Peter Pays Paul

Buying right is disciplined work.

The work is not so difficult that only an elite few can do it.

However, it does require a meticulous and detailed approach that most people lack the discipline to perform.

At a recent conference I attended, this bit of wisdom slipped out:

“You cannot tell if a property is a good deal by looking at the price the last owner paid for it and the discount you are receiving. If the last owner overpaid by 20%, are you really getting a good value with a 20% discount from the last price?”

Buying with the End in Mind

In order to be successful at buying real estate for the right price, an investor needs to have a defined strategy - What is the purpose of the property? Cash flow? Appreciation? Rehab? Conversion?

Knowing the end goal allows you to work from that goal back to the present and to determine a price point at which you can reasonably achieve your goal.

In order for a property to cash flow, the rental rates must be higher than all of the combined expenses including the mortgage, taxes, maintenance, vacancy factor, and reserves.

For rehab properties the Acceptable Purchase Price = Sales Price – [Sales Costs (Marketing + Closing Costs) + Rehab Costs (Construction + Carrying Costs) + Desired Profit].

Details

The devil is in the details they say.

Details are the reason that most people fail to make wise buying decisions. Investors often fail to have the patience and discipline to crunch the numbers.

Many new real estate investors are like my wife at the department store. “Honey, it was 30% off! Do you know how much money I saved?!” No, but I do know how much you spent.

Many of the factors that go into determining the right purchase price are learned only with time and study. Estimating repair costs, knowing market rents, market growth rates, and projecting expenses are not innate to human knowledge.

Fortunately, they can be learned or ascertained over time. A wise investor will invest first in their own education.

The factors to determine a correct price can also be “borrowed” from a real estate agent with experience buying investment properties and knowledgeable in the target market. Only choose an agent that is going to listen to your goals, evaluate your present financial situation, and formulate a plan that fits your goals and financial abilities. Investors are not “one size fits all” and no one type of investment property is appropriate for all investors.

Understanding what your money is doing and how it is working for you is vitally important.

Buying right in real estate is not dependent so much on the discount from sales price; it’s dependent upon knowing what price will allow the investor to accomplish their investment goal.

Using a Little Stick to Move a Big Rock.

This is the description of leverage most common in Physics classes. Then you have the diagram: a person using a stick with a little rock underneath it to move a big rock on the other end.

The physical principle of leverage is very simple. A smaller weight over a long distance, when applied to the long end of a lever, can move a larger weight a small distance. Hence, a small man can move a rock larger than himself through the use of a lever.

The Principle of Financial Leverage

Financial leverage is similar to the physical concept. But instead of using a smaller weight to move a larger weight, a smaller equity investment is used, in combination with debt, to purchase a much larger investment.

Leverage has the effect of multiplying the return on investment, whether positive or negative. With a smaller initial equity (cash) investment control is gained over a larger investment and the returns on that larger investment are reaped.

Let’s look at an example. The first model is the purchase of a $100,000 investment with $20,000 of equity and by borrowing $80,000. The second model is the purchase of a $100,000 with $10,000 of equity and by borrowing $90,000. You will see two scenarios, one with 10% gain, the second with a 20% gain on the investment.

As you can see from the table, a return of 10% generates a 50% return on equity with a 20% investment. A return of 10% generates a 100% return on equity with a 10% investment. Debt always comes at the cost of interest. When the interest cost is less than the total return, a greater return on equity should be realized through the use of leverage over not having used leverage.

Leverage has a similar multiplication effect when an investment has a negative return. This means that you can lose more than your initial investment if the negative return is significant. Hence, leverage should be used cautiously and prudently.

This can mean reap huge rewards for a real estate investor. Imagine an investor with $100,000 of capital for investment in addition to their Sominex Account. With this capital as a 20% down payment they can purchase roughly $500,000 of investment property. Assume the property appreciates at a (moderate) rate of 8% per year for three years. At the end of the three years the equity in the property has increased over $120,000, a return on equity of 120%. When was the last time your IRA performed so well?

