Seventh Edition
“Donald Trump and I have created Trump University to offer the highest quality, success-driven education available. Our one goal is to help professionals build their careers, businesses, and wealth. That’s why we selected Gary Eldred to help us develop our first courses in real estate investing. His books stand out for their knowledge-packed content and success-driven advice.”
—Michael W. Sexton, CEO Trump University
“Gary has established himself as a wise and insightful real estate author. His teachings educate and inspire.”
—Mark Victor Hansen, Coauthor, Chicken Soup for the Soul
“I just finished reading your book, Investing in Real Estate. This is the best real estate investment book that I have read so far. Thanks for sharing your knowledge about real estate investment.”
—Gwan Kang
“I really enjoyed your book, Investing in Real Estate. I believe it’s one of the most well-written books on real estate investing currently on the market.”
—Josh Lowry Bellevue, WA President of Lowry Properties
“I just purchased about $140 worth of books on real estate and yours is the first one I finished reading because of the high reviews it got. I certainly wasn’t let down. Your book has shed light on so many things that I didn’t even consider. Your writing style is excellent. Thanks again.”
—Rick Reumann
“I am currently enjoying and learning a lot from your book, Investing in Real Estate. Indeed it’s a powerful book.”
—Douglas M. Mutavi
“Thanks so much for your valuable book. I read it cover to cover. I’m a tough audience, but you’ve made a fan here. Your writing is coherent, simple, and clean. You are generous to offer the benefits of your years of experience to those starting out in this venture.”
—Lara Ewing
Copyright © 2012 by Gary W. Eldred, PhD. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Eldred, Gary W.
Investing in real estate / Gary W. Eldred. — 7th edition.
pages cm
ISBN 978-1-118-17297-1 (pbk.); ISBN 978-1-118-22696-4 (ebk); ISBN 978-1-118-24002-1 (ebk); ISBN 978-1-118-26460-7 (ebk)
1. Real estate investment—United States. I. Title.
HD255.M374 2012
332.63’24—dc23
2011046343
Many people have contributed directly and indirectly to this 7th edition of Investing in Real Estate. Because of their efforts, this popular classic text on property investing will continue to provide beginning and experienced investors the timely, no-nonsense, practical know-how that has kept this book a bestseller for the past 25 years.
Accordingly, I thank Donald Trump and Michael Sexton for inviting me to work with them to help create some of the best real estate educational products and services available (especially Trump University books—all published by John Wiley & Sons). Working with the Trump team has provided me new perspectives on property investing.
I also express my appreciation to Dr. Malcolm Richards, dean of the School of Business and Management at the American University of Sharjah (AUS). In recognizing the critical need for real estate education in the Middle East—and the hypergrowth Sharjah/Dubai metroplex—Dean Richards designed a rewarding position for me from which I have added substantively to my knowledge and analytical abilities as they apply to international property markets. Under Dean Richards, the School of Business and Management of AUS has established itself as the premier school for business education in the Middle East—and I am pleased to have been able to participate in its development. Also, I thank Dennis Olsen, chair of the Department of Finance at AUS, for the counsel, insights, and collegial support that he has offered to facilitate my work and working environment at AUS.
My valued assistants at AUS, Mohsen Mofid, Faiza Farooq, Omer Shabbir, and Sadaf Ahmad Fasihnia, too, deserve recognition for their cheerful and competent assistance in my writing and teaching. (Alas, all have now graduated and I miss them greatly.)
My best-selling real estate titles—including Investing in Real Estate—have been translated into foreign languages such as Russian, Indonesian, Vietnamese, and Chinese. Thanks go to the skillful translators of these volumes and to my Asian property advisor Sit Ming (Laura) Lee.
Last, but far from least, I thank my supervising editor Shannon Vargo, senior production editor Deborah Schindlar, and the entire staff at John Wiley & Sons with whom I always enjoy working. This edition of Investing in Real Estate marks the 24th book manuscript that I have written for this 200-year-old company that represents the finest of publishing traditions. I look forward to completing many more.
—Gary W. Eldred
INVEST IN PROPERTY NOW
Invest in property now. Or forever live with your regrets.
Listen to the wealth-building wisdom of Warren Buffett: “Invest when fear, doubt, and uncertainty grip the mind of the crowd; sell when wild hopes and speculative fever burn away reason.”
The emotional herding of the crowd allows you and me to buy cheap and sell dear. Think through that wise advice offered by the Sage of Omaha. What type of markets offer the best opportunities for future profits? What type of market alleviates risk? To answer these questions, contrast those boom market conditions of yesteryear with the potential-filled market we experience today:
Today: Housing starts have fallen to fewer than 400,000 per year (the lowest level of building since World War II).
Today: A majority of potential investors and home buyers remain cautious, uncertain, and fearful. Open houses remain sparsely attended. To attract mere lookers, builders are slashing prices and doling out buyer concessions and incentives.
