5

SHARPEN YOUR ENTREPRENEURIAL THINKING

Organize your information for quick retrieval and thorough understanding.

EVER SINCE WILLIAM NICKERSON wrote his now classic How I Turned $1,000 into a Million in My Spare Time (1959), best-selling real estate authors have been revealing “the secrets of my success.” “Just follow these six steps,” they say. “I’ll give you everything you need to know.” Sounds easy.

But here’s the catch: If you adopt an investment approach that was developed by someone else in another place and time, you may end up losing your bank account. And, most certainly, you will miss the best opportunities that actually present themselves to you (albeit often unannounced). Why? Because real estate markets experience continuous change.

PROBLEMS OR OPPORTUNITIES?

Nothing remains the same: interest rates; existing properties for sale; vacancy rates; property prices; rent levels; number of foreclosures; employment; population demographics; consumer tastes, preferences, attitudes, and lifestyles; the cost and supply of new construction; government zoning rules, regulations, and restrictions. Every change presents problems and opportunities.

Fuse knowledge with imagination. In no time, you’ll create something great to put in your “think big” tank.

That’s why the same business plan that blessed you with profits last year could turn into a curse next year. Just look at the brand-name companies (such as Lehman Brothers, Merrill Lynch, Countrywide, Polaroid, Kodak, Sears, General Motors, Ford, Conseco, AIG, Kmart) who once excelled with well-crafted business models but subsequently suffered fatal or near-fatal losses because they failed to revise their entrepreneurial strategies in response to changes in financial markets, technology, competition, consumer preferences, and/or emerging lifestyles.

Look at the dozens of homebuilding and mortgage lenders who were racking up record profits during the boom years, yet now face record losses, a salvage-value stock price, or maybe bankruptcy, merger, or liquidation. Look at those many condo speculators in Miami, Las Vegas, Dubai, and Mumbai who failed to monitor adverse market signals and now are desperate to sell—even if it means they lose big.

It All Depends

No one can tell you the easy way to real estate riches. It’s natural for people to believe that someone else can tell them exactly what they need to do to make a fortune in real estate. Most of us would like a simple five-step system that automatically loads our bank account with cash—better yet, a system that pretends, “no cash, no credit, no problem.” But real estate’s not simple. Learn from the experiences of others. Borrow ideas and adapt them to today’s circumstances. Do read everything you can find that might lead to improved performance.

Setbacks are a part of life. Don’t let them knock you off your feet.

Yet, before you follow a well-publicized investment technique or real estate guru, remember that your answer to the question “Will it work?” remains, “It all depends.” Near the peak of the recent property boom, a well-known author wrote a book titled 52 Houses in 52 Weeks. The subject: How to flip houses in Las Vegas. Any reader who jumped in to follow this author’s system would have shortly thereafter gone broke.

A Strategy of Your Own

In this book, neither I nor Mr. Trump misleads you with “five magic paths” or “seven easy steps” to real estate riches. We won’t pretend that you can profitably buy, improve, and manage properties without effort, time, intelligence, and at least a workable amount of seed capital.²

However, we do promise to provide the knowledge and techniques necessary for you to reason through a profitable, wealth-building strategy of your own. In the real world, you will conquer the challenges and vicissitudes of property markets only when you know how to discover and adapt as problems arise and opportunities unfold. In other words, from this book—as with no other—you will learn to think like an entrepreneur.

MVP: THE ONE CONSTANT RULE

To think like an entrepreneur, adopt one central rule: I call this unifying rule (or principle) the MVP (most valued property). When tenants (or buyers) search for a place to live or operate their business, they compare features, amenities, location, rent levels, lease terms, and dozens of other details that add to (or detract from) the benefits they expect that property to bring to them. They compare, contrast, weigh, and consider. In the end, which property do they eventually choose to rent (or buy)? The cheapest? Not necessarily. The best? Probably not. The biggest? Perhaps, but don’t count the money just yet.

