BABY STEPS INTO REAL ESTATE

Welcome to the magical world of real estate. The first exposure for most of us is the home in which we live.  Perhaps not surprisingly, if a youngster is raised in a rental unit, this becomes a factor in setting a way of life as an adult.  In short, buying, versus renting, can be attitudinal.  Let me express my bias from the onset: The goal is home ownership, and the sooner, the better.  This is important, for the purchase of a first residence is frequently the initial step in wealth building. 

At the very least, the longtime ownership of a home is often a key element in later life independence.  Many a retiree who bought an inexpensive tract house with a minuscule down payment thirty or more years ago, and systematically paid off the mortgage, one installment at a time, is today able to get by with little else than social security.  But for a residence, free of debt, this might not be possible.  There is, however, one element that tends to undermine the outcome.  If over the years there’s serious economic deterioration of the area where the property is located, full benefit may be lost.  Luckily it’s not entirely a crapshoot, but the factors which go into determining the future desirability of a location is beyond the scope of this article.  In the near future I’ll address this subject in detail.

After the home purchase, the next logical real estate investment for many an aspiring entrepreneur is residential rental property.  It’s a business – yes, a business  ̶  which offers many pitfalls.  The principal of Murphy's Law applies: Whatever can go wrong will. And there’s much to go wrong.  Although this is a discouraging aspect of owning rental property, in a perverse sort of way it can be an advantage.  In any potentially profitable enterprise, the field is soon crowded with competition.  If not for the regular aggravation and occasional downright misery, anybody and everybody could handle it with ease.  The downside then becomes an upside; if you plan to enter the field, you must take this attitude.

A final thought: If you develop an interest in the potential that rental real estate offers, there’s a remarkable book you must read.  It’s William Nickerson’s How I Turned $1,000 into a Million in Real Estate in my Spare Time (later editions change a Million to Three Million and thereafter to Five Million).  Though long out of print, used copies can still be found

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Al Jacobs, a professional investor for nearly a half-

century, issues a monthly newsletter in which he

shares his financial knowledge and experience.

You may view it on http://www.roadwaytoprosperity.com

 

LOCATION, LOCATION, LOCATION

Let me share my response the other day to the question of how I select the location of my rental properties.  I prefer an area with total population no less than one million, which limits me to major metropolitan areas.  Consider, for example, the Riverside County area of Southern California.  Though there’s no city there with that population, the smaller communities, mostly contiguous with one another, exceed that count.  In all, the area is a most satisfactory choice.

A second location consideration involves price range, which relates fair market purchase value (FMV) to monthly rental value.  In general, as FMV declines, rental value as a percentage of FMV increases.  A typical example: A 1,200 square foot house purchasable in the city of San Bernardino for $170,000 brings $1,600 per month rental.  A similarly sized house in the city of Cypress, Orange County, sells for $340,000 and rents for $2,400.  An identical house in the city of Huntington Beach, marketing for $500,000, generates $3,200.  These values are shown in the following table.

  Sales Price   Monthly Rental   % Rent to Price

  $  170,000       $ 1,600                   0.94

      340,000          2,400                   0.71

      500,000          3,200                   0.64

From this single criterion, it might seem advisable to seek areas with the lowest property values so to maximize percentage gross rental return.  But with this approach, there’s a problem.  Percentage "gross" return isn’t what you’re after; you really want percentage "net" return.  The fact is, total operating expense as a percentage of rental value generally rises as property value declines.

So, although properties of lowest price range give high percentage gross rentals, the disproportionately greater expenses result in lower net income.  At the other extreme, properties of highest value enjoy the lowest relative expenses, but their low percentage gross rentals suppress net income.  Admittedly, rental units in all price ranges can be satisfactory investments when properly structured and managed, but properties in the middle price range generally deliver the greatest net income per dollar invested.  More specifically, residential rental properties, whether houses or apartments, described disdainfully by the British as "lower middle class," are the most profitable.

