which is available at www.legalwiz.com.
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2. Cash—Nearly every seller says he or she wants all cash, but
few really need it. Instead, the typical seller wants the most net
cash from the deal. Often, the seller must pay closing costs, title
insurance, broker fees, and the balance of the existing financ-
ing. In addition, you may need to pay capital gains tax to Uncle
Sam. In many cases, the sale of a property by an installment sale
will net you more future yield than any source from which the
cash proceeds were reinvested.
3. Fast closing—Nothing holds up a sale more than new lender
financing. In some areas of the country, it can take months for
a buyer to qualify and close a new loan to purchase your prop-
erty. Because most standard real estate contracts contain a fi-
nancing contingency, you may end up back at square one if
your buyer doesn’t qualify for a loan.
There are few assumable loans available to buyers and few sellers
offer these soft terms. Thus, an owner-carry sale makes your house
unique. Furthermore, an owner-carry transaction can be consum-
mated in a matter of days. That’s because there is no appraisal, under-
writing, or survey involved. In many cases, you’ll be able to sell the
property with owner financing and save thousands of dollars in real
estate brokers’ fees.
Pitfalls and risks of owner financing. The main risk of offering
owner financing is that the buyer may default, requiring you to go
through a legal proceeding to get the property back. An unrecorded
land sale contract (a.k.a. “contract for deed”) is often a viable strategy
to allow you to sell the property and quickly remove the buyer for non-
payment. It can be challenging, though, because the process is not
well defined in many states, resulting in uncertainty as to the legal
process and thus the cost and time involved.
A foreclosure on an owner-financed deal may take several months
and cost many thousands in legal fees; all the while, you’re paying your
existing loan payments, property taxes, and so on. It’s important to dis-
cuss the process with a local attorney before proceeding with an
owner-financing sale.
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7 / Have Multiple Exit Strategies 99
Exit Strategies and Financing Options
As a real estate investor, your exit strategy will play a major role in
deciding the kind of financing option you may need or want. The main
factor will be your anticipated time from loan initiation to loan payoff.
Short-Term Financing
Short-term financing is a temporary source of money that you may
use, assuming you’ll refinance or resell the property quickly. Short-term
financing generally has a higher rate of interest and a balloon or payoff
deadline within six to 12 months. Generally, you access short-term fi-
nancing through smaller commercial banks or private hard-money
lenders (called equity lenders) who make their money on up-front
points and fees.
Short-term financing is useful even when long-term financing may
be a better deal for two reasons: availability and speed.
Availability of financing is often more important than cost. Al-
though short-term loans are often costly, even a high-interest loan can
make sense when you plan to keep the property for a short time be-
fore selling or refinancing it. This does involve some risk, though—if
something unexpected happens and you can’t sell or refinance the
property quickly, you’ll be forced to endure that high interest rate.
You can quickly obtain funds with short-term financing. Generally,
long-term financing takes more time and requires more documenta-
tion, which potentially means a lost opportunity for a good deal. With
short-term financing, equity lenders are more concerned with the col-
lateral they are lending against than the credit or income of the bor-
rower so funding can be completed in a matter of days. Availability of
quick financing can be important to your real estate investing business
because decisions are made by a smaller, more flexible lender who will
finance deals that the big players won’t.
While equity lenders won’t go as high on loan-to-value as the credit-
based lenders, they base their loan-to-value calculation on whichever is
highest: the purchase price or appraisal. Remember, credit lenders gen-
erally base their loans as a percentage of whichever is less: the pur-
chase price or the appraisal price. This means that even if you
purchase a property at 50 percent of value, you can’t do this type of
loan with no money down.
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100 DEFENSIVE REAL ESTATE INVESTING
Bill’s Advice: Buy “Subject to”
Existing Financing
If possible, try to buy the property “subject to” the existing financing as
an alternative to short-term financing. Buying “subject to” means you get
the seller simply to deed you the property without paying off the existing
loan. As the buyer and investor, you would make the payments until you sell
or refinance the property. Buying “subject to” existing financing is fast, less
costly (no new loan costs are involved), and doesn’t tie up your credit.
In most cases, the mortgage or deed of trust securing the existing loan
contains a due-on-sale restriction, allowing the lender to call the balance
owed immediately due and payable. Some misinformed real estate “profes-
sionals” will tell you that it’s illegal to transfer ownership of a property with-
out notifying the lender. This is hogwash. First of all, most lenders could care
less, especially if the payments are being made on time. Second, by the time
they find out, you’ll have paid off the loan by reselling the property or refi-
nancing the debt. It’s a good idea, however, to make sure there is full dis-
closure in writing to the seller about the implications of leaving the loan in
his or her name. Some states have a mandated disclosure for taking “subject
to” properties in foreclosure.
Keep in mind also that if you sell a property by a lease/option or land sale
contract (a.k.a. “contract for deed”), it will also trigger the due-on-sale process
on your underlying loan. However, most lenders don’t find out because the
agreement is not recorded. In most cases, lenders don’t even care as long as
the loan is being paid; their only incentive to enforce the due-on-sale is fi-
nancial. If market interest rates are higher than the existing loan, it makes
sense for the lender to make you pay it off so they can refinance you (or your
buyer) at a higher rate. Therefore, it’s recommended that you place some sort
of “out” position (e.g., a balloon date or option expiration date) so you aren’t
tied to the deal indefinitely and risk the lender calling in the loan.
