How Does the ‘Super Strategy’ Work in a Down Economy?

Last week we looked at a ‘Super Strategy’ that mixed the best of ‘Fix and Flips’ and ‘Long-Term-Rental’. You can review that at:

http://www.sabanabooks.com/a-super-strategy-merging-flips-rentals/

With this strategy we:

  • buy a property that is really beat up at a wholesale price;
  • renovate it;
  • get it rented out at higher rents;
  • refinance it, based on its new, higher value;
  • get most or all of your original investment back, and then
  • continue to hold it as a long-term investment.

This merged strategy helps to eliminate the major drawback of flipping; which is selling into a down market. It also helps to eliminate the major drawback of long term rentals; which is the long time required to recoup your money. It also works with any type of property and any budget – from single family homes to multi-family to commercial and industrial.

It makes sense that this strategy would work best in an economy where real estate prices are increasing (or even flat; i.e. you original budget shows the finished product being worth $x and it actually is when you are done). In these markets this strategy is a ‘home run’. But how does it work in a market where values are falling? Even in that scenario it is still a solid ‘double’.

From 2011 to the end of 2014, in the area where I invest, the economy was very positive and robust. Real estate values were increasing at a very healthy rate. In late 2014, with the fall of the value of oil, the local economy started to retract and eventually started to recede. Currently, in the Spring of 2016, with the price of oil not showing any sign of a quick rebound, values continue to drop.

In the Summer of 2014 a partner and I bought three apartment buildings with a total of 33 ‘doors’ in a smaller market. We didn’t get a screaming deal but we didn’t overpay either. They were well bought. We took possession in November of 2014 which is about the time that oil started to drop. Still, at that time, we had no real fear of the economy going into a tailspin.

The buildings didn’t have any major issues; the previous owner had owned them for close to 30 years and simply hadn’t put a penny into them more than he absolutely had to. They were simply run down and needed some love. He also had let anybody rent a unit if they paid a bit more money.

Our plan was to fix the units at an even rate over the next four years as tenants turned over, with major common and exterior issues being dealt with in the first year. We had a higher interest, private lender mortgage for the first year with the plan to refinance after one year with traditional lenders.

Almost immediately however, with a contracting economy and a new sheriff in town, we had 1/3 of the tenants move out. That meant that through most of 2015 our projected rents were significantly lower and our renovation costs were double our original estimates. Cash flow became an issue and we had to have a cash call from the owners. Not good.

However, by the end of 2015 we had the situation under control, the units were full with better tenants and we were ready to go back for refinancing as per the original plan. As we went back for refinancing, even though we had spent all of this money on renovations and the buildings were full, the newly appraised values were barely higher than what we paid for them. Instead of being able to get most or all of my partners money back we barely refinanced for enough money to repay the higher interest lender and get the partners back 10% of the money they invested.

The economy really kicked us in the butt. We were able to get better tenants into the suites but the sluggish economy and higher vacancy rates meant we couldn’t raise rents. It was considered lucky that we had full buildings. Remember that the values of apartment buildings are based on the profitability of the buildings and comparable sales in the area – both of which are compromised in a down market.

So we have little choice now but to continue to own the buildings (which was always the goal) with a significant amount of money still invested (which was not the original goal). We also had no choice but to lock in the new financing for five years (to even get financing in a small market and to get a decent interest rate).

As time goes on and the economy inevitably improves we will be able to refinance and get a second mortgage to help get the partners more of their money back. The buildings are in much better shape than when we first took possession with a tremendous upside in both future rents and valuation. The underlying assets remain strong. Not the home run we had at first thought but still a really good investments and our plans were just delayed a couple of years – a good solid double.

So, even when it doesn’t work out perfectly, the Super Strategy should still work out okay no matter the economy – good, flat or down. Just keep the above, real life example in mind if you try to do this strategy in a falling economy.

Read more about this in Comparing Real Estate Strategies.

A Super Strategy: Merging Flips & Rentals

The Best of Both Worlds

As real estate investors we tend to stick to a single strategy that works for us. For most that either means fix and flip or long term rentals. But those two strategies don’t have to be mutually exclusive. If you mix them the right way it can lead to a very profitable hybrid.

