A couple of weeks ago I attended the annual meeting of the National Association of Business Economists in Washington D.C.. The event featured some interesting speakers, including recent Nobel laureate Paul Krugman and Fed Chairman Ben Bernenke. After a day of hearing smart guys w/ lots of letters after their name wax poetic about credit default swaps, mortgage backed assets, and government bailouts I came away with a single conclusion: no one knows how this thing is going to turn out. There was some suggestion in using the word “bailout” the Treasury did a poor job in selling the $700billion plan to the American public – perhaps “rescue” would have been more appropriate. Krugman added some levity by suggesting some media-friendly nicknames: how about “Bailie May?” Or perhaps “Hanky Panky” after Treasury Secretary Henry Paulson.

So I came away from the three day event with a more profound understanding of my failure to understand this whole mess; but I don’t feel particularly bad about it because no one else really understands it either. Bernenke’s reassuring message: we don’t really know how we’re going to price these distressed assets that the Treasury is gonna be buying with your $700 billion, and we don’t know who we’ll by them from or how we’re going to do it. This will be a trial and error process. But we’ll work it out.

Mmmmmkay. But Bernenke delivers the message with such an aura of academic cool that the audience seemed assured that he’ll succeed in making the best of a bad situation.

So, generally speaking, I’m not feeling to great about all of this. Basically I think we’re headed into one of two possible scenarios:

• Scenario 1: We’re already in a recession but we’ll muddle through. The market is cyclical. This is a particularly brutal cycle we’re dipping into, but fundamentally no different than those we’ve slogged through before. We’ll get some discouraging GDP numbers, the Dow with flit around 9,000 for a while, but eventually the market will give back some of that money it’s taken out of your 401k plan.
• Scenario 2: The wheels are about to come off. The banking system is not just in a superficial funk fueled by poor investor-confidence; it’s really in trouble. As banks write down toxic mortgage backed assets their balance sheets will be fundamentally damaged to the extent that credit will continue to tighten, consequentially decreasing spending, chopping profits, raising unemployment, and fueling foreclosures – which in turn worsens the state of the mortgage backed assets which started the whole mess. Repeat. Deflating prices, which initially feel kinda good (who can argue with $2.50 gas?) accentuates the woes of the business community which will be unable to justify new investments at lower revenue levels, further cutting business spending and jobs, pushing down demand, and deflating prices further. Repeat. Once you’re in this spiral it’s tough to engineer an exit.

Now I think (hope) that we’re in scenario #1. That’s the best case. I don’t think we’re headed towards the meltdown case, but it is something that I worry about. As further evidence that I believe in scenario #1 I recently made two long term trades, buying exchange traded funds (ETF) that track the S&P (RSU) and the Dow (QLD). Someday we’ll look back at 2008 and realize that the dow in the 8,000’s was a buying opportunity.

A few observations:

• You know this already, but if you’re going to need your retirement money in the next few years then you can’t have it socked away in the stock market.
• If your company 401k plan automatically loads you up with company stock, then you need to periodically go in and rebalance. I never cease to be amazed at smart, educated folks who have 40% of their wealth in a single stock. This is goofy.
• Rethink “diversification”. I have stocks divided between small-cap funds, large-cap funds, value funds, growth funds, and international funds. They’re all in the same toilet now. One lesson of the current crisis is that markets are now linked like they’ve never been linked before.

And yes, this is a real estate blog, so a few thoughts here:

• Hooray for Texas: We didn’t run up during the boom so we’re not getting whacked right now, but I’m expecting flat prices for a while. My strategy for finding and investing in long-term value projects is treating me pretty well right now. Plus, that’s a hunk of money I have in properties instead of in the stock market. This is effective diversification.
• Some markets really are feeling the pain. I was in Minneapolis last weekend, and as I walked the streets of some of these neighborhoods it seemed like every third house was a foreclosure. It’s gonna take a while for the market to absorb this carnage.
• All real estate is local – that is, unless the economy is melting down. I won’t be feeling so smug about Texas property values if we got into the doomsday economic scenario that I outlined above. If the banking system goes into the tank then we’re all gonna be in the same boat.
• A buying opportunity? I’m nervous about our economy, but I’m not quite ready to bury my life savings in coffee cans in my back yard. Investors who can still get loans should think about investing now, depending on how your local market conditions look.

Most of Houston is back to normal.  Among the properties that I own we suffered a few downed fences and an uprooted tree or two, along with a tenant who appears to have disappeared and abandoned her lease (I'll write about that as well).  All and all I've been pretty lucky - and thanks to those of you who sent your best wishes. 

But take a look at the JPMorganChase tower in Downtown Houston.  Looks like they've cornered the local plywood market. 

While our thoughts now are on everyone's safety, soon enough we'll be thinking about insurance, deductables, repairs and contractors.  No one buys an investment property with the expecation that it will get knocked down by a hurricane - but unexpected things happen, and when they do they're usually bad. 

Skimping on insurance is a way that some investors nudge a borderline property into positive cashflow territory.  Ask yourself about the risk/reward tradeoff.

The housing market breathed a sigh of relief – but no cheers from the stockholders of the two firms. Fannie Mae [FNM] was trading at around $7.00 towards the end of last week and immediately collapsed to about a buck on news of the announcement. As of close today it’s hovering around $0.74.

For investors Fannie and Freddie have seemed like a pretty safe play for years. Stodgy, even. A publically traded pseudo-government entity which was crucial to the U.S. economy and backed by government guarantees seemed like a pretty safe place to stash away some cash that you didn’t want invested in risky stuff; let the day-traders mess with the bio-techs and dot.coms.

But what a difference a week makes.

A lot of investors took a bath on this one. We’re still in the shadow of Enron, WorldCom, Quest, Tyco, and others – but I never cease to be amazed when I speak to folks who have large percentages of their net worth tied up in a single stock. Sometimes it’s because it’s a “safe bet”, or because they’re comfortable and haven’t bothered to rebalance. But most often it’s because they work for the company in question.

This isn’t smart behavior. Real estate investors understand that there is no reward without risk, but diversification is the way that smart, tactical investors hedge their bets. Anything else is just gambling.

Contrast this to the advice that millions of Americans swallow then they read what is undoubtedly the worst personal finance book ever: Robert Kiyosaki’s Rich Dad Poor Dad. Diversification, according to get-rich-guru Kiyosaki, is for suckers. “Put a lot of your eggs in a few baskets,” he exhorts. “Do not do what poor and middle class people do: put their few eggs in many baskets.” A balanced portfolio “…is not the way that successful investors play the game.” These are quotes from the book; I’m not making this stuff up. The biggest problem with Rich Dad Poor Dad is not that it’s filled with vague motivational psycho-babble; it’s that hidden in the self-help hucksterism there are gems like this that are actually dangerous.

Kiyosaki is undoubtedly a smart businessman and has made millions of dollars selling his books and courses, but I’d encourage his true believers out there to take a critical look at some of the ideas that he’s promoting.

Related:

• Why I don't like Rich Dad Poor Dad
• The Black Swan :: The highly improbable and real estate
• Another bailout on the horizon?  Fannie and Freddie

When I started this website I funded it with the backing of Partners Bank of Texas, a small Houston based private bank with assets of less than $200 million. Last year Partners was acquired by Texas based Sterling Bank. Sterling is somewhat larger than Partners - with assets of around $4 billion - but they're very small when compared to, say, Wells Fargo, which has assets of around $600 billion.

In the past I've relied on companies like USAA ($68 billion in assets) and Wells Fargo, but Sterling is my go-to bank now. USAA is the financial institution dedicated to serving current and former members of the military community, and I've been a member for over twenty years, starting when I was a cadet at the United States Military Academy. I still appreciate their great customer service (although some of their lending practices have annoyed me). But even though I have a military connection with USAA, at the end of the day I'm just a number. No one knows me there. They put my data into a computer and it spits out an answer.

But when I talk to Sterling, I'm sitting across the table from the guy who is gonna make the decision. And I like that. When I trying to get this website funded I spent almost a year jumping through hoops for the guys over at Bank of America ($1.7 trillion in assets) and the venture capitalists wanted me to sign away my first born. But at Partners (now Sterling) I got to sit across from someone and pitch my idea; and the woman who I talked to was the same person empowered to make the decision.

I'll still shop the big boys for the plain vanilla deals I'm considering. But when I'm looking at some more challenging opportunities in this crazy market - raw land and multi-family - my first stop is Sterling. Real estate investing is all about relationships, and smart investors know that their reputation can be one of their most valuable assets.

Folks of all political stripes who read this blog will probably be willing to give Senator McCain a little slack on this one. We’re real estate investors and we buy and sell properties. We might not have married a $100 million heiress like Senator McCain (or made $4 million off a lucrative book deal like Senator Obama, for that matter) but we can understand how LLC’s and partnership purchases might turn a seemingly simple question into one that can be a little more tricky.

So my concern is not that Senator McCain was unable to rattle off the right answer. My concern was his startled, confused reaction. His rambling, mumbling response: "I think -- I'll have my staff get to you -- um -- its condominiums where -- I'll have them get to you.” In today’s complex world the ability to think on your feet and stay on message is an important prerequisite to being the President of the United States of America. The fact that Senator McCain was so visibly unhinged by this question will worry some voters.

I don’t’ think that the average American begrudges Senator McCain family their $100 million fortune; Americans don’t resent wealth – we aspire to it. But folks who are struggling to make ends meet want to feel that the President understands their challenges, and those who have invested in the ownership society want a leader who will get the economy back on the rails. When Senator McCain facetiously quipped last week that $5 million per year is the cutoff for being wealthy, a lot of folks felt left out of the joke.

I feel that we facing an immediate future of complex economic challenges – one in which prudent real estate investors will be comparatively well positioned. But in the end the returns that we realize will be linked closely to the fortunes of our fragile economy, which in turn will be heavily impacted by gas prices and – ultimately - oil.

Oil is an international fungible commodity, and therefore oil prices – the single more important driver in our economy – will be largely outside of our control. The biggest factor in what will happen with oil prices lies in direction of international stability, or lack thereof. Neither party talks much about this particular elephant in the room – the reason being that both parties realize, rightly, that there isn’t much that we can do about it. Our recent adventure to send our Armed Forces to the Middle East to spread freedom and democracy isn’t entirely to blame, but it has been an exacerbating factor that has undoubtably made things worse and weakened our influence, both politically and militarily.

In the future there will be a link between what we do overseas and our economic fate here at home – and it’s a new relationship that will be strikingly different from what we’ve seen in the past. As retired Army Colonel and Niebuhr scholar Andrew Bacevich writes in his excellent book The Limits of Power, our economy can no longer be sustained by expansion abroad enforced by our military. As a former military officer myself this is a new way of thinking. I now tend to put less of a premium on “experience” as traditionally defined; I want a leader who can see the new patterns as the world continuously rewrites the rules.

So while I can forgive Senator McCain the fact that he doesn’t know how many houses he has, I am more concerned about the prospect that having spent decades as a fabulously wealthy United States Senator has dulled his ability to identify the shifting currents of the new world economy.

One thing I’m noticing is the challenge to get quality tenants. I have some properties that rent like hotcakes w/ zero vacancy time. But others, for some reason, have been more challenging. Like most property owners, I have a number of rules-of-thumb that I follow when it comes to screening tenants. But rules of thumb aren’t written in stone; they’re just guidelines. Every now and then I come across an applicant who I think will make a great tenant, but there is something or other that makes me second guess myself.

The fact of the matter is that good people get caught in bad situations sometimes, and a quality applicant can sometimes appear brandishing a blemished credit report. Don’t get me wrong – my mantra #1 is that renting to a bad tenant is twice as expensive as sitting on a vacancy for an extra month – but what is a landlord to do when her gut tells her that she should take a chance on an applicant? Well here are three steps I sometime take::

• Ask for first and last months' rent upfront, plus one month’s deposit. This does three things for you. First, the applicant will have to cough up three months’ rent upfront before he moves in. If the applicant can do this it is an indicator that he’s not living paycheck to paycheck, a good sign that he will be responsible. Secondly, it mitigates your risk by ensuring the final month is paid. Lastly, that final month’s rent sits in your bank account collecting interest (or, better, is out in the market working for you) for the entire time the tenant resides in the property. I write the lease to state that the last month’s rent paid upfront will be credited to the final month that the tenant resides in the property.  PROs:  will scare off bad/risky applicants.  CONs:  may eliminate some good applicants as well. 
• Shorten the term. Write a lease with a short term; four months or six months. Agree to renew if the tenant pays each month on time; you can put this in writing in the contract if you wish. If there is a problem you’re still going to suffer, but you wont’ have a deadbeat sitting in your property with a contractual right to stick around for an entire year.  PROs:  limits the period you're at risk.  CONs: no financial benefit to the landlord, who is still stuck with evicting the tenant if he doesn't work out. 
• Charge a higher rent. This doesn’t do much for you in the risk mitigation category, but if you’ve trust yourself as a judge of character and you’re willing to rent to an applicant that other landlords have turned away, you should get compensated for the extra risk you’re assuming.  PROs:  higher return on the property, a good thing.  CONs: doesn't lower your risk.

Smart landlords use these strategies in combination. Increase the rent and offer a shorter term. Offer a shorter term w/ first and last month paid upfront (great risk mitigation).

But I’m still getting a mailbox full of junk – mainly due to a daily avalanche of catalogs. Big box retailers. Pet shops. Travel agents. Watches. Cigars (I’m a non-smoker). Wedding supplies (I’m already married). I get it all. The photo shows the haul of stuff that I threw out today.

This is a) a pain, b) dangerous, cause it makes it easier to lose something important like a bill or a check, and c) shamefully wasteful.

But there may be something that consumers can do.  The vast majority of this stuff is sent out by a single outfit, the Direct Marketing Association. If you go to their website you can opt out – either online or via mail. The online option requires that you submit a credit card.

I don’t yet know if this works – I just tried it today. According to their website it takes up to sixty days for your new preference to be registered. I’ll post a follow-up in two months time to see if my situation has improved.

Addendum, 6 August::  EA from New Hampshire points out in the comments that Catalog Choice is another option for shutting off the flow of unsolicited mail.  The DMA is the industry advocay group, whereas Catalog Choice is a non-profit environmental organization.  You can sign up on their website and customize delivery options. 

Any more bright ideas out there?

But we know what happened next – they continued to tumble, and the bottom feeders who jumped in too early took a beating.

Today Case Shiller reported a 15.8% drop in their housing price index. This isn’t really news, actually – it’s the twenty second consecutive month that the index is down. And if I were a betting man I’d count on it being down next month too.

Foreclosures are hammering the market as banks unload their inventory of REO’s, pushing down the averages. There are some indications that Congress and the Fed are ready to step in – witness this week’s housing bill. This will reassure Wall Street, but it remains to be seen if the positive impact that this has on credit liquidity is neutralized by banks reevaluating the risk of the government unilaterally resetting the terms of the loans that they make.

I’ve remarked in earlier posts that there is a difference between investing and speculating – and that either one may be ok for you, but the danger is when you think that you’re doing one but you’re actually doing the other. “Investors” out there who are trying to catch the bounce aren’t investors; they’re speculators. In my view it’s more important than ever for investors to evaluate the risks, take a sober look at a potential cashflow that an investment will produce, and ask themselves what kind of return their investment will yield if they’re forced to hold for a few years.

It remains to be seen who will benefit from this legislation, but one group of folks that surely are breathing a sigh of relief are the shareholders of Fannie and Freddie. It’s unlikely that these two publically traded stocks will return to their previous levels anytime soon, but this intervention at least makes it more unlikely that they’ll go belly-up.

Nationwide, foreclosure rates continue to skyrocket. RealtyTrac yesterday reported that foreclosure activity was up a whopping 14 percent in the second quarter, a rise of 121 percent over the second quarter of 2007.

It is hoped that the passage of this regulation will soothe Wall Street’s frazzled nerves. Oil prices (too high) and housing prices (falling too fast) are surely the two most troubling elements in our fragile economic situation. Both are complex and have deep reaching tentacles. The reassuring thing about the housing picture is that, unlike oil, it is an American market – therefore Congress may have some success in turning the ship. Washington hasn’t produced any legislation on energy– neither to curb speculation nor to increase offshore drilling. Lawmakers take some lumps from the public for their inaction, but it’s probably just as well since neither approach has the potential to improve the situation. The US controls a tiny percentage of global reserves, and traders move a small percentage of barrels traded, which leads us to a troubling conclusion: the U.S. economy is just one piece in the global puzzle, and things that happen outside of our borders are going to hit us in the pocketbook here at home.

But even if we’re struggling with our oil addiction, it’s hopeful that this piece of legislation might help the housing market. Much of the impact may be psychological, however. Democrats estimate that around 400,000 households might benefit from the bill, but last quarter alone saw almost twice that number of foureclosures – around 740,000 according to RealtyTrac. But we can hope that this bill shows that Congress is willing to act if necessary, and that might be enough to get banks lending again. And that might lead to fewer foreclosures, more buyers buying, more sellers selling, a shrinking housing inventory, and eventually a recovery in prices.

Andrew likes routines and patterns, as do most kids his age. Our bedtime routine is a standard, unvarying series of activities – disrobing, placing his shoes, selecting pajamas – that winds his little three year old brain down to a state where it is ready to absorb a bed time story, climb into bed, and go to sleep.

Part of his routine is brushing his teeth. Immediately after putting on his pajamas I sing (to the tune of Mary had a Little Lamb) “Now it’s time to...” and he responds “...brush the teeth!” Then he brushes his teeth. Seven notes, total. We do this every night. But a couple of days ago I sang my opening line, and instead of immediately popping off with his line as he usually does he paused for a second, and then responded with “...wash the hands!”

This, to Andrew, was the funniest thing that anyone had ever said, and he cracked up with peals of genuine laughter. Not the giddy, hysterical laughter that you get when you tickle him. This was a belly laugh; a “damn that was funny” laugh. The boy had cracked himself up. He’d pulled the old switcheroo, the change-up. He’d yanked the rug out from under daddy’s expectation. Funny!

Now as jokes go this wasn’t a particularly funny one. It hardly a joke at all, really. But a couple of things really caught my attention about the episode. First, of course, was his reaction, which in itself was funny. It’s hard to watch a kid laugh and not laugh yourself, especially when the kid in question is your son.

But the thing that really got me was the fact that, at that very moment, I saw him come up with the concept of humor. Andrew invented the joke. He’d never told a joke before, and to my knowledge he’d never heard one that he understood. The fact that comedians have been telling jokes since the dawn of man is irrelevant. He didn’t plagiarize their work; his little brain came up with this concept on his own. The joke! Funny!

Of course there’s nothing special about my kid in this regard; every kid goes through this, I imagine. But as I watch it unfold in my own son it dawns on me how little original thinking I do. Over the course of the day I normally do very little real thinking at all. Like most of us I travel the well worn grooves and patterns of my life, and rarely encounter a situation that requires a response outside of the reflex reaction which has been conditioned over my lifetime of accumulated experiences. Rarely do I have to figure anything out; I can get through the average day without making any real decisions. At forty years old my predefined prejudices, expectations and habits are so ingrained that there is a pre-determined response to all of the myriad forks in the road I encounter on a daily basis. Every now and then a novel problem pops up, but as a rule life doesn’t require a lot of thought.

But a kid? Now that’s a different story. Kids are operating with a blank slate. They’re filling that slate at a breakneck pace, but early in the game they’re still figuring out the rules. The computer in Andrew’s head has a blazing fast processor but the hard drive is empty. When Andrew is in the park and encounters a big duck he doesn’t know whether a) it will be friendly or b) it will charge him and try to take the cracker he’s waving around in his fist. So he has to stop and consider everything. Eventually he’ll accumulate enough experience to know intuitively which ducks will wait for him to toss the cracker and which ones will try to knock him down, but for now a lot of thinking is required. He has to try to interpret the duck’s body language and extrapolate this to predict the animal’s intention and probable course of action. He has to think!  Often, getting it wrong teaches him more than getting it right.

There is an appeal to looking at the world through a child’s eyes, but I’m not going to try to jettison all of my accumulated rules and patterns; I would not be able to function as an adult without them. But watching my son I am reminded that it is useful to at least be mindful of my prejudices, and allow that mindfulness to prompt me to challenge some of my assumptions.

This is particularly important for investors, for whom mental models are particularly strongly imbedded by the non-ambiguous feedback of winning and losing money. Some of the turbulence in today’s market we’ve seen before, and remembering the past will help us prepare for the future. But not always. Good investors have to question which features of the market simply part of the economy’s cyclical nature, and which represent fundamental shifts, and therefore require us to consider new paradigms. In short, it reminds me that good investors can’t rely exclusively on experience; they have to think.

I’m lucky to have someone to remind me of this. I just hope his jokes get better.

I’m big on outsourcing jobs that I have no business doing. Yeah, I could roll up my sleves and lay a new carpet myself in that vacant unit I’m turning – I could get a knee kicker and a power stretcher and wrestle my way through the job, but I’d burn a whole weekend in the process and the results would probably look pretty lousy. Actually I’d burn two weekends – I’d have to ask one of my buddies to help me and as a quid pro quo I’d end up helping him move at some point in the future.

So is property management something that real estate investors should outsource? My answer: “no” for beginners, and “maybe” later on. Here’s how I see things...

Start out on your own: There’s a lot of real estate investment advice out there that I will charitably describe as being of “questionable quality”. There’s a reason for this: folks giving you advice are not trying to make you a better investor. They’re trying to sell you something. To this end they often are trying to assuage your fears so you’ll whip out your credit card and buy their get-rich course. And one of the biggest fears of aspiring real estate investors: dealing with tenants. “Don’t worry,” you’ll be told, “just get a property manager and he’ll take care of everything.”

Don’t buy this line of reasoning. If you don’t want to deal with tenants then take your down payment and invest it in a mutual fund (right now perhaps the bond market is safer). In the real estate game there’s no getting around dealing with people, and if you’re squeamish about this then you’re going to have a tough time.

Even if you use a property manager, the buck stops with you. It’s your property. As I learned when I was a young Army lieutenant, you can delegate authority but not responsibility. This is why I believe that new investors must mange their own properties. This is the only way to get the feel for what makes a good tenant, and for what improvements are discretionary and what maintenance cannot be deferred. This is how you learn how to build the right kind of relationships with contractors, and how to avoid being ripped off. This is the blocking and tackling of real estate investing. You don’t have to do it forever, but if you don’t learn the fundamentals you won’t make it to the next step. And you learn by doing.

Property management is a force multiplier: I seem to be stuck on the military metaphors today, but this is the best way I know to put it. If you’re like the vast majority of investors then you’re a part-time investor. You spend your days teaching kids or fighting fires or working in an office, and you invest in real estate on the side as a means of securing your economic freedom. So you can’t let your investments take over your life. Having a property manager may be the difference between owning a couple of single family homes and owning a larger portfolio of properties.

Since you’ve spent some time managing your own investments you’re now in a better position to supervise a professional property manager. Even if you’re working with an honest property manager, you’ll create a better relationship with your manager if you know the ropes – if you’ve done it yourself.

Write the contract that suits your needs: There’s a standard all-encompassing property management model out there – a turnkey service that essentially pulls you out of the picture. You’ll pay up to 10% of gross rental income for this type of service. This is suitable for some investors – particular out-of-state owners – but might not be right for you. Don’t feel constrained by the contract that you have in front of you. Re-write it to reflect your desires. This is an open negotiation between you and the manager; the only “right” answer is the one that you’re comfortable with.

Turn to your realtor: When I started using a property manager I thought about the qualities I wanted: good people skills, effective communication, meticulous. That describes a lot of real estate agents. I need a manager to handle inquires from tenants, chase down contractors, make small capital decisions, and generally keep everyone happy. My Realtor provides all of this for me, and for a reasonable fee.

And the upside for her: my fourplex produces a steady stream of young professionals (resident physicians, law students, interns) who often become buyers once they move. This is a steady stream of potential clients with whom the Realtor/manager can cultivate a relationship. It works.

Tight credit, flat prices, and a narrowing pool of buyers have caused many Realtors to take a more entrepreneurial/flexible approach to diversifying their income sources from chasing sales commissions. Each year I pay a lump-sum upfront payment for the coming year. This is a nice, symbiotic relationship.  Many Realtors don't want to be property managers (most, perhaps) and some don't have the right skill set - but when it works it's a great solution. 

Both Fannie Mae [FNM $13.20] and Freddie Mac [FRE $8.00] are for-profit companies chartered by congress and trade publically on the New York Stock Exchange. Washington is taking its lumps over the recent bail-out of Wall Street firm Bear Sterns, so there is heightened interest in the government’s potential reaction to this latest round of troubles. It’s clear, however, that these companies play a more central role in our economy than Bear Sterns, and the Washington Post states that their federal sponsorship carries an “implicit guarantee” of government intervention in the eyes of many investors and analysts.

Also witness another $5 jump in crude oil today, a factor in the economy that I wrote about in a recent post.

Fannie Mae and Freddie Mac both plunged today, each tanking by around 20%. The market as a whole is hovering at around 20% below recent highs, a level that many observers use to signal official bear territory. Credit markets are in disarray, liquidity is tight, and the Federal Reserve is trying to eye inflationary pressures on one hand and stagnant growth on the other. These are scary days.

Things will turn around. Eventually. But my fear is that our economy’s recovery is contingent on a single factor: oil. And for me this isn’t a comforting thought.

Watching our current administration wrestle with energy policy is enough to make me lose my faith in government entirely. As we wade into this crisis, Washington has responded with – drumroll – more hearings and meetings. Witness a couple of recent high profile examples. Back in March the Select Committee on Energy Independence and Global Warming dragged the CEOs of the big oil companies to Washington so that they could get a proper public scolding. This was political theatrics at its worse with the committee members mugging for the cameras (and their constituencies back home) and competing to see who could poke the bad guys in the eye the hardest. No serious issues were discussed.

Not to be outdone, the Congressional Committee on Energy and Commerce (yes, an entirely separate and unrelated congressional committee) had hearings of their own last week. According to these guys the evil oil companies aren’t to blame after all – it’s the evil energy speculators who are the problem. And who is going to stick up for a bunch of hedge fund billionaires? Shut down their excessive trading, we’re told, and gas prices will come down. In no time we’ll be back to filling up our Hummers and Escalades with smiles on our faces.

Well as it turns out the later committee is the “administration friendly” effort: they’re shilling for low taxes and offshore drilling. The competing committee was established last year by Nancy Pelosi – they’re all for windfall profit taxes on the oil companies and conservation. It doesn’t appear that the committees spend too much time coordinating their efforts.

This isn’t encouraging. Snappy sound-bites on CNN don’t lead to smart policy. The proposed gas tax holiday was a quick-fix that would have done more harm than good. And drilling our offshore reserves is a medium-term proposal (at least ten years) that won’t have a measurable impact; less that 5% of global reserves are in the United States. It’s great politics to talk about “energy independence”, but for a fungible global commodity like oil this is a mirage. There’s no such thing.

But there is one factor that we can have some influence over: demand. And this has swung the wrong way over the past couple of decades. Witness our love affair with the automobile. Trains and fuel efficient cars are for Euro-geeks. As Newt Gingrich put it in a recent New York Times article “our culture favors driving long distances in powerful vehicles and the car as a social expression.”

We’re seeing the first small steps of a reversal. If you’re driving a Ford F-150 or a Lincoln Navigator you’re not going to have a smile on your face when you check out the current trade-in value. Nothing signals an evolving cultural change like the all mighty market, and the plummeting resale market for gas guzzlers is an early indication that high prices are starting to have some impact on our behavior. Are we starting to reexamine our national mantra of more-more-more?

Take a look at our collective relationship with our homes: yes the value of the average single family homes has blown up over the past couple of decades, but one fact that is often overlooked is that comparing values now with those in the seventies and eighties is really an apples-and-oranges comparison. According to census figures average size of a new single family home increased from 1,500 in 1970 to over 2,200 in 2000, while the average household size declined. It’s not just our Hummers and Escalades that we’ve super-sized.

This trend has to flatten, and this colors the way that I look at the real estate market. I don’t see the market for McMansions in the outer suburbs rebounding for a long time. Gas prices are going to stay high and this will continue to drive the reverse migration from the burbs to the urban areas. An exception, in my view, lies in areas that can reinvent themselves as city centers in their own right. An example of this is Katy Texas – a Houston suburb that is starting to attract more jobs.

So this is a scary time, overall. But as the stock market wobbles into treacherous territory real estate makes more sense than ever – assuming you’re pursuing opportunities that generate enough revenue to keep you afloat if things go south. Run the numbers, make reasonable assumptions for vacancies and repairs, then ask yourself: will I survive if this property takes a 15% hit? If so you’ve established your worst case scenario (hold tight) and you’ve done a nice job of diversifying your stock market risk while setting yourself up to profit nicely from the market’s recovery. Whenever that might happen…

His example, in my opinon, actually understates his case.  He compares a investor who puts $100k down (40%) on an expensive $250k property in a high value region to an investor who puts $100k (10%) down on $1 million worth of rental properties in a cheap region.  If the first market goes up by 10% then the investor makes $25k in appreciation.  But if the second market just goes up by 5%, on the other hand, then that investor makes $50k. 

The thing that jumps out at me here is that a one year 10% rise in property prices is huge.  Yeah, it's happened a lot in recent years in CA, FL, etc - but an investor who jumps in with the expectation that this will happen might as well take his down payemnt to Vegas and put it on red.  This isn't investing, it's speculating. 

Which is to say: I agree with Jeff's argument even more strongly than the example he puts out there. 

Look yourself up - you might find that there is more info on you out there on the web than you thought.  One drawback: search for a generic name (like, say, Chris Smith) and you'll get a whole boatload of info on all the other Chris Smith's out there.   [19 June] Ironic postscript:  As of today this page that you're reading right now comes up on page 1 of a Google search for "Chris Smith"

When you're screening tenants you'll still need to pay for a real background check, but I think this site might be useful for the quick preliminary screens I used to do on Google. 

It's not my custom to shill for realtors, but I've often written in the past about building business relationships and how this is a key to successful investing - so I figure it's time to give a some credit where credit is due.  Eurika is an agent that has helped me to maintain my sanity over the past few years. 

Unfortunately she works for a high-end firm with zero tolerance for reduced commissions - which means she doesn't represent me when I'm making a sale - but I do work with her when I'm on the buy-side of the transaction, and she does a great job of pre-screening tenants when I'm filling vacancies. 

If you're an investor in Houston (or just buying or selling a home) then give her a call.  Tell her I sent you. 

Related Link ::

• Eurika Coleman, REALTOR®

The tree, it turns out, was dead. Last time I’d driven past the property was early spring, and I noted that the tree seemed a little late in sprouting leaves. I made a mental note to follow up on this, but never got around to it. That was a mistake, and one that could have been costly had the tree fallen on the house, on someone’s car – or worse of all had hurt someone. As it turns out a gusty windstorm blew it over into the road where it caused a minor inconvenience but no real damage.

The neighbor has a chain saw and a truck so I paid him to haul it away. I don’t know what killed the tree – it was fine last year but for some reason didn’t bounce back this year. But I’m happy that I’m writing about a close call and minor annoyance instead of a major incident.