Create your business plan before you buy. You want to have Plan A, Plan B, and Plan C for adding value to the property.

At the moment of truth, prospective tenants (buyers) will choose the property that offers the best value relative to all the other properties that they have considered. Hence, your entrepreneurial thinking should guide you to provide the MVP for your intended customers. From your perspective, MVP also means the property designs, features, and use that will add the most value to your net worth (i.e., the most valuable property). In other words, the MVP principle urges you to give your target customers their best value, while also maximizing the economic value of the property to you.

FEW OWNERS ACHIEVE MVP

During the past 20 years, I have looked at thousands of for-rent or for-sale properties. At least 90 percent of these fell short of MVP status for both their customers and their investors.

The property’s owner, manager, or sales agent had not fully answered the question that MVP poses: “How can we enhance our total value proposition in ways that would better satisfy (wow) our customers (tenants, buyers) and at the same time pull more dollars into our bank accounts?”

Every building that carries my name promises the highest quality available.

Make MVP Your Goal

To improve your life, you must want to improve. You must make the effort. You must believe that the effort will pay off. You reprogram your mental tapes with positive self-talk and possibility thinking. In sum, you develop an entrepreneurial attitude (which will elevate your altitude). Let’s discuss the Demand, Utility, Scarcity, Transfer (DUST) process guide that will help you formulate your entrepreneurial flight plan.

THE DUST ENTREPRENEURIAL FRAMEWORK

Without education and using your brains, your ignorance will cost you a fortune.

Study Figure 5.1 from top to bottom. Use this analytical framework to guide your strategic reasoning process. It will guide all future discussions throughout this book. I use it to perform my own property analyses. It will help you estimate, forecast, and create property value.

You create MVP (most valued property, most valuable property) when you design your property features to meet demand and differentiate from supply competitors. Then you formulate your transfer process (promote, negotiate, and contract) to lease or sell. DUST addresses your six decision points:

I. Explore your entrepreneurial objectives (personal and financial).

II. Set up your due diligence investigation.

III. Advance your market strategy (DUST) through data collection, analysis, and discovery of opportunities.

IV. Value the tactical and strategic possibilities from the perspective of customers and your financial goals.

V. Synthesize, interpret, and decide.

VI. Execute, monitor, and revise your tactics and strategy to create and enhance the property’s MVP.

ENTREPRENEURIAL OBJECTIVES

Who are you? What goals do you want to achieve? Take stock of your personal and financial resources, your talents, and your risk tolerance. Then choose an investment program and market strategy that will serve your purposes and desired style of life. Let your priorities and values guide your decision process. “I want to make a lot of money” may reflect your base desire. But to achieve that goal, align your efforts, feelings, and resources.

Figure 5.1 DUST Entrepreneurial Decision Framework for Creating Wealth through Real Estate. Copyright © Gary W. Eldred. Reprinted with permission.

Talents, Inclinations, Resources, Priorities

When I began buying and renovating properties, I not only lacked a clear entrepreneurial plan but also failed to inventory my talents and inclinations. Only after trial and error did I manage to create an investment program that worked personally and financially. Many would-be real estate investors (speculators) choose without thinking. They fail. Then they give up without ever realizing their true potential and possibilities.

Assess your interests. What do you love? Create a blueprint for your life. Without goals, no momentum. Without momentum, you are daydreaming.

Become proactive. Design your investing to align with your personal values, abilities, resources, likes, dislikes, and priorities. “No pain, no gain” still rules. As you deliberate choices, envision the life of freedom and financial security you want. But, to realize your dreams, sacrifice and trade-offs must also play a role:

1. Time and Money: How many hours per week or per month are you willing to invest? What does your financial profile look like (credit, cash, earnings, borrowing power)?

2. Trade Skills: What types of manual fix-up or renovation skills do you possess? Do you enjoy working with hammers, saws, and paint brushes?

3. Creativity and Design: Do you enjoy the search for new ideas? Are you willing to learn and adapt the ideas of others? Do you like to look at properties, attend trade shows, and browse through magazines and journals on property management, creative improvements, and related topics?

