JF2375: 3 Immutable Laws Of Real Estate Investment | Actively Passive Investing Show With Theo Hicks & Travis Watts
Today Theo and Travis are talking about three things that allow people to succeed in the real estate business. While many people focus on the markets, demographics, projections, and other specifics of the business plan, some fundamental things should be right about the deal for it to work. Occasionally, real estate investors get lucky and make a decent return even when some of these laws are bypassed. However, those are exceptions, not the rule.
We also have a Syndication School series about the “How To’s” of apartment syndications, and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening.
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Theo Hicks: Hello, Best Ever listeners, and welcome to another episode of the Actively Passive Investing Show. As always, I am your co-host, with Travis Watts. Travis, how’s it going?
Travis Watts: Hey, thrilled to be here.
Theo Hicks: Yeah, thanks for joining us, again. Thank you also Best Ever listeners for joining us. And today, we are going to talk about the Three Immutable Laws of Real Estate Investing. So Travis just told me beforehand that he just came across this article, and it’s something that’s been up on our website for – gosh, since 2016, probably, in the middle of the economic expansion. And we’ve kind of reiterated these points throughout the past five or so years, after the different elections and after the COVID pandemic hits… But right now, since we’re, I guess, technically, maybe still in a recession, we thought this would be a really good topic to bring up. And we also haven’t talked about it from the perspective of passive investors either; we were mostly focused on it from an active perspective.
So we’re going to go over these three immutable laws of real estate investing are, but first, as always, Travis is going to let us know why we are covering this and then I’ll kind of also go into a quick little myth that people have when they think about investing in real estate.
Travis Watts: Yeah, I appreciate it. Well, I think you did a good job covering why we’re covering it. But yeah, that’s my confession, is that this has been out there for years and years. And I’ve read so many of the blogs, and of course, the books. I’m sure I’ve skimmed across this, but it really just sunk in for some reason this week. I came across it, written years ago, and I thought, “This is really a foundational concept that everybody needs to be aware of, active or passive really”, but it was looking at it through the lens of being a passive investor. I really want to share and reiterate even if you’re listening today and you’ve heard this before in some other fashion, we’re going to dive a little bit deeper into it. I wanted to pick and share a few stories of how this has been true for me in my own experience.
If I’m not mistaken, Theo, you know better than I, but I believe this is really comprised of Joe interviewing thousands of different investors and putting together the most successful three points, basically, to investing in real estate. So for any regard, these are the things I followed myself, these things I firmly believe in, and they’re just laws or rules to follow, if you will, and good for both sides of the coin. So that’s it, what’s the myth that you want to cover?
Theo Hicks: So from the perspective of the active syndicator, one goal is always to make money for you. But the overall goal is at all times is to not lose your money; at the very least to conserve that initial capital, so that if something happens to the deal or to the market, at the very least, you’ll still get your equity back. That’s the number one rule of investing. I think that’s like Warren Buffett’s number one rule for investing, is capital preservation, right?
And so in order to do that, the syndicators focus on the different things that could happen to the investment that will result in you losing your money. So in apartment syndications, the three main risk points are going to be the business plan, the market, and then the team. So the team could mess up and lose your money, it could be a bad market and you could lose your money, or it could be the wrong business plan or the business plan fails and you can lose your money. And so the focus has to be on “Well, what are they doing in order to minimize risks in those three areas?”
Now, when it comes to the market, that is probably the least risky point. When I say market, I mean the actual location, because you can make money investing in any market… People have invested in New York or in the middle of nowhere in Iowa, and they made money investing in real estate… As long as it obviously has some of the right metrics, and Travis and I have talked about this on the show before, how to evaluate each market, so I’m going to focus on that one as much. Obviously, there’s the team investing with the right GP, we also talked about that, and the other one is going to be the business plan.
So why is it that one apartment syndication deal can do really well in the exact same market, following the exact same business plan, and maybe by the exact same team, and the other one doesn’t do very well? It comes down to, as Travis said, these three points we’re going to go over it. So these three points are things that Joe has learned from his experience and from interviewing people, that allowed people to be successful regardless of where they invest, regardless of what they invest in, or if they didn’t do well, here are the things that they realized that they should have done differently.
And so at the end of the day, there’s this idea, the myth of it’s all about the location, it’s all about investing in the perfect markets. It’s helpful, it’s beneficial, but at the end of the day, any operator following any business plan is not going to be successful just because they invest in some market that the rents are supposed to grow by 10%. There’s other factors involved, and the one we’re going to focus on today is going to be the actual business plan.