The premise of the company is that they identify investment possibilities for you, and for a $5,000 fee they’ll provide the investor with title and a bridge loan, then refinance at an 80% LTV. Their main pitch is that they’re offering you, the investor, “20% equity built-in as a head start.”

The details of how they propose to accomplish this are hazy. I’m a smart enough guy, but over the course of a couple of unsolicited phone calls and a few emails I haven’t really figured it out. Here’s their financing overview from their website:

There’s an interesting footnote to the right side of the diagram: “Depending on your loan structure, Blue Moon cannot guarantee no money down at refinance.”  Which to me means that it's likelly that you'll have to pony up 20% of the purchase price in order to get that 20% built-in equity.  Plus the $5k fee upfront.

Well I haven’t done exhaustive due diligence on this company, but I do know that chasing a something-for-nothing strategy is a sucker’s game – especially when the opportunity shows up via a cold call. Remember what your mom told you about deals that look too good to be true.

But I will say that being on the road non-stop (I’m writing this dispatch on a plane from North Carolina to Puerto Rico) has acquainted me with some of the finer points of being a long distance landlord – a good reminder of why I prefer to invest close to home where I can keep an eye on things. What’s saved me is the fact that I have developed a bullet-proof relationship with an excellent realtor that I trust and with a handyman/contractor that values me as a repeat customer and not an easy mark. So although I like to keep an eye on things I realize that the world isn’t going to come unglued while the cat’s away.Good investors who have developed reliable relationships realize that they’re not indispensable - their businesses continue to run in their absence.

I right now am looking at an article in the Economist that is reviewing the current foreclosure/subprime mess that we’re in. The article considers, among other things, the ratio of rents to property values as an indicator that many regions of the country have farther to fall. This is a metric that I’ve written about before, and one that, in my opinion, is not written about enough in real estate circles. Consider it a P/E ratio for real estate which assumes that the price of a property “reflects the discounted value of future ownership, ether as rental income or as rent saved by an owner who lives in the house.” According to the popular Case-Shiller index property values would have to fall an additional 10-15% over the next year and a half for the ratio to return to the historical average of between 5% and 5.5% (it reached 3.5% at the height of the boom.)

And yes – I do understand that all real estate is local. But this stuff is important – the credit market is a tide that lifts and lowers all boats, so I for one am keeping an eye on the broader market as I think about my next entry point.

But before you build that McMansion consider this: like aspirin and fine wine, more of a good thing will not necessarily lead to a superior outcome. Yes you should own your own home, but if you supersize it then you’ll be paying a cost.

Consider a buyer trying to decide between buying a $600k house and a $300k house (you can either double or halve these numbers depending on property values in your neighborhood). There are some that will argue that by splashing out on fancier digs that they’re investing in their future. But not so fast…buying an $600k pad is certainly better than renting a $600k pad (under most market conditions) but it doesn’t beat buying a $300k pad. Follow the numbers…

Assumptions:

• 6.5% fixed rate mortgage
• 0.75% property tax
• 4.5% property appreciation rate
• 9% stock market return. All excess cash (from tax deductions and lower mortgage payments) are reinvested at this rate.

The more expensive house generates a big gain through property appreciation – over $330k in ten years - assuming the market behaves roughly in line with the long term historical average of 4.5% per annum gains. Adding the pay-down of the loan balance and income tax deductions from interest and property taxes (which are continuously invested in the stock market), the $600k house creates around $500k in wealth over ten years.  Not too shabby.

Compare this to the option of buying the cheaper house.

The $300k house generates considerably less in terms of property appreciation over ten years vs. the more expensive home. But compare the two mortgage payments: around $46k per year for the larger house vs. $23k for the smaller one. This is an extra $23k that can be invested in other vehicles, plus savings in property taxes. When these funds are reinvested on a yearly basis then they can generate dramatic returns.

Result:

• $300k House: $506k of value created in ten years
• $600k House: $590k of value created in ten years

Extend the anaylsis out to fifteen years then the results are even wider.  And if you take that extra cash and put in into income generating real estate instead of the stock market - now you're really cookin' with gas.   

Is this an argument against the flahsier house? Well…maybe so, but maybe not. Perhaps ten years spent living in the nicer home is worth that $84k in foregone wealth. Fair enough.  Just don’t convince yourself that you’re making a strategic investment by going big. The house you’re living in doesn’t generate income – it only generates expenses. Living large is nice, but there’s a cost.

Vo won the election. But now it’s Vo who finds himself in the news. And this falls squarely into the “what was he thinking?” category. Vo, as it turns out, is a genuine card carrying slumlord.

Vo is a wealthy public figure. The four apartment complexes that he owns are public places. His ownership is a matter of public record. Real, live people live there; they raise families and hold jobs. But they’re living with broken and boarded-up windows, an algae-filled swimming pool, overflowing dumpsters, and other hazards – all documented in a recent article in the Houston Chronicle.

Remember, as landlords, we’re just behind oil company executives and sub-prime lenders as people that the media loves to hate. That’s too bad, because the vast majority of us are committed to providing safe, affordable housing to the public. That’s not because we’re altruists – it’s because providing safe, affordable housing is good business. And as State Representative Vo is now finding out, running an ugly, dangerous, violation-filled property is not a good way to make a profit.

For the third time in as many years I’m having to hire a guy in a bee suit to pull a hive out of an investment property. This is a pain. Bees aren’t like other garden variety insects. You can’t just throw some spray around and call it a day. You have to find the hive, get rid of the queen, and caulk the living daylights out of the opening so the next wandering swarm doesn’t take up residence a week later.

And as an added bonus: honey bees will freak out your tenants.

So when you get a call about bees, just accept the fact that you’ve drawn the short straw. You’ll save yourself some grief by being doing it right. Meaning:

• Call a professional. Don’t try to get rid of the colony yourself. DIY will NOT save you any money.  Suck it up and pull out your checkbook.  You've budgeted for this sort of thing, right?
• Bees can be ornery. If your tenant gets attacked by a swarm of bees that you’ve neglected then you’re gonna end up in court. Even if you show up wearing your sunday best suit you're still not going to cut a sympathetic figure.
• Make sure you get rid of the honeycomb itself, not just the bees. This is for three reasons. First: a rotting hive will attract the next swarm of bees. Second: a rotting hive stinks. Third: a rotting hive will attract other critters.
• Caulk up the scene of the crime. Bees have some sort of chemical, collective memory thing going. They’ll be back, so don’t make it easy for ‘em.

The conventional wisdom has it that foreclosed owners will be scurrying for somewhere to live, pushing up demand and, therefore, rental rates. In some areas this is exactly what has happened.  Landlords in these areas are sitting pretty.

In other areas, however, the situation is the reverse. Tightness in the financial markets has pushed many first-time buyers out of the market. Sellers, unable to find buyers, have converted low end houses into rental. Voila – supply goes up, and the glut of properties pushes rental rates down.

Some aggressive pricing and judicious screening will land a tenant for my vacancy. And as I get a good feel for where the rental market really is I’ll be looking for buying opportunities. Cycles, by definition, don’t last forever. Just when everyone is starting to feel squeezed is the time when you want to think about getting out your checkbook.

So how's the rental market in your region?

Here are five discrete thoughts that have emerged from experiences that I’ve written about recently.

• Honest investors are fearless investors: I have a lot of philosophical reasons for being honest, but I also have a practical one: I’m not clever enough to keep a web of deceptions straight in my head. That’s too much work. And as I tried to show in yesterday’s post, a deception which one commits doesn’t disappear. Ever. It sticks around; you can’t un-ring a bell. But honest men have no fear of such things.
• Ethics is good business: Honesty, truly, is its own reward. Honesty is the foundation of relationships, and relationships are the foundation of business. Honest business people can at times feel that they’re at a disadvantage (how can you break even if you never screw anyone but others screw?) but it’s my observation that the world doesn’t work like this. The short term gain that one may achieve through some slimy deception or half truth rarely translates into a long term gain.
• It’s ok to evangelize ethical behavior: And that means pointing out unethical businesses. When I run into a dishonest player I tell the world about it. I try to use the same respectful, measured terms that I use when I write – but I don’t pull punches when laying out the facts. Side note: a great key to persuasive communication is to lay off the adjectives. Write a review on Angie’s list. Send a letter to your local Better Business Bureau.
• Ethical investors avoid bad deals: A while ago I wrote about a fraud scam whereby investors were sucked into overpaying for rental properties. The consultant convinced them that tenants were lined up and ready to go, and all they had to do is sign on the dotted line for their zero down loans. Of course they got tricked – and most of them ended up being foreclosed. But the full story shows that the papers which these investors signed were full of fabrications and exaggerations regarding the investors’ financial situation. While it’s true that the consultant was the one who concocted the whole confusing scheme, the investors themselves surely knew that something fishy was going on. But the investors convinced themselves that it was the consultant’s dishonesty on those forms, not theirs, and they turned a blind eye. And it was the investors, in the end, that ended up getting hammered. Bottom line: if you smell something fishy then it’s probable that the entire deal stinks.  My grandmother used to say "if they'll crook with you then they'll crook on you."  Smart woman. 
• The benefits of unethical behavior are outweighed by the risks: We read a lot about lawsuits and malpractice costs running rampant in the healthcare field, but there’s a subtext that a lot of people aren’t aware of. Bad doctors aren’t the ones who get sued. Doctors who get sued are the ones who are rude, arrogant, and dishonest. Even with matters pertaining with one’s health most Americans understand that honest mistakes happen, which means that most patients aren’t on the hotline to the nearest ambulance chaser when something bad happens. But...if the doctor was a jerk...they’ll pick up that phone in a flash. There’s no reason to assume that real estate is any different. The goodwill that you generate by treating people in a transparent, respectful manner is good insurance against getting dragged into court if something goes wrong in the future.

We agreed on a $2,000 month-to-month retainer to do some marketing work. I paid him the first month’s two grand, he cashed my check and then disappeared. Vanished.

So here are some things I learned from this experience.

• Trust is crucial. I do business based on looking someone in the eye and shaking their hand. You can’t do business without taking risks. Trust is a big factor in my decision making process, and this experience won't change that fact.  But it does emphasize the importance of having a rock solid contract, and an organized file of every check that you’ve paid for services. A great convenience of today’s internet banking world is the fact that you can easily log on, click on a payment, and print out a front-and-back copy of the endorsed check. This guy took me for a ride, but I archived the paper trail and stayed prepared for round two.  This ain't over.   
• You can’t sue someone you can’t find. That was the big hangup in this case. I got all the prep work done to take my flaky business partner to court, but have never been able to serve him with papers.
• Don’t give up. The statute of limitations in Texas for civil cases is a leisurely four years. That’s an eternity. Take your paperwork and seal it in a file for safe keeping. And periodically take a look around – the creep might show up.  Even though you've written off the loss it doesn't cost you anything to stay on the trail. 
• Assume you’re going to court, prepare accordingly, and be ready to win. Once you track the guy down, hit him with a cool, well organized declaration explaining how you’re about to sue him back to the stone age. The other guy may be lazy and dishonest (which is why he stole from you in the first place) but chances are that he’s neither stupid nor insane. If you have your ducks in a row then nine times out of ten the guy will see the light and pay up before he suffers the indignity of being dragged into court.  The small claims court process isn’t difficult. If you’re savvy enough to buy and sell houses then you’re savvy enough to manage a small claims court case (up to $10,000 in Texas). Go get a brochure from your courthouse and follow the instructions.

Happy Ending

So here’s what happened in my case:  Every six months or so I’d take a look around for this guy online to see if he popped up somewhere. And last week – voila – there he was on www.linkedin.com, sort of a “facebook for professionals” (good website by the way, check it out.) No home address, of course, but he did list his current employer, and I was on the phone to his boss in a flash. Fear of professional embarrassment can work wonders, and now I have my two grand back – plus interest. Two years after the fact I closed the whole sorry mess in the course of a couple of days. It was like finding two thousand bucks in the back of my sock drawer.

Related Posts:

• How can contracts help me to build solid relationships?
• Real Estate Investing and the Psychology of Relationships
• You want to be a hippo, not a whale shark. 

The problem with the speech is that it will be blasted into a dozen Fox-news sized ten second snippets, and a truly honest discourse on race in America is not a topic that can be reduced into sound-bites. 

If you're a supporter of Senator Obama's then listen critically.  If you're not then listen with an open mind.  Either way - listen. 

Real estate investing is a long term play, and a few days ago I introduced five ideas that I feel are key to being successful as a buy-and-hold landlord.  I've already discussed the first two - here, as promised, are the final three...

Principle 3: Take care of your tenants

Nothing beats an investment that pays you every month – that’s why a prudently leveraged real estate portfolio beats the pants off the stock market in long term returns. But that rental property will only generate revenue if there is someone living in it. Vacancies are one of the greatest threats to achieving the financial performance that you expect out of your property, so once you’ve found the right tenant you’ll want them to stick around.

That means taking care of your tenants. But more importantly, perhaps, being responsive and respectful to your tenants will also increase the likelihood that they take care of your property. This will protect the unit’s value, and the end result is that happy tenants are likely to bother you less often.

This is what you want. Answer voicemails promptly and address needed repairs quickly – this is an investment that pays off. I recently had a tenant that would talk my ear off every time I came around. He was the first tenant to move into the property after I purchased it and made some upgrades, so I had to visit a few times after he moved it to get some problems ironed out. But building that goodwill paid dividends; they took great care of the house and I hardly ever got a call.

Principle 4: Don’t take shortcuts with repairs

Trying to save a few dollars on every repair is a short-sighted strategy. Your tenants will take note of how you treat the property and they’ll act accordingly; why should they respect your house when you don’t? A well cared for property is more likely to appreciate and in the end will cost you less to maintain and cause less trouble.

There’s no economic value in delaying a repair – you’re going to have to do it eventually, and if you wait not only will the problem have gotten worse (and, possibly, more expensive) but you will also have alienated your client: the tenant.

Principle 5: Know when to say “when”

The Peter Principle tells us that an individual tends to get promoted to his level of incompetence – essentially accumulating responsibility till he gets to the point where he can’t handle it, and that’s where he stays. Think Elliot Spitzer: great prosecutor, not such a great governor. So yeah, you’re trying to build your empire, but don’t overextend yourself with too many properties or projects. Most real estate investors have jobs to support their day-to-day lifestyle and invest in real-estate on the side as a long-term wealth building strategy. Assuming that you fit into this category (that you’re not a full time investor) it’s wise to make a deliberate decision as to how much you can take on in terms of workload and financial risk. Don’t cross that line.

You can do it

A well maintained property w/ a good tenant should not be a burden on your life. On an average month the only effort that is required of me is to take the rental checks out of my mailbox and deposit them into my bank account. But the key to maintaining this balance is being diligent in all of the steps along the way.

But the financial world is hearing the saber rattling of the politicians (broadcast through a megaphone as we plow though this politically charged season) and this is having a fortuitous side effect: the banks are preemptively starting to get their own houses in order. Note this week’s announcement by Freddie Mac and Fannie Mae mandating stricter standards for independent appraisals – a move which is likely to trickle through to other lenders.  Loose appraisal standards have been a major contributor to real estate fraud, so this is a step in the right direction.

The industry is out to save its skin – not only to slow the bleeding which was caused by their reckless practices, but also to put a positive public spin on their progress. To this end Hope Now, President Bush’s government-led alliance of lenders is now claiming to have helped 1 million home owners fend off foreclosure.  But don’t expect this to significantly alter the tone of the various presidential candidates for whom foreclosure is a big election issue.

Move over big oil – there’s a new bad guy in town, and it may be too little to late for the lenders.

But don’t underestimate the importance of the time part of the equation. In the past I’ve compared the performance of the real estate market with the stock market. For the disciplined investor, real estate performs favorably to the stock market over any reasonable period of time, but you’ll need a few years for the strategy to be effective. If you’re only going to stay in the game a year or two you might as well buy a mutual fund and call it a day. But investors with perseverance will see their wealth grow much faster by pursuing a prudent real estate strategy than they will betting on the stock market.  So to take advantage of time you’ll need a little endurance. Sticking with your real estate investing plan is a lot easier if you’re prudent about your decisions and keep your eye on some fundamental points.

Landlording and long-term investing go hand-in hand. Being a landlord isn’t for everyone, but if you have the right personality and decision making skills then it’s a snap.

Here are five tenants tenets that I’ve determined to be the most important. Ignore these at your peril…^*

• Principle #1: Look before you leap
• Principle 2: Select the right tenant
• Principle 3: Take care of your tenants
• Principle 4: Don’t take shortcuts with repairs
• Principle 5: Know when to say “when”

I'll talk about the first two in today's post:

Principle #1: Look before you leap

Many real estate investing courses are just personal motivation seminars with a thin veneer of real estate education . These courses may serve some use if they cause you to take charge of your financial future, but you don’t want to go charging into battle without the right tools.

A great source of real estate bargains is burned out investors who’ve jumped into a project without a realistic idea of what it would take to get it done. It’s easy to underestimate rehab costs when you’re bidding on a property. Don’t let your optimism lead you down the wrong path.

When a good deal pops up you’ll often have to act quickly, but even when under a deadline there is still time to conduct a basic economic evaluation. Compare the cash outflow (mortgage plus taxes and expenses) to the cash inflow (rental income) to get an idea whether or not you should expect the property to break even on a month-to-month basis. And things break, so don’t forget to include a reserve fund that should be around 1.5% of the property value per year. The best way to maintain your peace of mind is to invest in properties that offer an adequate return, and this will require you to do your homework.

Principle 2: Select the right tenant

Before I bought my first investment property my wife ran out and rented Pacific Heights on video and forced me to watch it. Perhaps you remember this movie: Michael Keaton plays a evil con-man who rents half of a San Francisco duplex from a naïve yuppie couple then turns their lives into a living hell. Bloodshed and drama ensue.

Well it’s not a great movie so I won’t recommend that you sit through it, but I will share with you the film’s primary insight: if you’re renting a high-end property do a credit check the applicant before signing the lease. Housing laws vary from state to state, but one trait that they have in common is that they’re designed to protect the tenant, not the landlord. If you end up renting to a family who destroys your house or refuses to pay the rent then you’ll surely spend a fortune and a lot of time and effort getting them out.

If you’re renting a lower-end property then doing a credit check on the applicant is less likely to yield any useful insights since applicants for inexpensive properties may not have established credit histories. You’ll have to rely on other methods of evaluating applicants, such as references from previous landlords and from employers. Call the references. Follow up.

And lastly, learn something about the applicants when you meet them (and yes, you should meet them – don’t leave this to your realtor). Do they arrive on time? Do they strike you as someone who will treat your property respectfully?

In the end you’ll have to trust your instincts. Having a vacancy is stressful, but it’s not nearly as stressful as having a unit occupied by a tenant who makes your life difficult. It’s not a good idea to indiscriminately accept the first applicant who waves some cash in your face, tempting though it may be. Remember – housing laws are first and foremost designed to protect the tenant; they’re not designed to protect your rights as a landlord. Renting your property to the wrong person is an expensive mistake.

I'll write about the other principles soon....stay tuned. 

* once you start writing tenets about tenants you're setting yourself up for this kind of typo.

The somewhat awkwardly named Emergency Home Ownership and Mortgage Equity Protection Act of 2007 and the Foreclosure Protection Act of 2008 are both being debated. Both are focused properties with nontraditional (neg am, interest only, etc) mortgages or subprime mortgages. Mortgage balances and monthly payments would be reduced based on how much a home’s value has decreased.

These won't impact investors directly, since they only applies to owner occupied properties. However, the measures are defiantly of interest to investors since it’s likely that it will impact the cost structure of the entire industry. The measure might decrease the number of underwater owners who walk away from mortgages, but essentially it forces the bank to eat the cost of the market downturn, instead of owners.

This is reform on the cheap, since short term the banks will be shouldering the cost. But the medium/long term effects won’t be good for consumers:

• Banks who are already reeling will be dealt an additional blow. This will lead to a real bail-out, paid for with real taxpayer dollars. The short term “reform on the cheap” won’t stay cheap for long.
• Banks are already recalibrating the way they quantify risk. But the current model assumes that a when a buyer purchases a home then said buyer will both enjoy the benefits of appreciation and the risk of a decrease in value. This assumption no longer holds, and the banks will be justified in charging accordingly. Home ownership will slip further out of reach of an increasingly large segment of the population.

Reform on the cheap doesn't work.  The banks will fix their own messes.  Some should fail - we should let them.  And if the government determines that citizens who are in trouble need help, we shouldn't fool ourselves that this can be accomplished without the government pulling out it's checkbook and spending some tax dollars.  Coercing the business sector to take an altruistic step will backfire in the end. 

Over on Money.com there’s an interesting piece on when is it ok to walk away from your mortgage, which reports on the deluge of homeowners who are upside down on their mortgages and are simply sending their housekeys back to the banks and walking away. "Jingle mail" they're calling it. 

Well the idea was enough to push me into a state of moral indignation, thinking about the great American blame game and the general lack of accountability in our society.

But, having though about it a bit, I’m not sure so sure...

But look at it a different way. The rules of the game are clear: you sign, you get the house, you pay. And just like in sports, the penalties for violating the rules are clear as well; in this case, if you walk away you get a nasty-gram in your credit file.

The banks know this when they sign up homeowners. That’s why they charge higher interest rates on riskier loans – rates which they themselves set.

So perhaps my moral indignation was...a bit misplaced.  And I think my opinion was changed a bit by reading some of the 1,000+ comments submitted by readers (and yes there are a lot of stupid comments in the mix as well – to be expected). Upside down borrowers who walk away stick it to the banks – and that in turn forces the banks to reevaluate their algorithms for evaluating risk. And that in turn forces them to get better at the game of offering competitive rates to creditworthy borrowers and also realize that peddling high-margin negative amortization loans isn’t good business in the long run.

So does a financially troubled homeowner have a moral obligation to keep paying the note on a property that suddenly has negative equity and a resetting ARM payment? What if the stress of making the payments threatens his marriage and/or pushes him towards bankruptcy?

So perhaps a homeowner who makes $50k per year and walks away from the $300k mortgage on a house now worth $250k that the bank financed for him using a zero down ARM is doing the system favor by sticking the bank with the loss and nudging it just a bit close to a sounder lending policy.

This isn't painless for the borrower, who sees his or her credit in tatters - but there is an argument that says that banks who make bad lending decisions deserve to get burned. 

Thoughts?

Towns like Akron, as it turns out, were a fertile feeding ground for illicit activity during the boom.  Even during the headiest days property values were appreciating too slowly to make a fortune quickly, so unfortunately there were some operators who combined greed and easy credit into a formula to bilk novice investors and, sometimes, the banks that financed the deals. 

Worth listening to.

Related stories:

• Real estate shell game :: Recognizing fraud
• Real estate shell game :: Part II
• Real estate shell game :: Part III

Most of us investors are part timers. And lots of us are somewhat handy and know something about houses (we live in houses ourselves, don’t we?) So those first three items are things we can generally get our collective heads around. We see roof jobs every day. We change the filters on our own AC system. Most of us have replaced a faucet or two in your time. So problems, both big and small, might not phase us when it comes to the roof, the AC system, or pipes.

But foundation problems? Woah Nellie. A sloping floor or suspicious cracks in the plaster will send most investors scurrying on to the next prospect. But this might be an opportunity. Less competition = fewer bids. Fewer bids = a lower price. And we like low prices when we’re buying, don’t we?

But not all foundation problems are created equal. Here in Texas (and perhaps where you live, as well) you’ll tend to find two types of foundation: slab, and pier & beam. If you tried to dig a basement in Houston you’d be playing table tennis underwater; Houston is essentially a paved over swamp with the water table a few feet below ground. In other parts of the country you’ll have other options – a crawl space foundation or a full basement. I don’t have any first hand experience with the structures I’ll I won’t say any more about them.

What I will say, however, is that pier and beam foundation problems scare me a lot less than slab foundation problems. Slab foundations mean buried pipes and no repair access. Fixing them is expensive. Last year I had a problem with some tree roots which grew about fifteen horizontal feet under a slab foundation and busted up the plumbing under a commode (lots of nutrients down there, I guess). Visualize jackhammers and annoyed tenants.

So I probably wouldn’t consider a property with major foundation issues if it had a slab foundation. A pier & beam foundation, however, is another matter. This is the preferred method for older homes, in which the home is constructed on beams which sit on piers which are driven into the ground for stability. I own a fourplex that was built in 1935: a hurricane-proof all-brick tank of a building. I wish I had ten more just like it. But it had some foundation problems a few years ago, but with a pier & beam foundation this was cheap to fix. So if you run into a prospect like this then you might want to give it a second thought before you put it in the “too hard” box and cross it off your list; you might be passing up a property you could snag at a bargain because it scares off all the newbies.

But make sure you get a structural engineer to take a look (not a foundation repair specialist, who will be trying to sell you something). The bottom line: a prospect w/ foundation problems might be worth another look if it’s a pier & beam structure. Go ahead and wave your arms and declare the house a disaster to the seller and to your Realtor, but know in the back of your head that this is a problem that most serious part-time investors can tackle.

Note: Graphic illustration includes diagrams taken from the Foundation Repair Network. 

Having a vision, taking a view, and running the numbers: the three pillars upon which you’ll build your ability to make sustainable decisions which will, over the long run, help you to achieve your financial goals. Well forming the vision is the fun part; we all enjoy thinking about where we want to end up in life. And you’ll have lots of help in taking a view; everyone and there dog is out there making predictions about what’s next for the real estate market – your task is separating the wheat from the chaff.

But what about running the numbers? How many of us get really excited about running economic models? Well in my view looking before you leap is the best way to keep your momentum as an investor, and that means having an idea about what to expect from an investment in terms of rate of return, cashflow and net present value.

But analysis is like aspirin, or fine wine, or just about anything, for that matter. A bit of it can make a big difference – but that doesn’t mean that a massive dose is a good idea. More isn’t necessarily better.

So how do you strike the right balance? Well watch out for two traps – 1) becoming infatuated with the analysis and forgetting about the underlying uncertainties (no analysis is perfect) and 2) becoming infatuated with perfecting the analysis to the extent that you never get a deal done. In other words: don't get paralyzed.

Both of these problems happen, probably more than you’d think.

So - how to avoid these issues? Again, it depends on your goals as an investor and your personality type, but I’d suggest a few rules of thumb:

• Remember: your analysis is based on your assumptions. Unless you have a working crystal ball you’re never going to get it all right. Your analysis will give you your base case. When you get your results ask yourself “is this target a good result? Does the potential reward justify the risks?” if the answer is “yes” then drive on and figure out how to make the deal work – don’t spend too much time fine tuning. 
• Analysis is a process: I worked for a while in strategic planning with a major corporation. We spit out huge, detailed plans. And we never followed them. Is this a bad result? Well, not necessarily, because the planning process in itself is hugely valuable. It forces executives to examine their assumptions, communicate their goals, and crystallize their thinking. The planning process helps organizations to articulate their vision and set their course, even if they don’t follow the resulting plans to the letter. Real estate analysis is similar: running the numbers will force you to consider the big questions around vacancies, rental rates, repairs, and other risks that you might not consider before jumping into the investment. 
• Evaluate the sensitivities: Don’t just look at the final “answer” – look at the sensitivities to understand how much risk you’re taking. Ok, you’re forecasting a 5% appreciation rate...but what if it’s -5%? Or 10%? Most investors who bought in 2006 didn't predict today's market - but there are a handfull who at least evaluated the risk of a downturn.  Investors who consider future risks are investors who are prepared to take action when things don't go right. 
• Be honest with yourself: There are two camps that you want to stay out of – the overly conservative camp that kills every deal that comes along by handicapping them with excess costs, and the rose-colored-glasses camp that tweaks all the variables up until they get the result they want. Nervous Nellies do no deals, and Pollyannas do bad ones. 
• Remember that once you’ve made your bed you’re going to have to lie in it: A single fortuitous event (a new rail line) or misfortune (a mold infestation or a disastrous tenant) will radically impact the performance of your investment. You’re still going to have a lot of uncertainty to manage once you make your investment; the purpose of the analysis is simply to ensure you’re pointed in the right direction before you pull the trigger.

You can expect a pretty heavy Realtor spin on things, but that's ok in my book; if you want a balanced worldview then it helps to hear both sides of the coin.  I'm a guy who gets his news from the Wall Street Journal (on the right) and the New York Times (on the left), so I believe that it's important to be open to different points of view.

You’ll see some of the boilerplate that you’ve read before, but pay attention to a reference to an influential paper written by Harvard economist Gregory Mankiw which back in 1989 predicted a precipitous decline in housing prices. The premise was that a shrinking body of first-time buyers along with a glut of downsizing baby boomers will collectively pull lots of demand out of the market, leading to an excess of supply and a sticky plunge in prices.

Regardless of whether or not you pay any attention to the experts’ predictions it’s important to have a view on what’s next; you can’t invest without having an opinion about the future. Personally, as prices slide and interest rates drop I’m actively pursuing multi-family opportunities. I don’t know that prices won’t continue to drop, but locally I’m also seeing strong demand for rentals and, in some cases, higher rental rates. According to the National Housing Council , rental rates are up 3.36% in Houston. Combine that with the fact that housing prices have slipped by 2.38% over the last year and you have a market in which an already competitive rent-to-value ratio has gotten even better. That, for me, is an acceptable risk.

Rental rates in some major markets are up even more: 8.87% in Dallas (accompanied by a big 6.18% slide in property values). Notably, some higher value markets like San Diego and Miami are showing strong double digit increases in market rents, but even with a little help you’re unlikely to find buying opportunities that will yield breakeven cashflow in those areas.

I’ll talk a bit more about the Center for Housing Policy’s recent press release on housing affordability in a post tomorrow.

There is an interesting article in today’s New York Times about a California woman who is suing her real estate agent because she feels she paid too much for her $1.2 million home.

The woman claims that her agent “ordered an appraisal of the house” for her and her husband but “...did not respond to the couple’s request to see it.” Shortly after moving in they got a flier from another realty agent showing a house just up the street sold for $105k less than theirs.

This reminds me of a hair-brained CNN story which was published recently about a woman who was debating the merits of suing her doctor for complications she suffered after a surgery.

Hmm...homebuyer purchases a home without ever laying eyes on an appraisal, then sues ‘cause she overpays. Patient suffers a complication during a major invasive surgery then sues her doctor for pain and suffering.

The who’s the blame phenomenon in American culture is one that I’ve written about before, but unfortunately I think we can look forward to reading a rash of stories in the real estate field in the coming months. Real estate is, in the best of cases, an inexact science. With prices falling these may be treacherous times for real estate agents in our litigious society.  So Realtors: when the guy down the street cuts a better deal than your client just inked, be ready to call your attorney. 

In discussing the concept of leverage, where an investor builds a profitable portfolio of investment properties over the year by occasionally executing a 1031 exchange, the Peter Principle might be relevant. As Max points out, you don’t want to get in over your head.

