John Keats, in his poem 'A Thing of Beauty' proclaims that a thing of beauty is a joy forever. Beauty never passes into nothingness. Our earth is replete with innumerable natural objects full of beauty. Keats wrote this poem while sitting outside a beautiful block of council houses in Bethnal Green. He was inspired by the flow of rents he could extract from these assets.
High-value men are masters of their minds, their bodies and their money. They do not work for money - instead they learn how to make money work for them. One way is through property investment., In this blog, I will look at the twelve cardinal rules of property investing,
Rule 1: Develop your Legitimate Cheapness
In the cult comedy "Seinfeld", George Costanza says "I'll sniff out a deal. I have a sixth sense" to which Jerry replies "Cheapness is not a sense". I would argue that cheapness is a gift. The first rule of real estate is the 15-20 percent rule. You need to find a real estate asset that is 15-20 percent below its market value. This is your margin of safety. If you need to sell the property sooner than expected, that margin of safety helps to cushion any losses. This instant equity in the property will also improve the return calculations. Your rent will be referenced to the market price and your return to the acquisition price.
Rule 2: Lust over Location
"Location, location, location" is a real estate cliche. The first is centrality. Cities are land, energy, and water-intensive. City councils are faced with the challenge of optimizing space usage and utilization of resources. The trend is urban densification is increasing the number of dwelling units and mixed-use spaces per acre. Densification encourages efficiency and conservation. It makes the city more sustainable and environmentally friendly. Filling vacant lots with shared spaces, cities can deliver water, electricity, and other municipal services to more people using fewer resources and less energy. Real estate investors need to focus on those central locations where densification is most pronounced.
The second is the neighborhood. It needs to be aesthetically pleasing, easily accessible and filled with high-quality amenities. You need to do a reconnaissance during rush hour to see how traffic flows. Look for green areas and parks that would be attractive to families. Make a map of the transportation and mobility alternatives. Look for ease of access to a subway or bus route, bike-sharing services or electric scooters. Assess the vibrancy of the suburb. Go there during an off-peak time of day and order an Uber. If the nearest car is 15 minutes away, the neighborhood may not be desirable or centralized. You also need to look for amenities. How many schools and universities are in the area? Being close to a university indicates that there should be a steady demand for tenants in the form of students – if you don't mind pot-smoking, flag-burning hippies as your tenants.
The third factor is development. It is not just existing amenities that matter, but also future ones. Plans for schools, hospitals, public transportation or other public infrastructure can improve property values. Commercial development can do the same. On the flip side, if the city is deciding to convert your nearby park into a legal drug zone where police are not allowed to enter and clean needles are distributed to the public, you want to get the hell out of there.
Fourthly you need to consider physical location within that great neighborhood. If your asset is on a busy road, you may pick it up cheaper, but the rent may also decline. Stay away from properties adjacent to commercial locals such as shopping centers and gas stations. You also want to see how many cars are parked on the streets. Streams of cars on the sidewalk may indicate you are close to a Satanic coven or a community center which is not desirable.
Finally, be on the lookout for a mass exodus from the neighborhood. Count the number of for-sale signs on the block. If every second house is for sale, jump on your horse and get the puck out of there. All these factors are key variables in the calculation of expected vacancies. The time the asset stands empty is a crucial variable in rentals. By focusing on these four points above, you can incorporate a margin of safety to ensure that your vacancies are minimized.
Rule 3: Do Not Obsess over the House
A house is not an appreciating asset. The bricks and mortar are the same as a car – they depreciate. It is the land that represents the underlying value. Consider the following two real estate assets. Asset one is on a big plot of land, but the house needs some love and attention. Asset two is on a plot of land that is half the size but the house is immaculate – recently refurbished, wooden floors and super modern finishings. Which asset would you buy if both were on sale for the same price? The uncircumcized masses would take the latter. In reality, the former would be the better investment. The house can be fixed, renovated and improved. The land, on the other hand, cannot. This does not mean that house prices do not go up. They may appreciate in the short to medium term, but over the longer term, it is the land that underpins the investment.
Rule 4: Use People’s Money (Loan to Value)
OPM or Other People's Money is an important driver of real estate returns. Take an apartment costing $100,000. You pay cash and rent it out for $7,000 per year net of costs and expenses. The return on investment is 7 percent. Now, using your wily charms, you convince your local bank to lend you 80 percent of the value of the asset at an interest rate of 5 percent over 20 years. You put $20,000 down on the apartment. Your net rent after interest (which is potentially deductible) is $2,000. The return on investment on your initial investment of $20,000 is 10 percent. Ten percent versus 7 percent does not sound like much but you need to consider the power of compounding. A $20,000 investment over 20 years at an interest rate of 7 percent will deliver $77,393. That same money invested at 10 percent would balloon to $134,550. This is almost double ignoring the tax benefits of writing off the interest on the OPM. The loan to value ratio, which is the percentage of the value of the property against which the bank is prepared to lend, is a key variable in profitability calculations. More equity in the property means less risk. More equity also means more of your own money tied up in the deal and a higher calculation base. Less equity means more risk, but more potential return. You need to find a happy equilibrium between risk and return.