Travis Watts: Exactly. And I’ve shared that story before on our show, Theo, of where I was an LP in a deal with a syndicator early on, bought a really good deal, good price, good market, etc. but unfortunately, this particular operator couldn’t execute their business plan, made a lot of mistakes in regard to that… And it was just one of those situations where, yeah, the market definitely helped boost the rents, helped boost the equity, but it really was to no avail of the operator. So we exited early. It was kind of an unfortunate situation. But yeah, markets are important, location was important, but at the end of the day, none of us got our projected returns or what we hoped to get out of that deal. So – great points.
So the first law that we’re going to cover from Joe is buy for cash flow. This is obviously my biggest message to the world; any podcast, I’m a guest on, any blog I ever do, it’s always about cash flow. That’s my passion. That’s what’s made the biggest impact in life, which is why I resonate so much, especially with this particular law. So it’s the opposite of what most people think of when you say, investing or “I’m an investor.”
In fact, I remember when I worked in the oil industry, there was this guy that came up to me, somehow he found out that I was buying single-family rentals… And he goes, “You’re an investor, right?” A very intense guy. I said, “Well, yeah, I buy real estate, I buy rental.” He goes, “Yeah, I get it.” He goes, “Buy low, sell high. It’s pretty simple.” And he walks away, and I thought, “Well, not exactly.” In my opinion, that’s pretty much just wrong… Because yeah, you can make money doing that, but I wasn’t trying to buy low and sell high. I had buy-and-hold rentals at that time and I was doing vacation rental stuff and things like this.
So it’s just kind of funny that – think of it as the opposite of appreciation. Natural appreciation is going to come from that story I just shared with that LP deal, where people are moving to an area and inflation is growing, expanding employment, wages – that’s going to lift values naturally. But that’s pretty risky, because mostly that’s out of our control. We can’t really control what the Fed’s going to do, when interest rates are going to do. Think about Texas right now; everyone’s moving to Texas, right? Well, what if Texas, this year, comes out and says, “You know what, we’re implementing a 10% state income tax.” Well, that’s pretty much going to change a lot of stuff over there about why people are moving there.
So things can evolve, things can change out of your control. That’s why I’m a big fan of forced appreciation, which is value-add investing, where you’re buying something that’s outdated, that needs fixing up, and you’re forcing the value back into it, therefore, you can justify lifting the rents etc, in terms of that.
So another quick story about cash flow is when I used to buy single-family rentals. I intended to do a flip one time – this was one of my first flips – and I was into the budget initially, and what I thought would cost me maybe 10 grand was already at 16 grand, and I thought, “This isn’t going to work out. The numbers aren’t going to work. By the time I sell, and I pay the commissions, I pay taxes, etc. I’m not even going to make a return.” And the only thing that saved me was cash flow. I pivoted my business plan. I said, “You know what, I’m going to make it a rental. And that’s going to give me time to start collecting money, so that I can build back the cash reserves that I wasn’t going to get.” So that was really a life-saver and a game-changer for me to realize how impactful cash flow really could be.
So at the end of the day, buy for cash flow. As long as you’ve got a supply of people willing to rent, you don’t really have to care too much about what the market is doing; the market’s really hot, the market’s declining, the market’s stagnant… Hey, man, if you got monthly income rolling in, at the end of the day, like we talked about on our last podcast, just to use simple numbers. I take 25K and put it into a deal; that deal produces 25K in cash flow. I take that 25K and do another deal. I’m reducing my risk as I go along that daisy chain, because my real risk is in that first investment. As long as that’s stabilized and cash-flowing, I really have little to worry about. So kind of my long-winded rant there, but that’s law number one, buy for cash flow.
Theo Hicks: Yep. And your last example is the perfect reason why. So if you buy for cash flow, but you can still have a potential value-add play or a potential market-driven appreciation play. But that’s more of like a cherry on top, so to speak. It’s cash-flowing, that’s the cake. And then if you’re able to force appreciation or if the market were to increase the value of the property or the rents naturally, then that’s great, you make even more money. But if it doesn’t happen, you’re still going to hit your projections, you’re still going to make money, and even if the market tanks, you are still not going to lose your money, as long as you’re following law number two.