There’s something to this. There’s an implicit assumption that over the course of your investment career your ability to manage the complexities of larger properties and a greater number of tenants will increase. Additionally, you will also put yourself in a position to make judicious use of property management services. But at some point an investor needs to know how to say “enough”. Smart investors need to recognize when they’ve gotten to that point.

But often they don’t. And if you can find one who has gotten beyond his comfort level then you may be in a position to negotiate a great purchase. There’s a phenomenon I’ve noted which I call the “two-fer” sale – keep your eyes open for these. From time to time I’ll notice two similar properties which hit the market simultaneously. Sometimes they’re FSBO’s, and you’ll notice them if there are two identical FSBO signs on the same block. In my experience, this is a sure sign of an investor who paid for some expensive Rich Dad type motivational seminar, and in a wave of enthusiasm and empowerment hit the streets and bought the first two houses he could get a mortgage for. Essentially, this investor hit the Peter Principle very early in the game. He wants out.

Two-fer’s can be a great opportunity. If you can find a reluctant landlord who’s struggling with the negative cashflow drain of two vacant properties, you negotiate a great bargain by saying you’ll take both of the properties off his hands: I’ll take ‘em both for $XXX,XXX. And that should be a really low combined price. But the reason that this tactic works is that you’re making the seller’s problem disappear in its entirety. This can make the seller shift into “cut my losses” mode in one fell swoop.

This is a tactic that works. This is how I bought the two properties (FSBOs) a few years ago that I’ve recently vowed to sell as my New Year’s resolution. And on the buy side I’m looking at a couple of similar opportunities as we speak.

So the Peter Principle is a sword that cuts both ways – so make sure you’re on the right side of this trade.

There, of course, is no single right answer to this questions – it will depend you’re your risk appetite, your local market, your time horizon, and your view of what the market is going to do next. But from where I sit I see five basic paths forward for investors in 2008:

• 1: Rebalance in the same market. This is what I’ll be doing this year. Investors who have been in the market for a while are sitting on a pile of equity that probably won’t perform too well in 2008. That means it’s time to sell, re-leverage, and put it back into properties that will give you the right cap rate. I wrote about my specific example a couple of days ago. Although it’s no fun selling in a soft market, when you’re buying and selling at the same time it’s a wash. Price your property right and it’ll sell – and at the same time look to buy a property at the same sort of discount.
• 2: Lift and shift. If you’re in a market like San Francisco, Los Angeles, Florida or Las Vegas then you might be concluding that your market has done its thing and the future looks a bit less rosy. Some investors might be tempted to try to hold on until the market turns around and hits the peaks that it enjoyed during the acme of the roller coaster ride, but a better idea might be to sell now, grab that equity, and re-invest in a market that is less overvalued. Consultants like Jeff Brown in San Diego are advising this type of strategy, moving investors from California to Texas.
• 3: Bargain hunt (speculative version). Fifteen years from now they’ll be asking “what did you do during the market correction?” Well unless you have your crystal ball you don’t know now what the best answer to this question will be, but investors with a speculative bent are looking for the bounce. Again, this is a speculative view. Not that there’s anything wrong with that – as long as you're aware of the risks you're shouldering. There’s nothing so dangerous as someone who thinks they’re an investor but in reality they’re acting like a speculator.
• 4: Bargain hunt (value version). Regardless of your view of what’s going to happen next, in many markets the current correction is creating some great value deals – properties that you can pluck straight form MLS that will generate a positive month-to-month cashlfow with only a 10% down payment. You won’t be seeing many of these in, say, Las Vegas. But you will in Fort Worth, Tulsa, and Kansas City. You’re not looking for the dip with this strategy – you’re just poking around in a relatively favorable market for positive cashflow investments. If the market bounces then great. If it doesn’t then you’re in good shape to weather the storm.
• 5: Ride it out (do nothing). Good traders will acknowledge that sometimes their best trade of a given week was one that they didn’t do. Strategies 1 and 2 require you to have some underperforming equity to re-deploy. Strategy 3 is strictly for speculative high-rollers, and Strategy 4 only works if you’re living in the right kind of market. So what if you’re in the “none of the above” camp? Well patience can be a virtue in investing, and I’m not in the “now is always the best time to buy” camp of real estate investors.

Information wants to be free: Real estate investing certainly has an element of secrecy, as does any business endeavor that involves negotiations. For example, when you’re on the buy leg of a 1031 exchange you don’t want the seller and you’re running short on time you don’t want the seller to know that you’re under pressure to make a deal work. And when you’re selling a property that you just bought FSBO you don’t want the buyer to know that you purchased it for a song.

But that said, there is a great amount of general information that you can be generous with. This isn’t altruism; information truly wants to be free, and professionals who are open with sharing their expertise will in the end benefit in many ways.

This is a principle that I try to demonstrate myself – in this blog, for example. Everything here is free. And I frequently receive emails from readers who compare the things they read here (and on other free resources) with the stuff that they pay thousands of dollars for. The internet is a sleazy place when it comes to real estate. Want to find out “…closely guarded secrets for real estate investing” or ways to get “a whole new level of jaw-dropping wealth and financial independence” then all you have to do is whip out our credit card. (note: these are actual quotes from various websites). If you’re paying for a secret you’re getting scammed; there are no secrets out there.

But this “free information” principle applies directly to all of us as investors. I deal with a relatively small number of real estate professionals: contractors, real estate agents, lenders. And I share with them what I’m doing – how I make deals work, what’s been successful and what’s failed, and what my strategies are. And they reciprocate – which means I learn a lot more about, say, peer-and-beam foundation leveling and realtor commissions than I otherwise would. Information wants to be free, but it’s also very valuable. Give a little and you’ll get a lot.

I want the people around me to make money: I’m not a big fan of paying a 6% commission to sell a property. But that doesn’t mean that I mind when the people around me profit when I do a deal. Most successful corporations don’t get that way be paying their employees the bare minimum; this rarely is a sustainable strategy. Likewise, most successful investors don’t get that way by squeezing every cent out of every deal at the expense of the people who support them. When I call my contractor or my real estate agent I want them to be happy to see my name on their caller ID. I want to be known as a repeat customer who closes deals. I expect to be charged a repeat-customer rate, but they know they won’t have to twist my arm to get paid fairly.

Relationships aren’t just about dollars and cents: This is an area that I have to be vigilant about reminding myself. I generally show appreciation through repeat business – and since I’m generally a dollars-and-cents type I might tend to think this is enough. But it isn’t. Independent professionals get a great deal of satisfaction from the appreciation that their clients show them. Good businesspeople aren’t in it just for the money, and they won’t know you appreciate their expertise and hard work unless you tell them. Write a note. Post a recommendation on Angie’s List. Remember them at Christmas.

My fun resolution is tied to my interest in photography – create a history of 2008 in 52 photos by selecting a photograph each week that I think is good enough to show, and spend a few minutes writing about why I picked the picture and what the moment meant. If you look around you’ll see a lot of photo-a-week galleries on the internet, but this will be a private project for my family. So no downloads for me…

And my professional resolution this year is…drumroll…exactly the same as my resolution last year: to sell some properties that have accumulated some equity and flip them into a fourplex using a 1031 exchange.

The two properties I need to sell are a couple of nice townhomes in the West Memorial section of Houston. I bought both of them from an investor a couple of years ago and the market has treated the area pretty well.

The market in Houston is a bit soft in this price range, but since I’m buying and selling at the same time I’m not that concerned; my main goal is to ensure that my portfolio has the right amount of leverage and that I’m generating a good cap rate on my investment. These properties have appreciated, but rent rates in the neighborhood haven’t kept up.

Last year, publically declaring my resolution seemed to have some psychological effect in making sure I got it done. Worked last year….we’ll see if it does this year too.

We're so accustomed to having our intelligence insulted by politicians that we rarely complain about the dumbed down worldview that we’re spoon-fed by both sides of the political aisle. The partisan mudslinging that we’re subjected to these days makes it hard to imagine a world in which candidates might campaign by voicing nuanced, well articulated views on the complex issues facing our country. That’s too much to ask for, but at least we get to watch the primaries, which offer up the entertaining spectacle of Democrats savaging fellow Democrats and Republicans bashing Republicans as they fight for their respective nominations.

But there are a couple of issues that I think we should all hold our candidates to a higher standard. One of these is immigration reform.

Even the language of immigration reform is fraught with semantic landmines. Do you talk about “illegal aliens” or “undocumented workers”? Do you open the discussion with allusions to Ellis Island or by invoking 9-11. Is this about security or fairness.   Economics or the American way?

But it's safe to say that we're all interested in the state of our economy and national security – these are two tides that lift all boats. And as real estate investors – we’re more interested than most in how the housing market weathers the current storm, not to mention how we operate as landlords and as consumers of labor intensive services like roofing, landscaping and construction.

More specifically – as politicians target employment, benefits, and housing as keys to the illegal immigration question, some municipalities have proposed legislation which would hold landlords accountable for policing the residency status of their tenants. These are bad laws.

The reality of the situation is that it is difficult to take a complex issue like immigration reform and turn it into an effective sound bite, so it’s rare that we see a candidate discuss immigration with any subtlety or insight. But when I hear anyone address immigration I’m listening for a couple of key things…

Does the candidate acknowledge the complexity of the issue, and our society’s complicity in creating it? George W. Bush has lately become fond of invoking our society’s dependence on foreign oil. This is a step in the right direction (although the solutions proposed are all wrong – that’s another post) but as a society we’ve yet to confront the fact that we’re also addicted to imported labor – especially when it comes to difficult, physically intensive, cheap, dangerous work. When I walk into a construction site, a rehab project, a house that’s being cleaned for showing, or a landscaping job I without fail see a group of workers made up almost exclusively of immigrants. Always. Granted, this fact is exacerbated by the fact that I’m in Houston, but many readers will find this to be a familiar observation.

I live in a suburb where the residents, generally speaking, are more inclined to lean towards the Tom Tancredo school of immigration reform than the Hillary Clinton view. But if you walk this neighborhood on any weekday you’ll see the streets dotted with landscaping and housekeeping crews made up of employees who are in the country illegally.  It's interesting that the "Assault on America" philosophy of immigration reform is so successfully sold to those socially conservative families who every week enjoy a beautifully manicured lawn for $35 a pop - courtesy of the invaders. 

Does the candidate appeal primarily to fear? In recent years folks who live in my neighborhood here in Houston have been subjected to some of the foulest, ugliest campaigning I can remember as Hubert Vo (D) and Talmadge Heflin (R) squared off for a seat in the Texas State House of Representatives. They both took the low road on numerous occasions on various issues; one of them was immigration. This ad to the right (actual scan of a flier which landed in my mailbox) won the prize for the crassest.  According to Heflin, his opponent was so uninterested in the general public safety that if he won then Osama himself would eventually stroll into a local Texas Department of Motor Vehicles and get a drivers’ license.

Heflin lost the election in a very tight race, and I like to think that there were at least a few voters, like me, who were pushed into the opponent’s camp because they were angry about having their intelligence insulted.

Does the candidate talk about people?  Immigration is a human issue.  Immigration is about people. I think most of us would agree on how we should treat an illegal alien who slips into the country to sell drugs. But how do we treat an undocumented worker who has spent the past twenty years toiling in a Tyson chicken processing plant, paying social security, contributing to his community, and raising his kids who were born here and are now in high school?

If we were to wave a magic wand and magically deport all 12 million people residing in our country illegally, every restaurant in Houston, San Antonio, Los Angeles, Las Vegas, Miami, and San Diego would immediately close. Our crops would rot on the vine. Poultry and meat would disappear from our supermarkets. Hotels would shut down. Residential level construction work will grind to a halt.

Some of these industries would eventally recover – but at a great increase in cost to the consumer.

So ask youself: is the candidate presenting the issue to me in all its complexity?

Postscript:  The squeaky wheel gets the grease, and there's no area where this principle applies more strongly than in politics.  This blog post got picked up today by topix.net.  Take a look at the comments.  The bottom line is that if the general public is apathic towards important issues then thoughtful voices will be shouted down by the lunatics on the fringes.  Is this the America that you want to live in?

The Global Insight uses a number of factors in determining the theoretical price equilibrium level for each market, to include tax rates, population density, income levels, plus a somewhat nebulous “desirability factor”. So, as with all economic studies there is some art mixed in with the science, but nonetheless I find this study to be an useful data point when thinking about the relative valuation of markets.

The fact that Houston is ranked as the most undervalued market is interesting in light of the underlying economic factors and the disparity between the market’s current reactions with how it behaved in the past. Nowadays when we think about real estate bubbles we immediately think of California, Las Vegas, Florida, and other regional markets that have grabbed headlines with their flying property values over the past several years. But we forget that the poster child for real estate market collapses was Houston in the mid-to-late eighties.

Texans were knee deep in irrational exuberance long before Alan Greenspan coined the term. When the Gulf States kicked off the Arab oil embargo in response to Western support for Israel in the Yom Kippur War, the resulting spike in oil prices fueled investments in the oil industry. This, in turn, pushed property values to unsustainable heights.  Everyone wanted their own Southfork Ranch. 

Fast forward to the early years of the 21st century. Two rounds of armed conflict in the Gulf, rising demand and tightening supply have again sent oil prices into the stratosphere; and I’d argue that this time around the increases have more fundamental sustainability than in years past. Money is flowing into operational oil centers like Texas and Louisiana. But, the real estate market hasn’t responded. Yet.

The graph below shows the Department of Energy refiner acquisition cost of imported oil. 

Will property values in Houston and other economic centers for energy go up? In the short term, perhaps not. Economic malaise and a jittery credit market will help to continue to keep a lid on the prices, but I love the fact that the downside risk in undervalued markets is relatively low. Currently, investors in some markets need to plop down a 40% down payment in order to get into an property that generates breakeven month-to-month cashflow. Getting into an undervalued one where 5% does the trick feels pretty prudent.

I wrote in a recent column that when an investment starts “getting good” – when it starts kicking off some cashflow and putting some dollars in your pocket on a month-to-month basis – then that’s the time to sell. This might sound counter-intuitive, but I’ll give a couple of examples that show why it is true.

Judged on the basis of simple price appreciation, the stock market beats the pants off of the real estate market. Over the past twenty years the S&P 500 has appreciated at an average rate of almost 10 percent per annum, and the NASDAQ has averaged over 11 percent. Over the same period the average home price in America has increased at around 5.6 percent. So why do we get excited about the real estate market? Because it allows the investor to prudently use leverage to increase her returns. So why should we consider selling when the investment starts kicking off cashflow? It’s because this is a good sign that your leverage is running out of steam.

Let’s look at a simple example. An investor puts 20% down on a $100,000 property. The investor starts out with $20,000 equity on a $100,000 house, giving him 5-to-1 leverage. Meaning: if the market goes up by 5% then the value of the house goes up by $5,000, a 25% return on the initial $20,000 investment. This is a basic concept you’re probably familiar with.

As time passes by two things are likely to happen: a) the property will appreciate in value (good) and b) your loan balance will go down (also good). But there’s an unintended by-product of these two factors: a decrease in your leverage.

The graph above assumes a fixed rate mortgage at 8% and a property appreciation rate of 4.5% per annum. Now this isn’t a bad investment – in fifteen years that initial $20,000 grows to over $120,000 in equity. That’s an annualized rate of return of around 14%, better than you'd expect out of the stock market. But look what happens to leverage. By year five you can expect to have paid off around $4,000 of the loan. And assuming a 4.5% rate of appreciation, the property will have gone up in value by around $24,000. That adds a total of $28,000 to your equity – so now you have $48,000 tied up in the property. So here’s the results:

• Initial leverage: $100,000 property ÷ $20,000 equity = 5 to 1 leverage
• Five years later: $124,000 property ÷ $48,000 equity = 2.6 to 1 leverage

I don’t day trade stocks and I don’t flip houses – but that doesn’t mean I’m a completely passive investor, either. Smart investors know when it’s time to rebalance – and when your leverage starts falling it’s time to think about re-balancing.

The chart above shows an investor who rolls up his sleeves every five years, sells his properties and reinvests the equity. In the example above, the investor’s $100,000 property had grown to $124,000 – that’s good. But the $48,000 in equity now translates into a 20% down payment on a $240,000 duplex.

Summary:  Sell the property for $124,000, extracting $48,000 in equity.  Use the $48k to put 20% down on a $240,000 property via a 1031 tax deferred exchange.  Five years later: repeat.

Adopting this philosophy can have a dramatic impact on the long term performance of your real estate portfolio. Let’s look at the equity from the two figures above. In the first case, as mentioned above, the initial $20,000 investment grows into just over $120,000 of equity over the fifteen year period. Not too shabby. But the re-leveraged case is far more lucrative, growing to over $250,000 in the same period.

I’m a buy-and-hold investor, but that doesn’t mean holding forever. By executing a 1031 exchange every five years a real estate investor is able to maintain the desired level of leverage and risk and ensures that his real estate portfolio maintains momentum over time.

Related links

• Why is cashflow important?
• 1031 Exchange :: build your portfolio tax free
• If you invested one dollar :: Real Estate vs. Stocks

I talk a lot about cashflow in this column, but cashflow isn't really my game when it comes to investing in real estate.  The cashflow question, to me, really isn't about "how much cash is this property going to put into my pocket on a month to month basis."  The cashflow question, to me, is really about "are the fundamentals of this property strong enough that it will support itself?"

In other words: will it reliably generate enough income to cover principal, interest, expenses and taxes, with a little left over to cover vacancies and incidental expenses. When I run the numbers this is the primary thing that I’m looking for.

This is a strategy for long term wealth building; it’s not one that will finance a short term increase in your quality of life.

Compared with other investing opportunities – the stock market in particular – there is a compelling case for real estate. Consider the following two opportunities to invest $20,000:

• Put $20,000 in the stock market (assume a return of 8% - around the historical average)
• Put a $20,000 down payment on a $100,000 single family house (assume a rate of appreciation of 4.5% - also around the historical average)

The stock market’s 8% trumps the real estate market’s 4.5% rate of appreciation, but take into consideration leveraged backed by casfhlow an it paints a new picture entirely.

Instead of making an 8% return on a $20,000 asset, you’re making a 4.5% return on a $100,000 asset. That’s a great trade-off. And if you’ve done your homework on estimating the property’s cashflow potential then you’ve increased your confidence that the rent the property generates covers all of the associated expenses.

So that property isn’t going to finance your new Porsche anytime in the next 12 months, but when you cash out in ten years you can expect to put almost $80,000 in your pocket. And that beats the pants off the $43,000 that the same investment would have generated in the stock market.

Want a bit more risk? Take that $20,000 and put 10% down on two $100,000 properties - in ten years your investment will have grown to almost $140,000.

There is a catch, however. It’s going to be tougher to make your cashflow proposition work on that 10% down case. Assuming an 8% interest rate your annual payments (principal plus interest) will go from around $7,000 per year to over $15,000. Taxes and expenses will also be higher - so you’re going to have to search more diligently and negotiate harder to make the numbers work.

And here’s the ironic part; eventually an investment will turn into a really “good” one – one that starts churning out cash. Your rents should go up over time and your mortgage payments should remain relatively flat (assuming you’re not in some toxic waste exotic, which is harder to get these days). And when the investment starts getting lucrative on a month-to-month basis, that’s exactly the time to sell…your leverage is running out on steam. More on that in a future post….

I’m usually leaving some money on the table when I return 100% of a tenant’s deposit, but for me that’s ok. If a tenant leaves the house clean and the landscaping looking nice then I won’t charge him just because he left a few coat hangers in the hall closet.

But unfortunately I’ve had a couple of cases recently where I had to keep 100%. In my experience these tend to fall into one of three categories:

• The tenant slinks into the night. This will happen when the tenant knows he’s trashed the place and doesn’t bother to contest the fact that you’re not returning the deposit. Note that if you do owe the tenant the deposit back you’re not relieved of this obligation simply because he doesn’t leave a forwarding address – so make sure your documentation is in order in case he decides to come back for the money.
• A negotiated deal where you retain the deposit in lieu of legal action. I had a recent case of a tenant who broke their lease and abandoned the property with unpaid rent due. It’s always advisable to have a strongly worded clause cautioning the applicant that the deposit cannot be considered security for unpaid rent. In most states the property code provides the protection to landlords (in Texas it does). Having this language helps you to negotiate from a position of strength. After a series of threatening pay-or-quit letters we signed an amendment via which I agreed to forego legal action in return for retaining the tenant’s pre-paid last month’s rent and the deposit plus a pro-rated charge for the last month that they stayed.
• The tenant howls. This is the one you need to be prepared for. Take photos. Keep itemized receipts. And within the 30 day window (check your state’s property code) present the ex-tenant with a neat statement detailing your charges. The best defense, in these cases, is simply to act as if you expect to be taken to court. Take this philosophy and you’ll end up clear, transparent, solid statement of charges that will probably take the wind out of your complaining ex-tenant’s sails.

Related Links

• Dealing with Deadbeat Tenants

Our current all-volunteer armed forces is the most effective that our nation has ever seen, but compared to the eras of WWII, Korea and Vietnam, today’s military is further removed from society at large than ever. During conscript days most citizens had a father, brother, uncle or cousin in uniform - whereas today's ubiquitous motto “support our troops” has become an abstract theme for many.

And it’s a theme which is used at every turn by our politicians as they attempt to promote/defeat whatever partisan bill congress happens to be debating at the time. I understand that most Americans who have a “support our troops” ribbon stuck on their bumper do so through genuine solidarity with our military, but it is a slogan that I’ve personally grown to dislike. It is rarely spoken with sincerity by our representatives in Washington, and generally translates into a show of support for a particular position on the ongoing war, not (as it purports) for those who have to fight it.

I’m a veteran, but I’ve opted to keep the bumper of my car slogan-free. So in lieu of a magnetic ribbon, here are three faces and stories of soldiers who have made the ultimate sacrifice for our country. Real faces, names and stories.

• MAJ Bill Hecker: West Point obituary
• 2LT Emily Perez: West Point Mourns a Font of Energy Laid to Rest
• MAJ Guy Baratteiri: Ex Seattle Policeman and Green Beret Killed in Iraq

I choose these three simply because they’re three people who happened to be close to me – family or West Point company-mates. But their stories are no more important than those of the thousands of other soldiers, sailors, airmen and marines who have given their lives. Thinking about them today helps me remember how much I truly have to be thankful for.  Thank you.

Much has been written on the ongoing push for legislation to protect consumers in the wake of the unfolding sub-prime collapse.  The House of Representatives recently passed H.R. 3915, the Mortgage Reform and Anti-Predatory Lending Act of 2007.  Commentary on this legislation most often focuses on the restrictions that it would place on lenders seeking to make loans. 

But there is another important feature in this bill which will be of interest (concern) to investors.  In case of foreclosure, the entity reclaiming the property will have to honor all preexisting leases.   And you thought that banks used to be annoyed about that REO bouncing back onto their books - now they get the property and the tenant. 

This, potentially, is a two-edged sword for investors.  On the bright side, while a tenant-occupied property is a pain for a bank, it can be a good thing for an investor (assuming the tenant is one that you'd want to keep).  Furthermore, it restricts the bank's options for selling the property - your competition in bidding for the property is pretty much restricted to other investors. 

On the flip side, though, this will make the banks take a second look at their policies for lending money to investors.  This change represents an additional risk and cost for the banks, and they're gonna pass it right along to you and me. 

If you're interested you can read the press release and the bill itself, along with a related article from the New York Times. 

This week's Fortune magzine featured an interesting article that puts an interesting spin on the housing market that takes a page from the real estate investor's playbook. 

Followers of the equities market will be familiar with the P/E ratio, the most often quoted financial ratio calculates a company's share price as a multiple of its earnings.  A high P/E ratio is evidence of the market's collective assessment that earnings are poised to grow dramatically, whereas a low P/E ratio tend to stick to companies with poor growth potential. Sky-high P/E ratios are not sustainable.  Either the companies blow up (pick the dot.com of your choice as an example) or they mature, stabilize, and earnings "grow into" the stock price (Ebay, Microsoft, etc.)

So what's the P/E ratio for the property market?  It's the relationship between property values and rents. 

Again, for investors, this is pretty intuitive.  How much do you want for that starter house?  $500 thousand you say?  And it should rent out for $2,000 per month?  Hmmm....I don't even have to plug that one into my economic model to figure out that those numbers don't work.  The only way that investment will pan out is if the market races along for another couple of years at double digit rates of appreciation.  If that's your belief and you're willing to put your money where you mouth is then by all means go ahead and write that earnest money check. 

But, like P/E ratios in the stock market, sky high price-to-rent ratios are not sustainable (which is why, for the time being, Jeff Brown is sending his sunny San Diego investors hunting for deals in the Great State of Texas).  The article quotes Yale economist Robert Shiller: "Like P/Es, price-to-rent ratios are mean-reverting."

There is a little bit of good news hidden in this analysis, however.  Once the price-to-rent ratio gets out a whack there are two ways for it to drift back in line: a) property prices fall or b) rent rates go up. 

Fortune crunches the numbers for the major metropolitan areas and they stack up pretty much how you'd expect them to.  The article isn't online so you'll have to hit the newsstand and plop your $4.99 down if you want the details. 

At the top of the list is Nevada, with one fourclosure filing for every 61 households, up over 200% from this time last year.  California is in second place, with 1 filing for every 88 homes. 

Investors will keep a close eye on their local situation in making investment decisions, but there are some interesting national trends forming.  Notably, 45 out of 50 states experienced year-on-year increases in foreclosures.  This, along with tightening credit, increasing oil prices and declining consumer confidence have the potential to have a broad national impact.  This is "the tide that lifts/lowers all boats."  So even though we may view national headlines with a shrug, smart investors in Oklahoma and Virginia realize that what's going on in California and Nevada really does matter. 

The Fed is caught between a rock and a hard place these days.  On the one hand Bernanke is now making much more direct statements about his concerns for the housing market, however with oil prices inching steadily into the $90 range there are also persistent concerns about inflation.  But today when the Fed had to choose between stepping on the gas (easing rates) and putting on the brakes they chose the former, to the tune of a quarter point rate cut. 

The challenges facing the economy are complex, and to a large extent they're still looming in the shadows as opposed to impacting us directly.  But the pessimistic scenario has American's holding on to their spending dollars as they fret about decreasing equity in their homes, compounded by sub-prime losses trickling throughout the banking sector as blue-chip firms like Merrill Lynch who bellied up to the mortgage-backed securities trough back when times were good start to see the chickens come home to roost. 

We all have our crystal balls tuned to different frequencies, but mine is telling me that now is the time to take off your speculation hat and put on your investor hat.  Cashflow is king when you're confronted with a skittish market and an uncertain immediate future.  And that, ladies and gentlemen, is what we're facing right now.  But medium term I'm still optimistic (even though my Countrywide trade isn't doing all that well) and I'm firm in my belief that investors who make smart investments during the downturns will fare well over the long term. 

Related posts

• Investing vs. Speculating
• Countrywide cheap @ $20?

I occasionally write editorial pieces on real estate and real estate investing for the Business Journal Network. I recently provided a column on avoiding fraud scams that appeared in several markets. Here’s the article as it appeared in the Silicon Valley / San Jose Business Journal.

This column emphasizes points that I've emphasized recently in blog postings on fraud and scams. 

Related Posts

• Real estate shell game :: Recognizing fraud
• Real estate shell game :: Part II
• Real estate shell game :: Part III

________________________

Chris,

I was approached by an acquaintance, Phil, to invest into a get rich quick scheme. I was to be the buyer and mortgage holder for two houses, but all documents and paperwork would be mailed to Phil’s residence and Phil would be responsible for all mortgage payments and monthly maintenance fees. I was promised a gift of cash in exchange for using my good credit. All was good for several months, and then I started receiving calls from American Servicing Company for non-payment.

Unfortunately, being very trusting of Phil, I did not ask for copies of any documents that I originally signed. Phil kept everything. At this time, I don’t know what to do. Phil does not return any phone calls. As of today, the two residences are unoccupied. Please, any advice is welcome.

___________________________

First of all, I'm not a lawyer and laws/property codes vary from state to state. This shouldn't be considered legal advice. You need to contact a lawyer.

A couple of things that I would do were I in your situation.

1) Don't ignore the mortgage company. Regardless of what happened between you and Phil it appears you’re currently on the hook for these mortgages. Call the lender.

2) Get ready to go to trial. I understand that you don’t have the paperwork, but you must have some documentation that a deal was done...receipts for cash payment, etc. Get these together, along with a written narrative of what occurred, and discuss these with a lawyer.

Now I'm guessing that one of two things might have happened here....

• Non-evil Phil case: Phil got all fired up from attending one of those Rich Dad Poor Dad seminars or some other such motivational pep rally. Then, realizing he had no credit, talked you into backing one of his deals. Phil overpaid for the houses, realized he couldn't lease them out, ran out of money, and buried his head in the sand. Now your phone is ringing off the hook as the bankers are looking for their money, which you owe.  It's possible that Phil didn't set out to rip you off, but he abused your trust and, in the end, skipped town. 
• Evil Phil case: Then again there are lots of ways to rip someone off in a case like this. Example...Phil found a seller selling his house for $100k. Phil offered $110k on the condition that the seller kicked back $10k at closing. The seller got his price, Phil pocketed $10k, and you’re stuck with a $110k mortgage on a house that's only worth $100k. There are many, many other schemes.  It's possible that Phil is a genuine scumball. 

In hindsight (not helpful, perhaps) there are lots of problems that led to this. The most important are a) you got into a deal that you didn't really understand, and b) you can't rely on trust; you need a contract.

This probably isn't much help, but at this point the horse is out of the barn.  Call a lawyer, deal with the mortgage companies, and good luck.

Related Posts

• Why I don't like Rich Dad Poor Dad
• Real estate investing psychology
• How contracts help me to build solid relationships
• Real estate shell game :: Recognizing fraud
• Real estate shell game :: Part II
• Real estate shell game :: Part III

I was going to write an article about this not to long ago when, bam, I ran into a problem: tenants who stopped paying.

The tenants were a flaky young couple that I knew I might be taking a chance back when they signed the lease in May. But I decided to rent to them and mitigated my risk by signing a short lease (six months, with renewal contingent on timely payment), charged them first and last month’s rent upfront, plus one month’s rent as deposit. I won’t go through the boring details, but they ended up breaking the lease and abandoning the property while they owed me money. If you find yourself in a situation like this one here are some points to keep in mind.

• Property codes, generally speaking, exist to protect the tenant. However, most tenants who end up in situations like this have not followed the law. On the other hand, you have – assuming you’re a responsible landlord. The party who is on the right side of the law (you) negotiates from a position of considerable strength.
• Ensure that you use a current, legally compliant lease contract that includes specific references to the property codes. For example, all of my leases state that tenants are prohibited from withholding payment for any portion of any month’s rent on grounds that the security deposit is security for unpaid rent, and that bad faith violations may subject the tenant to liability up to three times the rent wrongfully withheld plus Landlord’s reasonable attorney fees.
• We all have our own style, but in tenant/landlord disputes you want to be more like Agent Friday (“just the facts, ma’am”) than, say, John Madden. Communicate clearly, calmly, and factually. Quote relevant state property codes, chapter and verse. Read the relevant clauses from the lease that the tenant signed. Use the facts, the contract, and the law as a blunt instrument.  Don't call or email when you're angry. 
• Back up phone calls with written communication – email or a leter. Tell ‘em on the phone, the follow up in writing to tell ‘em what you told ‘em. Keep copies of everything.
• Once you feel a problem brewing, keep a written log of everything. Capture dates and times of phone calls and what each party said.
• Follow the law with regards to notices. You can’t just put deadbeats out on the street; you need to serve them with a Pay or Quit notice with the proper lead times. Consult your local property codes and know what your obligations are.

