The Three Immutable Laws of Real Estate Investing
Ask a room full of active real estate investors what they think is the most important factor that makes for a successful investment and a significant portion will respond with “it’s all about location, location, location.” The market in which you invest is one of the most impactful decisions you will make.
Or is it…?
Real estate investors have made money in every market across the country, and more recently the world, at every point in time since the first person purchased a piece of real estate for investment purposes. So, how can two investors investing in the same market see totally different results, with one thriving and one failing?
The answer is quite simply: the actual market means nothing if the investor cannot execute on the business plan properly.
This doesn’t mean that you can blindly invest in any real estate market. To maximize your chances of success, you should always evaluate a market before investing. However, from my experience scaling from a handful of single family rentals to controlling over $300 million in apartments, and from interviewing thousands of active, successful real estate professionals on my podcast, I identified a pattern.
I discovered that there are three laws that, when followed, result in a real estate investors ability to thrive in any market at any time in the market cycle. These Three Immutable Laws of Real Estate Investing are 1) don’t buy for appreciation, 2) don’t over-leverage and 3) don’t get forced to sell.
Law #1 – Don’t Buy For Appreciation
The first of these three laws is don’t buy for appreciation. And in particular, natural appreciation. Natural appreciation is completely out of your control because it fluctuates up and down based on the overall real estate market and economy. Whereas forced appreciation is the bread and butter of value-add investors. Forced appreciation involves making improvements to the asset that either decreases expenses or increases income, which in turn, increases the overall property value.
Many investors, past and present, buy for natural appreciation, and it is a gamble. Eventually, they all get burned – unless they’re extremely lucky. Buying for natural appreciation is like thinking you’ll get rich at the casino by playing roulette and only betting on black. Yeah, maybe you can double up a few times, but sooner or later the ball lands on red or – even worse – green, and you lose it all.
That’s why you should never buy for natural appreciation. Instead, buy for cash flow. Because when you buy for cash flow (and as long as you have a large supply of renters), you don’t care what the market is doing. In fact, if the market takes a dip, the demand for rentals will likely increase!
Law #2 – Don’t Over-Leverage
The second law is don’t over-leverage. Although, leverage is one of the main benefits of investing in real estate. Let’s say you have $100,000 to invest. If you decide to invest all of that money into a stock, you would control $100,000 worth of that stock (you can leverage a stock by investing in options contracts, but there is significantly more risk). On the other hand, if you wanted to invest all of that money in real estate, you could spend $100,000 on a down payment at 80% loan-to-value and control $500,000 worth of real estate. That’s the power of leverage.
But there’s also a catch. The less money put into a deal – or more specifically, the less equity you have in a deal – the more over-leveraged you are. Consequently, the higher your mortgage payments will be. In a hot market, over-leveraging may seem like a brilliant idea, but what happens when property value or rental rates start to drop? Well, if you purchase a property with less than 20% equity at close and the market drops by 5%, 10% or 20% (which has happened in the past) by the end of your business plan, you will lose a decent chunk of change at sale – if you even survive long enough to make it to that point.
Of course, if you never want to sell and bought a property that cash flows, then it doesn’t matter. However, if you are a value-add or distressed apartment syndicator, you make a large amount of money when we sell, so this needs to be factored in.
My advice? Have 20% equity in an apartment deal at minimum. You shouldn’t run into this problem if you are getting a commercial loan from a bank, as they will typically require at least 30% down. However, if you are pursuing a creative financing strategy, you may have the opportunity to purchase an apartment for significantly less than 20% down. Don’t be tempted. Similarly, a bridge loan (a short-term loan usually used to cover the purchase price and renovation costs before securing permanent longer-term financing) may offer a higher loan-to-value ratio. In these cases, have 20% of the total cost (purchase price plus renovations) in the deal.
Having 20% equity in a deal isn’t a requirement but failing to do so will expose you and your investors to more risk. Although doing so, in tandem with committing to not buy for natural appreciation, will allow you to continue covering your mortgage payments or avoid having negative equity in the event of a downturn.
Law #3 – Don’t Get Forced to Sell
The final law is don’t get forced to sell. When you are forced to sell, you will always lose money or won’t be able to maximize your returns.
The main reason investors are forced to sell or return properties to the bank is when they speculated and bought for appreciation, or they were caught up in a hot market and were over-leveraged.
You could also be forced to sell if you do not have the funds to cover an unexpected expense that occurs during operations. To mitigate this risk, I recommend having an operating budget of at least $250 per unit per year in reserves.
Another reason you would be forced to sell is if you have a balloon payment on your loan. A balloon payment is standard for commercial real estate loans. The problem investors have is when they have a balloon payment come due during a down turn in the market and don’t have enough equity in the deal to refinance to cover that payment.
A way to mitigate this risk – in addition to not buying for appreciation and not over-leveraging – is to be aware of when your balloon payment is due and plan years ahead of time for what type of exit strategy you are going to pursue. Some common exit strategies are:
- Selling the property
- Refinancing into another loan
By sticking to these Three Immutable Laws of Real Estate Investing, don’t buy for appreciation, don’t over-leverage and don’t get forced to sell, your investment portfolio will not just survive, but thrive in any real estate market and in any economic condition.
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