So all these laws, they all come together. You can’t just do one, you have to do all three, I forgot I mention in the beginning. All three of these come together; because Travis said, “Well, as long as there’s a steady supply of renters”, then you buy for cash flow and it’s okay, because you don’t really care what the markets doing, because you’re not going be forced to sell… As long as you also follow law number two, which is making sure you’re securing long-term debt. So whenever you’re investing in a syndication deal – unless you’re an institution or you’re a hedge fund – you’re going to get financing on the property. You’re going to get Freddie Mac agency debt in order to fund the majority of the project costs. Usually, the syndicators are going to raise 20% to 30% of the project cost from limited partners, and then the rest of the money comes from a bank.
Now, the law here is to secure debt that’s at least twice as long as the business plan. So let’s take a value-add business plan as an example. Let’s say the plan is to renovate 100% of the interiors over a 24 month period, and increase the rents by $100 per unit. So the business plan is two years; it takes two years to renovate all the units. So when the syndicators are going out and securing debt, they’ve got a couple of options.
One option is they can just find a two-year bridge loan that’s going to include all those renovation costs, which allows them to raise less money. But the problem is, well, what happens if they aren’t able to complete the renovations in two years? What happens if they complete the renovations, but they overestimated their rental premiums? What happens if, you know, let’s say a pandemic hits or something, two years in, and they are unable to hit those rental premiums?
Well, if they secure a two-year bridge loan, then they have no choice but to sell or refinance. And if they can’t refinance into agency loan because the deal isn’t stabilized, and they can’t refinance into a bridge loan because of what happened with the COVID pandemic, bridge lenders stopped lending – well, then they have to sell, and well, what if they can’t find a seller? They’re going to sell for a loss and can’t get all their money back, or they’re going to be foreclosed and they’re not going to get any of their money back.
So in order to avoid all those potential situations, the law says secure debt that’s twice as long as whenever the plan is to do any sort of refinance or sell or something. So in that example, you either secure a loan that’s at least four years, so that if something happens in year one or year two and you don’t hit their projections, then they can just wait, keep collecting the cash flow they’re making, make partial payments or no payments, but not be forced to do anything with the property or the loan. As I said, refinance— [unintelligible [00:15:31].16] or get foreclosed on. So at least two years is ideal. Some syndicators you will see that they’ll have a 5 year loan or a 7 year loan or a 10 year loan or a 12 year loan or even a 30 year loan.
And then the other option would be a bridge loan. Well, maybe they have to get a bridge loan for some reason. Well, if that’s the case, then they need to have the ability to extend that loan out to, again, that 2x period. So traditionally, bridge loans are about three years, but you can get multiple one year extensions. So ideally, they have a 3/1.1. So three, with the ability to have two one-year extensions to hit that 5 year mark, and that’s two times the business plan.
Travis Watts: Exactly. And what we’re really talking about, Theo, in all of this. I’m just zooming out, as you were speaking… I’m thinking, all this really is is reducing risk and being conservative. And that’s the foundation to me anyway of investing. Like you pointed out, Warren Buffett’s first rule “Don’t lose money”. Well, yeah, it makes sense, right? It’s pretty obvious. Who wants to lose money? So all of this is helping folks, active or passive, not lose money. That’s all we’re really talking about.
And so to that point, law number three is have adequate cash reserves. Sometimes I like to draw parallels, either to stocks or the stock market. In this case, what I think about is this personal finance. You hear all the time from the Dave Ramseys of the world, or the Suze Ormans or whatever, have six to 12 months of cash reserves on hand in case you lose your job, etc, so you don’t have to lose your house or not make your mortgage or rent, and these types of things.
Same concept here – when you’re underwriting or if you’re buying a property, I don’t care if we’re talking about single-family, multifamily, have cash reserves on-hand to cover the unexpected expenses, which are going to happen. I just used that example of my fix and flip earlier, where I budgeted 10, but it took 16. Well, fortunately, I had the extra six sitting around because I thought, “Yeah, that’s a possibility. I’m going to need some extra cash for something.” I did. What if I hadn’t had it? I could have been in a really bad situation.
So when you can’t cover your unexpected expenses – speaking to syndications, the theme of our show – you’re either going to have to do a capital call, which is collecting more money from your investors; that’s never a good thing. First of all, you don’t want that on your track record as a GP. Second, what investor wants to have to fork up money unexpectedly for a deal that they shouldn’t have had to do that for? That’s not a good thing. Or if you don’t do that, you might have to, to your point earlier, sell that property at a loss. No one wants that either. You don’t want that on your track record, and LPs certainly don’t want that; or you may have to just give the property back to the bank, whether that’s in a short sale, or a foreclosure, whatever. It’s not going to be good. These are not good options. So what saves you? Having adequate cash reserves.