The idea of all of this is that you’ll be following a rational, well planned strategy. If you end up in front of a judge, either in an effort to evict the tenant or suing for damages, your ducks will be in a row.

This reminds me of my brother. Greg isn’t always right about everything, but if he offers to bet me about something then there’s a 99.9% chance he is. Greg hates to lose, so when he puts his money where his mouth is and offers to shake on a bet then I tend to back down. If you end up in court you want to be like Greg; you should know you’re going to win. Smart, ethical landlords don’t lose these cases.

And if you follow these guidelines then, in the end, the tenant (if he has a rational bone in his body) will often back down. That’s what happened in my case; they paid and got out, and I didn’t have to drag them to court. They saw the handwriting in on the wall.  Sure I wasted some time hammering out threatening letters and trying to chase them on the phone, but all in all it wasn’t a bad outcome.

The first thing that I think when I see a bandit sign is "here's a guy who's willing to do something illegal to make a little money."  Not exactly a first impression that inspires me to pick up the phone and strike up a business relationship.

Laws vary from region to region, but in most areas the city comes around periodically to collect these things eyesores.  There's so much of it that I doubt that anyone gets prosecuted for breaking city ordinances.  That might be enough to make you think "hey these guys are getting some pretty good free advertising; I'm missing out."

Well there's another way - a better one.  When I'm looking to find a tenant for a home that doesn't have good exposure to traffic I'll simply knock on a few doors.  I'll pick a nearby house that does have good traffic, and then offer the owner $10 or $20 to plop a sign in their front yard.  You can get a sign from the FSBO center at Lowes or Home Depot for fifteen bucks or so, and some vinyl stick-on letters (recommended) for a few bucks more.  

Advantages:

1)  It's legal.  Ok, I know that not everyone out there is as uptight about the bandit sign thing as I am.  But some folks are - and bandit sign users turn off these potential applicants.  

2) It looks better and makes a better impression:   Bandit signs need to be cheap.  Why?  Because they're disposable; someone eventually will come along and toss them in the trash.  Therefore bandit signs tend to be cheap, flimsy and ugly.  But if your sign is legal then you're less likely to lose it, so you can spend a few bucks on a nice sign with stick-on letters. 

3)  It's an excuse to strike up a conversation with your neighbor.  Sometimes they might know someone who is interested in renting the property.

 Related Link:

• Citizens Against Ugly Street Spam

I love real estate.  There are millions of honest, ethical investors out there making prudent, informed responsible investments to secure their financial future, but there are also a brigade of scumballs busying ruining it for the rest of us.  Keep your eyes peeled. 

A couple of rules of thumb:

• If it looks lucrative and easy then you're about to be taken for a ride.
• Beware of "package deals" where an advisor delivers the property, the lending, the appraisal and the tenants.  These parties, if delivered as a combo deal, will always collude against you. 
• Don't sign anything you don't understand.  Loan documents can be intimidating for new investors - but if it smells fishy then ask questions until your gut tells you everything is ok. 
• Any counterparty who is willing to be dishonest on your behalf will cheat you in the end.
• These people in this video aren't necessarily dumb.  The scam artists are pros, and they look for amateurs as their victims. 

Your mom's advice, general speaking, was pretty good: if it looks too good to be true it probably is.  But it's worthwhile to understand the mechanism of the basic real estate swindle.  There are many variations to this general scheme, but if you're considering a deal that in any way resembles this shell game then hold on to your wallet. 

The scam generally tends to unfold as follows:

If you get caught up in a scheme like this your opportunities for recourse are limited.  The fraudsters tend to prey on unsophisticated investors and convince them to sign loan documents that they don't understand, and the fact that the victim's signature appears all over a fraudulent no-doc loan package serves to incriminate the victim, even though he or she was acting out of ignorance. 

Additionally, the victim often is too embarrassed to go to the authorities. 

These schemes are bad for everyone.  The criminals often strike multiple times in the same neighborhood once they find a feeding ground with the right combination of properties and potential investors.  This is happening right now in Houston, and the problem has become so pervasive that the FBI has commissioned a special unit to crack down on mortgage fraud. 

But by then it's too late for the victims, who lose thousands of dollars and see their credit in tatters, and the communities which start to see zooming tax appraisals (based on the bogus inflated sales prices) coupled with boarded windows popping up from all the foreclosures.  That's an ugly double whammy. 

Related Links:

• Ethics plalys an important role in real estate investing
• New scrutiny for short sellers

As the presidential election looms, the issue of immigration - particularly illegal immigration - will move into the spotlight.   This has implications for all Americans, but it may have a particular relevance for landlords. 

An article in today's New York Times discusses the issue of local statues which impose penalties on landlords who rent to illegal immigrants.  In particular the article chronicles the story of Riverside, New Jersey, which is re-thinking legislation which it passed a year ago which criminalized employing or renting to an illegal immigrant.  The law has had the unintended consequence of driving away residents in large numbers, which has had an unexpectedly large impact on local businesses.  It appears that citizens who once lobbied for the law are now re-thinking their position. 

From the landlord's point of view, this is a sticky issue.  I live in Texas, a border state.  Regardless of your political affiliation it's obvious that illegal immigrants are firmly woven into the economic and social fabric of our society here.  I'm trying to imagine operating under legislation which requires me to ascertain an applicant's legal status.  Is that SSN real or bogus?  How about the ID card that the applicant has provided?  Or the driver's license?

There is an easy solution that many landlords will turn to: just don't rent to anyone who seems "suspicious".  This, obviously, is a law that invites investors to turn to discriminatory practices. 

I'm not a policeman or a Immigration Service agent.  That's not my job.  I'm a real estate investor, and part of being an investor is to offer safe, affordable housing - places where families want to create homes - and to do so profitably.  I'd strongly disapprove of a law that tries to turn me into a government enforcement agent. 

These are bad laws, and landlords should be vocal in their disapproval when they pop up locally. 

I'm interested in your opinion on this issue...

In my case, my example was in one of my most inexpensive properties; the tenants were a young family with no credit and not a lot of resources, but their references checked out and I rented to them, more or less, based on gut feel. And they were the best tenants I ever had: took great care of the place (flowers in the front yard), made minor repairs on their own and never were late paying the rent. Plus, they were a pleasure to deal with.

Your goal as an investor is to create a portfolio of properties filled with this kind of tenant. Identifying, attracting and retaining them is one of the most important factors to ensuring your success as a real estate investor. Getting the wrong tenant in your property is expensive in two ways: not only does it cost you money in repair, vacancies, and lost revenue – it can also cost you dearly in terms of investor burnout. Get a bad tenant or two and you’ll be ready to throw in the towel in no time, but if you develop a knack for renting to the right people then on the average month managing a property is as easy as cashing the rent check that shows up in your mailbox (on or before the first of the month!)

So what happens when you get a bad apple? Well don’t sit on your hands; take care of the issue. What follows are some fairly broad generalizations, but that’s how I conceptualize problems. Most of the situations I have dealt with fall, roughly, into these three categories:

Type	Key mitigation strategy
High maintenance: These tenants can be overly demanding and can sometimes be rude – especially when dealing with your Realtor or with your maintenance support. In my experience I’ve run into this type of tenants in units with higher rent and in more upscale neighborhoods, but they can pop up anywhere.	Set expectations early, and when problems arise handle the details yourself. It’s important to shield your support team from this type of personality. Tenants come and go but your relationship with your support team is for the long term. Real estate investing is all about building relationships. You can turn a high maintenance tenant into a good one with the right level of initiative and leadership.
Flaky/irresponsible: Undependable, pays late, sloppy with property upkeep.	Establishing a zero tolerance for late payment early is critical in managing this type of tenant. Many tenants are immature and simply don’t understand the consequences of being evicted from a property, so hitting them with a curtly worded Pay or Quit letter sometimes can work wonders.
Belligerent/destructive: Doesn’t pay, tears up your property, difficult to deal with. Upsets the neighbors. You may suspect illegal activity.  This is the type of tenant that makes you want to give up investing.	We all make mistakes. And when we do it’s critical to own up early and admit it. You goofed. You shouldn’t have rented to this guy. Now you have to get him out.

In all of these cases the key is action. Good relationships don’t happen automatically; you have to work at them. But if you establish a good relationship with your tenant early in the process then it’s easy to maintain, and will help to make your investing profitable and less stressful.

Related Posts:

• Four tips for sniffing out illicit activity in your Investment Property
• Navigating the Eviction Maze
• Avoiding Investor Burnout

The customer experience when you’re buying something from Gateway is brilliant. Smooth, efficient, friendly – my representative had me whipping out my credit card in a jiffy.

Then come...the problems.

My beautiful matte black widescreen 22” LCD monitor looked groovy coming out of the box, but once I plugged it the image flickered and flashed so badly that I thought it was going to give me an epileptic seizure.

Then comes...the real fun part.

I won’t bore you with the details (and they're many), but suffice to say that I spent multiple hours on hold waiting for someone from the returns department to talk to me. And I'd already spent multiple hours on the technical service chat line, where I was instructed to download all manner of patches and software in a futile effort to fix the problem.

This was all, well, pretty annoying. With every human being that I managed to speak with (all of them obstructive and unhelpful) I emphasized that I didn’t want an exchange (I wanted my money back) and that I didn’t expect to be charged a restocking fee. I was assured that I wouldn't.

Then I got my credit card statement. By now most of you see this coming. Bam: $50 restocking fee.

Another phone call. Another period on hold (this time shorter). And I’m finally curtly informed that Gateway reserves the right to charged me a 15% restocking fee, and they’re not going to waive it regardless of what any Gateway representative had previously told me. Case closed. And if I don’t like it then I can take the case to arbitration. Bye.

Lesson learned: be careful when doing business with a company that’s in its last death throes. Gateway, once an innovative dot.com darling, has seen its stock price collapse from a high of $84 down to the current level of $1.87. Gateway has finally thrown in the towel and is being acquired by Taiwan based Acer.

A note of caution to Acer: an embattled company like Gateway often manages to acquire some dysfunctional cultural traits that are difficult to root out and fix. In this case it’s a clear pattern professional front-office hospitality designed to lure orders followed by a phalanx of curt back-office trolls brandishing consumer-unfriendly policies to obstruct any poor sap (like me) who’s trying to return one of Gateway’s lemons.

This, clearly, is a deliberate strategy.  Had I suffered a single long hold time or had to deal with one rude return agent I could understand - maybe someone was having a bad day.  But when it consistently happens over and over...well that's no coincidence (especially compared with the cheery efficient folks who took my order.)

This is a penny-wise but dollar-foolish method of maximizing revenue. Yeah they’re going to keep my fifty bucks (which I suppose will help their bottom line) but believe me I’m going to tell anyone who will listen that they need to avoid Gateway (and Acer) products like the plague.

Acer will have some cultural problems to root out when they take the reins; I hope for their sake that they built this into the acquisition price.

Hudson Sangree with the Sacramento Bee recent wrote a story about a customer who decided to take Gateway to court over a defective computer and Gateway's subsequent customer service stonewalling.  I exchanged emails with Hudson and he indicated that he's received a lot of contacts from Gateway customers who have had similar experiences. 

Ironically, the plaintiff in the case, Dennis Sheehan, describes himself as "a retired real estate investor".  It's clear that real estate professionals need computers...so hey maybe this post wasn't so off-topic after all. 

-------------------

Epilogue [October 7th]: Subsequent to the events above I issued a formal complaint to American Express, the card I used for the purchase.  They temporarily suspended the $50 and promised to investigate with Gateway.  Today I received a letter indicating that American Express has issued a credit for $50 to my account to resolve the complaint.

This feels like a victory of sorts, I suppose, although I suspect that American Express is eating the cost.  However, American Express is a $72 billion company (market captialization) whereas Gateway is a $700 million company - around 1% of American Express' size.  As as a pattern of complaints develops concerning Gateway, customer-focused companies like American Express will start to reevaluate their relationship with the offending vendor. 

The moral: consumers who suffer a blatantly abusive experience with a vendor should look to their credit card company for recourse if dealing with the vendor directly yields no success. 

So...which is it? Back in the ‘60s a management theorist Douglas McGregor originally wrote about two theories about managing relationships: Theory X, which is a negative view that assumes that people are inherently lazy, dislike work, and need (want) to be controlled, and Theory Y which argues the opposite – that people are self-motivated and will choose to seek responsibility and do good work.

So...do you control and corral your relationships with contracts (Theory X) or do seek relationships based on trust and mutual interest (Theory Y).

Well..both. And that answer isn’t as wimpy as it sounds. I’m not sitting on the fence; there’s a role for both trust and clear legal boundaries (contracts) in each relationship. This applies to you and your investment partner, you and your broker, you and your property manager - basically any of the many relationships that you have to develop and nurture as a real estate investor. 

Basically there are four possible combinations, but only one good one:

• No Trust + No (or bad) Contract = This is a train wreck waiting to happen. Expect to see your partner in court sooner rather than later.
• No Trust + Good Contract = You can keep your partner on his toes with an airtight contract, but it’s a litigious, tense way to do business. Expect to grind your relationship (and your nerves) into powder.
• Trust + No (or bad) Contract = George Bernard Shaw said that “the road to hell is paved with good intentions”. Trust is crucial, but we don’t always communicate well. If you don’t deal with the legal details then expect poor alignment, misunderstandings, and friends that turn into enemies.
• Trust + Good Contract = Voila. Finally. Combined trust with a thoughtful legal framework and you have a better chance of achieving a streamlined partnership that can focus on solving problems.

Related posts

• You want to be a hippo, not a whale shark
• How can contracts help me to build solid relationships?

So that said, what are real estate evaluation tools useful for?  Here's a few thoughts:

• Real estate investment software adds discipline to the investment process. Buying real estate, by its very nature, can be an emotional process. And that's ok; gut feel and intuition are qualities that are crucial to successful investing. But discipline is equally important. Software can bring some structure to your decision making process.
• Real estate investment software forces investors to explicitly state their assumptions. GIGO :: garbage-in-garbage-out. You can punch in assumptions to make any investment look like a barn burner - but if you're buying a starter duplex in Los Angeles for $500k that rents for $2,500 per month then you're actually going to have to assume a 20% appreciation rate for the investment to break even. And you're actually going to have to type those numbers - "20%" -  into the model. Being forced to explicitly articulate your assumptions in this way can be a good gut check - and sometimes can be just the wake-up call you need to get you to take off those rose colored glasses.
• Software helps investors to compare dissimilar investment opportunities. Should I buy a fourplex, that duplex around the corner, or a couple of single family homes? I have a different view on each, how do they stack up?
• Real estate investment software helps geeks to pull the trigger. This, for me, is the big enchilada. I'm an engineer by training, which means that sometimes I can't spell too good (as some of you will have noticed from the occasional typo on this blog) and that I need to see some numbers before I can get off of the fence and take action.

Read here to see more pros and cons of the real estate software approach.

• Look before you Leap
• Five Things to Remember when Running Economic Analysis
• Is a Real Estate Investment Software package right for you?

I've stated before that real estate investing is all about dealing with people - that's one of the ongoing themes of my writing.  Even the most savvy negotiation, however, will eventually end up in a situation where she needs to understand relevant state laws concerning evictions. 

The eviction process can actually be completed fairly quickly if - and that's a big "if" - the landlord knows the law and follows the rules of the game.  Every landlord should review the relevant State requirements.  Here's a general flowchart for the process in Texas, my home state. 

In my opinion, the most important step in this process is the first one: the Pay or Quit / Cure or Quit step.  These are the notices that identify the problem in writing (rent not paid, dog on premises, excessive noise, whatever) and inform the tenant that eviction in imminent if the problem isn't remedied. 

It's my belief that most people are generally reasonable.  (Note:  If you have a tenant that defies this norm then you probably need to take a look at your applicant screening process.)  A tenant who gets behind on his rent might simply need to have expectations clearly set out; every month he needs to pay for his cell phone, car note, and other expenses - but nothing comes before keeping a roof over his head.  Paying you needs to be his first priority every month. 

The Pay or Quit notice is a legally mandated step in the eviction process in most states, but it can be more than that.  A sharply worded Pay or Quit notice should be the first arrow in your quiver to negotiating a successful resolution without going to court.   If the tenant complies then you can avoid the expense and inconvenience of proceeding with the eviction process, and then you can reconsider your options at lease renewal time. 

Related links:

• Establishing Ground Rules with your Tenants

Countrywide’s 52 week high is $45.26, so now bouncing around $20 it looks like a bargain, in my view. The company’s price-to-earnings ratio is around 5.5, which is in the basement of the industry, whereas the operating margin of 32% puts it at the top of its peers. This, combined with my general consensus that the Chicken Little’s are ruling the day makes me think that this is a stock worth buying.

Is this an investment? No. It’s rank speculation. If I’m wrong about the direction of the market I’m going to take a bath on this one, but in my view the upside outweighs the downside. And as I’ve stated before, it’s my belief that speculative positions should play a role in most portfolios.

But a public declaration like this is something of an experiment for me. I’ll revisit in six months; depending on how things play out I’ll either proclaim myself a genius or offer a bunch of explanations (to my readers and to my wife) about why I was wrong.

The keys to managing relationships are of course numerous and complex. There is one that we often overlook, however: the contract.

Robert Frost said that “good fences make good neighbors”. The same can be said for a well written contract. Clear, honest communication is one of the things that helps build and maintain relationships, and there’s nothing like putting your intentions down on paper if you want to expose potential future rifts and conflicts.

I just entered into a contract with my Realtor to manage a multi-family property that I bought with her assistance. This is an agent that I’ve worked with for years and we’ve developed a healthy, symbiotic relationship based on trust and mutual benefit. We do a lot of things off the cuff (just get it done and we’ll settle later) just because it helps us to stay flexible and get things done. However, that’s not how I wanted to handle this particular arrangement.

In my opinion there are a couple important things to remember about contracts.

1) Sweat the details and address the hard issues head on. By spelling things out you make your intent clear. Your goal is to write a contract in which there is very little latitude for interpretation. The process of writing the contract can do wonders in terms of partner alignment. In my opinion, the definition of a good contract is one that sign and then stick in a file and never look at again.

2) One size doesn’t necessarily fit all. You’ll often start with a standard contract, say for property management or residential lease. Don’t be afraid to adapt or modify to suit your unique situation. For example – what I need from a property manager differs fairly significantly from the service that most full service property managers offer (I’ll write about this in a future post) so I’ve tailored our agreement appropriately.

For critical agreements (like joint investment partnerships, etc.) it’s always important to get counsel from a qualified lawyer (which I’m not). But some of this stuff you can do yourself. There are great references on the web that have contract templates. A new one is the Microsoft reference which has all sorts of contract templates from FindLaw.com, including a Property Management contract .

Case in point: as the sub-prime market melts down, housing prices drop and inventory levels creep towards historic highs much of the mainstream media coverage has been devoted to figuring out who is behind all of this. The banks? Builders? The Fed?

Real estate investors (and in some cases, speculators) get an unflattering light shone upon them in this environment; witness today’s Money.com article with the musically alliterative title Flippers Fuel Foreclosures  which claims that investors are “...driving defaults in four of the states with the fastest rising default rates in the nation...” The article sites statistics from Nevada, Arizona, California and Florida.

If you look for it, though, there is a more interesting fact buried in the article: nationwide non-owner occupied properties accounted for just 13 percent of prime loan defaults and 11 percent of subprime defaults.

Consider this: according to recent census figures around the homeownership rate in the United States hovers around 68%. Meaning that over thirty percent of homeowners live in properties that are owned by someone else. Some of this housing is owned by corporations, but according to census figures the vast majority is owned by individual investors.

It would appear from the numbers that investors, as a whole, haven’t been doing a bad job at making prudent decisions. Investment properties are perceived as a higher risk than owner-occupied properties, but in many regions they default as a lower rate.

As investors we’re not trying to win any popularity contests, but it’s good to remember that prudent, responsible investing and property management is just good business. An investor who maintains a property that a tenant is proud to call home is probably an investor who also realizes low vacancy rates, inexpensive turnover, timely payment and low incidental expenses. This, along with prudent buy/sell decisions adds up to a profitable investment. And low default rates.

But things like this are expensive, so they’re an occasional indulgence. When I glance down at my wrist I see my daily watch: the venerable Casio W-201. Date, time, alarm, stopwatch, water resistant to 50 meters. Accurate to fifteen seconds per month, and the battery lasts ten years without changing.

And the best part is that it costs about fourteen bucks at Wal-Mart.

So if I make a big windfall profit on my next sale how is it going to change my life? Well, not much, actually. I’m happy with the watch I have right now and buying a newer, more expensive one isn’t going to make me happier. This is a good proxy for my life in general - or at least the philosophy that I aspire to live by. Being happy with the here-and-now helps me greatly in trying to be good at what I do.  As a real estate investor it gives me the patience to do good long-term deals that build wealth, and the courage the take prudent risks when the right opportunity arises.

So for now I’m sticking with my plastic watch. And as an added bonus: whether I’m pushing a broom or swinging a golf club it’s so light I don’t notice it’s there!

The reason that this doesn’t represent a national correction is the fact that even though the national median is down, there are still some regional markets that are flat or rising. Investors know this and we’re watching our local markets.

The New York Times writes about the housing number, and two things jump out at me from this article. The Times refers to the median drop as a national decline, stating that the statistic contradicts “widely held notion that there is no such thing as a nationwide housing slump.” This is a statement written by a journalist, not an investor. It’s not true for the reason that I’ve stated above.

A second annoyance is that the article is full of predictions, from the likes of Global Insights and Moody’s. Predictions made by economists are notoriously un-useful.

But a decline in the national median may be significant if it adds fear and confusion to an increasingly volatile lending market.  Liquidity is already starting to dry up in some areas which pulls competition out of the market.  Bad for sellers, but good for buyers.  Bargain hunters looking for a quick flip better have better confidence in thier crystal ball than I have in mine, but buy-and-hold investors in undervalued markets should have their eyes peeled for solid positive cashflow investments that will be able to weather the current storm and which will have some upside once the market turns - whenever that may be. 

This is a philosophy that I’ve learned over time, and one that doesn’t really jive too well with my background as an Army officer and my academic training as an engineer – two disciplines where finding the right solution is pretty darn important. So this is something that I have to work at.

This extends to the way that I deal with people. Real estate is a people business. Yeah there’s financing, and strategies and technical know-how, but at the end of the day it’s all about you and the person sitting across the table from you – whether she’s a contractor, a Realtor, or a buyer.

So I’m rarely thinking about cutting the best deal I can. I focus on cutting a good deal; one that I’m satisfied with, which gives me a good return and one which builds the relationship. A good relationship today will yield more good deals tomorrow.

Loyalty is important to me, and that is a value I try to communicate through my actions. Case in point - when I have a maintenance issue that I have to deal with here’s what I like to do: I call the contractor and tell him to head over to 123 Elm Street and take care of it, then send me the bill. No bid. Just fix it.

Now I certainly can’t always do this because many contractors are evil and dishonest (sorry if I offend anyone, but this is a statement of fact.) But I can do this with one particular contractor that I work with on a regular basis. I trust him, he trusts me, and we have a symbiotic relationship – this is a relationship that I value like gold. I know he’s not going to rip me off because he knows I’ll be coming back – he values the repeat business. And he knows I will treat him fairly, because he knows that our arrangement helps me manage my life – I value the ease and convenience. We both value the relationship and we both take care of it. Honesty. Trust. Case closed.

Reciprocal, symbiotic relationships don’t grow on trees and they don’t happen overnight. I always think of those hippos on the Discover Channel with the little birds perched in their wide open mouths. A real win-win deal: the hippo gets clean gums and the little bird gets an easy, risk-free meal of leeches and whatever else hippos end up getting stuck between their teeth. Kind of a disgusting analogy, when you really think about it.  Anyway, what you don’t want is to realize that you’re more like one of those whale sharks that has a bunch of blood sucking remoras attached to his underside; the remoras get a free meal and free transportation to boot, but the whale shark gets jack.

So relationships are something you have to keep reevaluating; make sure you're getting what you think you're getting. 

In terms of importance money is like oxygen: having loads of it won’t necessarily make you happier, but if you don’t have enough it’s awful hard to think about anything else.

The idea of hedonism, in the colloquial sense, is often associated with visions of vice and amoral excess. Even the term Epicurean carries this connotation, even though Epicurus, the philosopher for whom the term is named viewed pleasure primarily as the absence of suffering. So in the classical sense the idea of hedonism actually had an air of responsiblity to it.  Meaning: fun times today leads to less fun stuff tomorrow – be it loads of credit card debt, a root canal, an unexpected pregnancy, acid indigestion, or that extra twenty pounds that’s magically appeared around your hips.

A couple of things brought these thoughts to mind today. First, I’m reading Milan Kundera’s excellent short novel Slowness, which talks about the topic. And second: I just ran across this excellent photo essay about money at SavingAdvice.com. I found it insightful and occasionally funny.

Related Link:

• Photo Essay - 25 Money Confessions

The relationship between investors and real estate agents is a weird one. I have a long-term relationship with an agent that’s based primarily on loyalty and trust; I know she’ll take care of me and get the details taken care of, and she knows I’ll be back. I don’t get a lot of useful advice and she never brings me a deal, but she helps make sure I get the work done. So, generally speaking, when I’m buying a property or looking for a tenant I’ll often work with her.

But...that’s kind pricey when it comes to buying. The notion that the buyer doesn’t pay a commission is a fallacy – the buyer does indeed bear this cost via an increased sales price – so I’m actually paying an awful lot for convenience and comfort.

So, time to try something new. Hungry Agents allows buyers and sellers to solicit bids from real estate agents for reduced commissions / commission rebates. So I gave it a try. I’m looking to make an offer on a multi-family property and placed my solicitation on Hungry Agents. Within 24 hours I had ten bids back offering rebates of 10% to 60%. Each bid is accompanied w/ some basic information about the agent: office location, rebate percentage, years of experience, franchise, and in come cases a biography page.

The buyer/seller who placed the bid can request a contact online. If the agent is interested in speaking with you then he can then give you a call.

Clearly this solution won’t work for everyone. But I generally find my own deals and make my own decisions with regards to pricing and terms, so basically I need someone to make sure the paperwork happens efficiently.   I’m not looking for advice, leads, negotiation assistance, or to be chauffeured around Houston.  Hungry Agents makes the a la carte approach a bit easier.

Too bad about that logo, though. Strange marketing move for a company that needs to build a positive relationship with the real estate agent community...

I’ve discussed in the past the folly of forecasting. A good case in point is the diverse smorgasbord of forecasts for the housing market, each offering served up by an immensely qualified expert running a sophisticated model.  Go with Peter Schiff of Euro Pacific Capital who predicts a fifty percent collapse in some high priced markets. A little more optimistic? Go with David Wyss from Standard and Poor’s who is looking for a more modest 8% drop.  Or if you’re ready to buy then the guy you want to listen to is Lawrence Yun, the senior economist from the always-optimistic National Association of Realtors, who happily tells you that “…further declines, if any, are likely to be modest given the accumulating pent-up demand.” The only thing missing is a smiley face emoticon.

So if the experts aren’t useful in giving us a heads up on the market’s direction then what’s an investor to do? Well it might be the right time to sit on your hands and wait it out, but it might be the time for action.

In these situations I look out the window at my own local market and ask myself a question: am I waiting for the bottom or am I waiting for affordability?

If you’re waiting for the bottom them now might be the right time to start looking. If you’re waiting for affordability then you might want to cool your heels for a while.

I’ll explain:

Bottom fishing: I got to watch Pete Sampras play at Wimbledon back in 1997. Of all the amazing things that I remember about that match one thing stands out: Pete knew when a ball coming his way was out of reach and he didn’t go for a shot that he couldn’t get to. There’s an analogy here for investors. When you’re shooting for the bottom the only thing that you know is that you won’t hit it; you’ll buy too early or too late but either way you’ll never buy at the bottom of the price trough. So why try?

If you’re bottom fishing then you’ve already come to the conclusion that a recovery is ahead. So don’t try to time it. If market conditions are such that you can negotiate hard, get a good price, and secure an investment that yields positive cashflow then it might be the right time to go for it.

Waiting for affordability: You might find yourself thinking gosh, prices have run so hard in the past few years it’s just natural that they’ve finally taken a breather. If they dip a little more then it will be a great time to get in.

If this is your view you’re probably banking on the good old days coming back again, a highly speculative move. Investors with this viewpoint are often living in markets where it is impossible to get into a real estate investment that produces positive cashflow – and in this situation a property must experience booming appreciation rates in order to yield a decent return. These investments, in my book, get the yellow light.

Don’t fit into either of the camps above? Then what signposts do you look for…?

Related Posts:

• The Black Swan :: The Highly Improbable and Real Estate Investors
• In Defense of Real Estate Speculators

In discussing books for investors I often end up recommending books that aren’t really real estate books, but which hold some insights that investors would be wise to heed. Nassim Nicholas Taleb’s recent release The Black Swan falls into this category.

The Black Swan discusses highly improbable events - like the occurrence of a black swan in nature – and how they impact our society. Taleb comments on our collective overestimation of what we know (and our underestimation of what we don’t), our reliance on phony experts and the general folly of forecasting.

The book isn’t without it’s drawbacks. First and foremost is Taleb’s unsufferable tone; one gets the distinct impression from reading Taleb’s prose that he’s one of those types that’s entirely too fond of the sound of his own voice. Much of the book is spent ridiculing famous figures whose theories he disagrees with - including Nobel prize winners Myron Scholes and Harry Markowitz. He lauds the guys who “get it” (from street-savvy traders to literary sophisticates) while heaping scorn on the squares (from tenured academics to pencil pushers in corporate America). It would appear that Mr. Taleb’s intention is to syle himself as an out-of-the-box intellectual maverick, but unfortunately he comes across as preening and petty.

And that indeed is unfortunate, because beneath these annoyances there is a lot to like about The Black Swan. Many of the book’s revelations are relevant to real estate investors. Among them:

We’re hooked on phony experts.

Taleb calls this the “empty suit” problem; he opines that there are many fields in which the “experts” are no better at predicting the future or producing effective results than a reasonably informed layman.

According to Taleb, there are experts who tend to be true experts and experts who tend to be…not experts.

• In the “real experts” category fall (among others): livestock judges, astronomers, test pilots, physicists, and accountants...
• In the “empty suit” (faux experts) category fall (among others): stockbrokers, psychiatrists, college admissions officers, intelligence analysts, economists, and personal financial advisers...