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7 / Have Multiple Exit Strategies 101
Long-Term Financing
Long-term financing will give you more options if you’re not
pressed for time to close, when loan-to-value isn’t an issue or you plan
to keep the property as a rental. Many options for long-term financing
are available if you have good credit. These include fixed-rate, ad-
justable-rate, and interest-only payment loans, and the option ad-
justable rate mortgage (ARM).
In a rising interest rate market, fixed-rate loans may be the way to
go if you plan to keep a property for a long time. However, a 30-year
fixed-rate loan is generally the most expensive type of long-term loan
in terms of fees and interest rates. Adjustable-rate and interest-only pay-
ment loans can be a cheaper option, depending on your back-end strat-
egy. Generally speaking, a loan that adjusts based on the market rate of
interest charged is less risky for lenders because it hedges their bets
against rising interest rates. Accordingly, they’ll offer you a cheaper
starting rate than if the rate were fixed over 30 years.
Of course, the same risk works against you if interest rates rise in
the future. Many adjustable rate loans are fixed for a certain time pe-
riod (e.g., three years) and/or can only adjust a certain percentage per
year. You don’t want any big surprises. If you plan to sell the property
on a lease/option within a few years, then an adjustable rate mortgage
may be the way to go.
One of the most misunderstood loans is the called the option ARM.
With an ARM, the interest rate is based on an index like the London In-
terbank Offered Rate (LIBOR). The loan has four payment options,
each of which can change monthly based on the interest rate the loan
is indexed to.
These options are:
• Interest only
• Amortized for 15 years
• Amortized for 30 years
• Minimum payment
Depending on the market interest rate, the minimum payment may
create a negative amortization, which means the loan balance may in-
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102 DEFENSIVE REAL ESTATE INVESTING
crease with time. Carefully used, an option ARM can be an excellent
way to hedge your bets with rental properties because this provides a
low-payment option if you have unexpected repairs or vacancies. The
ARM is particularly effective in a rising price market because it gives
you some breathing room if your loan balance is increasing.
Prepayment Penalties
Carefully check when you get a loan to see if there’s a prepayment
penalty. Often, loan reps quote you a better rate than their competi-
tors; you find out why when you go to sell the property and discover
that there’s a prepayment penalty. A prepayment penalty is a fee you
must pay to the lender for paying off the loan early. In most cases, the
penalty only applies in the first few years of the loan. A prepayment
penalty is typically three to six months of interest payments based on
the original amount of the loan.
Prepayment penalties are not always a bad thing. If you have no in-
tention of selling or refinancing the loan within the first few years,
then having a prepayment penalty won’t be a problem. In fact, it may
allow you to pay less in loan fees or have a lower interest rate. If you’re
uncertain of your exit strategy and want the most options, you may
have to pay a fee up front to get rid of the prepayment penalty.
Gary’s Advice:
Don’t Be Tricked!
Two types of prepayment penalties exist: “hard” and “soft.” The soft pre-
payment penalty applies whenever you refinance the property and don’t sell
it. A hard prepayment penalty is paid for the term of the penalty, whether
you transfer title in any manner or refinance it. No matter what your mort-
gage broker says, read the documents carefully at closing. Many investors
get tricked into signing documents with a prepayment penalty. When they
realize the mistake, it’s often too late, so beware!
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Remember, the lending business changes often, and this can affect
your exit strategy if you had planned to refinance the property a few
years down the road. You need to work with a knowledgeable mort-
gage professional before you go into a deal.
What to Do When Plan A Doesn’t Work
When your primary plan of action doesn’t work, you need to have
a backup strategy. This may involve switching gears from a retail sale to
a rental or rent-to-own deal. However, before you give up, here are a
few tricks that may work and a variety of backup strategies.
Stage It
The cheapest way to create appeal for your property is to stage it—
that is, dress it up so it doesn’t look empty. The idea is to upgrade the
appearance of the property, so you wouldn’t use cheap-looking items
or those that might appear too personal in taste. You may feel qualified
to make all the decisions regarding your décor and presentation, but it
would be wise to get second opinions from an interior decorator,
friend, or real estate expert. Visit show homes in new neighborhoods
to gather ideas. You can even borrow a few items from your home if
you don’t have sentimental attachment to them.
Professional staging companies will decorate the house and bring
the furniture with them. Depending on the size of the house and price
range, this may make sense. It isn’t uncommon for sellers to pay
$10,000 to decorate a $1,000,000 home professionally. Of course, this
may be overkill in a small starter home or condominium priced under
$250,000. Although the term home staging is trademarked, it has be-
come a common expression in the industry and refers to the process
of decorating houses for resale.
Visit these Web sites to learn about easy ways to stage your prop-
erties for sale:
• www.simpleappeal.com
• www.stagedhomes.com
• www.homestagers.com
7 / Have Multiple Exit Strategies 103
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Offer Attractive Sales Terms
Every type of business acknowledges the value of offering attractive
financing terms to attract customers—especially in cases involving a
backlog of inventory that needs to be sold. Auto dealers frequently em-
ploy this strategy, especially at the end of the year when they need to
clear out last year’s models to make room for the coming year’s mod-
els. This is when you’ll see commercials promising “zero-percent fi-
nancing” deals or similar offers.