Today: Interest rates of 4.0 to 5.0 percent prevail (at least for now).
Today: Trillions of dollars of deficits, government borrowings, and quantitative easing seem likely to push inflation (and interest rates) to much higher levels within the coming decade.
Today: You can buy properties at 20 to 70 percent below their cost to rebuild new.
Today: Tight credit and high unemployment lead many people to double up (or even triple up) on their housing. Boomerang kids and even three-generation households have increased to the highest levels since World War II. Loan reps and appraisers must comply with strict new regulations that inhibit collusion.
Today: Financial distress and millions of short sales, foreclosures, and bank REOs (real estate owned) create a ready supply of desperately motivated sellers (and lenders). Buyers—not sellers—set prices.
Today: Market prices have fallen to the point where rental income yields from properties substantially exceed the income yields available from bonds and stocks (that is, interest and dividends). Investors can reasonably expect to achieve positive cash flows—either immediately or within a few years. Capitalization rates have increased. Gross rent multipliers have decreased. Rents are heading up, vacancies down.
Today: Many of those same starry-eyed investors have sadly awoken to the reality that safe investing requires reserves of cash and credit, knowledge, thought, an effective operating system, and a tenant-pleasing strategy.
Today: Talk shows and financial news spew out a steady stream of gloom and doom.
[For historical perspective, recall other previous times of economic hardship such as the early to mid-1970s, the early 1980s, and even as far back as 1937—when the hoped-for Depression recovery suffered a discouraging setback (the stock market again fell more than 30 percent. Or say Texas in the late 1980s and early 1990s when the RTC (Resolution Trust Corporation) was selling masses of foreclosures and nearly all of the banks and savings and loans within the state became insolvent. Or revisit the severe recession and real estate collapse that occurred in California during the early 1990s (La Jolla houses at less than $300,000; Los Angeles condominiums at less than $100,000).
Were those so-called bad times actually good times to invest in property? No doubt about it. Investors who bought during any of those doom-and-gloom eras earned extraordinary returns for their insight and foresight. Now’s your sure opportunity to buy a winning ticket. You can match their gains. History does repeat itself. You do not need a “back to the future” time machine to return you to those past golden years.
Today when I travel and tell people that I live part of the year at my home in Florida, they predictably respond, “Florida! The real estate market there is really bad, isn’t it?”
I reply, “Bad? What do you mean, bad? You are mistaken. The Florida market today represents one of the best property markets that I have ever seen—anywhere, at any previous time. I am an investor. Relative to income and cash flows, property prices look good. Relative to risk-adjusted potential for capital gain, property prices look great.”]
In these seemingly bleak days of the real estate cycle, fear looms. Cash balances in banks build up. Most would-be investors and savers crowd onto a flight to quality. They accept certificates of deposit (CDs) and money market accounts that pay negligibly low-single-digit interest rates. These fearful and uncertain folks think, “Who cares about return on capital? I want to feel confident that I am protecting a return of my capital.”
In his perpetually popular book, The Intelligent Investor, Ben Graham (Warren Buffett’s graduate school professor at New York’s Columbia University) created the parable of Mr. Market. Mr. Market represents the crowd mentality whose moods swing like a pendulum from irrational exuberance to bewildered fear and confusion. Which market mood provides the best investment opportunities and possibilities? Which mood of Mr. Market lures investors into taking the highest degree of actual risk? Which mood of Mr. Market presents the least amount of actual risk?
During the irrationally exuberant boom times, investors perceive little risk, but real risks loom larger and larger as prices climb higher and higher, rental income yields fall, and unsustainable amounts of mortgage debt pile up—even though rent collections remain too low to cover operating expenses and debt service.
During the boom in Las Vegas, so-called investors (actually speculators) believed that flipping properties for magnificent gains would never end. Few perceived that their property risks actually laid down poorer odds than the slots at Caesar’s Palace. And who but a fool (or Panglossian optimist) would borrow money to play the slots?
Yet, Las Vegas property buyers loaded up with dangerously high loan-to-value (LTV) ratios of 90, 95, and 100 percent (or more). They naïvely assumed that the future would continue to pay off those same jackpots that they had won in the recent past. Those thousands of Californians stampeding to Vegas thought they had discovered another Sutter’s Mill.
They did not see the fool’s gold. They did not comprehend why the growing gap between mortgage payments and rent levels could not persist. On typically purchased Las Vegas properties, loan payments (principal, interest, taxes, and insurance [PITI]) often approached $2,000 a month. Potential rents for these same properties would reach no more than $1,200 a month.
When such a huge alligator is chewing off your leg, you are in a world of danger (and a world of hurt). As I have often written, high debt, low rental income yields, and exaggerated hopes for outsized continuing increases in price (for stocks, gold, or properties) always trigger a reversal of fortune. (See especially my Value Investing in Real Estate, John Wiley & Sons, 2002.)