The Pros and Cons of Flips

Buying property that has been mismanaged or that is in bad physical condition and turning it around is a time tested strategy. It can be very lucrative; the time needed to complete the job is relatively quick compared to rentals and you get the satisfaction of seeing the beginning, middle and end of a project while helping to revitalize a neighborhood.

The downside is that it is speculative in nature and you can find yourself having finished the renovations and ready to go to market just as the economy turns on you. If you happen to hit an upswing, you look like a genius; if you happen to hit a down market, you can lose a significant amount of money.  The risks are high. Flips are also not conducive to regular cash flow as you don’t see any return until the final sale.

The Pros and Cons of Rentals

The beauty of rental real estate is that you have three streams of income working for you:

  • Long term appreciation (typically & historically)
  • Month to month positive cash flow
  • Long term principal pay down of the mortgage

Time works in your favor to make rental real estate investing one of the safest options available. Long term rental real estate isn’t about getting rich quickly; it is about getting VERY rich slowly.

The problem with rentals is that it takes a long time to get your original investment back. You either have to wait a few years to refinance or sell the property. Plus there is usually not a lot of cash flow available to you during the first few years of your investment. Finally, you are usually buying your property at full retail and not a wholesale price.

Merging the Two Strategies Together

A better way to invest may be to merge these two strategies together. The general concept is:

  • buy a property that is really beat up at a wholesale price;
  • renovate it;
  • get it rented out at higher rents;
  • refinance it, based on its new, higher value;
  • get most or all of your original investment back, and then
  • continue to hold it as a long-term investment.

With our merged strategy, we take the best of these two strategies and eliminate the worst. By buying a building that is beat up at a wholesale value (it doesn’t matter if it is a single-family home, a multi-family apartment building, a commercial unit, or an industrial building), you can get an immediate profit boost once it is fixed up.

As we have seen, normally long-term buy-and-hold makes money in three ways: long-term value appreciation, month to month cash flow, and mortgage pay down (done by your renters bit by bit each month). Buying wholesale adds a fourth element to that mix. This is a definite plus.

Not selling that property once it is fixed up eliminates the speculative nature of that strategy. By renting the newly renovated property instead of selling it immediately, you can wait until the market is right for you to sell at a high profit thereby eliminating a lot of risk.

Keeping it over a longer period can even ease some of the hit you would normally take if you spent too much or took too long to complete your renovations. A $20,000 overage doesn’t look quite as bad over 10 years as it does over 10 months.

Finally, because you are refinancing the property as soon as the renovations are done and getting most or all of your original investment back, the cash flow that does come from that property is mostly free.

You have an income stream that you put little or no money in to. So as long as it cash flows positively (which it should or you shouldn’t have done the investment in the first place), whatever cash flow it does provide is a bonus.

This strategy is very resistant to down markets; in fact, it can work in any market. In a down or flat market, hold onto the status quo and rent it out, making sure that you are at least breaking even. In an up market, you can decide whether you want to sell the property for a nice profit or increase the rents and continue to hold for the long term.

This strategy works for all budgets as well. It works on a single-family home just as well as it does on a fourplex, an apartment building, a commercial property, or an industrial property.

A Real Life Example from My Own Portfolio

The following example is an eight suite apartment building that I renovated but the concepts would work just as well with a single family home.

A joint venture partner and I bought an eight suite apartment building out of foreclosure. It had been empty for two years. The roof leaked and as a result there was grass and mushrooms growing on the carpet on the top floor. There was no heat, light or power to the building and most of the windows had been broken by kids.

We bought it for $900,000 with my partner putting up the 25% down payment. We then obtained an 8% loan from a private lender (banks tend not to loan on mushrooms and grass). After that we spent $500,000 to renovate the building.

Once completed the building looked great and we were able to fill it with great tenants within six weeks. The rents we were able to charge were on the higher end of what similar suites in that neighborhood could command. We then went to a normal lender and had the property appraised at $1,750,000 as an apartment building. The building had also been condominiumized and as eight individual units it appraised at $2,000,000.