It’s no different in real estate. Investors who have properties that
haven’t been selling can often increase a buyer’s interest by offering at-
tractive financing options. For example, you can offer to pay the clos-
ing costs or you can “buy down” the buyer’s interest rate by offering to
prepay six months of payments on the buyer’s loan. Another strategy
is to offer to carry back 10 percent or more of the purchase price with
a note secured by a lien on the property. By making arrangements in
advance to help buyers with financing, you can attract more buyers.
104 DEFENSIVE REAL ESTATE INVESTING
Bill’s Advice: Don’t Cross the Line
from “Creative” to “Criminal”
Whatever creative financing you do, make sure it’s aboveboard and dis-
closed on the settlement statement (HUD-1 form) at closing. Sometimes
sellers (at the suggestion of the buyer, the buyer’s real estate broker, or
mortgage broker) mark up the sales price and give the seller his or her
down payment back after closing. In this way, the buyer can get 100 percent
financing. This is illegal—don’t do it.
Change Your Exit Plan
Your exit strategy may have been to sell the property retail, but if
that doesn’t work out, you could refinance and rent the property
awhile. On the other hand, you could offer a lease/option or owner fi-
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nancing. You might also consider the advantages of wholesaling to
other investors, not only for cash but also for alternative terms.
7 / Have Multiple Exit Strategies 105
Bill’s Advice: It
Pays to Be Flexible
I once put a rehab property under contract and tried to flip it wholesale,
only to find out there was a slim profit margin for a fix-and-flip. The investor
who bought it from me gave me a note, which was paid when he resold the
property. The total cash in my pocket wasn’t substantial, but I only spent a
few hours on the deal. Sometimes it pays to be flexible and receive your
profits on a marginal deal, which is better than losing a deal altogether.
Bring in a Partner
Sometimes a partner can bring something to the table that you
don’t have. The missing resource could be credit (the ability to borrow
to refinance the debt), cash, or experience. Bringing in a partner to re-
work the deal can be effective, particularly if there’s enough equity to
share. For example, if your credit is shaky, you’re overextended, or you
simply ran out of cash, a partner can help fund negative cash flow or
lend his or her credit to refinance the property in exchange for a per-
centage of the back-end profit. Remember, there must be enough eq-
uity in the deal for a second person to profit; otherwise you won’t find
too many willing partners.
Bail Out and Cut Your Losses
Sometimes the only option is to bail out and cut your losses. It takes
a big person to look in the mirror and say, “I made a mistake.” Too
many investors let their egos get in the way and hold on longer than
they should and the bleeding never stops. If it’s a retail deal, then drop
your price, even if it means losing money. If it’s a rental, drop your rent
low enough to attract a solid tenant. If your monthly carrying cost is
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$1,000 on a unit, it makes sense to drop your rent by $80 a month
rather than have a vacancy. In fact, if you’re offering the property on a
lease with the option to purchase, you may consider dropping the rent
below market and taking a monthly loss to make it up on the back end,
assuming there’s enough equity to justify the monthly loss.
For example, suppose you buy a house for $150,000 and it’s worth
$200,000, but because of a poor financing choice, your monthly pay-
ment is $1,300 a month. Even if market rents are $1,100 a month, that
doesn’t mean you must hold out for $1,300 a month. Rather, it makes
sense to rent it for $1,100 or even $1,000 to get a qualified tenant who
can eventually buy it for $200,000 in two years. A loss of $300 for 24
months is only $6,800, which is justified when you make $50,000
profit on the back end. Words of caution, though, never compromise
your rental standards because it will cost you more in the long run for
evictions and repairs.
Over the past few years, many novice investors got into precon-
struction deals, anticipating a huge increase in prices by the time the
development finished. Instead, the values flattened or dropped. Rather
than walk away from their deposits, many insisted on completing their
purchases, hoping the market would come back. They were often
wrong, and ended up selling the property for less than they bought it
for. If they had stayed in the game long term or had devised a viable al-
ternative exit strategy (such as renting in the meantime) then they may
have come out on top. More often than not, however, the best course
of action may be to cut your losses early.
106 DEFENSIVE REAL ESTATE INVESTING
Real-Life Story: Sometimes
Cutting Your Losses Is Best
An investor we know put up over $100,000 in deposits on new con-
struction condos in Las Vegas. By the time the first half of the development
was half built, “reservation” prices on the second preconstruction phase
were higher than the first phase prices. The investor figured that the differ-
ence between the so-called “market” prices of reservations on the second
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Renegotiate the Debt
If you end up owing more on a property than it’s worth (or on sev-
eral properties for that matter); you could be in a real pickle. There’s
no room to drop your prices if the market value of your houses is less
than your debt.
In this case, you can either wait out the market or negotiate with
the lenders who hold the liens on your properties. Your likely options
are short sale, forbearance, and deed in lieu, discussed next.