4. Partners: Do you prefer to play as a one-man band? Or would you like to join with others to share equity financing, work, responsibilities, and decision making?

5. Tenants: What types of people would you like to attract as tenants?

6. Real Estate Agents: Do you want to search, buy, and sell on your own? Or will you enlist the help of real estate agents?

7. Numbers: Can you learn to work with income statements, cash flows, rate-of-return calculations, cost estimates, budgets, and tight rehab and renovation budgets and schedules?

8. Personal Achievement: What types of real estate would give you the greatest sense of personal achievement and pride of accomplishment?

To succeed as a real estate entrepreneur, anticipate and prepare. Match your expectations to reality. Some property owners try to “do it all.” They burn out. Others buy with “little or nothing down” and then find they lack the cash or credit necessary to handle repairs or cover losses from vacancies or bad debts. (Today, many such investors or homeowners have become distressed sellers who must sell at bargain prices—“just to get rid of this financial headache.” Their failures have now become your opportunities.)

Passion conquers fear. Take a tip from Nike—“Just do it.”

Review Your Spending and Borrowing

The promoters of nothing-down real estate have pulled too many starry-eyed investor wannabes down the path to financial ruin with their mantra of “no cash, no credit, no problem.” Although you can buy real estate without cash or credit, that fact begs the question. If that’s your situation, why do you lack cash or credit? Indeed, the foreclosure auctions now brim with properties once owned by the “no cash, no credit” buyers. Sad to say it, but their pain now sets the opportunity for your gain.

So, respect yourself, and exercise financial discipline and responsibility. “No cash, no credit” can create big problems and big risks for those whose empty wallets result from destructive spending and borrowing. Investing in real estate steers you onto the road to financial freedom only when you borrow constructively and spend miserly (or at least, conservatively).³

Review your credit score and constructive borrowing power, your available cash, and your monthly cash flow. How much money can you come up with to acquire real estate and pay for fix-up work—while you still maintain a reserve to meet contingencies and unanticipated setbacks? Because you run some chance of mistake, stay well within your limits. Use your first properties to gain experience. Fine-tune your abilities and strategy without overextending yourself.

What is your credit score? In their efforts to judge your credit-worthiness, mortgage lenders (and many owner-will-carry sellers) will check your credit score. Although a variety of credit-scoring systems exist, among the most widely used scores are those calculated by the Fair Isaac Corporation (FICO). To learn your FICO scores, go to www.myfico.com. For around $40, FICO will provide three scores (as calculated from your credit data on file with Experian, TransUnion, and Equifax), suggest ways you can improve your scores, and let you know how your scores compare to the general population. On the basis of your credit profile, FICO estimates the interest rate that lenders will charge you. (However, note that your credit score influences the cost and availability of mortgage money—but other factors also contribute to the approval and interest cost equation.)

What is your net worth? Your financial net worth consists of the total value of what you own less the total amount you owe to others. (If you’ve previously completed a mortgage application, you’re probably familiar with this form, which is called a personal balance sheet.)

How liquid are you? Mortgage lenders tally up your assets, liabilities, and net worth, but they also examine your cash position. The more cash in your accounts, the easier you can weather setbacks. You (or your partners) will also need cash to close your purchase (down payment, loan costs, property repairs, escrow payments, and perhaps property improvements). If your balance sheet shows little cash (including near cash such as stocks, bonds, or certificate of deposits), sell some assets (cars, boats, vacation home, jewelry, and so on) to beef up your cash account. Liquidity adds to your borrowing power and it gives you the ready money to jump on good deals when you spot them.

How much free cash flow do you generate each month? Some people spend and borrow so heavily that there’s little if any money left at the end of the month. People who struggle payday to payday rarely build wealth.