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Al Jacobs, a professional investor for nearly a half-

century, issues a monthly newsletter in which he

shares his financial knowledge and experience.

You may view it on http://www.roadwaytoprosperity.com

 

MORTGAGING YOUR HOME

This repeating newspaper ad finally caught my attention: “Are You House Rich and Cash Poor?” The investment program, offered at a seminar, seemed clear enough.  The homeowner incurs a mortgage loan through the featured Mortgage Consultant and then permits the predesignated Wealth Strategist to invest that money.

As the ad explained, a justification for borrowing on your personal residence is that “You’re earning a 0% return on that untapped equity. You have all that money locked up and you’re getting absolutely nothing for it. It’s just sitting there, virtually unemployed.”

Let me offer a second opinion. Home equity is not unproductive. My residence, delightfully free and clear of mortgage, has a potential monthly rental value of, perhaps, $10,000. I’d need to generate a pile of pre-tax income if I had to rent my own house.  Who sez I’m getting nothing by having it paid-off?

But economics aside, it’s the concept I reject. It’s unwise to incur a loan on your home, which must be paid, to invest in something that may or may not produce the cash flow to make the payments. Admittedly, it can be argued that if the investment is a surefire winner which you personally direct, with a return well in excess of the borrowing cost, it might warrant the risk. In this particular offering, however, you’ll not be in control.  Rather, your fate will be in the hands of a mortgage consultant and a wealth strategist who will explain things as you enjoy a full complementary meal at their “free educational investment seminar.”

As implausible as it may seem, many persons select their investments no more judiciously than by response to mass solicitation advertising. This is not a winning formula. Rather, the route to financial independence requires that you scrupulously avoid questionable enterprises, that you know exactly what you’re doing, and that you at least oversee, if not directly control, the substance of your investments.

 

Al Jacobs, a professional investor for nearly a half-

century, issues a monthly newsletter in which he

shares his financial knowledge and experience.

You may view it on http://www.roadwaytoprosperity.com

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BEWARE OF FREE OFFERS

A few days ago I received a notice from an organization of which I’ve been a member for many years. It said: “As directed by the President, I have upgraded your membership, FREE OF CHARGE. This is a special courtesy to you in recognition of your continued membership.” Acceptance required only my signature on the enclosed acknowledgement. At the risk of looking a gift horse in the mouth, I scrutinized the offering and there, buried in the fine print, I found the hooker – “free of charge” extends only 94 days.  At the end of that time my upgraded membership renews at a newly increased rate unless I specifically instruct otherwise. As for the benefits of the upgraded membership: a few meager tidbits of no particular concern; the annual dues increase: from $69 to $117, up about 70%.

There’s no mystery as to the offer’s intent. It’s a scheme to peddle a grossly overpriced product disguised as a benefit. This artifice, taught in marketing schools throughout the nation, is known as Opt-in/Opt-out marketing. It’s based on the premise that a predetermined portion of persons who accept an initially attractive offer will, if required to perform some function, fail to cancel out when the benefits end. The task of its designers is adjusting the parameters so to predict, within statistical accuracy, what percentage will neglect, for whatever reason, to opt out.

Though I regularly receive such duplicitous offerings from various companies – an even more egregious proposal arrived from a major bank the following day – I don’t normally take offense at deceptive pitches. I fully expect the nation’s financial community to operate in a high-handed manner, almost as a matter of course. My surprise was being treated in this fashion by an organization for which I had regard. However, perhaps it’s to be expected. It appears that as an entity grows in size, the activities of its marketing department become more remote from its fundamental business or service operation. And as these departments tend to hire persons with marketing school degrees, all taught the same techniques, the results are inevitable.

A concluding thought: It’s a hostile world out there, so you must be continually on guard to avoid being ripped off. And above all, be aware that there are no sure guidelines by which to distinguish the good guys from the bad guys.

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