So let’s get specific with it. I think Joe points out a couple things… And maybe this has changed, because this is a 2016 article; I don’t know if he’s got a different view on it. But still, the concept remains the same; have $250 per unit in cash reserves per year. That’s one thing. Additionally, you might want to have an upfront operating account of 1% to 5% of what the purchase price is.
So none of these things have to be exact; you might have a different take, a different opinion, a different percentage, a different dollar amount. The fact is, have adequate cash reserves. Don’t think optimistically, best-case scenario, “We shouldn’t have things pop up, there’s not going to be a kitchen fire, we probably aren’t in a flood zone, so that won’t happen. Tornadoes never come through this area…” Just expect that all of that is going to happen, and have adequate reserves to cover it.
And I’ll share with you one other story… I was actually in a syndication deal that we had to do a capital call unfortunately, for all of these reasons that we’re talking about… And it was unfortunate. It ended up being – I think, it was 10% of what we had originally put in. So you think, okay, I put in 100 grand or whatever—I don’t know what I put into that deal. I can’t remember. But let’s just say for simplicity, that’s what I did.
So all of a sudden, you get this email or this phone call, “We need you to put up 10k ASAP. Can you do it this week?” That’s never a good call. Even if you have the 10k, that’s not what I wanted to do with it. Maybe I had other plans for that money. So it does happen. It really does. So it’s something to think about, and pretty simple in concept; adequate cash reserves, pretty self-explanatory.
Theo Hicks: Yeah. So now, the only real change, at least as we’re recording this, would be that the syndicator is probably going to be on the higher end of the upfront reserves number, towards the 5%, because of the additional reserves that lenders are requiring right now. For some loans, it is up to 18 months of principal and interest, which is a lot. Usually, it’s 3-6 months. So as Travis said – and I like the way you said that – all these rules are to save you and save the syndicator if something happens. So buy for cash flow, making sure that you’re not forced to do anything, and making sure that there’s no capital calls… All the rules are just very, very conservative ways to make sure that you don’t lose your money.
And one last note on the adequate cash reserves is that if you don’t use this stuff, then you get it back. So if it’s not used, it’s not like the money just disappears, or the bank just keeps it. Because a lot of the things are acquired by lenders to be staying in the account for a certain number of months, and then it can be distributed or used for something else.
But yeah, all of these things are just ways to reduce risk. And by risk, I mean, losing your money. So just to quickly summarize – one, buy for cash flow; not market-driven or natural appreciation. Two, secure long-term debts. You are not forced to do anything. And then three is to have those adequate cash reserves, both upfront and then on an ongoing basis. Travis, is there anything else that you wanted to mention before we sign off?
Travis Watts: Just to iterate how these three points came to be one more time, because I think it’s important and it’s a strategy I’ve used for years and years and years. And Theo, we talked about this – God, like, when we first started this podcast, one of the first episodes.
When I’m learning something new – let me give you an example unrelated to this. Let’s say something I don’t know much about, that I’m certainly not an expert in and that I want to learn. So let’s say interior decorating; it’s not really my thing. So if I were to want to know what to do with a house or a room or something, what I would do is I would hire, not one person and get one opinion, I’d probably hire three people and get three opinions, and I would do my own homework and due diligence and whatnot. I would end up with maybe let’s say 10 different ideas, and then I would find the commonalities. So let’s say out of 10 different opinions on a living room, seven people said, “You really ought of paint this wall a lighter color. Maybe a neutral gray or something.” I’m going to take that and hone in on that. That’s what these three points are, are interviews with thousands of real estate investors and finding the commonalities; how many people say, “Buy for cash flow. Be conservative in your underwriting. Have adequate cash reserves. That’s what these are. This isn’t just one person’s opinion, “Here’s what I think about real estate.” That doesn’t really matter. I think what matters is a survey of many successful people. And that’s something to keep in mind and why we did this show.
Other than that, anyone listening, if you guys have an idea for topics or any questions, please email firstname.lastname@example.org and we’re happy to implement that onto one of our shows.
Theo Hicks: Yep. And then also kind of on a similar note, we’re doing something even more specific, which is our 60-second question. The same – email us topics or questions you have, and then we’ll kind of decide if it makes sense to do it on this show, or if we’ll do it on a 60-second question episode, which we have on the YouTube channel.
Travis, thanks again for joining us. I’m glad we got to dive deep into the three immutable laws of real estate investing. Best Ever listeners, as always, thank you for listening. Have a best ever day and we’ll talk to you tomorrow.
Travis Watts: Thanks, Theo. Thanks, everybody.
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