Lenders realize that taking back properties in mass isn’t good for
their portfolios. Often, they’re willing to take a discount on what is
owed. Called a short sale, the lender essentially accepts less than the
full amount as a payoff, contemporaneously with a sale. The lender
won’t allow you to profit from the deal so a refinance isn’t possible;
you need to sell the property to a buyer at an arms’-length transaction
(that is, to someone who’s not related to you by family, friendship, or
business). Make sure the debt is settled in “full satisfaction”; otherwise,
the lender could sue you for a deficiency. Keep in mind, also, the ex-
tent that the debt is forgiven by the lender because you may have tax-
7 / Have Multiple Exit Strategies 107
phase and the prices he had reserved in the first phase amounted to about
$500,000 in equity.
We tried to explain to him that this equity was like fool’s gold because
neither phase of the construction was complete and by the time he’d actually
resell those units, the true market price could be lower than his acquisition
price due to competition from other condo projects.
When the time came for the next required payment on the condo units
(over $250,000), we suggested he either sell one-half of his interest in his “eq-
uity” to a partner for $100,000 (limiting his risk to zero) or walk way. He was in-
credulous, insisting that he had $500,000 in equity. Unfortunately, many
novice investors don’t think defensively when it comes to real estate. Time will
tell who’s right on this deal, but there’s a lesson to be learned. As the old ex-
pression goes, “pigs get fat, hogs get slaughtered.”
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108 DEFENSIVE REAL ESTATE INVESTING
able income. We strongly suggest reviewing this exit strategy with your
tax advisor before proceeding.
If all you need is more time to try to sell a property, sometimes you
can work a forbearance with the lender. A forbearance happens when
the lender agrees to work with you on back payments. If you have the
property actively listed, the lender may delay proceeding with foreclo-
sure on the property, which gives you more time to sell it. Remember,
the more contact you have with your lender, the more the lender will
be willing to work with you. Silence is the worst tactic when you’re in
default on a loan with your lender.
If the lender is willing, another option is to accept a deed in lieu
of foreclosing the property. This involves simply deeding the property
to the lender in exchange for the lender’s promise not to sue you for
a deficiency.
Buy It Right
As stressed earlier, you need to make your money when you buy.
Thus, you can see how your exit strategy is often dictated by two fac-
tors: your purchase price and your local market. The better deal you
get when you buy, the more options you’ll have on your exit. Too many
investors make the colossal mistake of paying too much for a property
and assuming they’ll “make it up” on the back end of the deal.
The following common mistakes shed light on how investors can
fail to “buy it right.”
The “Skinny” Rehab
Let’s say your rehab strategy is to buy at 75 percent of the after-re-
paired value, less repair costs. The property is worth $200,000 in per-
fect condition and needs $20,000 in repairs. The maximum you want to
pay is 75 percent of $200,000 ($150,000) minus $20,000, which equals
$130,000. You offer $130,000 and the seller counters at $150,000. You
arrive at a negotiated price of $143,000. It’s more than you wanted to
pay so you figure you’ll spend a little extra in repairs to make it extra
nice so you can sell the property for $205,000. However, when you get
into the project, you realize it will cost $30,000 in repairs. Then you’d
have to list it for $209,000—without a single comp in the neighborhood
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to support that price. You end up holding the property too long, drop-
ping the price, and selling the property for $193,000. After loan costs,
holding costs, seller concessions, and real estate broker commissions,
you barely break even. This is a common tale.
The moral of this story is that you have to be conservative in your
repair estimates and your resale price on rehabs. There’s rarely such a
thing as a “skinny” rehab unless you are keeping it as a rental or are
lucky enough to be in a hot market where properties sell no matter
what their condition.
The “Skinny” Lease/Option
You buy a property worth $200,000 for $180,000. It only needs car-
pet and paint, or so you think. Your strategy is to sell it on lease/option
for $209,000. Once you fork over $4,000 in loan costs to acquire the
property, you realize the small “carpet and paint” job also involves re-
placing a furnace and hot water heater, totaling $8,000. The property
sits vacant for two months while you look for a tenant. This brings your
total acquisition cost to $200,000. To top it off, your tenant/buyer
leaves after three months. Your property is once again vacant and
you’re losing money.
The moral of the story is that you shouldn’t pay top dollar for a
property just because you have a built-in back end, because that back
end may not work. Instead, develop multiple exit strategies in case
your initial plan doesn’t work out. Certainly you’ll save a few bucks by
not having to advertise for a tenant and pay monthly mortgage pay-
ments in the meantime, but that doesn’t justify paying $20,000 more
than you should.
The “Greater Fool” Deal
You’re trying to wholesale fixer-upper properties to other investors
without a clue about what other investors want to pay. You get a
$200,000 fixer-upper property under contract for $166,000, then at-
tempt to find someone who’ll buy it from you. Three investors tell you
that you’re asking too much. On top of that, you want $10,000 to as-
sign the contract. You figure you’ll advertise it in the paper and flip it
to a novice investor. Once in a while, you can justify it by saying,
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“Well, that person is just less discriminating than I am.” The point here
is you need to have ethics in this business; taking advantage of others
should not be a basis for your investing practices.