He poses the following thought experiment: Would you rather have your upcoming brain surgery performed by a newspaper’s science reporter or by a certified brain surgeon? The answer to this question is obvious – but it can’t automatically be projected on all professions. His follow-up question is whether one would rather listen to an economic forecast from a prominent academic with a PhD from a respected institution, or from a newspaper business writer. The answer here isn’t obvious.

This example will sound familiar to most real estate investors. Chances are you’ve heard it before – from a Realtor. Your average Realtor will consider herself closer to the brain surgeon analogy.  I disagree. There certainly are notable exceptions, but for a well prepared investor with at least one deal under his belt the vast majority of Realtors will offer little or nothing in terms of expert real estate investing advice. A Realtor can be extremely useful in helping you to get through the myriad steps to get to closing on time, but be careful about relying on him for “advice” on which market is gonna be hot, which one isn’t, and when to buy/sell. He’ll tell you that he knows, but he doesn’t.  You are every bit as good as "the expert."

So the next time you’re listening to an outook on housing prices, consider the fact that your prediction about what’s gonna happen is every bit as valid as the one you're listening to.

We don’t know what we don’t know.

We often tend to overestimate how much we know and underestimate our ignorance. This error tends to increase as we get more educated, meaning that an educated person has an even more unrealistic view of what he knows than an uneducated one. Chalk it up to our educational system’s focus on building self esteem. This has lots of implications for investors.

All industry groups produce reams of forecasts about future price movements. This is all a bunch of hooey – made even worse by the fact that industry groups aren’t unbiased observers.

This also gives investors something to think about when using a real estate investment evaluation software package – including the one offered here at EquityScout.com. All evaluation software packages rely on assumptions – the old garbage-in-garbage-out phenomenon. The primary use of a real estate evaluation software package should be to force you to consider and weigh your assumptions and think about the fundamentals of the deal. One way to do this is to look at what your assumptions mean in terms of future results, but bear in mind that this isn’t a forecast.

The only thing you know about your assumption around property appreciation rates over the next ten years is that it will be wrong. But, it’s vital to know if your investment will yield a reasonable return at a 3% rate of appreciation (as it will in many undervalued areas or if you grab a bargain) or if you’ll need a 10% or 15% rate of appreciation in order to break even (as is the case if you’re buying in many overheated areas, such as areas of California, Florida and Nevada).

You can’t see the future, but on the other hand you shouldn’t make a decision without knowing how various future scenarios might impact your investment.

Summary: I got some interesting insights from this book. Taleb takes many positions that I disagree with, but he’s a persuasive author who takes a stand, and some portions of this book changed the way that I think about certain things.

Related links

• Why I don't like Rich Dad Poor Dad

• Five things real estate investors should remember when running economic analysis

Well now that the housing market is starting to slow in some regions flipping is starting to lose its shine. Perhaps one of the most telling pieces of evidence that the pendulum is starting to swing is that allegations of fraud are starting to pop up even in the sanitized, staged world of reality TV. One Flip This House participant evidently didn’t even own the properties that he allegedly was flipping for big bucks. If you can’t believe what you see on reality TV then whom can you trust these days?

So these are additional bits of evidence on a fact that we already knew: flipping isn’t investing, it’s speculating. Not that there’s anything wrong with that, as they say on Seinfeld, but it’s important to know that flipping is a speculative technique that works well if the market is flying and you have a healthy risk appetite.

Flipping is glam and flash – high rollers and big bucks. But that’s so 2006, so what trend are they going to selling us next?

Well one man’s pain is another man’s profit, so expect the spotlight to fall on the short sellers and pre-foreclosure investors.  Not as glamorous as the fast rolling world of the flippers since it requires the investor to manage the unpleasant task of dealing with folks who are having their home foreclosed, but in an environment of stagnating prices and embattled mortgage holders short selling can work.

Quick primer: The bank doesn’t want to get stuck with a foreclosure. I’m always annoyed when I read these exposés about banks licking their chops to kick grandma out of her house and sell it at the auction block the minute she gets behind on her mortgage payments. In the eyes of a bank a foreclosure is a black eye; banks don’t want to own real estate, especially a house that has been trashed by a aggrieved foreclosed owner.

If the owner is getting foreclosed on a house with zero or negative equity then there is little he can do. Say his house is worth $150 thousand and he owes $160 thousand; trying to sell won’t help.

Enter the short seller. He cuts a deal w/ the owner to give him the house and simultaneously cuts a deal with the bank that he’ll pay, say, $125 thousand for them to release the lien. Voila, everyone is happy: the investor gets a quick $25 thousand in equity, the previous owner avoids the indignity of a foreclosure, and the bank avoids the time, cost and expense of trying to unload the property – a process that probably would have cost them more than the $35 thousand it just wrote off.

Note that this is nothing new. People have been doing it for years. But it about to be the new thing which will be promoted online and in the media.

If the flipping phenomenon was vulnerable to fraud, this one will be as well. Two reasons:

• It’s hard: Making money flipping houses in a booming market is as easy as falling off a log. All you need is guts and the right level of risk appetite. Making money off of pre-foreclosures and short sales is hard. There are a lot of moving parts to these deals and pulling them off requires knowledge, negotiating skill and patience.
• Dealing with vulnerable people: Short sellers promote themselves as investors who help people. And indeed many of them are good, decent people. But investing isn’t an altruistic pastime, and when a dishonest investor comes into contact with a troubled owner who is looking for a lifeline there is a potential for bad things to happen.

I’m trying to look into the crystal ball on this one. I’ll revisit in a couple of months…

I wrote a similar post over at ActiveRain, a real estate network populated primarily by Realtors. A fairly interesting dialogue ensued, but overall I felt about as welcome as Don Imus at a rap concert.

But no surprise there; ours isn’t an industry that embraces change. But some of the comments did illustrate the fact that working with Realtors is an important topic for real estate investors, and it’s one that’s worth spending a few minutes considering.

Just to set the record straight: I’m a fan of Realtors. The good ones are part financial analyst, part industry specialist, with a healthy dollop of psychologist in the mix. There are a couple of Realtors out there in blogland who write particularly good copy for real estate investors – particularly Jeff Brown and Chris Lengquist (Jeff might be a little in-your-face for sensitive readers; make sure you bring your sense of humor).

But, ironically, having these guys around can be a little dangerous – especially for new investors. Is it because they give bad advice. No – they give great advice – and that’s just the point. It’s a fair bet that the Realtor that gave you that magnet advertisement that’s stuck to your refrigerator right now is billing himself as an investment specialist too; but the chances are slim to none that he has the experience or background that Jeff and Chris have. Don’t be fooled; your chances of finding a Jeff or a Chris in the real world: slim to none.

So: what’s an investor to do? Well you gotta know what to expect, so here’s four things that I think you should keep in mind…

• Realtors help you get deals done. The vast majority of investors – yours truly included – are part time investors. You invest in real estate to diversify your investments, earn a superior rate of return, and secure your future – but you have a day job too. There will be times that if you try to do everything yourself you either won’t get the deal done, or you won’t run all of the traps and end up making a mistake. Here’s my analogy: I can put a tile floor in myself – but this is work that I tend to outsource. Getting help will assist you in making things happen. Hire one when you need to.
• Realtors won’t bring you deals. In my experience you’ll never get a Realtor to bring you a good deal. That’s just not the way it works. A Realtor with the ability to spot a good deal will take it for herself when one comes along. So by definition if a Realtor hands you an opportunity it means either a) she doesn’t know a good deal when she sees one or b) she does know a good deal when she sees one and this one ain’t. But hey, in her view a commission is a commission. Word to the wise: expect to find your own deals.
• A Realtor is unlikely to be able to give you good investing advice. But you should expect him to give you competent advice on buying and selling a house. I use a Realtor at times, and she doesn’t really know much about investing. And that’s ok with me; I’m not paying her to give me investing advice. I read some writers insist that investors should only work with Realtors who own real estate investments themselves, but that advice strikes me as a bit wrongheaded; you shouldn’t be depending on the person who’s going to bag a commission from your purchase/sale to give you advice on whether or not said purchase/sale is a good investment.
• Loyalty, loyalty, loyalty. Ours is a business of relationships, and creating a symbiotic, mutually beneficial relationship is one of the best investments that you can make. Your average homebuyer buys a home and sticks around a while. Your average investor buys a home, then buys another one, then buys another one. Create a relationship with your Realtor and show him that you value his services and it won’t take him long to figure out that you’ll be coming back – and there’s no way to get a service provider’s undivided attention than being a repeat customer.

The four points above apply to everyone. Here’s another couple for those of you with a few deals under your belt.

• Take charge of the negotiation. You should be in the driver’s seat, not your Realtor. Call your own shots, drive the negotiation tactics, set your own pricing strategy. Your Realtor should be there to advise and execute, not to decide.
• Cut costs when you sell. That means FSBO, flat fee, or deep discount. In the past I’ve argued that the buyer bears part of the sales commission via an increased sales price, but when you’re the seller there’s no doubt that this hits you in the pocketbook. Once you’re confident about handling the deal yourself an extra 6% in your pocket at closing is no small deal.

I wrote in a recent post that real estate investors who work with a Realtor will generally end up overpaying for their services; if you pay a $12,000 commission check it’s highly unlikely that you’ve actually gotten $12,000 worth of time or effort out of the Realtor that supported you. And note that a healthy portion of that fee will be passed directly to the buyer – the idea that “the buyer doesn’t pay a commission” is a myth.

This isn’t to suggest, however, that agents are greedy or that they’re raking in the big bucks. Average Realtor income, according to the National Association of Realtors, is under $50,000. This is more than the average elementary school teacher but less than a financial service representative or an engineer.

Buyers and sellers pay too much in commission but many agents still struggle. What gives? The answer is simple too many real estate agents.  

But there is an odd phenomenon at work here. Usually when there is a glut of supply for services the price for those services drops accordingly. Supply and demand reset that price accordingly, delivering better value for the consumer at the new equilibrium point. However, in this case the National Association of Realtors has done everything in its power to resist the market’s natural ability to find equilibrium: everything from attempting to monopolize MLS data to doggedly defending the current commission structure to fighting to keep the banks out of the game.

I lived in Bogotá Colombia for three years. Bogotá is a beautiful city with great people and I enjoyed my time there. But the traffic is awful – mainly because there are too many taxi cabs on the roads. And the taxi drivers have to work morning, noon and night just to scrape by because there is so much competition – and that just keeps everyone on the road more hours (using more gasoline) which in turn creates more completion...and so on and so on.

The same thing is happening here in our real estate industry. As the market booms more and more agents are pulled into the industry chasing the same number of 6% commissions. And the industry’s leadership clings to the status quo instead of encouraging new business models that will evolve with the consumer’s needs.

:: So what does this mean for investors?

First of all a new business model is coming. Will it be Redfin? This question makes me think of a now forgotten company who’s stock I bought back during the dot com boom. This particular company was working on a groundbreaking new music format called MP3. I saw that this technology was going to be big, but unfortunately I bet on the wrong horse. Apple won and the stock I bought tanked.

So...has Redfin picked the right model? I think so. But will they win the race? Who knows – but the odds are against them. If I were a betting man I’d put my money on someone coming out of left field. Citibank? Google?

But for now: no investor should be paying 6% to sell a house. New options are already popping up – I'll talk about this in a future post.

Update - 11 July:  I posted this topic over on Active Rain, a blogging network populated primarily by Realtors.  I got a pretty lively reaction...

Philosophers from Machiavelli to Rousseau have debated human nature, and although I’ve run across more than my fair share of jerks in my time I nonetheless reject the Machiavellian view of human nature as fundamentally dishonest and mean spirited. The guy you’re negotiating a sale with isn’t out to get you. That contractor you’re haggling with isn’t stupid or evil. People might act in ways that are fearful or greedy, but in my view most people aren't bad.  So I see it, a critical key to being a successful negotiator is initiative, backed by fearless, transparent honesty. But it this only works if you have a plan...

Not too long ago I was involved in a major corporate merger and had an interaction with a senior executive who was a direct party to the negotiations. He declared “well we all agree on everything…except for the price.” There’s a lot to that simple statement – that bottom line dollar figure can make people act in strange ways. A dollar figure is hard and concrete – you can get your head around it. But often the price is just the catalyst for conflict and the real concerns lie beneath.

In my experience, the biggest concern that the person on the other side of the table has is that she'll be taken advantage of. She can probably live with a 10% increase or decrease in the price...but she can’t live with looking foolish. Therein lies your challenge.

:: Example

I recently purchased a multi-family property. I made an offer and contentious back-and-forth ensued .  Finally we had an agreement, pending inspections. This was a tough process and it took a lot of work to get to a price that worked for me and which the sellers could accept.

Then: the inspection. I use a guy named Robert Goodspeed . He’s ruthless but fair. Meticulously thorough. If there is a nail out of place he’ll note it. I love working with Robert – if there’s something wrong he’ll find it.  I can negotiate with confidence when I have a Goodspeed inspection report in my hand, and that makes me a repeat customer. 

Now aside from a long laundry list of minor items this particular building was in solid shape. But there were three items of concern that Robert noted:

• Pier and beam foundation had recently been repaired. There wasn’t necessarily an immediate problem, but we needed to ensure that the work had been done correctly.
• There were some electrical problems in one of the units, the breaker tripped while we were inspecting
• The elevated back deck (over the carport) was not up to code with regards to the railing.

I sent the Goodspeed report and the list of three items that I needed to have repaired.  Predictably, the sellers freaked.

:: Getting into the sellers’ heads

At this point it would have been easy enough for the various personalities to take over the negotiation; for us both to cross our arms and let the deal die. What I try to do in these situations is try to put myself in the other guy’s shoes.

What I’m thinking	What I think the other guy is thinking
I want for the final price to reflect the deal I thought I was getting into before the inspection. I’m not using the inspection as a negotiation tool. I’m using the inspection to ensure that I don’t run into any surprises later. That’s what the option period is for. This is about mitigating risk, not sweetening the deal.	This guy is trying to screw me. He agreed to a price but now he’s trying to get more concessions out of me. I’ve already insisted that the agreed price is as low as I can go – if I give in I’ll be humiliated.

Time to take the initiative and take control of the discussion.  The key, in this case, was to give the seller a way to save face and keep the deal moving forward. To do this I emphasized not our respective positions (“fix it!” “no, I won’t fix it!”) but the principle at stake: in this case the purpose and intent of the option period.

I didn’t want money – I wanted assurances that everything was as they had represented it when they offered the property. The sellers cooled down. They brought out some certified, licensed inspectors: a structural engineer and an electrician.

The foundation, as it turns out, was rock solid. The electrician found a couple of problems – nothing major. And since the seller uncovered these problems with their contractor (who I approved) it was not contentious to get them to pay for the repairs. The railing on the back deck I agreed to pay for – this was an item I could have identified by site via my pre-offer casual inspection, and it was only a $1,000 item.

The seller’s initial reaction and refusal to budge was a reaction based in fear. Fear of being treated unfairly. Fear of looking foolish. And that reaction could have easily triggered a fearful reaction in me: these guys are trying to hide something! They’re out to get me! Too risky...no deal!

But by putting myself in the other guy’s shoes I was able to efficiently get to a fair solution and acquire a great property.

There are exceptions, however, and a notable one is Stanley and Danko’s The Millionaire Next Door, an enlightening study on how most wealthy Americans earned (and keep) their net worth. They theorize, in a nutshell, that most wealthy Americans got that way though a combination of shrewd business sense and frugal living.

My two cents is that Stanley and Danko could stand to lighten up a little; if at some point along the road I decide to trade in my ’85 escort and splash out on a new sports car then it’s not going to be the end of the world. But generally speaking their message is excellent. Americans are great at consuming and terrible about saving – this is a message the people need to hear.

Pat Kitano over at Transparent Real Estate uses a format that I like when he compares two different ideas, services, or trends. Imitation is the sincerest form of flattery, so with apologies to Pat here’s how I compare Kiyosaki’s Rich Dad series with The Millionaire Next Door by Stanley and Danko.

Note:  those of you who read my recent post on Rich Dad Poor Dad already know I'm not a fan of Kiyosaki's philosophy.  But hey, this is a blog - I don't have to be objective.  You want Fair and Balanced then go to Fox News. 

	Rich Dad Poor Dad	The Millionaire Next Door
Core Philosophy	Wealth is a state of mind. There are secrets that wealthy people have that poor and middle class people don’t. Learning and internalizing these mindsets will allow you to get rich.	Wealth is about your habits. If you change your habits then you can accumulate wealth
Material Things	Wealth is a gateway to a lifestyle. Follow the Rich Dad methods and you’ll be able to afford the cars, early retirement, and expensive golf clubs that Kiyosaki emphasizes in his book.	Attachment to material things is the primary obstacle to wealth. Living below your means is an important key to allowing your money to work for you. Keeping up with the Joneses is deadly to your financial well being.
Work	Your money works for you, not the other way around. The traditional concept of “work” is a trap which the poor and middle class fall into, but which the rich have learned to avoid. Learning the secrets of wealth is more important than generating an income. You get rich by buying assets and letting them work for you.	Frugality combined with a prudent stewardship of your income provide a path to financial security for anyone willing to save diligently, invest wisely, and spend frugally. Most wealthy people are self employed. You get rich by being good at what you do.
Education	Kiyosaki’s “rags to riches” philosophy does not value education. Kiyosaki emphasizes practical knowledge over theoretical.	Stanley and Danko point out that the wealthy value education, and that most wealthy parents emphasize the value of education to their children.
Motivation	Kiyosaki’s philosophy is about understanding the “secrets of wealth” – things that rich people know that others don’t. Wealth, in the Rich Dad Poor Dad paradigm, is an end in itself.	Successful people learn to do something well, and as a result end up rich. Wealth is a by-product. Most of the wealthy people surveyed by Stanley and Danko are business owners who are motivated by building their business, not by building wealth.

Kiyosaki has developed an almost religious following (how else could one sell a Monopoly-like boardgame for $149.99) so the conventional wisdom is that I won’t win a lot of friends by criticizing his approach in a public forum like this one. But… dissenters are starting to pop up – interestingly John T. Reed’s blistering critique shows up at the top of a Google search for both “Kiyosaki” and “Rich Dad”.

Kiyosaki has become wildly wealthy selling his books and tapes and he couldn’t have done this without making an emotional connection with a lot of people. However, whether or not Kiyosaki is an investor that one would want to emulate is subject to debate; Rich Dad is full of questionable, vague advice and it’s tough to verify that he had any real success in his pre Rich Dad career.

The problem that I have with the Rich Dad is that the philosophy that he’s selling is not what the majority of readers really need. Analogies abound. Take a look at weight loss: Slim-fast, Hoodia and Anatrim all offer seductive sales pitches to overweight customers and rake in the big bucks doing so, but what these customers really need is a change in lifestyle, not a pill.

But lifestyle change is hard - doesn’t matter if you’re talking about getting a bit more exercise, or starting to save and invest with discipline – and advocating hard solutions doesn’t sell books. So better to offer up some folksy stories, a few vague truisms, and a heaping helping of motivational prose. There is a silver lining of wisdom that runs through Rich Dad, but the sales pitch is to glamorize a lifestyle of wealth and ease, and to do this Kiyosaki repeatedly emphasizes the material trappings of wealth. If the book motivates a few people to get off the sofa and take charge of their financial future then good for him, but the real message his is a compelling vision of a unlimited wealth just around the corner. You can glimpse it in the hazy distance when you read Rich Dad, but the implicit promise is that you’ll be able to pull it a bit closer with every Rich Dad product you buy. And, voila, before you know it you end up purchasing the $79.99 DVD and the $149.99 boardgame.

There’s not much substantive advice on investing offered in Rich Dad. His main theme is that you get rich by buying assets. Period. Most investors (and some speculators) realize that this isn’t true. You don’t get rich by buying assets, you get rich by buying the right assets. And buying the right assets is something that involves skill, discipline and knowledge. Education helps. So does a bit of luck and a lot of hard work.

Education and hard work are two elements that Kiyosaki specifically downplays. Working hard is for suckers in the Rich Dad world, and education is for dreamers who want to waste their time working for the man. That, in my view, is the greatest danger that Rich Dad holds for most readers. A solid college education, hands down, is the best investment that any young person can make. No other investment offers the return that can beat investing in a college education.

But that’s not a viewpoint that sells books. Kiyosaki’s target audience is made up primarily of folks who covet the lifestyle of the rich and famous, and he doesn’t want them to think that a lack of a formal education is an obstacle. His “education is a waste of time” pitch is designed to sell books.

Can you get ahead without an education?  Sure you can.  But arguing that an education is a waste of time is wrongheaded. 

In reality, real estate investing isn’t fluff. And it’s not rocket science or mysterious. It’s a practical, hands-on form of investing and a proven way to diversify your returns and build wealth. It’s not particularly sexy to talk about discipline, managing risk, building credit, evaluating properties, managing tenants and negotiating with contractors – but that’s what real estate investing is all about.

They say that imitation is the sincerest form of flattery and there are Kiyosaki imitators all over the net – but scattered here and there you’ll find a few solid resources that will help point you towards the practices and skills you need to be a long-term successful investor.

Here are a few that I like:

• CRE Online Forum The forum is great, but careful about the courses
• Landlord Success Blog  Tales from the trenches.  Hands-on, informative, and sometimes entertaining
• The Mortgage Professor  Wharton Professor Jack Guttentag's take on the mortgage market
• John T. Reed's Guru Guide  Probably not the most objective piece of journalism you'll ever read, but this will keep you wary of some of the courses on offer out there.  

Unrelated sidenote:  I was profiled yesterday by OneBlogADay.com, a great site for discovering new destinations on the web - and I'd say that even if they hadn't profiled me.  Go check 'em out.  

Update, 10 August:  There's an interesting thread over at the Consumerism Commentary blog. 

At least that’s the point I wanted to make. But it would appear from some comments that my post was interpreted as bashing speculators. That’s not my view.  Sometimes you gotta roll the dice. 

So today as we stand in the shadow of Enron and the collapse of the dot.coms and foreclosures pop up all around us like mushrooms who in his right mind would try and defend the defamed speculator?  Well...I would.  Risk and reward are correlated in efficient markets, so there's nothing wrong with taking a risky position if you know what you're getting into.  So..here are four points that I like to keep in mind when it comes to speculation:

• Buy what you know: Ever had someone tell you “my brother’s roommate says that nanotechnology is the next big thing…and here’s a penny stock in the sector that’s about to go through the roof!”   That's bad advice, probably. Take your money and go to Vegas instead – at least you’ll have some fun in the process. However, taking a speculative view in a market that you know intimately is a different proposition. Example: I recently bought a fourplex that had yielded a decent return, but the real reason I bought it is that I’m bullish on the neighborhood, and I expect that the city might announce a light rail station a block away. This was a speculative view, but it’s a risk-reward that I’m happy to shoulder.  I know the market.  I know the risks.  And I accept the trade-off.
• Be ready to lose: Speculators win big and lose big. Gambling your retirement on a speculative position is silly. Having some speculative purchases in your portfolio is a good diversification strategy, in my book, but don’t bet more than you’re willing to lose. USA Today wrote a goofy article recently about real estate investors which was really about speculators. It was full of misinformation, but it did highlight the fact that people sometime do foolish things when it comes to real estate.
• Flippers are speculators, not investors:  Well, most of them are. If you have mastered techniques that allow you to consistently buy at 20% below market value then you have a strategy that’s fit for all seasons. But by now most of us have noticed that the flippers come out of the woodwork during a bull market and they disappear back to their day jobs once the markets correct and cool. Why is that? It’s because flipping in inherently a speculative activity. Here’s a news flash: it’s not the tile that you put in the foyer or the paint job that added $50 thousand to the price of that house you just bought and flipped; it was the rising market. In a falling market you can’t make money making cosmetic improvements to an ugly house.
• Buying in an overheated market? You’re a speculator:  Here’s a test – do you need a double digit rate of appreciation to get a decent rate of return on a property? If you’re buying right now in most areas of California, Florida, and a lot of other hot markets then that’s going to be the case. If you’re investing in a property that doesn’t immediately yield positive cashflow then you’re betting on a rising market. Again – that might be okay – as long as you realize that’s what you’re doing.

So here’s to the real estate speculators - at least to the prudent speculators who don’t get in over their heads and don’t bet more than they’re willing to lose. But with investors suing to back out of underwater deals and states like Massachusetts taking measures to protect overleveraged investors from foreclosure  it would appear that prudent speculators are outnumbered by the get-rich-quick guys who get themselves in trouble.

But that’s okay…a rash of foreclosures just means more distressed below-market properties for smart investors to scoop up.

They tested this by evaluating sales in Madison Wisconsin from 1998 to 2004. The dominance of a single local FSBO website makes Madison an ideal location to compare results – working with the local MLS and www.fsbomadison.com the authors of the study were able to access nearly every sale that occurred during the period.

The results are surprising: the average sale price of FSBO homes is higher than the average price of homes sold by a Realtor.

This directly contradicts a claim made by the National Association of Realtors that using a Realtor results in a 16 percent increase in average sales price. The NAR does not detail their methodology or the assumptions that they used to reach this number.

The Northwestern University study, however, is meticulous and transparent. The authors discuss the consistency of their data sets, study methodology, and their approach to resolving biases in the data sets.

But…the gig isn’t up for Realtors…yet.

1. The study was conducted in a relatively special place – Madison, Wisconsin – a region which has, for reasons not discussed in the study, developed a special culture in which FSBO sales have captured a significant percentage of the market. This fact, in itself, might skew the results. FSBO penetration hasn’t reached these levels in most other markets, and an FSBO seller is more likely to be viewed as an oddball, and that matters.

2. There’s a self-selecting factor which the study doesn’t adequately address. Negotiating a sale isn’t for everyone. Logic dictates that a) sellers who are good negotiators are more likely to get a higher price whether or not they use a Realtor and, b) sellers who are good negotiations are more likely, on average, to sell FSBO. The study addresses this, but not to my satisfaction (if anyone cares about this you can ask in the comments…)

FSBO conditions haven’t spread nationwide, and FSBO isn’t for everyone. The later condition won’t change, but the first one will.

So…who cares? What does this mean to me?

You’re an investor and this trend will impact you. Thoughtful studies like this one will continue to demonstrate that paying a Realtor $18,000 to sell your $300,000 house isn’t good value. FSBO listings will proliferate, and that’s a good thing for the investor market. A commission is a classic transaction cost, and transaction costs decrease liquidity and pull profit out of every trade, both for the buyer and the seller.

Realtors, however, will continue to be an important part of your business as a real estate investor. To respond to market pressures the real estate industry will have to start offering a suite of products that meet your needs and price them accordingly. As an investor you don’t need help finding your dream home, you don’t need a negotiator, and you don’t need to have your hand held through the transaction. What you do need is a competent business partner to supervise the paperwork drill and help make sure the deal closes efficiently.

That’s not $18 thousand worth of service that you’re asking for. Realtors who understand this and tailor their offerings and pricing will have investors beating a path to their doors

The worst offender among the popular press, hands down, is USA Today.  Check out the feature story on Real Estate entitled Many Investors Feel Like Running Away by Matt Krantz.

If you take this article as light entertainment – kind of like reality TV – I guess an article like this might be relatively harmless. But many people go to USA Today for information – and that makes journalists like Krantz dangerous.

Where to start? Well here are some of the more egregious flaws in the article’s reasoning:

Cash in the stocks, baby, we’re buyin’ real estate! The article states that the current market is “a complete flip-flop from 2002, when investors tired of the bear market ravaging Wall Street cashed in their stocks and bought homes and investment property.” This is goofy. Smart investors might tilt their investment portfolio more heavily in one direction than the other, but it doesn’t make sense to flip your life savings from one asset class to the other in an effort to catch a hot market.  Articles like this treat investing and speculating as interchangable concepts.  They're not.  

Taxes, toilets and tenants! For some reason, the popular press loves to exaggerate the pain and suffering that landlords go through. USA Today comments that “wannabe real estate tycoons stuck with properties they can't sell have been turned into landlords, forced to fix toilets and take tenant calls in the middle of the night.” Ok – show of hands – how many of you landlords are running out at 2 in the morning with a plunger in your hand? Note that these articles are written by journalists who don’t know anything about investing – take their advice at your peril.

Stocks have always outperformed real estate! The article suggests that real estate investors who are underwater now could have “shaved themselves some trouble if they had done some research,” pointing out that stocks have appreciated at a faster rate than real estate over the short and long term.

That's silly.  The source neglects many key factors about real estate and stocks.  Here's two of them:

• Leverage: the gains that you realize due to the appreciation of your real estate investment are backed by the bank’s money via a mortgage. Unless you’re a mega-aggressive margin investor, your stock portfolio is backed primarily by cash out of your pocket.

• Cashflow: The article points out that the average new home has appreciated from $4,030 to $276,400 from 1920 to 2006, a rate of appreciation that does not beat the stock market. However, this doesn’t consider the fact that real estate puts cash in your pocket. That $276k in investment properties that were purchased decades ago would be free and clear of a mortgage and would be generating from $30,000 to $35,000 per year in rental income. Compare that the dividends that an equivalent portfolio of stocks would be generating.

An interesting note: the article quotes Nigel Swaby, who’s hooked up with that iamfacingforeclosure.com guy. You’ll often see Nigel’s comments on various forums giving “advice” to investors on getting rich, but from his quotes in the article it appears that he’s sitting on the sidelines.

The bottom line: USA Today is fluff. But it’s fluff with an audience: 5.2 million daily readers. That’s a lot of bad information soaked up by a lot of people. And it’s not just the USA Today that gets basic concepts wrong; lots of other publications are just as bad.  It’s up to all of us to be discriminating consumers of information.

But here's the good news - and it's something you know already.  All markets are cyclical, and misinformation like this is great for spooking the herd.  That can be a good thing; keep your eyes open for buying opportunities. 

I'm a fan of Blog Carnivals and we're happy to be hosting this week's Carinval of Real Estate Investing here at EquityScout.com. 

No snappy theme this week - we're gonna keep it simple with a top three and a couple of honorable mention posts.  Check 'em out. 

Taking poll position, The Landlord channels Real Estate Investing's favorite curmudgeon John T. Reed in 4 lies that the Gurus will tell you posted at Lording the Land. These are points that you can't hear too often. 

Running a close second, Steve Faber discusses an alternate way of investing in real estate with- REITs – A good Investment for Tishman Speyer Properties, But Is a REIT Right for You?

Rounding out the trio, The Dough Roller presents The 1% Solution to Real Estate Investing posted at The Dough Roller, saying, The 1% rule is a rule-of-thumb that has fallen out of favor in many markets as property prices have outraced rental rates - but it's a good screening tool - if you stray too far then you're more of a speculator than an investor. 

Congratulations to the top three!  Some other notable entries follow...

Bryce Beattie presents Seven Habits of Highly-Successful Real Estate Investors. posted at Middle Class Millionaires.  I'm not sure I agree with Bryce's habit #1, avoid overleveraging to reduce negative cashflow.  In some markets good investors can find quality investments that will produce positive cashflow even with 100% financing. 

• MoneySmartLife is hosting the Carnival of Personal Finance, and the EquityScout.com entry on Real Estate Investing vs. Speculating was featured as an editor's choice. 
• Real-Real Estate Investing is hosting the Carnival of Real Estate Investing, and the EquityScout.com entry on real estate investors working with Realtors took first place. 

