There is a subtle transition underway in real estate investing these days. It involves a shift in the way people think about their real estate investment, a movement toward being more dispassionate, a movement toward being more quantitative than qualitative.
People traditionally look at real estate differently than they do other investments. They look at real estate with the same perspective that they look at their house - with some pride of ownership. You wouldn’t look on your technology stock with pride of ownership (unless it was Apple and you were a Macophile, I guess). But with real estate, there tends to not only be pride, but - to extend the stock analogy - a buy-and-hold mentality.
What I’m both seeing and suggesting is a shift away from that. For one thing, if you go into real estate investing with that attitude, it’ll break your heart. You can’t think about investment property with the same pride of ownership that you have for your primary residence. We are protective of our primary residences. We strive to make sure it looks good and stays that way. When tenants leave a property, it’s likely to be in less-than-pristine condition. Every time someone departs, you have to call in the painters and carpet layers.
Real estate investment, like any other investment, is about either making money or reducing your tax liability. It requires an entrance strategy, a holding strategy, and an exit strategy. It requires thinking about numbers, because it involves either time or money, or both. For instance, here are some questions real estate investors need to ask themselves:
- Are you researching available properties yourself or working with a professional? If the former, there are plenty of opportunities at sites such as Bigger Pockets and EconoHomes.
- Will you be managing the property yourself, or will you pay someone to do it?
- Do you want to buy property with little cash (i.e., be highly leveraged) or do you want to make a big down payment in order to retain more of the value and increase your passive income? Do you want to invest in residential or commercial property?
- If residential, do you want to invest in distressed properties in depressed areas that may increase in value or middle-class or upper-class properties that are more likely to hold their value?
In the transition to being dispassionate, there are even more numbers that investors need to think about, both prior to and after the investment.
- ROI. You need to think about the return on your investment - what’s your payback? Are there better ways to invest your money? Real estate isn’t the automatic jackpot it used to be.
- GRM. This statistic is the Gross Rent Multiplier, which is derived from comparing the annual income of the property to the property’s value; 10 is a good measure ($12,000 annual gross rent / property value of $120,000 = GRM of 10).
- Capitalization Rate. How much is it costing you to service your investment (i.e., paint, carpet, mortgages plus other expenses? Your cap rate comes from an analysis of costs vs. income.
Finally, there’s the exit strategy. Remember, your identity should not be tied up in this investment. You should be as dispassionate about getting rid of it as you were about acquiring it. Are you going to sell entirely, or do an exchange? Exchange is an investment term for buying up or down. In a positive exchange, you sell a $100,000 house and use the proceeds to buy a $200,000 house. In a negative exchange, you sell a $100,000 house and buy a $50,000 house. It depends on how leveraged you want to be. You can also sell the house and carry the financing yourself to get the monthly cash flow as a return on your investment.
But however you do invest, you have to do it with your head, not your heart.
In Part 2, we’ll talk about more about carrying the financing in a discussion of land contracts.