We see these mistakes every single day in our business; they’re all
too common. The bottom line is that you need to obtain a property
that’s cheap enough to leave yourself multiple exit strategies. If you
buy a cheap enough property but it won’t sell, drop the price. If it
won’t rent, you’ll have enough room to sell it cheap—and the more eq-
uity you have, it’s easier to bring in a partner or refinance the property.
110 DEFENSIVE REAL ESTATE INVESTING
Gary’s Advice: Shoot for
20 Percent Equity
The magic number for investor financing is 80 percent. As long as you
have a bona fide 20 percent equity position (or better), financing is gener-
ally fairly easy. Once you try to go higher than 80 percent loan-to-value fi-
nancing, your options are limited.
Key Points to Remember
The defensive investor is always thinking “exit strategy.” Better yet
is having a backup plan, making you a really smart investor. The name
of the game is “risk” and the more contingencies you plan for, the bet-
ter your chance of success.
The most important concepts addressed in this chapter are:
• Never get into a transaction without having a plan to get out of it.
• Having one exit strategy isn’t enough. You also need to have a
Plan B as a backup.
• Sometimes your only option is to cut and run.
• Buy right and you’ll have multiple exit strategies.
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CHAPTER
111
You’ve Earned It, Now
Learn How to Keep It
“A lawyer with his briefcase can steal more than a hundred men
with guns.”
—Mario Puzo, author of The Godfather
Unfortunately, we live in a litigious society where many people
seek to place blame on others. Some people believe that if you treat
people right and carry sufficient insurance, you’ll be fine, but that’s
naïve thinking, which can get you into a lot of trouble. One lawsuit can
ruin everything you’ve worked hard to create, which is why it’s critical
to apply the eighth principle, learning how to keep your wealth.
Real estate is a high-risk business, particularly when dealing with
rental properties, tenants, and rehab projects. There are a lot of ways
to mess up a deal and lose your investment—and potentially more if
someone has a good lawyer. Every investor needs to learn some defen-
sive strategies to keep what they have, including limiting taxes and
avoiding lawsuits.
Know the Laws
Start by knowing the laws as they apply to your real estate business.
The old expression “ignorance of the law is no defense” is true. You’re
8
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expected to know the law as it applies to your business. Your state, city,
or municipality may have particular laws, codes, and regulations with
which you must become familiar. Discuss your business practices regu-
larly with a local attorney and other investors in your business. Review
your forms, agreements, and contracts to make sure the disclosures and
clauses are appropriate for the particular way you do business.
Common Investor Legal Mistakes
You can’t expect to reduce your risk of getting sued to zero, but
you can take steps to reduce your risk as much as possible. In any sit-
uation where your money is at risk, ask yourself, “Is there a better
way?” Know the legal and financial risks of the situations in which you
place yourself, your business, your family, and your assets.
Without covering every issue involved, here are a few common mis-
takes that investors make, novice and experienced alike.
Poor legal forms. It’s amazing how short-sighted novice investors
can be when it comes to shelling out money for good legal contracts.
They often buy contracts at discount office supply stores, from Inter-
net Web sites, or borrow them from friends. However, a real estate deal
is only worth the paper it’s written on. Like the old expression, “every
tax strategy works until you get audited,” it can be said that “every con-
tract works until you have a dispute.” Therefore, invest in a good set of
legal forms that apply to your practice and ask a local real estate attor-
ney to review them. Also, make certain you fill in the forms correctly—
a good real estate attorney will review contracts for just a few hundred
dollars.
Too many people rely on real estate brokers to fill out contracts,
which is fine for a “standard” deal. However, most brokers aren’t
trained in legal matters and often create long contract addendums that
are insufficient to protect your interests.
Illegal discrimination. The Fair Housing Act of 1968, as amended,
prohibits discrimination on the basis of race, color, religion, national-
ity, familial status, age, and gender. Many state and local laws also for-
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bid discrimination on the basis of sexuality or source of income and
the Americans with Disabilities Act makes it illegal to discriminate
against disabled people. If you harbor any such prejudices and would
allow them to come into play when renting a housing unit, then you’re
probably not cut out to be a landlord. However, many sincere real es-
tate investors make honest mistakes that result in discrimination law-
suits. The best way to avoid these lawsuits is to be informed.
The Fair Housing Act may appear to be common sense and most
people would never think of discriminating against people of different
races or religions or on the basis of gender. However, it’s important to
note that the Act extends beyond the screening process and into ad-
vertising as well, so watch the wording in your ads. This is where many
landlords and property managers make critical mistakes. Some people
scour the classifieds looking for inappropriately worded ads so they
can pounce on them and threaten a lawsuit. While someone must have
standing to bring suit, these scoundrels often work in coalitions to en-
sure that all of their bases are covered.
For example, if you own a rental property in a predominantly Jew-
ish community, its proximity to the local synagogue could be a major
feature. However, if your ad says “within walking distance of the syna-
gogue,” you could be sending the message “Gentiles need not apply”—
even though this wasn’t your intent. Keep in mind also that you may
not discriminate on the basis of whether a couple is married and
whether children are to live in the unit. You may also not discriminate
on the basis of age. Often, novice landlords aren’t aware of these areas
of concern—and while it’s good that citizens are more aware of their
rights today, it can create a bad situation for well-meaning landlords
who are out of step with the law.