When the market was flying it would seem that everyone was making big bucks, if you took media coverage at face value. That led to a big increase in speculative buying. This hasn’t painted a pretty picture in many areas, and an ugly convergence of flattening/declining prices, declining sales, and a collapsing sub-prime lenders has turned many a get-rich-quick scheme into a sob story.

How about the Florida couple – an administrative assistant and a carpenter with a combined household income of $90,000 – who took out $750,000 in financing to buy three investment properties. Now that the market has tanked and they’re facing foreclosure they’re suing the lender – claiming that the bank never should have trusted them with the money in the first place.

These sordid stories aren’t hard to dig up, and they highlight a fundamental truth: There’s a difference between investing and speculating. Either approach may be right for you…but the danger comes when you think you’re doing one but you’re actually doing the other.

Investors and speculators have fundamentally different objectives and risk profiles, and consequently require two distinct skill sets. I’d argue that in today’s economy we all need to be investors. The job-for-life-guaranteed-pension world of previous generations has evaporated in recent years, and social security is looking increasingly rickety as it prepares to bear the weight of the retiring baby boomers. Many Americans are waking up to the fact that they’re gong to be responsible for their own future livelihoods.

Few of us, on the other hand, are cut out to be speculators. What’s the difference? Well there’s been no shortage of ink and pixels spent on the subject, but here’s my take:

	Investors	Speculators
Objective	Make money: Pursue investments that have sound, quantifiable fundamentals.	Make money: Buy assets that are expected to appreciate rapidly in value, with the hope of selling for a large profit.
Risk profile	Moderate risk: All real estate investments carry risk, but investors will look for properties with positive cashflow that will allow the investor to carry them through downturns in the market.	High risk: Speculators stand to make big profits from leaps in the market, but are exposed to foreclosure if the market flattens or declines. Seeks quick profits but can tolerate large losses.
Time horizon	Long: Investors will tend to seek out buy-and-hold quality properties, even though they may subsequently sell them in a shorter period to rebalance their portfolio.	Short: Speculators look to get in and get out. Having funds tied up for an extended time is expensive, due to the fact that most speculative properties generate negative cashflow
Tactics	Buy properties, preferably at a market discount, that will yield positive cashflow. Build equity by selecting quality tenants who make timely payments. Grow a portfolio of real estate holdings through 1031 exchanges.	Buy properties in hot markets, catching trends early and getting out before the trend ends.
Skill set	Strategic thinker. Strong people skills. Good negotiator. Disciplined.	Intuitive and decisive. Risk seeking. High tolerance for losses. Financially secure.

Most people can easily place themselves in one category or the other.

There’s a lot to be said for having the speculator personality and skill set in a market that is hot, but smart speculators know when to sit on the sidelines. Flipping and pre-construction investing are, almost without exception, speculative activities. Many of us have talked to people who purchased an ugly starter home, slapped a new coat of paint and fixed up the landscaping, and the sold it for a big profit. Here’s a news flash: it wasn’t the paint or the shrubs that pushed up the price of the house – it was the rising market. This is a strategy that only works in bull markets. It’s a speculative play.

Most of us, myself included, belong on the left column.

Which side are you on?

It’s honey bee season here in Houston. If your'e a real estate investor in a  bee-prone city then you’ll know what I’m talking about.  Or you will soon.

Every colony has a queen, who rules the roost. Every now and again she’ll get a wild hair and decide to relocate. And it seems, for whatever reason, that Houston honeybee queens like to relocate to rental properties that I own. Go figure.

Getting rid of a hive is a three step process. First, you have to kill the bees. Second, you have to extract the hive, and third you have to seal up the house – caulking whatever cracks the bees were using to get into the structure. If you skip a step that’s ok, it just means that you’ll get to repeat the whole process the following year because the bees will come back.

Here’s something that I’ve found out: a lot of landlords ‘round here do this on the cheap, which means that I buy a nice bee-free property only to find that an infestation pops up when summer arrives and a colony returns that had been there the previous year. I got a call just this week about one of my single family homes in Katy, a Houston suburb. I met the bee guy out there and we took care of it this afternoon. (note: you have to get yourself a “bee guy”…when you’re calling around for exterminators you’re just as likely as not to get the response “oh we don’t do bees.”) This was a quick job and relatively cheap.

I wasn’t so lucky last year when a colony took up residence in the siding of a townhouse that I own. Seems these guys were returning to a large honeycomb that had been left a year or two back, and the guy had to do a significant amount of work to get the whole thing out.

sidenote: a second drawback to not extracting the hive is a rotting honeycomb which a) stinks and b) will attract every raccoon, rat, and miscellaneous critter for miles.  Not good.

So when you’re buying ask the sellers if they’ve ever had a bee problem. If so go check it out, and even if there’s not a bee in sight make sure you caulk up the crime scene, otherwise you’re gonna get to deal with it later.

I always love talking to exterminators; maybe I just attract exterminators with good attitudes, but in my experience they tend to be enthusiastic about their jobs and love what they do.  The guy that came out today told me that in the past you would be able to get a beekeeper to come out and instead of killing the bees they'd extract the hive for free.  They'd  they'd collect the comb, the queen, and as many bees as they could gather up and transport the whole lot out to the farm to produce honey.  But nowadays with aggressive Africanized bees popping up they're nervous about harvesting wild colonies and introducing them to thier farms.  So much for that angle... 

It’s a popular area so I got lots of calls. Some of them, of course, were from Realtors who wanted to help me lease the house. I like developing relationships with Realtors (as I’ll explain below) so I agreed to meet one. She rolled up on Saturday afternoon in a massive shiny SUV with a magnetized sign featuring a large glossy portrait of her smiling face.

She took a look at the place, declared that she thought she could help me, and explained that the charge would be one month’s rent plus a $150 listing fee. And free of charge she offered me lots of advice, like check the applicant’s credit and make sure the property is clean before you show it and call the applicant’s references before signing a contract.

She called me the following Tuesday to see if I was ready to list the property with her, but by then I already had it leased out myself.  This particular unit rented for $1,250/month, so I saved myself a total of $1,400.  Well, $1,380, including the $20 bucks I gave the neighbor to allow me to put the sign up. 

Realtors can offer a lot of value to investors…

…it’s just that your needs are different than the needs of standard consumers.

What the standard consumer wants	What you, the investor, need
Service: The Realtor guides the homebuyer through a scary and unfamiliar process. Helps them to make a tough, life changing decision. This is personalized, time consuming attention.	Service: You’re an investor. You don’t need reassurance and you don’t need to be chauffeured around town in comfort; you need someone who can open the front door when you want to see a property, and make sure the paperwork happens right and on time.
Advice: The average homebuyer does not buy/sell a house frequently, and therefore will not have a good checklist of things to consider. A Realtor will help the consumer prioritize, organize, and make a good decision. This requires a lot of personal attention.	Advice: It’s probable that you have a lot more experience transacting real estate deals than the average consumer. You don’t need generic pointers. What you do need is the straight dope about what’s happening now in the market. If you’re like the majority of investors you’re a part-timer. Realtors are full timers, and may have better info than you on what the city’s planning for that proposed light rail station or the next school zone redistricting than you do. When your Realtor has a tip, you want him to take a moment to give you call.
Buying: The average homebuyer is looking her dream home, and many look to a Realtor to help her find it.	Buying: There are exceptions, but my experience is that Realtors don’t bring many deals. And anything a Realtor points out on MLS you could have found yourself.
Selling: Selling your home is an emotional process. A Realtor will help the customer make objective decisions. And if she’s good she won’t be shy about telling the seller that the “artistic” color scheme he's using in the bedroom is going to scare off potential buyers. Working with sellers takes patience, people skills, and time.	Selling: Selling an investment is an economic decision. Get it clean. Use neutral colors. Price it consistent with the market. And it’s easier to show once the tenant is out. You already know this stuff. What you really need is simply for someone to get your joint onto MLS so people can find it.
Negotiations: When it comes to negotiating a purchase or a sale, one of the Realtor’s main jobs is to save the client from his own temper/ego/impatience. The Realtor is the buffer, sets the strategy, paces the negotiation and gets the client to closing.	Negotiations: Any investor worth is salt will be a better-than-average negotiator. And if you’re a better-than-average negotiator, then the more intermediaries and middlemen are in the way the more difficult it will be for you to execute a strategy. This is something you should want to do yourself.

Bottom line: your needs, as an investor, are different than Joe Homebuyer’s needs.

There are three ways that Realtors will tend to react to this:

• Offer the same package of “value” that they offer to the general consumer and insist that you pay what the general consumer pays. You’ll get the “my services are worth it” angle from these Realtors. But that’s like arguing that a circular saw is worth fifty bucks: it might be worth that and more, but if the job calls for a drill then you’re paying for the wrong tool. Verdict: wrong answer.
• Offer you the “investor services” that fit the value drivers on the right hand side of the table above, but insist that you pay the same rate that they charge for the suite of services on the left. This is an “entitlement” mentality; the agent feels that his fee isn’t for service rendered, it’s for having his expertise supporting your deal. If you’re an investor this isn’t reasoning that you should accept. You should pay for the time and effort that agent puts into the deal; if you’re doing much of the heavy lifting then you shouldn’t pay the same as the next guy who buys a property once every other decade and needs his hand held through the entire transaction. Verdict: wrong answer.

• Offer you the “investor services” that fit the value drivers on the right hand side of the table above, and charge you appropriately. This…by process of elimination…is the “right answer.”

So, what does “charge you appropriately” mean? You’re the negotiator and so is your Realtor – sit down and work it out!

The article does not take any pains to discriminate between illegal fraud-based flipping and the the perfectly legal brand practiced by ethical real estate investors, but it was an interesting article nonetheless.

So here's a couple of case studies. These are actual situations that I have found myself in - slightly stylized for confidentiality purposes.

Situation A: New tenant applicant with shaky credit 

Scenario:	I had a vacancy coming up on a single family home, and a family who was interested in occupying the property. They were great candidates, interviewed well, and had decent employer references. The problem: shaky credit. The applicant did not appear to be habitual non-payers, but evidently had experienced some events that had damaged their credit score.
Potential Positions:	Negotiating to defend a position is a trap that can limit creativity.  I never rent to tenants with a credit score below____. I only sign leases of one year or longer.
Principle at stake:	I want to minimize vacancies, maximize cashflow, and take risks that are proportionate with the potential rewards.
Solution:	There are many solutions, of course, but here's what I did: My gut told me that this applicant might make a fine tenant.  So I set the rent at the higher end of the market range and signed a six month lease. I required the tenant to pay the first and last month in advance, plus one month’s rent as deposit. This decreases the risk of the deal in a few of ways. Two of the six months are pre-paid. I remained exposed on the middle four months, but this is a significantly lower risk than a standard one-year contract in which the tenant only pays the first month rent (plus deposit) at signing. The new tenant’s ability to produce three months rent (two months plus deposit) as a lump sum before they moved in increased my confidence that they had their financial situation under control. No tenant wants to move in, stick around for six months, then move out. I clearly stated that the six month term was a probation period, and I spelled out in the lease that I would sign a one year extension if they made all payments on time during the first six months. This clearly sets expectations and aligns the parties. Outcome: good cashflow, two months rent upfront, motivated tenant, well-defined exit strategy if things don’t go as planned.

Situation B: Tenant who is unsure about renewing lease 

Scenario:	I had a solid tenant who, at renewal time, was thinking about possibly moving out and buying a property at some time in the near future. The tenant didn’t want to sign a one year lease and asked me to sign a six month lease instead.
Potential Positions:	I only sign leases of one year or longer.
Principle at stake:	I want to minimize vacancies, reduce turnover, and minimize the amount of time and effort that I spend negotiating with tenants.  Meaning: I don't want to go through this every six months.
Solution:	I agreed to a six month lease, but I changed the terms of the lease as follows:  If no notice of termination was submitted by either side, instead of renewing on a rolling month-to-month basis, the new contract stipulated that at the end of the period the contract would renew for another six months, and that the rent would increase by 2.5% at each renewal. Outcome: I reasoned that it was possible that the tenant would leave at the end of the term, but in this case it was more likely that he’d stick around for a while. I didn’t want to be schlepping over there to start this negotiation all over again in six months, especially with regards to rent increases. With this tweak to the contract I created a solution which would allow the tenant to stay as long as he liked (subject to either of us terminating) and hardwired a 5% annual rent increase.

Next, I'll talk about generating creative options - a key tool that you need to have in your back pocket when going into a negotiation. 

Related posts:

• A critical skill overlooked by many Real Estate Investors
• Go light on the adjectives in written negotiations

Here's a bit of language that I insert into all of my rental agreeements:

• The property covered by this agreement is a no-smoking property. The tenants will not smoke and will not permit others to smoke anywhere within the structure. The tenants will be fully liable for any expenses related to cleaning which is necessary due to violating this restriction.

I don't consider myself an anti-smoking stormtrooper, and this is less of a problem these days since there are fewer smokers out there...but having this language included in your lease agreement will help ensure that your tenants step outside before lighting up.  And...your nose will tell you if they're following the rules when you come around for a visit or a repair. 

Or so goes Daniel Gross' reasoning in his new book Pop! Why Bubbles are Great for the Economy.  These trends, especially in America, have provided the audaciousness and courage necessary to create the great innovations of our time. If you're like me then you look back at the dot.com era with a sense of embarrasment about some of the stocks you might have bought, but it was that flurry of excitement and tenacity that spawned Google and other groundbreaking companies. And, as Gross points out, "...it is clear that some bubbles—some, not all—leave behind something that is a little bit boring but extremely useful: infrastructure." When the NASDAQ collapsed in 2002 it didn't just leave a black hole behind.

It remains to be seen how this phenomenon will pan out for the real estate sector. The days of buying a starter bungalow for $500,000 and flipping it a month later for $650,000 after throwing on a new coat of paint are probably behind us, but the roller coaster has breathed a lot of life into the market. Bad business models have blow up (New Century Financial proved to all of us that pitching negative amortization 40 year mortgages to cliens w/ shaky credit wasn't such a great idea after all) but in it's wake we should see greater transparency and smarter decisions by self-interested businesses. And the emergence of companies like Redfin will be welcomed by real esteate clients in general, and investors in particular.

Buy-and-hold real estate investors should bear this principle in mind when it comes to dealing with tenants. At the end of the day you are a service provider and the tenant is your client. Good tenants are a key component in your long-term investment strategy. That said, it’s important to realize that you have a leadership role in maintaining the landlord-tenant relationship.

The desired endgame is a happy tenant who is content with the property, stays long term, and who willingly agrees to fair, periodic increases in rent which are in line with inflation and the local housing market.

I always look at a new tenant as a great opportunity to shape a desired set of behaviors that will make my life easier, and will also make it easier for me as a landlord to provide a quality service to the tenant. In my opinion the following are the “big four”:

• Pay on time
• Take care of the property
• Alert me early about small problems that will turn into big problems (evidence of a roof leak; a problem with the air conditioner)
• Refrain from bothering me about small problems that will stay small and that the tenant can safely tackle himself (a toilet that runs, a burned out fuse, a leaky faucet)

The four desired behaviors in the bullet points above should be objectively laid out in your lease agreement, but in practice I’ve found that there are shades of gray in managing them, as there are in all human interactions.

Let’s look at each one in turn:

• Pay on time: The average person has a lot of financial obligations placed upon them every month. Telephone bill, gas, car payment, entertainment, and a myriad of other priorities compete for the tenant’s paycheck. Your job is to show them that every month paying the rent is in pole position when it comes to prioritizing. Your tenant’s mindset needs to be: it’s annoying to have my cell phone disconnected, but late rent payments will result in my eviction. But if your tenant views the phone company as the real priority she’ll start turning to you for a little slack when she’s having a touch time making ends meet. Once you let this happen one time you risk establishing a habit that will be impossible to break. This is an area where you need to be consistent and tough.

• Take care of the property: You can do some role modeling in this category before the place is even rented out. Be meticulous with cleaning the property before you show it. Take care with the landscaping. Show that you care about how it looks. If you show a property that is dirty and unkept you will be sending a clear message that you don’t care about it. And if you don’t care about it why should they?

• Alert me early about small problems that will turn into big problems: A water stain on the ceiling or a weird sound out of the AC unit should prompt an immediate phone call. And you can encourage this by acting immediately when they call. This is in your best interest. You want to catch a roof leak before it causes major damage (or, heaven forbid, causes a mold problem.) Note that these calls should be rare. If they’re not then it’s likely that you have a deferred maintenance problem.

• Refrain from bothering me about small problems that will stay small: This is a tricky one, because it is, to an extent, the flip side of the point above. You want to get a phone call when the tenant expects that a major problem has arisen, but you don’t want to be getting a call every time a knob on a kitchen cabinet comes lose. One way to deal with this is to ensure that there is a provision in your contract stipulating that the tenant will be responsible for the first $____ of any repair that you make on the property. I generally set this at $100 using standard language from the Texas Association of Realtors lease agreement: The Tenant will pay Landlord or any contractor Landlord directs Tenant to pay, the first $100 of the cost to repair each condition in need of repair, and Landlord will pay the remainder...

Related posts

• Send your tenants to the bank
• Act early on mold problems

Software, however, is not a panacea; it’s a tool to help you make good decisions but it won’t turn bad investors into good ones. In the past I’ve written about the information hierarchy:

_{DATA => INFORMATION => KNOWLEDGE}

We hear lots about the “information age” and the value of information, but not everything that we term as “information” is equal. There’s lots of data out there: listings, rental rates, interest rate forecasts, data on fees and taxes. This stuff is only useful when we can process it into something that gives us insight – turn it into information. Mastering that process will generate the knowledge that investors need to make good decisions.

Real estate investment software is a tool to turn data into information. What you do with it after that is up to you. The following is a summary of what you can expect real estate investment software to do for you…and (more importantly) what you shouldn’t expect it to do for you:

In summary, Real estate investment software can be useful for:

 Ivestors who want to quantify their decisions

• Investors who need a convenient way to save and compare opportunities
• Investors who want to add some rigor to their thought process
• Investors who want a checklist of variable to consider in the analysis
• Real estate professionals who want to present ideas to investors
• Investors who want to present ideas to sources of funding (hard money lenders, banks, etc.)

Real estate investment software is probably not suitable for

• Investors using advanced creative financing techniques or executing complicated deals
• Investors who are comfortable building their own cashflow/analysis models in spreadsheets.

Excerpt from a Commonwealth of Massachusetts press release:  In an ongoing response to the state’s foreclosure crisis, Governor Deval Patrick today directed Commissioner of Banks Steven L. Antonakes to seek delays from mortgage lenders, on a case-by-case basis, for any Massachusetts homeowner who has filed a complaint with the Division of Banks as part of their consumer assistance outreach efforts.

The Massachusetts Attorney General has framed this announcement as a measure to "combat predatory lending practices", but some media outlets have declared the move to be a "moratoriam on foreclosures." 

Note that Governor Patrick's press release emphasizes the "case by case" nature of the measure.  As written it would appear that the measure may be largely symbolic, but in practice placing a new bureaucratic hurdle in the foreclosure process may materially impact the risks that mortgagee banks assume.  This, on top of the ongoing subprime debacle, may continue to pull liquidity out of the market and if left unchecked will have the effect of increasing costs to borrowers and lowering the availability of funds.  This, I'm sure, is not what the government and community groups had in mind. 

The government should move aggressively to identify and prosecute companies that illegally engaged in predatory lending tactics, but new regulations are not the cure for what ails this market. 

For the unitiatied:  a Blog Carnival is regularly scheduled event in which bloggers submit posts on a particular subject.  The carnival will be hosted by different blog authors on a rotating basis. 

Here are a few carnivals that I follow, and occasionally submit to and host.

• Carnival of Real Estate Investing:  Posts relating to real estate investors.  The most recent version was hosted by House Wealthy. 
• Carnival of Personal Finance:  Posts here cover a wide spectrum; from investing to wealth building strategies to debt reduction.  The most recent version was hosted by We're in Debt. 
• Carnival of Real Estate:  All things Real Estate, with a particular focus on real estate professionals (primarily Realtors).  The most recent version was hosted by Pat Kitano at Transparent Real Estate. 

Check out the main Blog Carnival page and you can find a carnival for any topic under the sun. 

Note:  you'll find some interesting stuff at the various carnivals and discover some good new writers.  You'll also find some bad posts with bad advice.  This is the internet: be a discriminating consumer of information. 

The answer, of course, will depend on your resources, your risk appetite, and your goals. But for investors who still have a fair amount of runway ahead of them before they hit retirement, most comparisons fail to highlight the true benefits of investing in real estate. 

The bottom line:

Over the long run, the stock market has yielded great returns. From 1987 to the present the S&P 500 has appreciated at an average rate of almost 10% per annum, and the NASDAQ has averaged over 11%. Over the same period the average home price in America has increased at around 5.6 percent. 

This is the comparison upon which many analysts focus. One dollar invested in real estate in 1987 would be worth around $2.84 today. That same dollar would be worth $5.74 or $7.31 were it invested in the S&P 500 or the NASDAQ, respectively. But this is the whole picture

Volatility: Real Estate Bubbles vs. the Stock Market

We’ll get to leverage in a moment – that’s where these conversations inevitably lead. But the first thing to consider is volatility. 

Yeah - we know that stocks yielded an average of 10% to 11% over the past twenty years or so, but how did we get from point A to point B? Investors will remember the period from 1999 to 2002 which were rough years for the sock market. From its peak in August of 2000 to the bottom in September of 2002 the S&P 500 lost over 40 percent of its value. Over roughly the same period the NASDAQ declined by a whopping 75 percent. Eventually the market managed to shake off these doldrums, but this was a tough period for investors. 

Real estate has hit some hard road bumps too. It’s interesting to compare the severity of regional real estate downturns with the stock market collapses listed above. Global Insight periodically releases a study of market valuations in which they list, among other things, a summary of major past price corrections. The most severe being associated with the oil bust in the ’80s; fellow Texans will remember this period.

• Lafayette LA, declined by 35% over 15 quarters
• Odessa TX, declined by 28% over 18 quarters
• Abilene TX, declined by 28% over 11 quarters

All three of these markets were significantly overvalued before they fell. The lesson here being: what goes up must come down, and investors who live in regions characterized by overvalued markets have reason to be concerned. 

If you live in certain parts of Florida, California, and other overheated regions of the country, this means you.   But for the rest of you: note that the three historical cases above are the worst of the worst. There never in recent history has been a major national correction in real estate prices, and most regions have experienced continuous growth in property values for decades. Watch out for regional markets that have been spiked into a speculative frenzy - but overall, volatility in housing prices is low.

It doesn’t make sense to talk about leverage without first talking about volatility. You can use leverage to turbo-charge the returns on about any investment, but high volatility usually makes leverage prohibitively risky. 

Not so with real estate.

Aside from a handful of regional exceptions notwithstanding, real estate prices historically have marched steadily upwards at a steady 5.6 percent per annum. Factoring in leverage this return ratchets up to over 13% per annum; considerably better than stock market returns at lower volatility. 

What is leverage?

Simply put: a dollar invested in stocks buys you one dollar’s worth of stock. But that’s not the way we buy real estate. A typical investor might put $20,000 down to buy a $100,000 home. So instead of getting one dollar’s worth of house for your one dollar investment you’re getting control over five dollars worth of house. 

That’s 5:1 leverage. One buck from you, and four bucks from the bank. 

That $5 invested in the housing market in 1987 would be worth around $14.18 today. Assuming that you hadn’t paid down any of the mortgage your $1 investment would be worth $10.18. Compare that against the $5.74 that your S&P 500 investment would be worth or the $7.31 that your NASDAQ would have netted. 

The upside...

I’ve made some simplifications, but overall they’re conservative ones:

• Dividends and rental cashflow. I left ‘em both out of the analysis. But any property that you’ve had for twenty years will be raking it in cashflow-wise, whereas corporate dividends these days are pretty skinny. Advantage: Real Estate.
• Paying down the mortgage. Back in the late '80s interest rates were hovering around 10% (gasp!). At this rate a standard fixed 30 year mortgage would have paid off around 30% of its principal balance over twenty years. That’s another advantage that I haven’t included in the comparison. Advantage: Real Estate

Timing can be important and in some regions now isn't the best time to be jumping into the market, but over the long term it's hard to argue that real estate doesn't have a place in your portfolio. 

You might have heard about the event at NASA which got some national coverage.  But unless you live in Houston it’s unlikely that you heard about a second killing, in which a tenant who was on the verge of eviction killed the property manager at the apartment where he lived.

The second event was the one that really got my attention.

Stop for a moment and think back on how you thought about landlords before you became one.  From the point of view of the tenant, you, as a landlord, are in a position of enormous power and authority.  It may not feel like it at times - especially as you’re wrestling with taxes, eying interest rates, and dealing with contractors – but you are in control from the vantage point of the families who live in your houses.  You own the walls that surround them, the roof over their heads, and provide the shelter that keeps them safe.   

You invest in real estate in order to secure your financial future.  And if you’re like me then you’re into real estate because you enjoy negotiating, you like crawling around under houses, and you’re into making deals.  But in your rush to build equity and wealth don’t forget about the lives that you touch every day – meaning: don’t be cavalier with the influence that you wield. 

This is a reminder that being consistent, clear and fair with your tenants is a key to building good relationships.  And building good relationships is an important key to being a profitable buy-and-hold investor. 

But sometimes that isn't enough.  The one thing that all of these instances have in common is that the perpetrators were mentally ill.  Dr. Peter Marzuk, associate professor of psychiatry at New York-Presbyterian/Weill Cornell points out some warning signs in a recent ABC news interview, including:

• Past history of violence
• Loneliness and social isolation
• Stalking and other antisocial or criminal behavior
• Paranoid behavior

Pre-screen your tenants well.   And even after you've done your due diligence trust your gut.  If you feel that you’re in danger then listen to your instincts.  As Malcolm Gladwell explains in his excellent book Blink, we sometimes know things even when we don’t know why we know them. 
 
Note:  The strange thing about this post is that I actually sat down with the intention of writing something funny to comply w/ Pat Kitano’s call for funny submissions for the upcoming Carnival of Real Estate.  But for some reason this is what came out.  Oh well; maybe I'll be able to write something funny tomorrow.  But to lighten it up a bit here’s a funny clip.  I’m told that I’ve been living under a rock and everyone in the universe has already seen this, but I just saw it yesterday and thought it was hilarious. 

Here are a few cool sites by real estate investors who are out there making it happen, and who are using blogs to chronicle their experiences. 

• Check out I bought a duplex.  A young woman late-20's talks about her adventure in landlording and real estate investing. 
• Follow a Texas investor's experience from December '04 to today at My Real Estate Investing Venture. 
• The Successful Landlord Blog follows the experiences of a landlord in Melbourne Beach, Florida. 
• And you can find everything from newbies to grizzled veterans at the Creative Real Estate Online Forum - a great place to hang around and get a new idea or two. 
• Tenants will do the craziest things, and they've seen it all over at Tenant Tales.  Entertaining reading. 
• I like Shaun from Arizona's description of his site as meant for people who want to get into this investment area but need some encouragement, help, or just a general push in the right direction.... you'll see it's really not that difficult or scary.

I have a lot of respect for investors who put their experiences, successes and and mistakes out there for others to learn from.  Visit their websites and see what you think 

 April 25th:  Omission - I forgot Fred de la Riva's excellent Working with Real Estate Investors.  A great resource, especially for real estate agents who want to specialize in investor clients. 

 The characters

	the Investor is played by Christopher Smith
	the Lender is played by Wells Fargo
	the Insurer (aka, the Villain) is played by a Houston based Farmers Insurance Agent 2

The setting: 

The Investor makes a New Years Resolution to sell a high-end rental property and use a 1031 exchange to reinvest in a multi-family property.  He sells property the property to the current tenant and identifies a fourplex to buy, negotiates a deal, and heads to closing. 

Act I:  Week of closing

The Investor calls the Insurer for a quote.  The Insurer provides a written Farmers quote.  The Investor accepts the quote and asks the Insurer to proceed and provide coverage.  The Investor calls the Insurer several times to ensure everything is in place; the Insurer assures the Investor that everything is in order.  The Insurer says they're having some problems getting the printout, but not to worry. 

Act II:  The closing - Friday the 13th of April

At closing the Lender calls the title company to inquire about the insurance binder, which hasn't been received.  The title company calls the Insurer.  The Insurer gives verbal confirmation of coverage.  Based on verbal confirmation the Lender instructs the title company to proceed with the closing. 

But…drumroll…it turns out that the Insurer had quoted the Investor in error, but for some reason doesn't want to admit his mistake.  Farmers, as it turns out, is not writing coverage for multi-family properties in Houston. 

Instead of admitting his mistake, the Insurer scrambles around to find a quote from a third party carrier but doesn't tell the Investor; he just tries to slip a revised invoice to the title company after the closing - considerably more money for less coverage. 

However, the Insurer takes no steps to bind the policy.  None of the paperwork is in place.  Based on the Insurer's fraudulent statements the property closes with no insurance in place. 

The Investor now owns the property, but unbeknownst to him (and the Lender) there is no coverage. 

Act III: The cleanup

On Wednesday of the following week the Investor gets a call from the Lender.  "Hey man," the Lender states, "you need to call your insurance guys."  So the Investor calls the Insurer.

the Investor:	Uh, what's up with my insurance?
the Insurer:	Farmers isn't writing policies in Texas.
the Investor:	Okay, closing was five days ago, why didn't you call me?
the Insurer:	Well I sent some forms to the title company.3
the Investor:	Ok, whatever.  Is the property insured?
the Insurer:	Yeah, it's insured with South Texas General
the Investor:	Can you give me their phone number so I can confirm?
the Insurer:	I don't know their phone number.
the Investor:	Goodbye

Investor finds South Texas General in the phone book and calls them.  They have nothing on record.

The Investor gets insurance with another carrier on the 18th of April, five days after closing.

 --------------------

The moral of the play: 

We like to assume that representatives of major companies will behave like responsible, ethical professionals, but sometimes this is not the case. In order to avoid revealing his mistake, the Farmers Insurance agent wove a web of lies over a five day period which resulted me assuming a huge risk. 

Had a fire occurred during the uninsured period I would have entered a hellish maze of he-said-she-said which would have made a bunch of lawyers a lot of money.  Something seemed fishy from the start; had I followed up more aggressively I would have uncovered one of the agent's lies at an earlier stage.

Footnote ¹:  This of course is a stylized account of the course of events, but my official complaints to Farmers Insurance and to the State Insurance Regulatory Agency will document the Agent's fraud in explicit, meticulous, gory detail, along with supporting witnesses. 

Footnote ²:  I debated long and hard about whether or not to reveal the name of the Farmers Agent on this blog.  In the end I decided not to.  If you're a Houston based investor and want to steer clear of this guy then send me a note via the contacts page. 

Footnote ³:  In the text above I didn't list all of the false statements that the agent made.  This is just a sample of one.  And no, the agent didn't send any forms to the title company. 