So increase your free cash flow. What spending can you slash? What debts can you eliminate? What luxuries (frivolities) can you do without? As financial planners emphasize, to build wealth while you’re still young enough to enjoy it, spend conservatively and never borrow to make ends meet. Live below your means. Each $1,000 you invest today can easily pay you back $10,000 or more within a decade (or less).

Financial Goals

Okay, you’ve reviewed your financial wherewithal and personal talents and inclinations. It’s now time to set goals. How much wealth would you like to create during the next 5, 10, or 20 years? How many properties would you like to acquire? In what price range? Do you plan to fix and flip, fix and hold, or passively buy and hold? Write out the numbers. Explore possibilities. Think big. Once you set a goal, draft a business plan. Attach a timetable. Schedule deadlines. Without a written business plan, goals, and a timetable, you procrastinate, you drift. You eventually settle into “woulda, coulda, shoulda.” Navigate away from this trap. Commit yourself to a plan and specific action steps.

Though we haven’t yet itemized the full variety of financial returns that you (entrepreneurial) investors can earn, when you have read through later chapter discussions on “running the numbers,” you can revisit this issue. For now, think about setting your goals. Then, as you read through later chapters, note the ideas that might work for you. Apply ideas and relate them to your own possibilities.

SET UP YOUR DUE DILIGENCE INVESTIGATION

With goals in place, it’s time to investigate markets and properties. Before you randomly look at potential investments, investigate these issues:

• Explore the investment questions you must answer.

• Identify the physical property.

• Identify the relevant property rights.

• Identify the area(s) from which you will draw customers (tenants, buyers) and identify the location and sources of potential competitors.

• What period of time defines your investment horizon (your holding period)?

Explore the Questions You Want to Answer

As a real estate entrepreneur, you face many types of questions that require intelligent and informed answers. What’s the market value of a specific property? Where’s the competition headed? What cities or neighborhoods offer good opportunities for growth? What cities or neighborhoods offer good cash flows? What tenant segments offer great potential? What features would advance your MVP strategy? What lease terms would enhance your MVP strategy? How might a property’s value go up if its zoning were changed?

Throughout your investing career, you’ll answer questions such as these as well as many others. But you can’t address all of them at the same time. Instead, focus. Each question requires its own data and methods. Market value questions, for example, differ from market forecasts. Cash flow questions differ from those that forecast appreciation potential.

You’ll discover other essential questions as you read later chapters. For now, focus on these three points:

1. Begin every investment decision with questions. Probe for details.

2. Never decide to buy, improve, or sell without looking at the property from multiple perspectives. (For example, although that bargain price may appeal to you, maybe the property yields weak cash flows or holds little potential for price growth—maybe this property’s a flipper, not a keeper.)

3. The greater your ability to identify and ask questions, the greater your profit potential. Questions alert you to opportunities that ordinary investors, property owners, and managers overlook. (“Could I get zoning changed?” “Could I split the lot?” “Could I go after the corporate (serviced apartment) rental market?” “Could I split the building into multiple units?” “Could I create a view?” (Questions alert you to possibilities.)

Identify and Describe the Physical Property

It might surprise you to learn that when some people buy property, they really do not know what they are getting. Why? Because they do not closely inspect the details of the property. To prevent this mistake, verify these features:

• Number and mix of the rental units.

• Square footages of the total building and each rental unit.

• Site size and features.

• Type of construction, architectural style, and overall condition.

• Personal property and fixtures.

As you look at a property, list defects and deficiencies. But look, too, for opportunities to create value. So, first, put on your Sherlock Holmes hat, grab your magnifying glass, and ferret out potential costly repairs, tenant turnover, or high energy bills. Next, to form an opportunity perspective, put on your rose-colored glasses. Imagine how the property could perform after you work your magic.

Number and Mix of Rooms and Rental Units

As with square footage (see the next section), sellers and their agents sometimes generously describe the number and mix of rental units within a building. I have seen so-called two-bedroom apartments that lacked closets, efficiencies that were nothing more than a sleeping room with a hot plate and a dorm fridge, and damp, musty basement suites with no natural light. (To technically qualify as a bedroom, a room must include a closet.)