Be aware of your local laws and use good business sense. State law
and local ordinances can extend similar protections granted under the
Fair Housing Act to other groups. For example, California, Minnesota,
and North Dakota prohibit discrimination based on source of income. In
other words, landlords can’t discriminate against would-be tenants who
rely on public assistance. Putting the political perspective of the landlord
aside, such discrimination makes little business sense because people on
welfare or social security are virtually assured of a fixed income.
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The Americans with Disabilities Act (ADA) prohibits discrimination
against the disabled and also requires landlords to make “reasonable ac-
commodations” to disabled tenants. Who decides what’s reasonable?
Typically, courts, if it comes to that; but while most landlords are aware
of the ADA and would never stoop to discriminate against a person in
a wheelchair. However, many are unaware that the ADA also protects
mentally disabled tenants. A mental disability could also include recov-
ering alcoholics and drug addicts.
Improper disclosures. Improper disclosures are a common mistake
for investors. It’s critical to be aware of the federal and state require-
ments for disclosures. For example, federal law requires a lead-based
paint disclosure on the sale or rental of properties that were built be-
fore 1978. State laws may have additional regulations.
It’s become common practice for real estate brokers to use a prop-
erty disclosure form for all aspects of the house. Even if you’re selling
your house on your own, be sure to use one of these forms (refer to
the sample in Appendix 6). Whenever in doubt, disclose what you
know, especially something the buyer or tenant may not know about,
such as dangerous conditions, water damage, electrical issues, or
plumbing problems.
Illegal solicitation of money. Many novice investors try to solicit
money for investing via public advertising or mailings. This is com-
monly referred to as syndication. You may inadvertently cross over a
variety of federal and state securities regulations when trying to raise
capital. Chatting with friends over the dinner table about a real estate
deal is one thing, but advertising to the public in mass may be consid-
ered a “public offering”. Before soliciting money from strangers, re-
view your marketing, paperwork, and solicitation strategies with a
local attorney well versed in this area of law. You may be able to get
away with a good set of written disclosures if you solicit money on a
limited basis, but it’s better to be safe than sorry.
Independent contractor liability. The IRS and your state depart-
ment of labor are on the lookout for employers who don’t collect and
pay withholding taxes, unemployment, and workers’ compensation in-
surance. If you have employees that are “off the books,” you’re looking
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for trouble. If you get caught, you’ll have to pay withholding taxes and
as much as a 25 percent penalty. Intentionally failing to file W-2 forms
will subject you to a $100 fine per form.
If you hire people to do contract work for you on a per-diem basis,
the IRS may consider them employees. If any workers fail to pay their
estimated taxes, you may still be liable for withholding.
To protect yourself, you should:
• Hire only contract workers who own their own corporation or
get the business card and letterhead of any unincorporated con-
tractors you may use so you can prove these workers aren’t
your employees.
• Require proof of insurance (liability, unemployment, and work-
ers’ compensation) in writing.
• Get written contracts or estimates on workers’ letterhead that
states they’ll work their own hours and that you don’t have di-
rect supervision over the details of the work. (Refer to the sam-
ple independent contractor agreement in Appendix 7.)
• Have letters of reference from other people for whom the con-
tractors worked to show that the contractors didn’t work solely
for you. Keep these in your files.
• File IRS Form 1099 for every unincorporated worker to whom
you pay more than $600 per year.
In addition to possible tax implications, an independent contractor
can create liability for you if a court determines the contractor is your
employee. For example, if your independent contractor is negligent
and injures another person, the injured party can sue you directly. If
facts show that you exercised enough control over your contractor, a
court may rule that this contractor is your employee for liability pur-
poses. As you may know, an employer is “vicariously liable” for the acts
of his or her employees—the employer is liable as a matter of law with-
out proof of fault on the part of the employer. Make certain you follow
these guidelines when hiring contractors and pay particular attention
to the issue of control.
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Finally, under your state’s law be aware which duties are considered
inherently dangerous, such as providing adequate security for tenants
in a multiunit building. These duties can’t be delegated to an inde-
pendent contractor without liability on your part, regardless of
whether the person you hire is considered an independent contractor
or an employee.
Insurance—Your First Line of Defense
We suggest you insure each property you buy with plenty of liabil-
ity coverage. Most investors don’t specifically ask for liability coverage
so they get a standard policy that may have adequate replacement cov-
erage but minimal liability coverage. We recommend you get
$1,000,000 in liability coverage for each property, even if it’s a cheap
property. Investors often fall into the trap of thinking, “Gee, it’s just a
cheap little condo,” when, in fact, an injury can result in the same lia-
bility as an expensive property.
You may even consider a “builder’s risk” policy if you do a lot of
rehab projects. If you’re concerned about cost, get insurance with a
large liability portion and a high deductible. If you carry your property
liability, personal residence, and business insurance with a single car-
rier, they will offer you an umbrella policy for several million dollars of
additional coverage at a reasonable price. Be aware that certain
claims—such as breach of contract, discrimination, and misrepresenta-
tion—aren’t covered by insurance. In fact, most insurance won’t cover
any intentional act. Therefore, while having insurance is a good thing,
it’s only your first line of defense to lawsuits.