True, the hot speculative fever in Las Vegas (as well as Miami, Dubai, coastal Spain, Ajman, Dublin, Phoenix, and so on) does stand out as beyond-the-norm mania. Most other cities did not experience such heightened frenzy among both builders and buyers. Nevertheless, irrational exuberance fueled the manic moods and mind-sets of property buyers and borrowers throughout much of the United States and other countries (though, during the boom of late, not Dallas, Berlin, or Tokyo—each of these cities had suffered its own irrationally exuberant property market 15 to 20 years back, and sat out this most recent party).
With most right-brain dominant speculative buyers now knocked out of the game, today investing in real estate once again offers outstanding profit potential with vanquished risk.
During the past five years, property prices throughout the United States (and various other countries) have fallen by 15 to 70 percent from their previous peak levels. Relative to current rent levels and replacement (construction) costs, today’s property prices offer the most favorable buying opportunities since World War II. With property prices sitting well below construction costs (for the most part), builders cannot profitably bring new product to market. Today’s investors are protected from new competition. Builders will not even ramp up to half speed until the market prices of housing increase enough to generate a decent profit margin.
To make investing even better, mortgage interest rates have fallen to less than 5 percent (though these low rates are always subject to increase). I am taking advantage of today’s property and mortgage market. During the past several months, I have purchased multiple properties (in good to excellent condition) at discounts of 50 to 65 percent off their earlier peak sales prices.
Of course, you may wonder: Is now really the time to buy? Might prices go lower? Could we encounter a double-dip recession? Will the pipeline of foreclosures flood the market with an increased number of distress sales? Even the good opportunities of today might be surpassed with even better bargains in the near future.
Possibly, yes. But, do not forget interest rates. Over a property holding period, the extra costs of higher interest rates could dwarf any savings that you might score in price. Nevertheless, if you do choose to delay, do so intelligently.
Monitor the market (foreclosures, existing home sales, interest rates, unemployment and employment figures, new construction starts, and so on). Detect turning points in the data as well as investor and buyer confidence. Intelligent monitoring and opportunistic waiting differ from inattentive procrastination. Moreover, property investing offers multiple ways to earn a good return, among which “market bottom, lowest price” represents only one—and not necessarily the most important—reason to invest.
Journalists and their media molls (especially economists, Wall Street mavens, and mutual fund analysts), love to play the game of short-term forecasting. They do it with stocks, gold, commodities, interest rates, and, for the past 10 years, properties. Are prices climbing? Buy. Are prices falling? Get out of the game and watch from the sidelines. As they persistently obsess over short-term price movements, the media distort and confuse the idea of investing in real estate.
Contrary to media hype, most experienced and successful real estate investors do not emphasize short-term price forecasts. Instead, we typically look to an investing horizon of 3 to 10 years (or longer). We realize that property provides multiple sources of return. The smart money investors weigh, evaluate, and understand that to earn great returns, they need to achieve only several (maybe only one) sources of reward.
Here are many (but certainly not all) of the profit possibilities that property offers:
I explain each of these possible sources of return in Chapter 1 and then illustrate and elaborate to varying degrees in the chapters that follow. With this extensive range of possibilities in view, you can always find profitable ways to invest in real estate.
Unlike investing (or speculating) in stocks, bonds, gold, or commodities, you can generate returns from properties through active participation (research, reasoning, knowledge, and entrepreneurial talents). When you buy stocks, you can only pray that the market price goes up, because that’s your one single possibility to receive a reasonable return.1 (Dividend yields on stocks now average around 2 percent—though many pay nothing, and a relative few pay 3 to 4 percent per year.)
Today’s markets offer multiple low-risk, high-profit possibilities. Over a time horizon of three to seven years—if you follow the principles laid out in this book—you will earn high returns. I encourage you to invest now. No one can perfectly forecast price movements during the next year or two. But today, you can find and negotiate solid investments in any market.
Two frequent mistakes block people from profiting with property: (1) they wait too long to enter and then cannot exit an irrationally exuberant market, and (2) they wait too long to take advantage of the possibilities that are theirs for the taking (that is, they perpetually procrastinate and then regret).
As you read through the following chapters, you will discover how to create, develop, and exploit at least 22 sources of financial returns. To buy, improve, and hold income properties—especially when you invest in difficult economic times and finance with smart leverage—does offer the surest, safest, and, yes, even the quickest way to build your net worth. But even long-term investors like me will venture along other avenues when opportunities arise.
In addition to the buy, improve, and hold houses and apartment buildings approach, other profit-generating techniques include discounted paper, commercial properties, condominium conversions, fix and flip, adaptive reuse, tax liens, mobile home parks, self-storage centers, lease options, and triple net leases. (I discuss and explain each of these techniques in later chapters.)
To secure your future—a future free from financial worries, with a life that you can live as you would like to live—property, especially property in today’s distressed markets, provides a near-certain route to personal freedom and prosperity. All that remains is for you to develop and execute your own investment plan now.