Before you buy a building, inspect each unit in the property. Sometimes agents (or sellers) will say, “The units are all basically alike; you don’t want to look at all of them, do you?”

You should answer, “Yes, I think I do. You don’t mind, do you?”

Square Footages of the Total Building and Each Rental Unit

Agents and owners may quote two types of square-footage figures. One figure applies to the total size of the building. The other applies to the sizes of the individual units. The naive investor accepts these square-footage figures at face value. The smart investor questions the figures closely.

What areas are counted within the square footage figures? Apartment buildings, for example, devote space to hallways; basements; balconies; laundry facilities; heating, ventilating, and air-conditioning equipment; as well as the actual living units. Break down square-footage totals and allocate them across the various uses within the building. Carefully investigate square footage for two reasons:

1. No consistent standard applies to square-footage measurements. Some sellers or agents may count basements and balconies. Others may not. Precise space measurements enable you to uniformly compare buildings.

2. Count rentable square footage. Some buildings waste square footage because of inefficient design. A building of 13,500 square feet might actually include more rentable square feet than another property that measures 15,000 square feet. (This principle of rentable/usable square footage applies to single-family houses, office buildings, shopping centers, and industrial uses.)

Owners and agents sometimes promote their properties as a “great buy” because such properties compare favorably to the asking /sales prices of other properties when calculated as price-per-square-foot. However, when the quality of a seller’s square footage stands inferior to peer properties, then that property deserves to sell at a discounted price per square foot. Its lower asking price does not signal the great buy that the seller claims. All square footages are not worth the same price.

Are the square footage figures accurate? Even though sellers and their agents avoid warranting their estimates of square footage, beginning investors often rely on such figures—only to learn too late that the figures erred. In instances where price per square foot counts heavily in your property comparisons and evaluations, pull out your tape measure. Measure the dimensions. Guard against the shock of fewer square feet than you bargained for—and thus a higher price per square foot than you thought you were paying.

Site Size and Features

In many cities, the value of the lot on which a building sits can account for 30 to 70 percent of the property’s total value. Even small differences in site size or features can add (or subtract) tens of thousands of dollars compared with other, seemingly similar properties.

Consider two similarly sized triplexes. Both properties brought in about the same amount of net rental income. Yet one triplex was listed at $289,000. The other was listed at $309,000. If you compare the buildings alone, the $289,000 property looks like the better buy. But, the $309,000 property offered “hidden value” in the site. It turns out that this property’s site size (and zoning) would permit its owner to build a fourth rental unit.

Additional site size might permit you to add on to a building, expand parking or storage space, create a view, or provide better privacy. To evaluate a site, note the quality of its landscaping, its ingress and egress (how easily cars can pull in and out of the property), and amenities such as swimming pool, tennis courts, workshop, or storage shed. When comparing size and features, itemize all those differences that can make a difference.

Personal Property and Fixtures

When you buy real estate, you pay for the land and the buildings, which are called real property. A seller’s asking price might also include personal property, which refers to washers and dryers, refrigerators, stoves, furniture, curtains, blinds, window air-conditioning units, wall mirrors, and similar items not attached permanently to the land or building.

The list price for a property will include items that have been so adapted for use with the building that the law classifies these items as fixtures. Fixtures may include ceiling fans, lighting, chandeliers, garage door openers, garbage disposals, built-in cabinets and bookshelves, and built-in dishwashers. All other things equal, a property that includes a washer, dryer, ceiling fans, range, dishwasher, and refrigerator is worth more than one that omits such items. To value a property, itemize the personal property and fixtures that the transaction includes. (Sometimes, after a sale, sellers remove fixtures even though legally these fixtures should remain with the property. For that reason and others, perform a final walk-through just before closing or taking possession.)

Avoid confusion and disappointment. Negotiate “what stays with property, what goes with the sellers.” Identify and list these items in your sales contract or attach via an addendum.