Corporate Entities—Your Second Line of Defense
You can know the laws and carry lots of insurance, but if you do
enough business, you’ll end up with a lawsuit that won’t be covered by
insurance. Setting up a corporation or LLC creates a barrier of protec-
tion from liability.
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Avoid Being a Sole Proprietor
Most people starting their own businesses do so as sole propri-
etors. This means they are doing business as individuals or under ficti-
tious “Doing Business As” (DBA) names. This scenario offers absolutely
no liability protection. If your business gets sued, all your personal as-
sets are at risk as a sole proprietor—your home, savings accounts, cars,
and more. If you’re the buyer or seller on a real estate contract, you
(not your fictitious DBA) will be sued in the case of a breach of con-
tract. If you sign a warranty deed as seller and any problems with title
arise, you can be sued personally for breach of warranty, even if you
paid for title insurance. If workers are injured on your property while
you’re rehabbing it, say hello to their lawyer. The fact is, there are
dozens of scenarios that can lead to liability, and you’re fully exposed
when you conduct a real estate investment business in your own name.
The best way to protect yourself is to avoid getting sued person-
ally—that is, form a legal entity to wedge between yourself and the li-
abilities that your business creates.
Set Up a Corporation or LLC
For less than $100 in most states, you can form a corporation or lim-
ited liability company (LLC) to do your business or trade. If properly
maintained, a corporation or LLC will shield your personal assets if
your business gets sued or goes bankrupt. A corporation can also pro-
vide you with some tax benefits, if used properly. Furthermore, a cor-
poration or LLC gives you a more professional look when dealing with
people in business. A corporation can be formed with a single owner,
as can an LLC.
Some people may think that incorporating your business to limit
your financial exposure is somehow unethical. Others think lawsuits
are the equivalent of legal extortion. How you want to limit your lia-
bility is a call you’ll have to make, but if you do incorporate your busi-
ness, you’ll have greater protection.
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118 DEFENSIVE REAL ESTATE INVESTING
Bill’s Advice: Know the
Difference Between an
LLC and a Corporation
Both a corporation and an LLC are formed under state law by filing pa-
pers with your state department of corporations or secretary of state. Both
limit the liability of their owners, but these entities are taxed differently. You
should discuss appropriate tax issues with your CPA or tax advisor before pro-
ceeding. For example, a C corporation, if used properly, can save you tens of
thousands of dollars in taxes if you know how to use it. Most people believe a
C corporation is bad because of double taxation. While this is true, an S cor-
poration or LLC isn’t necessarily better than a C corporation. For example, a C
corporation can give you the ability to deduct 100 percent of your medical ex-
penses and medical insurance through your company. You may also save
thousands of dollars in federal income taxes if you learn how to “split” your in-
come between your corporation and your personal return or other entities.
For more information on C corporations and how they can work for you,
you can order “How to Create a Bulletproof Corporation” program from
www.legalwiz.com.
Gary’s Advice: Another Benefit
of Corporations and LLCs
There’s a Catch-22 when starting out as a real estate investor. If you go to
the bank for financing, the lender will require that you have two years of real
estate investing experience. How do you get a loan to begin investing if you
don’t have investing experience? One of the first items of business is to set up
a corporation or LLC that’s registered with your state. After two years, lenders
will recognize that you’ve been in business the required minimum time.
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Doing Business with Partners
When it comes to liability, doing business with a partner can be
even worse than doing business as a sole proprietor. A partnership is
formed when two or more people decide to do business together for
profit. It doesn’t require a formal partnership agreement or filing of any
official documents, although it’s often formed that way. Moreover, you
can create a partnership even if you didn’t intend to! (We explain this
in a following section.)
Here’s the problem with partnerships: If your partner does some-
thing foolish, you’re liable. If you allow your partner to commit the
partnership to a contract, the partnership and its partners can be held
liable for that debt. If your partner slanders someone, commits a negli-
gent act, or incurs a debt on behalf of the partnership, you’re on the
hook—even if your partner files for bankruptcy. This is the doctrine of
“joint and several liability.” Regardless of the percentage of fault be-
tween you and your partners, a judgment by a creditor for any tortious
acts is 100 percent collectible from any one of the partners. Joint and
several liability can be particularly disastrous if you’re the silent partner
with all the money.
Another problem is the accidental partnership. Here’s an example:
Harry finds a good business deal. He needs capital so he approaches
Fred. Fred agrees to invest with Harry as the silent partner. Harry deals
with the public, often referring to his “partner” Fred. Fred and Harry
do business, make money, and part ways. A month later, Harry gets into
financial trouble. Creditors come knocking on his door, but he has no
money to pay them, so these creditors come after his “partner” Fred.
Is Fred liable? In some cases, the answer is yes if the public thought
Harry and Fred were partners and Fred did nothing to stop Harry from
presenting them as partners.
If you only want to do a one-shot deal with a partner, consider draft-
ing a joint venture agreement. (Refer to the sample joint venture agree-
ment in Appendix 8.) Basically, a joint venture is a partnership for a
specific purpose. If you intend to do business with partners for the
long term, consider forming a corporation or limited liability company.