We had several choices. We could have flipped it relatively quickly as an apartment building and made between $350,000 and $400,000 after commissions. Alternatively, we could have sold the eight units individually, which would have taken longer, but we could have made closer to a $500,000 profit after commissions. Instead, as a third option, we decided to refinance and keep the building long term.

We were able to obtain a new first and second mortgage for a total of $1.45 M, which as you will recall, is higher than the original purchase price ($900,000) plus total renovations and interest costs ($500,000). In short, we got all of my J/V partner’s money back plus paid back the higher interest lender AND still owned the property. The property has a positive cash flow of $1,500 per month and that income is FREE as neither my partner nor I have a penny invested in the building. Plus the equity of $600,000 is still there waiting for a future sale to be claimed.

Recycling Your Money

We were able to accomplish the above in about 18 months. Think about that. A normal J/V partnership o a long term rental typically takes five years. During which time the money partner’s money is at risk. While real estate is far less risky than most investments anytime your money is out working for you there is an element of risk.

By getting my J/V partner his money back early we eliminated that risk while at the same time greatly increasing his yield. The yield of an investment is the return compared to time. The shorter the time frame the greater the yield. Not only that but we were able to redeploy that same money on another investment. We recycled that money. If you are able to do this every 18 months you could conceivably use the same money three times over the same period of time as a normal joint venture partnership. That is a very effective use of cash.

Summary

You might say this is a unique experience but I have been able to do this several times in my investing career with properties of various size and dollar amounts invested. Sometimes I have gotten 100% of mine and my partner’s money back, other times I have gotten a significant portion back. It is definitely possible. Once I was even able to refinance and received $100,000 profit over and above getting everybody their initial investment back.

To make this strategy work look for properties that are in rough shape or that have been badly mismanaged without any serious structural defects. Then instead of flipping, as you normally would as a flipper, or ignoring it altogether, as you might do as a rental investor; give some serious thought to what the returns on a fix and hold might look like. You might be pleasantly surprised.

Read more about this in Comparing Real Estate Strategies.

Staging Your Real Estate Purchases & Exits

Staging your Purchases

“Hello. My name is Darcy and I am a real estate addict.”

I love to buy real estate. My wife says I never saw a building I didn’t like. I love to look for deals. I love to do the quick analysis to see if something is going to work for me. I love to calculate the cash flow and cash-on-cash returns. I love to negotiate the terms and conditions with the seller. I love to come up with a plan and a J/V partner to buy the property with me. I love all of that stuff. In short, I love the hunt.

All of my life, whenever I have had money to invest, I would make sure all of my money was working for me. I thought money not invested was being wasted. For example, as a teenager with a few hundred dollars I would invest in Term Deposits. The minute it came due I would be down at the bank reinvesting it. As I grew older and I started doing flips, the minute I sold a property and collected my money I would be on the hunt for the next property.

So I used to buy, buy, buy. Unfortunately, that often left my finances in a precarious position as all of my cash was always fully invested. Invariably, I would have cash flow issues and be left wondering if I would be able to buy groceries. I was the poster boy for asset rich and cash poor.

To break out of that cycle I decided to a) work less with my own money and more with J/V partners and b) stage my purchases better. For example, in 2012 my wife and I were able to buy 9 properties – all with our own money. Then, normally, we would have bought more properties in 2013 too, but this time something strange happened.

I went cold turkey (something very new for me) and didn’t buy a single property in 2013. Instead, my wife and I used that year to normalize the properties that we bought in 2012. We renovated the suites that were in bad shape, kicked out the bad tenants we inherited (legally of course), increased rents accordingly, filled empty suites, cut operational costs, found new forms of revenue, and refinanced several properties.

By the end of 2013, a surprising thing happened (at least surprising to me); we were in the best financial shape of our lives after normalizing these buildings. Our cash flow was higher than ever. Our cash-on-cash return across our entire portfolio was higher than ever. Our cash reserves were higher than ever and our loan-to-value percentage (the amount of our total mortgages vs. the value of all of our buildings) was lower than ever across our entire portfolio (around only 58%). In short, we made money by NOT buying real estate.

