Market Update: The Need For Bread & Butter Investing ~ By Chris Anderson, Ph.D.September 6 , 2006
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Remember back when George Bush Sr. was defeated, in large part because people felt he did not address the tough economic conditions that voters faced? In fact, there became a slogan that reminded him "It's the economy, stupid!" Since the voters felt like he did not properly address those issues, he was replaced.
As real estate investors, we are facing a similar situation today... "It's the real estate market, stupid!" Read most any news source and you will rapidly convince yourself that these are not the exploding markets seen during 2003, 2004, and parts of 2005. So as a real estate investor, what are you going to do? While I let you mull over that question, let's digress a little.
In our next article, I highlight two trips that I took last week; one to a resort location in Florida and one to resort location in Texas. Want to talk about a Dr. Jekyll and Mr. Hyde scenario. In one location, I wouldn't wish a property there onto my worst enemy (even though I love the location) and in the other, I would buy the right property there without a second thought.
An interesting discussion ensued as my staff and I discussed bringing out a project from the second location. What we discovered was that even though it was a great opportunity, we also realized it does not have the "sex appeal" that many properties have had in the past. Yet, when we analyzed what we considered to be solid opportunities, we came to the conclusion that many fit this category: very solid, no brainer opportunities even though they have a very low sizzle factor.
After continued discussions, my staff encouraged me to put the Florida/Texas article on hold for a week and write about what is probably forefront in many real estate investors minds... What now for real estate investors?
THE MARKET CHANGE
Here is a news flash for you:
Explosive Growth In The National Real Estate Market Has Slowed Or Reversed
Hopefully that does not surprise or concern you. The period of time that we have traveled through was phenomenal for investors.. Off the charts. IT WAS ECONOMICALLY IMPOSSIBLE TO CONTINUE THAT GROWTH RATE.
On the other hand, experienced real estate investors KNOW that there are still perfectly good opportunities out there now, will be 6 months from now, 1 year, etc. However, for many investors, they must come to grips with what were unrealistic expectations fueled by the explosive market. Let me give you an example.
I can show you several projects where you can walk into $20,000 of real, no BS equity and be able to cashflow the project. But, in the day and age of fast, easy money in real estate, unless somebody thinks they are going to score a quick $50K -$100K, then they just YAWN at $20K in equity.
But let's put this in perspective. Suppose I could show you a very low-risk, cash flowing opportunity that puts $20K equity in your pocket and has good upside. YAWN, right? How much money would you need to invest in CD's to accomplish that? Right now, CD's are paying around 5% so you would need to tie up $400,000 to create the same net effect. Ok, forget the CD idea. Let's consider investing in an index fund or its equivalent. Historically, this has AVERAGED 11% returns but we all know it may take 10+ years to "average" to 11% with many down years in between. So, you would need to invest about $180,000 to "average" that $20K return this year.
Bottom line is that if we get NORMAL appreciation, we get reasonable CASHFLOW, and we BUY RIGHT, we can far exceed the returns of other available investments and we can do this with very low risk (depends on property choice). This is how "plain Jane" real estate investment has worked for ages.
BREAD & BUTTER INVESTMENTS
In exploding markets, one of the great things is that you can buy just about anything and it will work out in your favor... At least, until the music stops and you are left without a chair. In more normal (or even declining markets), there are still PLENTY of opportunities but we just have to be a lot more selective.
Do you want to know the major difference between a new investor and a savvy, 20-year veteran with lots of battle scars? They focus on different things.
New Investor: How much money will I make?
Savvy Investor: What is upside potential relative to downside?
As I will show in an example below, the savvy investor works hard to put themselves in situations where there is MINIMAL risk but yet very high upside POTENTIAL. They are not naïve enough to think that all their investments will explode. They just know if they put themselves in enough good reward/risk situations, then some investments will break even/lose a little, some will make reasonable returns, and some will explode and make them more money than they ever dreamed possible.
An interesting side point is that this is the same formula that many successful stock traders use. They develop a system by which they minimize any money at risk (by placing stops and covers) while letting the upside potential be great; a high
Reward to Risk ratio. With real estate investors, it is the exact same concept. The bread and butter basic for any investing is not "buy low and sell high." Rather, it is buy with minimal risk and with high upside potential.
For real estate investors, the ingredients for creating this bread and butter investment are simple:
Buying Right : They like to buy below market to add safety. In many cases, they know 5-20% or more below a stable market provides tremendous security.
Appreciation : They base their purchase decision on conservative appreciation estimates. They look for the RIGHT INGREDIENTS for explosive growth but never count on it occurring. When it does, they get a homerun.
Holding Costs : Using rents & cashflow, and possible appreciation during a construction phase, they try to either minimize their holding costs or create a slight positive cashflow.
Natural Demand : The want to see that there should be lots of natural demand for their investment whenever they are ready to sell or to rent out. This way, they know they have a good exit whenever they chose.
When these components are present, and the numbers make sense, they buy the investment. Successful investing is a simple, and boring, as that.
A "BORING" EXAMPLE
Let me give you an example of a personal investment that I did in the Destin FL area. This occurred before GetPreConstructionDeals.com was formed but illustrates several key points. Here are the details:
Purchase Price: $200,000
Fair market value at time: $210,000
Build Time: 9 Months
Market Rents: $1,200 - $1,300
"Expert Estimates" Of Value $235,000 after construction
Down Payment $20,000
If you looked at the property, the plans, etc., absolutely nothing remarkable about this project. For most, this property was a first class YAWN! The people buying high flying condos on the beach laughed at this "opportunity". Unfortunately, many of these same high flyers are now facing -$10,000 or more negative cashflow, per month, on the beach. What we knew was that there was a need for this type of product and that getting this rented would be easy if we did not sell it immediately.
From a risk standpoint, we knew there was almost zero risk since at worst, we could rent these out and break even. We saw no way that the prices would likely reverse backwards from this point. From a reward standpoint, it looked like that if everything played out as planned, we could probably net $20K from a $20K investment, over a 9-12 month period. YAWN! Not bad but not substantial.
From a homerun side, yes the ingredients were in place for Destin to keep exploding but Destin had already seen 2 years of substantial appreciation. Would it continue? I was not counting on it. Long story short, the explosion did occur and the value of those townhomes exploded to $315,000... That was pure "luck" but was created by investing when all the right ingredients were in place. When you do that repeatedly, then sometimes you will get "lucky". Since the peak, the value of these units has fallen back to around $270,000 which is still great when you paid $200,000 for them and they are cash flowing.