The baton passes to EquityScout.com for this week's Carnival of Real Estate Investing. 

The real estate investing muse must not have been in full swing this week and the carnival didn't get a lot of submissions.  We've been having some beautiful spring weather here in Houston, so if other areas are getting a taste of this as well then perhaps it's getting some bloggers away from the keyboard.  Not a bad thing, in my book. 

But what this edition lacks in quantity it makes up in quality:  Two Bloodhounders, an insurance warning, and a couple of tips for newbies. 

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That's it for this week.  Got a post you want to share?  Submit it to next week's carnival.   And you can check out past editions on the    blog carnival index page.

Set up a business checking account.  This is a step that the majority of readers will already have taken.  Sign up for online access.

Set up a second account earmarked especially for deposits, and link it to your first account.  Most major banks will allow you to do this; from personal experience I know you can do it with Citibank, Bank of America, and Washington Mutual.  

Print a book of deposit slips for each unit that you own.  Bank of America allows you to customize the slips, which lets you put the property address on each slip.  

When you sign a lease with your tenant give him or her an appropriate number of slips along with their copy of the lease (12 slips for a 1 year lease).  Instruct the tenant to deposit directly to the bank. This can be done either by going to the counter, going through the drive-through, or mailing to your branch attn: DEPOSIT.

On the first of the month go online and check your deposits.  As they arrive transfer them from your deposit account to your main account.  

• Safe. It all works because the tenant never has your primary bank account number.  The tenant only has the deposit account number, and you’ll keep this account at a zero balance by transferring the deposits to your primary account as they come in.  
• Easier recordkeeping. This method creates an effective electronic paper trail.  You can view/print/save the scanned pdf’s of the deposit tickets and checks online from the conveninece of your desk.
• Convenient for the tenant. Bank of America is big here in Houston w/ over 350 branches.  Choose a branch that gives your tenants lots of options.  Plus – they’ll walk away each time with a deposit confirmation, which gives a bit more peace of mind than dropping a stamped envelope in the mail.  

A last hitch was getting the place insured, and to my surprise I found a dearth of companies willing to quote me a rate.  Here in a nutshell are my experiences.  Note that insurer rules and policies vary from state to state, but here's what I ran into trying to get a policy for a fourplex in Houston:

	Nationwide:  was willing to make me a quote for a policy, but required me to switch the insurance policy for my primary residence to Nationwide as a prerequisite.  I'm happy with my current insurer (USAA) so this was a non-starter.  No quote.
	Allstate:  The "good hands" people.  Refused to insure any property with galvanized plumbing.  This property has been thoroughly rennovated, including much of the plumbing - but the building was built in the '30s, which essentially insures that there is still some of the stuff around.  No quote.
	State Farm:  Agent informed me that they consider a four-unit multi-family residence to be an apartment - meaning: commercial.  The agent referred me to a relative of his who got me a quote from a small carrier which was prohibatively expensive. .
	USAA:  I've used USAA before and have generally been hapy with them.  But unfortunately there is a limited number of non-owner occupied properties that they're willing to invest for any individual, and I'm already maxed out.  No quote.
	Farmers:  Gave me a fast on-the-spot quote over the phone at a good rate. ***see update, below

So the winner: Farmers. I'm a new customer.   ****  Update:  See below

Lesson:  I waited too late in the game to take care of this so I caused myself some unnecessary stress.  Do yourself a favor; start early and give yourself some slack time. 

**** April 18th Update - Farmers: run for your life.  I'm in the middle of a post-closing horror story that I'll write about soon (when I have time).  But consider this an official revocation of the blue ribbon that I'd awarded Farmers.  Stay tuned...

In recent posts I expressed frustration with USAA's mortgage service. First for a $50 fee per-property for pre-approval (I was negotiating on three properties, so the agent quoted me $150), then for their $350 fee to take an application and lock in a rate.

I don't believe in hogging the mic here at EquityScout, so it's only fair to give equal airtime to the response that I recently received from Chris Sandoval at USAA:

 Hello – this is Chris Sandoval with USAA. In addition to seeing your recent posts about USAA, we also received your letter detailing some pretty frustrating experiences you’ve had with USAA. I wanted to get in touch with you and your readers, and your blog seemed like the quickest way.

 

It looks like you have two main concerns stemming from your recent interaction with USAA:

 

 - A $50 fee to receive a mortgage pre-approval.

- A $350 application fee for a mortgage pricing quote.

 

 Regarding your first concern, we do collect a deposit to provide a true credit-approved pre-approval if you choose to do so over the phone – we do not collect this deposit when members seek a pre-approval on usaa.com (which most of our members choose to do). This deposit is applied toward a member’s cost when they close their loan with USAA.

 

 Regardless of whether or not you used our online pre-approval process, you would not incur a $150 charge for three pre-approvals. When we pre-approve a member, we approve the member’s credit in general. If I understand your situation correctly, you requested pre-approval for three properties by contacting us on the phone. This process should have incurred only one $50 deposit - again, the pre-approval process does not incur this deposit at usaa.com. I apologize if we did not accurately convey that to you at the time.

 

 In response to your second concern, members do not have to submit an application or a $350 fee simply to obtain a pricing quote. When members choose to apply for a mortgage with us (not when they ask for a quote), we do collect a $350 good faith deposit that is credited toward their costs at closing. This sort of deposit is common in the industry and is sometimes known as an appraisal fee or underwriting fee. Again, I apologize if we provided you with inaccurate information.

 

 I hope this information helps clarify some of the confusion caused by your latest correspondence with USAA. If you have any further questions, please don’t hesitate to contact me. Just log into usaa.com and use our secure message feature: click "Contact Us" and then click "Email Us." Start your message with "Attention Chris Sandoval, eCommerce" and paste in the URL of this blog post. I’m more than happy to help with any other questions you may have.

 

While we failed to win your recent mortgage, we value your business and the opportunity to serve all your financial needs.   ### end message

• No fee for online pre-approval; USAA only charges for pre-approvals given by phone. Fair enough, but the competition doesn't charge me to talk to them on the phone. This is an annoying policy and isn't investor-friendly.
• The $50 fee should have been a one-time charge instead of three seperate fees applied against three seperate properties. Again, not happy about paying a fee for a representative's phone time, but a one-time general fee is much more investor friendly than having to pony up for each property considered.
• No fee to "obtain a pricing quote." I'm going to interpret this to mean that USAA will be willing to give me a firm rate at no charge. Note that this isn't the story I got from the representative, who told me that she couldn't give me a firm rate unless I paid; that she could only give me a general idea.

I picked this up from the guys over at Selsius.  Tired of automated directory hell?  Don't care how to get instructions in Spanish, or that the menu has changed recently?  This service is a universal secret decoder ring for getting straight to a human being. 

• No comps: I’m buying an updated four-unit complex in the trendy Montrose section of Houston.  There basically are two types of properties that you find in the comps: teardowns and new construction.  The building that I’m buying was originally built in the ‘30s, but has been updated with new wood floors, central air conditioning, a raised outdoor deck, and a number of amenities that make it a rare building.  Which means: there’s nothing to compare it to. Which in turn means: you have to trust your numbers because there’s really not much of a “market”. 
• Time pressures: The sale side of the 1031 was triggered by my selling the property to the tenant who I was renting to.  This was fortuitous in that I avoided vacancy, sales commissions, and all of the other hassles and expenses that are associated w/ marketing a property, but it also happened a bit quicker than I had expected – which meant that  I needed to be expeditious in my search in order to identify a replacement property within the IRS mandated 45 day window. But nothing like a deadline to keep you from getting paralyzed by the analysis. 
• Challenging negotiation: The goal of a negotiation is to efficiently reach a wise agreement in an ethical way.  This is easies when there is some alignment of the goals of the two parties and they negotiate directly. Well in this case the “alignment” part was potentially there. But the other elements weren’t. First: both the sellers and I were using agents – that in itself injects two additional degrees of separation into the negotiation, which makes effective communication more difficult. Add to this the fact that the seller was not a single individual; the property was owned by a group of three physicians who had teamed up on the investment, and who, based on their disjointed and confusing responses, had conflicting agendas. Messy. Once I get this deal tied up I’ll write about how some of the Getting to Yes principles helped keep the deal from stalling. 

But...looks like we're close to the finish line on this deal.  And appropriately, the deal is set to close on Friday the 13^th.  Not that I'm superstitious or anything...

• What does this mean to me? Gibson was ham-fisted in his response to this crisis, but in the end he was negotiating from a position of power. If you put your foot in your mouth while you’re holding a good hand then it might pay to concentrate on landing your next success instead of dwelling on the mess you’re in. 

• What does this mean to me? I think I’m a smart enough guy, but when I can choose between relying on being smart and being prepared I’ll choose the latter any day of the week. Be ready to think on your feet if you need to, but in high stakes situations it pays to spend some time beforehand getting your strategy straight. In their negotiation masterwork Getting To Yes Fisher and Ury call this “generating creative options.” Think ‘em through beforehand and have them in your back pocket if you don’t want to look like Michael Richards stumbling through his ad-lib on Letterman. 

• What does this mean to me? Gibson followed up his disgraceful tirade with a box office smash and may be on his way to redemption. Richards, on the other hand, will probably never land another acting gig. Imus was smart enough to realize his situation was a bit closer to Richards than Gibson, and he acted accordingly – so this will likely be a temporary humiliation (a la Gibson) than a death sentence like Richards.  When you're in trouble, pretending like everything is ok doesn't work.  Act. 

------

Follow-up ::   Hmmm....well in hindsight it looks like I got that little detail about Imus being on the road to redemption kinda wrong.  Guess my crystal ball wasn't working too well.  But you can't get 'em all right...

• As to the Adjective: When in doubt, strike it out.  Pudd'nhead Wilson, 1894
• God only exhibits his thunder and lightning at intervals, and so they always command attention. These are God's adjectives. You thunder and lightning too much; the reader ceases to get under the bed, by and by.  Letter to Orion Clemens, 1878

• A critical skill overlooked by many Real Estate Investors

As a sidenote: I always find it odd that companies don't clean up their website when they end up in this situation.  You can still find out about New Century's groundbreaking products and even apply for a job of you're so inclined.  Go figure. 

Negotiating is a core skill which real estate investors must master in order to be successful. Negotiating a successful purchase or sale is only the start; other negotiations are just as critical, and many are significantly more complicated. Consider the following:

•  You need to increase the rent on one of your units but want to do so without damaging your long-term relationship with a reliable tenant.
• You need to get a lower rate from a trusted contractor on a rehab job in order to stay under budget.
• A loft that you own belongs to a homeowners association which wants to replace the roofs on all of the units in the complex, requiring all of the owners to pony up. Most of the other owners support the measure, but you've calculated that it's not in your financial best interest.
• Your tenant has just purchased a new home and wants to break his lease, which would create an unexpected vacancy for you.
• Your tenant is pressuring you to make some renovations to the unit that they’re renting, but you feel that it’s already fairly priced for the current condition. 

These aren’t hypothetical situations; they’re a sample of specific issues that I’ve had to deal with over the course of the past several months. 

When placed in these positions people tend to take one of two routes. The hard style: we’re playing hardball so it’s my way or the highway. The goal is to win. And the soft style: the goal is agreement, be flexible and compromise. Like Rodney King said – can’t we all get along?

Well both of these approaches are sub-optimal. The hard guy wins a few battles, but in the end he loses the war.  He grinds his relationships into powder, walks away from good deals, spends lots of time in court, stresses himself out and damages his business. The soft guy keeps his relationships intact, but often ends up getting taken to the cleaners.  

There’s a third way. In their seminal tome Getting To Yes Roger Fisher and William Ury outline an approach which they call principled negotiation - negotiating based on principles as opposed to staking out positions to be either defended or yielded. Getting To Yes is one of those books that I re-read every few years, and it’s guided me through all of the situations I mentioned above in addition to helping me in my day-to-day life. Everything we do, essentially, is a negotiation. Gonna ask your boss for a raise? Or perhaps your employees are going to ask you for a raise. How about setting your kid’s allowance, or deciding where to take the family vacation. In all these cases you want to efficiently get to a wise decision which concludes amicably. 

This is a book that I recommend to real estate investors. In future posts I’ll be referring to some of the principles in this book and how they apply to situations which investors face. 

• Getting to Yes by Fisher and Ury at Amazon.com

Concerns about flatting property prices tend to get the most press time, along with the ongoing sub-prime lending soap opera. And we’re all keeping an eye on interest rates and hang on Bernanke’s every word. But in my opinion the real story will be how all these factors impact all those risky loans out there, and this is a die that has yet to be cast. 

First American CoreLogic recently released a study on Mortgage Payment Reset and the potential impact that it will have on our economy. Note that First American CoreLogic is an arm of First American – and many visitors will be familiar with First American Title, one of the nation’s largest Title companies. The point being: just like the National Association of Realtors the title industry has a dog in this fight so be careful about taking all of CoreLogic’s conclusions without a bit of scrutiny. But that said, there’s a lot of good data in this report. 

Here’s something that jumped out at me. In 2006 lenders issued $200 billion in ARMs w/ their first reset in 2006. Of that $200 billion worth of quick reset mortgages the vast majority was at super-low teaser rates of less than 2%. Seemed like a good idea at the time: rising prices and brisk home sales made the risks easier to stomach.  Now that market has cooled those 2006 resets are causing problems for many buyers who were overstretched in the first place, and that’s what’s triggering the current wave of foreclosures. 

But, there’s more to come. Most of the ARMS originated in 2006 w/ 2008 resets ranged from 6% to 9% initial rates. Sub-prime territory. And these folks, based on CoreLogic’s assumptions, will be facing increases of from 30% to 50%. The second half of this story is that 23.9% of ARMs originated in 2006 have negative equity, versus only 10.3% of fixed rate loans taken in the same period. 

So not only were ARMS used by the most vulnerable buyers, they were also more than twice as likely to be used for properties in which the owners had no equity. The punchline: during the run-up ARMS were used as an instrument to buy homes that people couldn’t really afford. 

The New York Times ran an interesting article today advising those homeowners who are about to get into trouble to negotiate with their lenders. Many owners don’t realize what we do as real estate investors: the bank doesn’t want your house. Foreclosure is a disaster for the homeowner, but it’s no picnic for the bank. Expect troubled owners to take a page out of the short-seller’s playbook.

Well I decided to give 'em another chance.  I actually want to be a USAA customer.  I've been with them for seventeen years.  So now that I have a property under contract I gave them a call for a quote.

Yeah, they'll quote me a rate.  But first I'd need to fill out an application for a $350 fee.  And if I don't like the rate?  That's fine - I could simply go with another lender and they'll keep my $350.

What?

So unfortunately this is the second and last strike for USAA as a mortgage lender (this ain't baseball).  Was hoping to be writing a happy post about how the company that serves our nation's servicemen and women came through in the end, but unfortunately it wasn't meant to be.  Oh well.   Looks like I'll be going with Wells Fargo (who I've also done business with in the past, and who treats me like a repeat customer.)

Note: I got a much cooler poll widget from Pat Kitano than the one I was previously using, so I'm trying it out.  If you voted previously it's been deleted, so feel free to vote again.  It's neither fair nor scientific, but hey this is just a blog.  Don't demand a recount. 

Related Posts:

•  Bernanke & Co. shrug at the sub-prime meltdown
• More woes for the sub-prime mortgage market :: What it means for investors
• Sub-Prime lenders take a hit

Also, be aware that the website sells courses (many costing hundreds of dollars) which I categorically don't recommend - so don't take this post as an endorsement of anything that they're selling.  But make up your own mind, and I'd be interested in any feedback that anyone might have. 

• Reference to inflation concerns:  check
• Reference to housing market concerns: check
• Reference to economic expansion: check

Notably absent: any reference to the ongoing meltdown in the sub-prime market.  Perhaps they're simply trying to avoid throwing more gasoline on the fire, but the non-cynical view is that the sages at the Fed just see this as more noise in the data. 

For now investors should still be concerned that the fall-out of the sub-prime train wreck might hit the low end of the market as liquidity dries up and pulls buyers out of the market...but...

...it remains possible that this shake-up just weeds out a few of the more aggressive of the sub-prime lenders - bad apples with flawed business models.  Like a forrest after a fire the system as a whole will be healthier after the purge, and  the surviving companies will hop in to pick up the slack.  To be determined...

Check these two sites out. And if you’re interested in the interview you can listen in the player below. 

I’m in the middle of a 1031 exchange – selling a property and putting the proceeds into a tax deferred account to invest in another property. I’ve done the sell part, now I need to buy something. 

I put offers in on three small multi-family properties this week and needed pre-approvals to submit along with the contract. So I called USAA. The fee to fax me three pre-approvals: $150 bucks. $50 bucks per property, which would be refunded only on those contracts that closed and were financed via USAA. 

I called PHH mortgage. They took my info and faxed me the three pre-approvals for free. And fast.  I’ll do the loans with them. 

Strikes me as peculiar that USAA would chase off a customer w/ great credit and a seventeen year track record. I wrote them a letter of complaint; I’ll let you know if I get a response.  

Well the first part of that mission has been accomplished; I sold the property, a three-story townhouse loft.  And what does that have to do with the headline on this post?  Well it highlights a couple of things that investors often overlook when screening for tenants.

1 :: Your tenant is a potential buyer.  I ended up making this sale to the tenant who was in the property.  This has some major advantages. 

Easier and cheaper for you :: No vacancy period.  No showings.  And no real estate agent – which means no commission. 

Easier and cheaper for the buyer :: No relocation costs, no inconvenience of moving

When the stars line up like this it tends to make it easier for the two parties to negotiate mutually beneficial terms.  So when you’re screening your tenants give extra points to applicants who might be potential buyers.  Note: (I’m not a rent to own fan – I’ll talk about this an another post soon.)

2 :: If you’re using a real estate agent to find a tenant make sure there’s not a clause in the contract which stipulates that she can come back and demand a commission in the tenant decides to buy the place from you in a year or two.  This is a flat non-starter for me.  If your agent demands that this is included then find someone else.  Going rate for placing a tenant here in Houston is one month’s rent – fair enough – but I don’t expect to pay the agent a big windfall in a year or two if I manage to build a relationship with the tenant and later negotiate a sale. 

Note:  as an investor you want to work with an agent who values your repeat business, not one who is trying to squeeze every cent out of each deal that you do.  Got a good agent (like I do)? Well share and let other investors know. 

Another new feature is our preferred vendor page.  One benefit of the proliferation of blogs dedicated to real estate services is that we can get acquainted with service providers around the country.  Interestingly, we don't run into too many who focus on real estate investors - but when we run across a professional who shows some insight we'll put 'em on this list.  So check it out, and let me know if there's someone that you work with that makes your life as an investor easier. 

This, as it turned out, was not a buying opportunity; in fact it was only the start of the bad news.  Today New Century came out with statements which draw into question the company’s future viability.  Wall Street responded decisively, further selling off the company’s stock and driving it down to the low single digits.  Failure to meet filing deadlines may trigger repurchase obligations with New Century will be unable to satisfy, an event that could send the company into a death spiral.  

This isn’t a good sign for the economy in general, and the housing market in particular.  If (when) New Century goes down there will be considerably less liquidity in the sub-prime mortgage market which will cut off many potential buyers from the credit they need to buy a home.  This could lead to lots of things that may not be music to investors’ ears: fewer buyers, higher interest rates, downward price pressure.  

So what does it mean to me?  This is bad news for investors w/ shaky credit who jumped into risky mortgages with the expectation of refinancing later on.  If this sounds like you then look out – that bank that was eager to put you into an Option ARM last year might not be so eager to refinance now.  It’s going to get worse; if you’re in a mortgage situation that you’re not too crazy about then now is the time to do something about it.  

Aside from the obvious social and economic costs to the landlord, a meth lab has a particularly destructive impact on the building where it is housed.  Toxic chemicals can permeate any porous surface: drywall, wood floors, carpet, ceilings – practically all of the materials that go into building a house.  

The best case is that this will turn into a nasty cleaning bill.  Worst case – depending on how long the activity was going on – is that your rental property becomes a teardown candidate.  

A meth lab isn't the only type of illicit mischief that your tenants might be getting into; I'm sure you could come up with a list of shady activities that that would make you life difficult if you were to make the mistake of signing a lease with a bad apple.  But in many ways criminals aren't too creative, so there are some patterns that may tip you off that something bad is going on in there.  Here are four things to look out for:

• 1:: Tenant pre-pays rent: six months or even a year.  This is a tough one.  Investors know that cash is king, and it’s tough to turn down a big pre-payment.  But be aware that there may be a darker motive.  By paying several months in advance the tenant may be sending you a signal that you don’t need to come around for a while.  Not all pre-payments are sinister in nature (I’ve accepted prepayments before) but when an applicants offers it should cause your antenna to go up.
• 2:: Tenant pays exclusively in cash: Again, cash is king – but resist the temptation to look the other way.  Nuff said.
• 3:: Lots of traffic at odd hours:  You’ll notice this if you live nearby, but you might not if you don’t.  That is, unless you make an effort to – which you should.  
• 4:: Tenant never contacts you:  I don’t get a lot of calls from my tenants, so it’s not like my phone is ringing off the hook in the middle of the nights or I’m schlepping around unclogging toilets.  Far from it; well maintained investment properties inhabited by responsible, well screened tenants are very easy to manage and require very little of my time.  But that said – every blue moon I’ll get an inquiry from even the lowest-maintenance tenant I have.  Be suspicious of a tenant who never ever calls you, not even once.  That guy might be sending you a message that he doesn’t want you coming around.  So go check him out.

There are some other things to look for specifically when it comes to sniffing out meth labs.  If that’s a particular concern in your area then check out the KCI Anti-Meth site.  

Day-to-day volatility grabs headlines.  Money.com recently fielded in inquiry from a reader regarding the pros and cons of buying now in a buyer’s market vs. waiting for rates to drop.  Another story reported on the fact that mortgage rates ticked down a bit over the past week, down to 6.22 percent from 6.30 percent a week ago.  

But you’re a real estate investor, not a day trader trying to time the bond market, so be careful about letting the media push impact your decision making process.  One thing I like to do is look at long-term data series – a practice that helps me put the day’s headlines in proper perspective.  Take the interest rate example.  HSH Associates is a financial publishing company that provides some excellent historical information on a number of statistics, including national monthly averages for fixed rate and adjustable rate mortgages .  The chart below shows the monthly national average for 30 year fixed rate mortgages since 1986:

 
The Federal Reserve raised rates 17 consecutive times over the past couple of years responding to fears of inflationary pressures, so we’re not reading about record lows like we were back in ’03 and ’04.  

The green part of the series represents data points that are lower than the current rate, whereas the red data points are higher.  So yeah, there's a good bit of green over the past few years.  But when you look at twenty years of data you realize that in a historical context rates are still extremely low.  

I’ve used ARM’s before but right now I’m a fan of the 30 year fixed.  The spread between a 1 year ARM and the 30 year fixed can get up to 3 or 4 percent, but currently it’s contracted back to around half a percent.  And with national averages still hovering in the mid six’s long term investors should see a lot to like about locking in at these levels.  
 
 

So in my view looking before you leap is the best way to keep your momentum as an investor, and that means having an idea about what to expect from an investment in terms of rate of return, cashflow and net present value.  

But analysis is like aspirin, or fine wine, or just about anything, for that matter.  A bit of it can make a big difference – but that doesn’t mean that a massive dose is a good idea.  More isn’t necessarily better.  

How do you strike the right balance?  Well that depends on the investor.  Personally, I’m an engineer by training and I love numbers; that’s why I ended up building this site.  I see the value in using a tool to catch all of those assumptions wrapping them into a cashflow projection.  Plus, I love to tinker.  But therein lies two danger – 1) becoming infatuated with the analysis and forgetting about the underlying uncertainties (no analysis is perfect) and 2) becoming infatuated with perfecting the analysis to the extent that you never get a deal done.  In other words: don't get paralyzed.

Both of these problems happen...probably more than you’d think.  

So...how to avoid these issues?  Again, it depends on the investor and your personality type, but I’d suggest the following rules of thumb: 

• Remember: your analysis is based on your assumptions.  Unless you have a working crystal ball you’re never going to get it all right.  Your analysis will give you your base case.  When you get your results ask yourself “is this target a good result?  Does the potential reward justify the risks?”  if the answer is “yes” then drive on and figure out how to make the deal work – don’t spend time fine tuning.  
• Analysis is a process:  I worked for a while in strategic planning with a major corporation.  We spit out huge, detailed plans.  And we never followed them.  Is this a bad result?  Well, not necessarily – the planning process itself is hugely valuable.  It forces executives to examine their assumptions, communicate their goals, and crystallize their thinking.  The planning process helps organizations to articulate their vision and set their course, even if they don’t follow the resulting plans to the letter.  Real estate analysis is similar: running the numbers will force you to consider the big questions around vacancies, rental rates, repairs, and other risks that you might not consider before jumping into the investment.  
• Evaluate the sensitivities:  Don’t just look at the final “answer” – look at the sensitivities to understand how much risk you’re taking.  Ok, you’re forecasting a 5% appreciation rate...but what if it’s 3%?  Or 8%?  The EquityScout tornado diagrams will help you do this, but if you’re running spreadsheets you can do the same thing manually.  
• Be honest with yourself:  There are two camps that you want to stay out of – the overly conservative camp that kills every deal that comes along by handicapping them with excess costs, and the rose-colored-glasses camp that tweaks all the variables up until they get the result they want.  Nervous Nellies do no deals, and the Pollyannas do bad ones.  
• Remember: once you’ve made your bed you’re going to have to lie in it.  A single fortuitous event (a upgrade in the neighborhood) or misfortune (a mold infestation or a disastrous tenant) will radically impact the performance of your investment.  You’re still going to have a lot of uncertainty to manage once you make your investment; the purpose of the analysis is simply to ensure you’re pointed in the right direction before you pull the trigger.  

• Consider the source.  It’s fine that the National Association of Realtors® has a voice in the press, but don’t give their forecasts and vies the same weight that you’d give to an impartial market expert.  The NAR has a point of view that they’re trying to sell. 

• Look at the underlying numbers.  Even a bad article like this can yield some information.  National median sales price for an existing single family home is down 2.7% nationwide from the same period last year – so instead of trending upwards with inflation (the natural path) the market has entered into a quantifiable correction.  Ask yourself “is this enough.”  What’s your view on your own area. 

• Be skeptical about some “information” you get from the popular press.  I note that on the same page of the USA Today they have a color photograph of the new Ford Edge HySeries prototype SUV, a fuel-cell plug-in hybrid that the paper refers to as “pollution free”.  This is simply wrong.  A car that you plug into your wall to recharge runs on electricity, and the vast majority of electricity in the United States is produced by power plants that burn hydrocarbons – primarily coal and natural gas.  Electricity isn’t free, and it can’t be produced unless you burn something, which creates pollution.  Fuel cells run off of hydrogen, which in itself is clean, but is produced as a by-product of natural gas – again, a hydrocarbon. All cars pollute – it just makes us feel a bit greener if the pollution is coming from the smokestacks of a remote power plant or hydrogen facility instead of the tailpipe of the car we’re driving.  A tangent from the topic of real estate?  Perhaps – but for me it’s a clear example of the fact that the press will simplify issues until they’re simply wrong – and that’s dangerous for an investor.  

New Century Financial Corp (NEW) took a big hit late last week on the back of news of  an unexpected fourth quarter loss .

New Century Financial focuses on sub-prime lending, the market that is taking a disproportionate share of the blow being dealt to financial institutions by rising default levels.  Sub-prime lenders get a lot of scrutiny from watchdog groups and consumer advocacy organizations - and rightly so; this is a market that is prone to abuse.  But inarguably sub-prime lenders provide a service to the real estate community by offering options to potential homeowners who otherwise would be unable to purchase a home.  Look for liquidity to be negatively impacted as these companies get clobbered – which will impact homeowners as they try to refinance adjustable rate mortgages that they entered into back in rosier days. 

So what does it mean to me?  Well a lot of real estate investors have jumped into risk/complicated loans during the easy-money days, with they expectation that they would either a) sell the property or b) refinance in the future.  Well refinancing will get harder if the current trend continues; they very companies that started the trends in sub-prime lending and exotic mortgages are on the brink of leading the market towards tightening lending standards.  Take a look at your situation and decide whether or not you need to take action. 

See also:

• Option ARMs in the news
• Mortgage choices for investors

• Aoccdrnig to a rscheearch at an Elingsh uinervtisy, it deosn't mttaer in waht oredr the ltteers in a wrod are, the olny iprmoetnt tihng is taht frist and lsat ltteer is at the rghit pclae. The rset can be a toatl mses and you can sitll raed it wouthit porbelm. Tihs is bcuseae we do not raed ervey lteter by itslef but the wrod as a wlohe.

In my unscientific survey everyone polled could read this without a pause. 

I could try to make some tortured analogy to tie this to real estate investing but I won't try; there are worse sins than the occasional irrelevant post. 

Property flipping has gotten a black eye as of late from shady practices that have victimized first-time buyers, at-risk communities, and the reputation of the real estate industry as a whole.  The matter hasn't been improved by the proliferation of quick-money real estate courses and goofy reality television programs like Flip this House and Flip that House (yes, these are two different programs - just another indication of the general public's manic appetite for all things real-estate related). 

From time to time I contribute pieces to publications on investing in real estate.  Recently I wrote an article that appeared in the Houston Business Journal on investing opportunities in the Houston market .  Markets are starting to turn south in some areas of the country, but there are three key points that prudent investors can follow that will help turn up opportunities in some sectors:

• Buy cashflow:  positive cashflow is your best hedge against the risk of falling property prices. 
• Understand the risks:  keep it simple, avoid complex mortgage products that you don’t understand. 
• Run the numbers:  don’t get paralyzed by the analysis, but check your assumptions and know what sort of return you can reasonably expect from your investment.

These can feel like truisms, but the key is considering what they mean to you and your particular market.  See the article for more…
 

• Dallas:  Should be a safe haven at these levels, undervalued by more than 20% according to the recent Global Insight study - yet it gives up ground, falling by half a percent in November. 
• Miami:  Continues to tear it up.  Overvalued by more than 60%, Miami is up almost 8% year-on-year and continues to rise, going up half a percent in November. 
• Boston:  Surprises as the biggest loser, down almost 2% in November. 

Investors...Expect a wild ride in coming months, and note that contrarian speculators with nerve can make profitable trades in markets like Miami as owners with jittery nerves hit the exits.  But note that I said "speculators", not "investors" - personally I'm still a fan of undervalued markets where your investing dollars land properties that yield positive cashflow.

In the near future I’ll be working with Jim Kimmons , the real estate business guide for About.com to provide some content on investing in real estate - from the perspective of both the investor and the real estate professional.  Jim is a real estate broker in Taos, New Mexico and an expert on technology and real estate.  Check out Jim’s blog, and look for more investor related content in the near future. 

And when you're done reading about real estate, About.com covers everything from roller-skating to soap operas to politics. 

So I get around to ticking off some to-do’s for the year towards the end of January, which ends up prompting me to set some boring but do-able goals that take me a few steps closer to where I’d like to be at the end of the year. 