Rule 5: Understand NOI
In the world of millennial speak, NOI means No Offense Intended. In real estate speak, it means Net Operating Income and is used to analyze the profitability of income-generating real estate investments.
NOI = Total Revenue from the Asset - Total Operating Expenses.
Total revenue would include rents, parking fees, on-site laundry costs, fines from rule violations such as defecating dogs, disturbance of the peace, public nudity and anyone with a mullet. Total Operating Expenses include the costs of running and maintaining the building, including insurance premiums, legal fees, utilities, property taxes, repair costs, and janitorial fees. If you want to go ultra-passive, you can pay a third party to manage the asset or assets and that would be included in the operating expenses. Operating expenses DO NOT include principal and interest payments on loans, capital expenditures (such as the installation of a new heating system throughout the building), depreciation, and amortization.
Rule 6: Calculate the Debt Service Coverage Ratio
Debt Service Coverage Ratio (DSCR) is the ratio of a property’s Net Operating Income (NOI) to its Annual Debt Service.
DSCR= NOI/Annual Debt Service
A DSCR of 1 means that you are breaking even. You are generating just enough free cash flow to cover your annual debt service. You are not generating any free cash flow. Experts will talk of a minimum hurdle rate of 1.2, which means that your NOI is 20 percent above your annual debt service. The honey pot will be located between 1.3 and 1.4.
Rule 7: Cracking the CAP
Rate The capitalization rate (cap rate) is the NOI divided by the market value of the asset. You know the NOI. You will need to cozy up with appraisers or property brokers for the market value. Your schmoozing strategy should be dictated by the generational profile of the appraisers. For baby boomers, a bottle of single malt scotch and a box of Cubans (cigars, not humans) should do the trick. Generation Xs can be bought with concert tickets to U2 or a yearlong subscription to ESPN Plus. For Millennials, any item of clothing from Lulu Lemon or any product that promotes multitasking or minimalism. For generation Z, anything from emoji makeup brushes to influencer-branded clothing lines will hit the spot. This capitalization rate is going to move around depending on the volatility of the market. During economic downturns, cap rates can fall to between 3 and 5 percent while during market upswings, they rise to the mid-teens. Seven to nine percent is the long-term market average. A lower run rate hardly seems worth the effort. You will need to do your homework on the cap rates in your area. It is also a good idea to scratch around the internet to get a better idea of economic activity in the region. You want to focus on growth rate projections, political agendas if you are approaching an election and broader macro or country trends.
Rule 8: Elvis is Dead – Cash is Now King
The intrinsic value of a financial asset is the present value of its cash flows. Negative cash flow means you need to dig into your pocketbook to make up the shortfall. High positive cash flow will help you weather the market downturns. A key metric that will determine your cash flows is the aggression of your leverage. High loan to value means that your service costs are high, your margins are lower and you are treading a fine line between solvency and insolvency.
Rule 9: C C R (Credence Clearwater Revival and Cash-on-Cash Returns)
This is a big one. It is the John Fogerty of real estate investing rules because it defines the real return on your investment. How much cash are you generating in any given year divided by the total cash you invested in the assets? The less capital you put in, the higher the potential returns. With this metric, you are looking for double-digit percentage returns.
Rule 10: Do Not Trust the Numbers from the Salesperson
Salespeople are by nature preppy and bubbly. They have been known to err on the positive when presenting rental and expense numbers to prospective investors. Their primary objective is to move the property and will do everything within their ethical wheelhouse to achieve this. You need to analyze the investment with real numbers, and not the pro forma "happy gas" numbers from the agent.
Rule 11: 50 Percent for Expenses
In a comedy skit, Chris Rock spoke out in defense of red meat: “Everyone says that red meat will kill ya. Red meat won’t kill ya. Green meat will kill ya.” In real estate investing, it is the expenses that are going to kill you, or more accurately, it is the underestimation of your expenses that will kill you. You should work on non-mortgage expenses being 50 percent of the rent charged. This sounds high, but it is prudent to err on the side of conservatism. This rule goes back to the Net Operating Income calculation.
Rule 12: The One Percent Rule
This is a quick and dirty calculation you do on the fly to separate the wheat from the chaff. The asset should generate 1 percent of the total purchase price per month. This means that if the total cost of the asset is $100,000 it should generate $1,000 per month in gross rent.
Exercise
Real estate investing is all about common sense. You need to hone this skill. Get out into the neighborhoods and sharpen you Sherlock Holmesian skills of observation and deduction. Hang out in the coffee shops. Speak to the barbers - the real people with real jobs. Go out and understand the market and sniff out the best deals.
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