In addition, this activity caught the attention of some new joint venture partners. As a result, in 2014, we went on another buying spree and bought 6 new buildings. But this time these were all bought with joint venture money. This helped keep our financial house in order. Following the pattern, 2015 was another year of normalization.

By purchasing at a slower pace and using J/V partners more frequently, I am nowhere near as stressed as I had been nor am I flirting with cash flow Armageddon all of the time. I have learned to stage my purchases and work in plateaus. Now my wife and I will buy new properties, let that level off in a plateau and then when we are in control, we buy more properties again. The financial benefits of this new approach have been noticeable as well.

Timing the Exit of Your Properties

When you buy real estate 100% with your own resources the monthly cash flow is 100% yours as well. When you buy a property with a Joint Venture partner traditionally (as the real estate expert) you won’t see any return from that property for five years or so until your sell or refinance. One option is great for cash flow while the other allows a long term return with no money invested.

Just like you can stage the purchases of your properties you can also time their sales. What if you time the exit of your various Joint Venture assets so that you create an annuity and get paid something every year? What if you could treat real estate like Term Deposits?

Term Deposits at your bank typically have terms (the length of time that you hold the investment) of 1, 2 and 3 years; the longer the term the better the return. Buyers, usually retirees, will often split their available investment money into different groups and buy one term deposit of each term.

For example, they may start out by buying a 1 year term, a 2 year term and a 3 year term. At the end of year one, they will take the principal from the 1-year TD that has come due and buy a new 3-year term deposit. Then, when the original 2-year TD comes due in year two, they will buy another new 3-year term TD. This process repeats itself; every year one of the TDs comes due and a new 3-year term is purchased so that within a short period of time the investor has nothing but 3 year TD’s with one coming due each year. In this way the investor can maximize the return and ensure interest money is coming in each year.

Spend the first few years of your real estate investing career buying long-term rental properties with J/V partners. Then after a few years, you can stop buying and just sell a building each year earning a nice retirement annuity. Those properties you bought with your own resources will create cash flow in the interim.

Joint ventures are great for long-term profits to the real estate expert who doesn’t have to put any money of his/her own in. However, they don’t typically help with your cash flow in the short term. For that reason, I tend to use my own money to buy properties that have exceptional cash-on-cash return with large positive cash flows.

I focus my own money (where I own 100% of the profits) on cash flowing, rental properties and use joint ventures as a long-term return. In this way, you get the best of both worlds. It is your own cash that will make you a positive cash flow in the short term while you wait for the J/V deals to payout some time down the road.

Merging Flips into This Strategy

Just because your main focus may be on long term rentals there is no reason not to mix in a flip or two along the way. For example, with the six purchases I made in 2014 (see above) I intend to convert one building from an apartment building into condos. Another of the buildings was boarded up due to fire damage and will be brought back on line as a rental. A third building had unbelievably low rents but not a lot of physical things to fix up—those rents will be adjusted and the final three buildings were close to 20% vacant and were in really bad shape. They need to be renovated and the quality of the tenants brought up while at the same time increasing the rents and filling the buildings.

We will sell the condominium conversion to bring in some short-term profit, while the other buildings will be refinanced and kept as long-term rentals with very good cash flow and cash-on-cash returns. Sometimes opportunities present themselves and a particular property might make more sense as a flip than as a long term hold. Never be scared to take profit.

 

Summary

Timing is important in most investments but you can turn it to your advantage with real estate. Learn to purchase your properties at a pace that makes sense for you and your situation – both your financial reality as well as your experience level. When you have your last purchase under control then go ahead with your next one. Buying too many properties at once can lead to financial headaches and a lot of lost sleep.

Similarly you can use time to your advantage on the way out too. Long term rentals that you own 100%, kept for cash flow, with a few joint ventures sprinkled in and sold occasionally can give you a nice mix of short and long term returns. This is also an effective use of your own cash reserves as you are buying when you can and using Joint Venture money when you are low on funds. This can definitely be the best of both worlds.

Read more about this topic in Cash Management in Real Estate Investing.