Now with close to $220,000 (initial $100,000 + $120,000) in equity the investor can gain control of $1,000,000 in investment property. If the $1,000,000 in investment property appreciates at the same 8% rate, the equity will grow by $80,000 per year.

Hopefully, you can see that real estate leverage can significantly increase return on equity. It needs to be used wisely and in accordance with a well developed plan. Using debt foolishly is called speculation and is the fast-track to foreclosure and ruin.

Jeff Brown has written a great article about the growth potential of $20,000. It makes you think about how you spend your money.

For most people a $20,000 decision is a huge. If you break it down, $20,000 is deciding 200 times how to spend $100. Or deciding 10 times how to spend $2,000. It may be 1000, $20 decisions. How are you going to get your $20,000? What decisions are you going to make?

A goal without a plan is just a wish.
- Antoine de Saint-Exupery

The Coming Train

Many of us have the goal of retirement. For some it is a small cloud of smoke on the horizon and for others the roar of the approaching train is growing and the locomotive ominous. Will the train of retirement be cramped and unbearable or will you be able to ride it comfortably into your sunset years?

Wishful Thinking

All of us hope for the latter option. We desire to enjoy retirement and do many of the things we could not do before. Maybe it is a trip to Europe, a vacation home, more time to fish or golf, more time with family, and the list is endless.

For a lot of people retirement is just a wish. They never plan for retirement. Few people even know what retirement looks like. They never stop and think what do I want to do in retirement? What kind of lifestyle do I hope to live? How much retirement income will I need to accomplish those goals?

How much income is available for the duration of retirement? Many planners recommend a withdrawal rate of between 3% and 5% of principal per year of retirement. This means that if you have $100,000, financial advisers recommend that you could withdraw $3000-$5000 in your first year of retirement. Does $3,000 plus Social Security meet the needs of your retirement dreams?

Setting a Destination

If we use a 4% withdrawal rate, our calculations are easier. We can multiply your present salary by 25 to achieve the necessary amount of accumulated wealth to retire at the same income. So if you make $50,000 annually you would need $1.25 million in accumulated wealth to replace your present income. If you earn $100,000 annually, $2.5 million dollars is the recommended savings to replace your current income. In Contra Costa County the median household income was $82,641 according to the Bay Area Census website. At that income level it would require $2,066,025 of investments to sustain a 4% withdrawal rate.

(Side-note: These calculations do not take into effect inflation. For every year until retirement your annual income should be increased by a factor of 2%-4% annually to negate the effects of inflation.)

The destination (number) should be in your mind. Now that you have it, how do you get there? You need a financial plan that will assist you towards your goal.

Developing the Strategy

The first part of your strategy should be a budget. You need to plan how you are going to spend your money this month. Spend less today in order to enjoy a better tomorrow. This is the process of delayed gratification. Put off an immediate reward for a greater reward in the future, namely retirement.

The second part of your strategy is your accumulation and growth plan. This is the longer-term plan. Hopefully, it involves a strategy that takes place over multiple years to accumulate and grow your wealth. This part of the plan should take place with a coach or adviser that will help you prepare, show you the pitfalls, and provide encouragement along the way.

Choosing an Investment Vehicle

If you are a baby-boomer, the retirement train will soon overtake you. Do you have the wealth to ride it comfortably?

There is hope, wealth can be built with the help of a solid plan and creativity. You may be wealthier than you think, if you own your home. You must choose a vehicle that will help you to arrive at your retirement destination quickly and comfortably.

One of the benefits of real estate is leverage. The wise use of leverage can dramatically increase your return on investment if done with a professional.

Don’t leave your retirement up to wishes on a star. Make a plan, get some help, and achieve your goal. Too much is at stake to leave it to chance. Take an active role in making your dreams come true.

Strategy Links

Below is a list of links to various resources that discuss developing a retirement strategy.

• Jeff Brown has some wonderful articles on what a good plan involves.
• The Financial Planning Association has a retirement planning checklist available.
• The National Endowment for Financial Education also has links to various resources and planning articles.
• Yahoo! Personal Finance has a retirement calculator to estimate your retirement savings needs.