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120 DEFENSIVE REAL ESTATE INVESTING
Release Yourself from Liability
Legal disputes can often lead to lawsuits; smart investors stay out of
court and away from expensive, risky lawsuits. However, most people
forget one simple step that’s crucial to the process of settling a dispute:
a written release of liability. Omitting this simple step could result in a
future lawsuit against you even if you settled the claim.
Consider an investor who settles with a tenant who was delinquent
on his rent: the owner accepts the keys, waives the tenant’s back rent,
and allows him to move out quietly. Nevertheless, the tenant can come
back and sue the owner at some point in the future, claiming damage
to his furniture because of a leaky pipe.
In another example, an investor accepts an earnest money deposit
on a real estate contract. However, the closing never happens and the
investor keeps the earnest money. Believe it or not, the investor can be
sued for breach of contract.
The secret to avoiding future liability on transactions such as these
is shockingly simple: Get a written release of liability. This release, also
known as a general release, is a simple document by which someone
agrees to release someone else from all liability. A properly drafted re-
lease prevents the signor of the document (the releaser) from bring-
ing any claims against you in the future for any claims before signing
the release.
Keep this in mind: If you have a dispute with another party that is
eventually settled, it’s imperative that you have the other party sign a
general release form before giving any money or consideration.
While we’re on the topic of consideration, you must actually give a
consideration for the release to make it legally binding. In other words,
you can’t just ask someone to sign a release with nothing in return. A
promise by you to waive your own legal rights against the releasor may
be insufficient consideration. Even if you don’t think the other party
deserves it, giving someone a few hundred bucks may be a good idea
to have a sufficient release. (Refer to the sample General Release form
in Appendix 9.)
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Get Educated on Tax Issues
The foolish investor waits until April 15 to file his or her taxes, and
then hands a shoebox full of receipts to the accountant. Be sure to plan
for your taxes at the beginning of the tax year and consult with your
tax advisors throughout the year. People who say the tax system isn’t
fair are just ignorant of the rules. Taxes will eat up a large percentage
of your income over your lifetime so learn how to make the rules work
for you!
Basic Taxation Rules
You must become schooled in the basic rules of federal taxation as
they apply to real estate. The biggest expense you’ll pay in your life is
taxes. We suggest you learn how to reduce your taxes, which is the eas-
iest way to have more profit in your business.
Take time to learn the difference between capital gains and ordi-
nary gains. Ordinary income is taxed at ordinary rates, which is the
same rate as wages earned from an employer. This can prove to be un-
fortunate for those who work extra hours and get taxed on their
wages. The system is set up to penalize wages and reward investments.
If you buy an investment property and hold it for 12 months or more,
this is considered a long-term capital asset. When you sell the property
then this long-term capital asset results in a long-term capital gain. The
long-term capital gains tax rate as of January 2007 maxes out at 15 per-
cent, depending on your income. This rate is significantly lower than
regular personal income tax rates, which can be as high as 35 percent.
Learn how to use depreciation to your advantage. If you hold a
property as a rental, you can deduct mortgage interest and property
tax payments as well as other operating expenses. You can also take
depreciation for the structures; in fact, you’re required to do so under
IRS rules. For example, if a property is valued at $150,000 and the
land is valued at $50,000, you would depreciate the $100,000 struc-
ture over 27.5 years according to the federal income tax rules. The
annual depreciation deduction for a $100,000 structure according to
the IRS schedules is about $3,600. In this example, you can have
$3,600 a year in positive cash flow without owing any taxes on this
income. If you have less than $3,600 in income from this property,
8 / You’ve Earned it, Now Learn How to Keep it 121
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you’ll end up a “loss,” at least on paper. You can use this loss to
“wash” other income you have as long as you meet certain rules. For
example, if you make $100,000 a year from your business or job, a
loss from your real estate activities will reduce your taxable income
so you end up paying fewer taxes on that income when your taxes
are due the following year.
To be able to take a loss on your taxes from rental properties, the
first rule you must meet is “active participation.” That is, you must
show you’re actively involved in managing the property, which usually
isn’t hard to do when you’re showing properties to tenants.
The second rule is that your gross income doesn’t exceed $100,000
for the particular tax year in which you’re trying to take the loss. If you
meet these two rules, you can deduct up to $25,000 in losses. If you’re
considered a real estate professional, you’re not limited by the $25,000
loss cap. Therefore, if you begin investing full time, it’ll be easy to meet
this rule—as long as you can show you work the requisite number of
hours (750 a year) and it’s more than 50 percent of what you do with
your work time.
If you sold a rental property and took depreciation, the deprecia-
tion is “recaptured” at sale, resulting in a gain. The depreciation re-
122 DEFENSIVE REAL ESTATE INVESTING
Flipping Properties Doesn’t
Incur Tax Penalties
Many people wrongly assume that flipping properties causes an in-
vestor to incur a tax penalty or other negative tax consequences. This as-
sessment isn’t completely accurate. A flip generally means the property is
bought and sold within 12 months or less, which means the property is
taxed as an ordinary gain (same rate as personal income) versus a long-term
capital gain (maximum 15 percent). In other words, the federal income tax
rates on a flip are the same as your ordinary income tax rates you pay on in-
come from wages.
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