Understand Rights and Restrictions

“This is my property! I’ll do with it whatever I want.” In times that predate zoning restrictions, building codes, tenants’ rights, mortgages, leases, and a multitude of other laws, ordinances, and contracts, your uncompromised claim to freedom may have carried weight. Not today.

Today, restrictions of one sort or another govern your rights to design, build, occupy, use, lease, mortgage, renovate, add on, or enjoy a property. Verify that your entrepreneurial plans for the properties you buy, manage, renovate, lease out, and sell comply with the legal rights that you actually possess (or can obtain).

On the other hand, zoning laws, contracts, ordinances, rules, covenants, and regulations do not merely restrict in a negative sense. Entrepreneurs rely on rules and restrictions to help fashion their target market strategy. Given the importance of legal restrictions, Chapter 8 provides you more guidelines. To value a property and craft your MVP, review the legal limits as well as the legal possibilities that govern the property.

What Geographic Area(s)?

Most investors limit their search for properties to a geographic area that falls within say, a 60-minute drive from their homes. These investors prefer to live near their properties so that they can easily deal with day-to-day issues (showing the property, making repairs, attending to tenants, and so on). Although their preference for proximity makes sense in some ways, it fails in others.

What if prices in your area have climbed beyond your reach? What if you can’t find properties that yield positive cash flows or good potential for appreciation? What if your local economy looks shaky? In other words, what if your area seems to lack good investment alternatives that you are willing and able to buy? Maybe you are right. Or, maybe, you feel this way because you have not fully explored the possibilities in your locale. Maybe you’ve accepted conventional wisdom and negative self-talk without a detailed look at the facts.

Regardless of whether your locale offers good possibilities or not, we advise you to open your mind to other geographic areas. During the next decade or two, real estate investors in some neighborhoods, cities, and countries will enjoy a doubling or tripling of their property values and rent levels. Property investors in other locales may do well to keep up with inflation. Or you might prefer to invest for cash flow more than for appreciation. Here again, different locales offer different potential. As to my own investment objectives, I look for areas where I can achieve at least four good sources of return: (1) cash flow, (2) market appreciation, (3) opportunities to add value, and (4) amortization (mortgage payoff).

In recent years, I have bought properties in North Carolina and Florida. All of my recently acquired properties yield positive cash flows and are worth today substantially more than I paid. I did not buy property in Dubai—even though I was working there throughout its boom years. Why? Because my personal investment strategy prohibits me from buying properties in locales where speculators dominate the market. Nor did I buy in Las Vegas, Phoenix, or Miami during their boom (i.e., speculative) years.

My point here is not to recommend a specific market area. That’s up to you to decide for yourself according to your goals (with help from Chapter 6). However, I encourage you explore and compare a variety of locales. If you decide to invest close to home, do it by design, not default.

Time Period

As part of your investment decision-making process, think about the length of time you plan to hold your properties. If you plan to fix and flip, your economic and market study need not forecast further out than say, 24 months. As a buy, improve, and hold investor, you would adopt a mid- to long-range perspective of, say, 5 to 20 years.

Different time perspectives lead to different investment choices. Many lower-priced neighborhoods and communities are primed for turnaround and attractive property appreciation. But such areas require a patient investor. To earn quick cash, find bargain-priced properties/foreclosures/REOs that you can fix up and immediately resell (or exchange). In any case, don’t choose your locations or your properties until you think through the timing of your entrance and exit strategy.

As many naive investors, homebuyers, and speculators have recently learned, property prices and rent levels rarely follow a neatly drawn, upward-sloping trend line. Indeed, the faster and longer prices increase, the more likely and severe their fall. Include timing in your entrepreneurial strategy. The MVP for a two-year horizon (or less) could vary greatly from an MVP strategy that extends over 5 to 10 years. Plan both your entry and exit with well-reasoned research and assumptions.

Now, let’s look at the types of data and investigations that you can use to forecast the demand and supply trends in the area(s) where you see possibilities.