And this year’s goal is to start practicing what I preach in two areas:

• First: Don’t hoard equity in an investment, and
• Second: Don’t  fall in love with a property.

These are good rules to live by, and ones I’ve talked about in the past in my writings.  And they’re also two rules that I’ve violated in one particular investment.  I own a townhouse loft in the Montrose district of Houston.  Towering floor to ceiling windows.  Acres of hardwood floors.  Street lined with majestic live oaks.  And, I happened to live there…and I happened to be living there when I met the woman who would later become my wife.  Fond memories.  So when we moved out I held on to it. 

It hasn’t done badly, all things considered.  Montrose is hopping, builders are building, and prices have started to tick up.  So it’s time to get rid of it, fond though I might be of the property.  Cashflow-wise the property does ok, but that’s because I bought it before the price ran up.  Now it’s time to put that equity to work. 

The graphic shows my plan: take the $130k in equity that’s sitting uselessly in this property and turn it into six multifamily units that will pay me $5,000 per month in rental income (vs. the $2,100 that the loft is generating).  And do it through a 1031 deferred tax exchange that will allow me to avoid paying capital gains tax on the profit. 

So now that I’ve publicly declared my resolution perhaps I’ll feel more compelled to stick to it.  I know a lot of investors have equity squirreled away in properties that have run up in value.  I’d love to have other investors join me in resolving to put that equity by pulling it out and investing it in bigger properties. 

…and , I trust someone will call me out in December and see if I’ve stuck to my goal.  We’ll see…

I'll write a post soon on the ins and outs of the 1031 exchange - the key to making this work. 

The condominium market is more vulnerable to large fluctuations in price because they disproportionately attract speculative investors, as opposed to single family homes.  Residential homebuyers tend to be less fickle – a property which is purchased as a home as opposed to an investment is less likely to be whipsawed by the market.  

That’s starting to show in some major metropolitan markets where condos used to be selling like hotcakes, but are now slowing down.  Buyers in some cases are forced to sell at a loss – or to rent them out at a rate that turns them into negative cashflow investments.  

This, undoubtedly, will turn out to be a blip in some areas, not a long term trend.  Nervy, contrarian investors can find bargains by jumping onboard when everyone else is headed to the lifeboats – and this current wave of woes was prompted by investors who did exactly the opposite: they broke ground when the market was white hot and development costs were through the roof.  

Check out these stats on the WashingtonDC area.  

Note:  the downturn at the tail end of the "condos sold" graph is in reality likely to be even more severe than the chart indicates, given that cancellations are probably not accounted for. 

Shoot me a note and let me know how your metro area is faring.   

I got a call from a tenant who lives in a single family patio home complaining of discoloration on the ceiling of the home’s second bathroom.  I went over to take a look and was fairly surprised at what I found – the ceiling which was bone white when I rented the property to the family a little more than a year ago had turned into a kaleidoscope of dark moldy colors. 

If you’re a Houston landlord then this isn’t something you want to see.  For the uninitiated: mold is big business around these parts.  Houston is basically a big paved over swamp.  Hot summers.  Lots of rain.  A good environment for both mold, mold remediation firms and for personal injury lawyers.  This has been a particularly hot issue in Texas since a jury awarded $32.1 million (later reduced) to a family whose home was infested with mold. 

So I called AMC Engineering & Environmental Services to come and take a look at the place.  The set up some equipment, took some air samples, charged me what seemed at the time to be an annoying amount of money, and eventually produced a clean bill of health for the property; the quantity of airborne particles in the bathroom being “less than the overall quantity of fungal structures identified in the outside ambient air.”
The report went on to state that there is no “absolute criteria” regarding mold and that the recommendations of the report were based on “standard environmental microbiological and industrial hygiene practices.”

Which brings us back to the Wall Street Journal report (note: the WSJ article is available online, but only to subscribers).  The science of mold is a pretty fuzzy one (sorry, couldn’t resist at least one pun) and the references frequently quoted in suits are a maze of conflicts of interest.  One frequently cited paper from the American College of Occupational and Environmental Medicine which was written by a group of experts who paid experts for the defense side in mold litigation. 

The punchline (for me, anyway):  You know this.  And your tenant probably knows too.  My wife is a physician and I’ve learned one interesting fact over the past few years: it’s not the bad doctors who get sued, it’s the obnoxious ones.  I don’t have the data to back it up, but I suspect that the same applies to landlords.  If you tenant brings up a health related issue then look into it.  If need be do an evaluation and show them the all-clear certificate.  It’s a good investment. 

Statistically this problem shows up in two ways.  First, as noted, the level of sales is overstated.  A second order problem is that the inventory is understated by a like amount as these houses are not added back to the count of houses on the market.  Estimates of the discrepancy vary widely from 100,000 to 200,000 sales that did not occur.  So whatever shift that occurs in the inventory numbers in early 2007 will be amplified by this adjustment.  

In a statement released today, Pat Vredevoogd Combs, the NAR Presidents, states:

• Realtors® provide extensive personal attention to consumers during the lengthy process of buying a home.  It would be difficult for banks to provide that type of counsel because of conflicts with their other business objectives.

Wow, where to start?  First, banks already offer advice on a vast array of services, and they do this well because of the brutal competition between them.  Sure, it’s probable that some banks will do a shabby job of representing real estate customers – and these are the banks who won’t manage to make any money doing it.  The phrase “extensive personal attention” is buzzword filler.  The consumer will determine the standard, and whatever market player meets this standard will capture the business.  This is the very definition of competition.

More importantly, the banks will jump in if and when it's profitable to do so -  which means using synergies to pull cost out of the system and using this to compete with customers based on price (lower fees).  Beware an industry group who seeks legislation to keep a class of competitors out of the market in the name of… drum roll…competition. 

But perhaps I’m not being completely fair here.  It’s hard to knock the NAR for backing their friends Kanjorski and Calvert – after all this legislation is unambiguously a threat to Realtors®.  In corporate America “synergies” is a code word for “redundancies”.  This isn’t corporate America we’re talking about here, but the concept remains the same. 

The real problem, though, is that all of the arrows in the NAR’s quiver look kinda similar.  Storm clouds on the economic horizon?  Just send David Lereah out to tell everyone that everything looks rosy! .  Sales are down?  Proclaim that now is the perfect time to buy and sell a house!  .  New technology players offering new options?  Use your leverage to muscle ‘em out. 

Facing an evolving market with a brave face and a vision isn’t an easy thing, but 1.3 million Realtors® out there are waiting for some direction.  Bad idea.  Some regional associations are taking matters in their own hands, but there’s trouble on the horizon for the rest. 

We also love to bash the popular press (infotainment hacks) and automated forecasts (love ‘em or hate ‘em you cant get away from Zillow conversations in the real estate blog world).

So what am I going to talk about today?  A CNN piece compiling economic data from Moody’s that makes some predictions about future home prices .  Why?  ‘Cause I love this stuff.  Just like Zillow gives you a potentially useful data point (not a certified appraisal upon which you’re going to write a contract) economic studies can give us a glimpse into how the factors that drive prices are lining up.  Plus – there’s an element of a self-fulfilling prophecy that comes from a forecast that is shotgunned out to huge swaths of the consuming public. 

So what’s next for real estate in ’07.  Well according to this study check out these markets:

1)  McAllen, TX
2) El Paso, TX
3) Albuquerque, NM
4) Salt Lake City, UT
5) Syracuse, NY
6) San Antonio, TX

The numbers aren’t too sexy, in terms of property appreciation – the best markets in the country are expected to rise at 7% to 9% in ’07.  But consider the fact that you’re leverage goes a long way in an undervalued market – which most of these are.  A zero down investment that appreciates at 7%...I’ll take that. 

But you can't manage 'em well if you've picked the wrong ones, as this story from the Bay Area Mercury News shows.  A San Jose tenant is charged with killing his landlord and torching the property.  The article says that the tenant was not there when firefires responded to the blaze, but "showed up several hours later and did not appear curious about what had happened" according to police.  Hmmm.....

Well violence and arson are a worst case situation, but the first step to tenant management is screening candidates before they sign on the dotted line .  There were a lot of dodgy signals in this case that should have been heeded - the suspect had a history of scrapes with the law and an established track record of anti-social behavior.  Having a vacancy is bad, but filling a vacancy with a bad tenant is a thousand times worse.  You already knew this, but it's always good to hear again. 

Real estate investors in some areas will greet this topic with a yawn...by the time a property hits MLS you're looking at a guaranteed negative cashflow investment.  In markets like this you need to find deals at significantly below market value to make the number work (short sales, foreclosure auctions, REO's, etc.)  But in undervalued areas where the rent-to-property value ratio is high you can still pluck some deals out of MLS if you keep your eyes on the ball. 

But competition can still be fierce.  I recently invested in a single family house that I'd bookmarked in the Houston Association of Realtors' excellent site www.HAR.com.  I got an update that the price of the property had been dropped by 10%.  This put the property within my investment threshhold.  I sent in an offer immediately; within the hour. 

Mine was the fifth one they got. 

I did end up getting the deal, though.  The guy who originally one didn't come though with financing and had to back out.  My offer wasn't the next best one, but it must have looked like the bird-in-the-hand to the seller.

Related posts:

• Another non-traditional player jumps into the MLS game
• Zillow.com :: How will the traditional real estate industry respond?

38th President of the United States of America.

My fellow Americans, our long national nightmare is over. Our Constitution works. Our great republic is a government of laws and not of men. Here, the people rule. ... As we bind up the internal wounds of Watergate, more painful and more poisonous than those of foreign wars, let us restore the Golden Rule to our political process and let brotherly love purge our hearts of suspicion and of hate.  August, 1974

You'll see the posts slow down for a few days as we enjoy the holiday season.  Looking forward to more good dialogue in 2007.

Regards,

Christopher Smith

EquityScout.com

• “You can spot the problem investors right away. They have absolutely no criteria for what they are looking for. Their criteria is "anything that is a good deal." Good luck with that. If you don't know what you want to buy you don't know what you are doing.”

Hmm….that sounds like pretty good criteria to me – that's something I say to my agent all the time.  And that’s a fact that many real estate agents take a while to understand.  But that’s okay – we just have to get the point across that as investors we’re looking for something different than the average homebuyer.  An investor isn’t going to say “go find me a nice 3 bed 2 bath with room for my quilt collection on a corner lot.”  An investor is simply looking for a bargain that’s going to generate cashflow. 

And in some areas, bargains are easier to find these days than others.  In Global Insight’s 3rd Quarter Housing Price Study, released this week, New Orleans took over pole position as the most undervalued market in the United Sates, a spot that was held by College Station, TX (home of the Texas A&M Aggies) last quarter. 

Overall, economists take a bad rap, and I understand there are those out there who don't like valuation studies.  But generally I thikn they're useful, and I like Global Insight’s approach.  One thing that does pop out me, though, is that New Orleans is…different.  The Global Insight algorighm seems to do a good job of tracking trends when applied to historical data, but one has to wonder how well it fits the situation in New Orleans post Katrina/Rita.  So I’d look at that particular data point with a bit of suspicion. 

Texas still dominates the bottom five (Dallas, College Station, Houston and Fort Worth, in addition to New Orleans).  No news there.  Other notables: Tulsa, OK; Rochester, NY; Charleston, WV; Wichita, KS; Columbia, MD; Indianapolis, IN.  Investors in these markets should have an easier time of finding investments that produce positive cashflow.  The coasts are still challenged, but as prices have flattened/declined so have the levels of overvaluation.

The main conclusion of the study is that the overall level of valuation is starting to ease nationwide.  Last quarter 66 metro areas were deemed “extremely overvalued”, whereas this quarter only 63 are.  This largely is due to price declines in some high value markets – 76 of the 317 metro areas surveyed experienced price declines during the quarter.  Nationwide, the average rate of appreciation for the quarter was 0.86% - significantly below the historical average. 

I thought the chart above was interesting – I took this from OFHEO data on the .gov website.  The cooling trend which accelerated last quarter continues.  National quarterly price appreciation topped 3% quite a few tiems over the past couple of years.  And note, these aren’t annualized numbers.  The peak was in Q3 2004 where the national index went up 4.44% in one quarter – that’s an annualized rate of 17.74%.  These, of course, are national averages – some metro regions were significantly higher. 

Real estate is local, but in a sense we’re all in the same economic boat so a soft landing will be good for the economy as a while.  But regardless of how it plays out, things will be tough for investors in a lot of markets for a while.  Look for shot sale opportunities as overextended homebuyers and speculative investors get squeezed out of homes with negative equity.

Regionally, most markets are within a few points of where they were when Global Insight last came out with their analysis last quarter, but interestingly four important bellweather markets (Las Vegas, San Francisco, Tampa and Washington DC) have inched their way back below the “extremely overvalued” threshold. 

Huh?  Well consider it sort of a virtual party game.  And this particular meme has instructions: tell five things about yourself that readers might not know, and pass the infection along by tagging five other Bloggers. 

So for your reading enjoyment, five things that you probably didn’t know about me: 

1.  I was a computer nerd early on, starting out with a TRS 80 and a Commodore Vic 20 (with tape drive!) when I was in middle school.  If you look at this photo and get a warm wave of nostalgia then you and I would get along. 

2.  I was an All American boxer in college and made it to the collegiate national championships in Reno Nevada my senior year.  I lost my final bout (my only bout that was televised) - a split decision loss to a hometown boy from UNR.  He was a south paw.  So now I have this thing about lefties...

3.  I lived in Bogotá Colombia for three years working for an oil company.  Best place I've ever lived.

4.  I have a cat that I adopted for $2 at a shelter in Bogotá and it cost me $300 to bring her back to the US when I moved back.  Well actually it cost the company that I was working for because I was able to expense it. 

5.  My favorite vice is Maggie Moo's cotton candy flavored ice cream, which comes in a industrial chemical shade of blue and stains your teeth, lips, and anything else it comes into contact with.  My wife thinks it is disgusting. 

So I’m tagging:  Jeremy Bencken at TenantMarket.com, Derrick Daye at Branding Strategy Insider, and fellow Houstonian Micahel Price of MLPodcast.com.  Those of you who are paying attention will notice that this is just three, not five.  But Pat, who passed this on to me, only tagged three – so I’m doing the same. 

And my inner geek thinks the following is pretty cool: tracking this particular meme back 17 generations:

• Drew of Drew’s Marketing Minute 
• Starbucker 
• Trevor Gay of Simplicity
• Phil of Make it Great 
• Kammie of Passion Meet’s Purpose
• Success from the Nest 
• Dave of Rothacker Reviews 
• Andrea Learned of Learned on Women
• Ann Handley of the Marketing Profs Daily Fix
• Nedra Weinreich, Spare Change 
• Toby Bloomberg, the Diva Marketer 
• Paul Chaney, Strategic Blogging
• Mary McKnight of RSSPieces
• Jim Cronin of Real Estate Tomato
• Joseph Ferrara  of Selsiusblog 
• Teresa Boardman  of St. Paul Real Estate
• Pat Kitano of Transparent Real Estate

1)  Real estate investors make up a niche market that needs a specialized set of skills from a real estate agent.  The field is getting more crowded by the day.  The first source of competition is that 1.3 million fellow agents out there; that’s a lot.  Add to that the technology companies that are popping in by the day:  Zillow, Google, Redfin, FSBO players, and who knows who else will declare their new initiative tomorrow.  There are a lot of new agents out there – see the chart.  Not all of them are going to manage to stay in the industry.  But in all fields, when things get tough for the generalists the specialists manage to survive and thrive.  What kind of client are you specializing in?  

2)  Real estate investors are repeat customers.  Most businesses thrive on long-term relationships, and real estate investors are customers who come back.  Again and again.  Investors value trust, whether it be from a lender, a contractor, or an agent.  Trust is comforting – build that relationship and they’ll be back.  This applies to all customers, of course, but you won’t have to wait for the investor to decide to move before he’ll be calling you again.  Your next deal may come the following week.   

3)  Real estate investors are in the market.  Investors are out there following trends, making contacts, and collecting information.  Your client will be looking to you for leads, but this can be a two-way street.  Invariably, investors come up with leads that don’t turn out to be viable investment opportunities, but which may turn into a listing for you. 

4)  Real estate investors can teach you something.  You’re good at what you do, and your investor clients should learn from you.  Likewise, if you’re working with smart investors you should learn from them as well.  A lot of agents are wondering how to get off of the sidelines to start building real estate equity for themselves; if you’re one of them then you might benefit from working with successful investors.

5)  Real estate investors can be easier to work with.  I include this last point with some trepidation.  I know there are some investors who are a royal pain to deal with.  But generally speaking, savvy investors are looking at the bottom line, want good advice, and you won’t have to cut through a layer of emotional attachment to get them to make good decision.  If you’ve ever had to play amateur psychologist to convince a seller that she needed to paint over her beautiful work-of-art wall sized mural to sell her house then you know what I’m talking about. 

It’s a jungle out there, but real estate agents who move now to upgrade to a client base that requires a specialized skill set will prosper and thrive, even as competition drives many of the recent entrants out of the profession.     

EquityScout's Results Dashboard presents gives you a graphical, easy-to-understand view of your investment's potential financial performance. 

• View Rate of Return to get a quick idea of the viability of the investment.  Does the return justify the risk?
• EquityScout categorizes the assumptions that may be contributing to a high or a low rate of return, and flags assumptions that may be out of line with the market.
• And as always, the user has access to a full suite of graphs, charts and reports to better understand the investment's potential cashflow.   

I'm always interested in your comments and suggestions.  Feel free to go to your contact us page and let us know what's on your mind!

Lots of news recently on non-traditional players in the Real Estate Industry moving into waters that traditionally has been jealously guarded by the National Association of Realtors.  From the if you can’t beat ‘em, join ‘em file: Google has just announced a partnership with the Houston Association of Realtors (HAR) to upload Multiple Listing Service (MLS) data for the Houston Area. 

HAR runs www.HAR.com, the excellent online database and one that I have some personal experience with as a Houston based real estate investor.  This is a story I’ll follow with interest. 
The various blogs and forums are abuzz with news of the Zillow.com announcement, but this one, potentially, is more interesting.  The question at hand is what kind of strategy the various MLS services can put together.  Seeing that they’re a loosely connected confederation of semi-independent participants it seems to me that a unified approach to keep the dot.coms of the Zillow/Google ilk out of the sandbox isn’t going to work.  Seems that HAR has seen the writing on the wall.  So the reaction over the next few months from the other major metropolitian areas will be an interesting indication of things to come.  Will HAR be viewed as the scabs crossing the picket line?  Or, will they be the first of an exodus?

An article in the Houston Business Journal makes an interesting point of the fact that Google’s first major foray w/ an MLS system is occurring in Texas, as opposed to their home turf of San Jose.   This might have something to do with the vision of Bob Hale, HAR’s president and CEO who has a reputation for his interest in emerging technology.  It might also be a reflection that perhaps the real estate industry in California has a stronger view of it’s ability to resist future changes than we do here in Texas.  Interestingly, James Harrison the President and CEO of the Silicon Valley MLS comments “They (Google negotiators) are friendly and young, but they are not willing to work out a deal unless it completely benefits Google.”

This post is directed at the real estate agents out there.  There sometimes can be an uneasy relationship between agents and investors; investors have a unique perspective which often is different from other homebuyers.

Real estate investors represent a special group of clients for agents.  As the field gets crowed both with agents (10,000 new Realtors® every year!) and technological innovations, finding a niche will be important for agents who want to thrive as the market evolves. 

I don't always use an agent, but I do sometimes - I have an agent that I trust and she helps me out a lot. 

Following are five things that I, as an investor, tend to value in an agent.  This is just my opinion, but it's informed by feedback from lots of other investors.

1)  Understand the risks of investing:  Some clients will need some help here.  Generally speaking, investors take two kinds of risks:  speculative risks and operational risks.  Speculative risk is high when an investment relies primarily on future property appreciation in order to be profitable.  Operational risks deal with all of the issues involved in maintaining a cashflow-positive property - vacancies, tenants, repairs, etc.  There are players who think they are investors, but actually they're speculators.  They might not know the difference - but you should. 

2)  Be the investor's eyes and ears:  My real estate agent is valuable to me because she has ways of finding things out.  She's plugged into the community and she's constantly talking to other brokers and agents.  She does this full time, I don't.  Once a property gets to MLS it's old news - I have to compete against all the other investors in my area.  But if I can get to something early - that's a tip that's valuable to me. 

3)  Understand the numbers:  If you're pitching an investment, or helping the investor to understand one that he's found himself, you should be able to answer the questions:  Should I expect this to be a positive cashflow investment?  How much will I be able to charge for rent?  Will that cover my expenses?  What sort of property appreciation will I need in order for this to yield a decent rate of return?  An investor who can't answer these questions (many cant!) is driving blind.  You can help. 

4)  Screen opportunities:  Know what your investor is looking for.  Bring her opportunities where the numbers work out.  Shelve the rest. 

5)  Know the neighborhoods.  This is an area where my agent helps me a lot.  Which areas are generating a lot of interest?  Which ones aren't?  Where are a lot of for-sale signs popping up?  You and your investor will come up with a strategy to decode this information; sometimes a preponderance of for-sale signs means opportunity, other times they signal trouble. 

The playing field is shifting out there; agents who evolve will stay ahead of the curve. 

A much better comparison is with a stockbroker - a skilled profession that offers a more similar service.  The stockbroker profession hasn't been eliminated, but it has changed radically, and margins have plummeted.  I use a realtor, but I don't use a stockbroker.  I go online, log onto vanguard.com or etrade.com, check my stocks, read the research, buy, sell, and manage my own portfolio.  Ten years ago they told us this would be financial suicide - but now it's commonplace.

Remember E.F Hutton - the stock brokerage firm?  "My broker is E.F. Hutton...and E.F. Hutton says"...then everyone turns around and listens w/ rapt attention.  Hutton and their ilk sneered at the internet startups.  Financial suicide for foolish investors, they said.  Cheapskate clients...we don't want 'em.

Well, E.F. Hutton is gone.  Bankrupt.  People stopped listening, and they stopped paying those fat commissions.  Meanwhile, E*Trade, Ameritrade, Fidelity, Schwab, and the rest of the online guys survived the dot.com collapse and are churning and burning.  The point being that all competitive landscapes change...and market participants who don't go with the flow - those that stick to their guns with a religious fervor - are doomed to the dustbins of history. 

Has real estate gone that far?  No.  Not yet.  But it will if the response from the National Association of Realtors is simply to point out Zillow's flaws, insist that the public will always pay 6% commission to sell their house, and that technology isn't a threat. 

Six percent has been a rule of thumb that the National Association of Realtors has done everything in its power to protect (just as any industry - auto, energy, consumer products, whatever - will always try to protect its margins).   

Problem is: in the long run this strategy simply won’t work.  The New York Times  ran a great article on this. A quote from the article:  Traditional agents still firmly control the M.L.S., which allows all participating brokers, including Redfin, to view almost every home for sale in a particular area, even those being offered through competitors' agencies. But the typical 6 percent commission, paid out of the seller's proceeds and split between the seller's and buyer's agents, is under attack because, as economists note, it does not serve consumers well.

Disruptive technologies are notoriously hard to predict.  Zillow may be a flash in the pan.  But eventually – soon – something will come along that isn’t.  There are some stockbrokers and travel agents who survived the onslaught of e*trade, Ameritrade, Orbit and Travelocety, et al – but many didn’t.  The ones that made it adapted found a niche where they added a special kind of value.  But the bread-and-butter business will soon go away. 

The new 300 pound gorilla, Zillow.com, has taken the logical next step.  Now you can go and post your home for free and get exposure to Zillow.com's massive customer base.  Interesting tag line:  It's FREE and anyone can do it.  Translation: you don't have to be a licensed real estate agent. 

Clearly, Zillow still has its problems, and the accuracy of its valuation algorithm has attracted lots of critics.  But one thing can't be denied: these guys have a lot of momentum and they know how to keep the public's ear. 

I saw a New Yorker cartoon the other day.  It showed a couple of dinosaurs chatting.  One was emphatically stating the time to develop the technology to destroy an earth-bound asteroid is now!  but the other dinosaur clearly wasn't interested.  And in that vein I'm looking forward to seeing the reaction from the National Association of Realtors.  To date their stock response has been to point out Zillow's flaws and insist that technology isn't a threat.  If they continue with this approach than this will herald the beginning of the end of the standard 6% commission. 

Stay tuned...

Now consider Hakeem Olajuwon. 

Olajuwon, a Nigerian émigré, played a long career with the NBA, leading his team to two championships in the process. 

And in the 10 years since hanging up his basketball shoes he’s managed to earn as much money in real estate as he did during his 17 years with the NBA. 
Olajuwon’s strategy has been described as “unorthodox yet disciplined.”  But no one can doubt his effectiveness.  Based on estimates his earnings in the real estate market easily exceed $100 million. 

Check out the excellent article in the New York Times. 

The industry is now looking at its practices and standards.  I can only hope, however, that the pendulum doesn’t swing too far in the opposite direction.  As the article points out, making the rules for qualifying for a mortgage overly restrictive will have the unintended effect of making a bad situation worse for squeezed homeowners looking to refinance out of their high-rate ARMs.

A website that appears to be on a pretty rapid growth curve is ActiveRain.  The company is based in Bellvue, WA and is focused on collaborating with real estate professionals – primarily agents.  Their stated goal is to Empower the real estate professional.

They offer a few tools designed to support agents and Realtors® such as lead management – but the main thing they offer is networking. 

Investors aren’t likely to find a lot of leads or tips, but it is well worth a look for agents and realtors or any other real estate professional who is building a business. 

When buyers check out a potential investment they’re basically looking for something not to like – a reason not to make the investment.  Your average buyer isn’t going to see the diamond in the rough – they’re not going to be able to look past an ugly photo.  If you’re wholesaling to an investor (selling fast and cheap) this might not make much difference, but photos matter when you’re selling to John Q. Public. 

Some buyers will arbitrarily narrow their search by the number of photos included in the listing, and they’ll focus on those photos that are effective in showing the property in a flattering light.  And here’s the rub: taking a good looking photo really doesn’t take much more effort than taking an ugly one. 

So in the interest of banishing ugly photos, here’s a few tips.  Photos are courtesy of the local MLS – all are for small starter single family homes…

1)  Think about perspective.  I think this is the single most important thing – and it’s completely in the photographer’s control.  A good angle is your friend.  The kitchen on the left is from a tiny starter home – under 900 square feet.  But it feels big and bright because the photographer chose a flattering angle.  The second photo is from a larger house, but the photographer has opted to take a weird angle of the kitchen floor looking into the laundry room – giving it a claustrophobic feel. 
 

Again, the photo on the left is from the smaller, cheaper house.  The photo on the right is from the larger, more expensive house - in the same neighborhood.  Which photo is more likely to get the seller a showing? 

2)  Get the lighting right:  There’s no reason to make the room look like a dungeon.  Open all the windows, turn off the flash, put the camera on a tripod and set it on auto exposure.  The second photo does a much better job.    

3)  Keep your horizons level:  Pay attention to the lines of the photo.  Make sure they’re straight.  There’s no reason to publish a photo that looks like these two.  

4)  Keep it simple:  Get rid of the clutter.  This seller seems to be enamored with her display of Christmas wonderland trinkets.  But the buyer probably won’t be.  It would have just taken a couple of minutes to stash this stuff in the closet before snapping the photo. 

5)  Focus:  When you’re reviewing your photos on that little screen on the back of your camera sometimes it’s hard to tell when a photo is out of focus.  But it will be obvious once you upload it. 

It's also possible that the blur was caused by camera shake - meaning that the photographer was not able to hold the camera steady enough.  This often happens in low light situations w/ shutter speeds slower than 1/30th of a second.  And if you don't know what this means don't worry - I won't get into it - just go out and get a cheap $20 tripod and that will fix the problem. 

6)  Don’t stretch/squash the photo:  A distorted photo doesn’t look right.  And in this case it makes the ceilings look lower than they are. 
 

There’s more.  But this is a start.  And as my might have guessed, photography is a hobby of mine – so it’s possible that I care about this stuff more than most – but I think that getting the photos right is a relatively effortless way to make sure that your property puts its best foot forward online. 

Check out a few of these blogs that take a national perspective in the impending collapse…

The Housing Bubble Published by Ben Jones from Arizona.  Examining the home price boom and its effect on owners, lenders, regulators, realtors and the economy as a whole.

Bubble Meter:  A blog dedicated to the premise that there is a Housing Bubble in many locales in the USA. With a particular focus on the: When will it pop?  I don't know much about the author, who identifies himself simply as "David from Maryland". 

David Lereah Watch :  This blog watches the comings and goings of David Lereah, the Chief Economist of the National Association of Realtors (NAR).  Written by the Bubble Meter guy, above. 

Probably the most mean-spirited of the blogs in this post; this blog takes NAR bashing to a new level.  The author refers to Lereah as a "shill" (one of the milder descriptions of Lereah on the site).  Strikes me as a bit unfair, however.  Lereah works for the NAR - of course he's going to be talking up the market.  He gets paid to support realtors, not to be objective.  What do you expect the guy to do?

Patrick.net: Website proclaims itself as the “top ranked Google result for “housing crash” and “housing bubble” for 3 years running. 

There’s a lot more out there – some of which take a more local approach (which, in my opinion, is more useful). 

• Advantage Software LLC :  Based out of Pardeeville, WI.  Advantage offers a downloadable windows based software package for $97.95 that produces reports, graphs, ratios, etc.  They offer some specialized products as well, including a program called Flip-it assistant for the same price. Their website includes screenshots of report graphs, etc. 
• RealData :  Based in Southport CT.  RealData sells a suite of Microsoft Excel ® spreadsheets, ranging in price from $99.00 (for their “ultra-light” model) to a high of $495 (for their standard spreadsheet).  To see how their offerings compare they’ve included a comparison chart .
• REI Wise   : Offers desktop products ranging in price from $59 to $499.  They have a demo of their commercial product that you can view on their site.  Like EquityScout.com, REI Wise offers some online products:  commercial for $24.95 and residential for $14.95.
• Doug Rutherford CPA.  Doug sells Microsoft Excel® spreadsheets from two different websites: RentalSoftware.com  and Landlord Software.  Doug offers two products, Landlord’s Cash Flow Analyzer Pro and Flipper’s Cash Flow Analyzer, both for $79.95.  He also offers coaching for $75/hr and a variety of courses. 
• Real Estate Informatics:  Based in Fairfax VA.    Sells Microsoft Excel ® spreadsheets ranging from the ROI Forecaster Spreadsheet download ($99.95)  to the Professional Edition w/ software mailed ($179).

Note:  no recommendations or critique in this post.  I'm interested in hearing from anyone out there who has any experience with any of these products/services.  More to come...

“There has never been a national real estate bubble."  Sheets comments.  "Even in the markets that are correcting, there are sub-markets that present incredible investment opportunities for the investor. With interest rates at historical lows and an ample inventory of properties, there has never been a better time to invest."

Ok this sounds a bit shrill, and the purpose of his comments obviously is to sooth jittery nerves of the aspiring millionaires who buy his late