Chapter Three
Design a Portfolio to Weather the Inevitable Storms
Keane is one of those English alternative rock bands whose music makes me think. Their song, Can't Stop Now, is all about the way life keeps moving—even if you don't. Well, real estate investment markets don't stand still either. Investments of all types have risks and rewards; they all encounter cycles, booms and storms. Real estate is no different, although strategic investors do have a modicum of additional control. Believe it or not, that control begins with actions you take before you buy. The more you do before you invest, the better your ship will be able to ride out the storms. In most other investments, your control of results is limited. With real estate, much of the outcome is in your hands—as long as you follow a long-term investment system.
Before I get into what you need to do to develop a portfolio that can weather inevitable economic turbulence, it is important to acknowledge that we are investing in historically complicated economic times. I know that a lot of readers have some serious questions about real estate investing and, in fact, any type of investing in the aftermath of the 2008 downturn. I don't blame anyone for remaining fearful, especially if they lost a lot of money or their job, or know someone who has. Honest concern aside, it is important to note that many thousands of investors more than weathered this latest storm, despite the rocky conditions it created. They did this by creating income and increasing their asset base during the crisis and its aftermath.
When the U.S. economy collapsed in September of 2008, American real estate markets took massive hits as this downturn pushed their markets back to and even below where it should have been on the long-term trend line. Those who got hurt the worst were those who thought that real estate would truck on forever. “Up, Up and Away!” was their motto. Unfortunately, they didn't understand just how over-priced the market was vis-à-vis the underlying softening of the world economy. Worse, that softening was accelerated with the banking crisis. Talk about the perfect storm! All the negatives hit real estate markets at once. As a market analyst whose view is shaped by my location north of the 49th parallel, I can honestly say that the collapse of the U.S. economy from the credit crisis generated a global economic collapse that few saw coming. During the run-up and fallout of this crisis, we kept an extra sharp eye on Canada's economy and housing market. Putting the attention of our research team solely on this important sequence of events allowed us to shed some critical light on the issues for REIN members.
Yes, we did take comfort in the knowledge that Canada's highly-regulated banking and mortgage industries provide Canadian consumers—and real estate investors—with some systemic protection from widespread market speculation and greed. However, we are never immune from world events, and what happens in China, the United States or Europe inevitably has effects on Canada, so keeping a close eye on the world economy is important. Stocks dropped sharply in both countries and real estate in many regions of Canada took a short-term drop (thankfully nothing like the States). We also saw that the regions (and stocks) that were strong on fundamentals came back the most quickly. As “supply versus demand” and “safe havens” became the watchwords, speculation disappeared. In stock markets, a demand for dividend-producing stocks increased while properties that created their own monthly dividends (cash flow) also rebounded quickly.
And therein lies one of the biggest investment lessons investors could learn from 2008. In sum, income was the difference between those who made it through the storm and those who didn't. The real estate investors who survived financially didn't particularly enjoy the ride, but all of the preparation they did to carefully choose their target geographic regions and then focus on creating positive cash flow generated a stability others lacked.
From my position at the helm of REIN, it was easy to see that some Canadian investors were poorly positioned to ride out the economic upheavals of the post-2008 world, typically because they were caught up in this notion of continual value increases. Others got through safely by hunkering down. They made income a priority and aggressively marketed for quality renters. They focused on reducing operations costs, just as any other strategic business owner would do who faces similarly tough times.
In contrast, non-strategic investors let greed and fear master their decision-making processes. This approach often led to wide-scale losses when Canadian portfolios had to be dispersed to pay lenders or avoid the continued financial pain of negative cash flow. Others got out of the investment business because they couldn't handle how the financial stress compromised their personal and business relationships.
Strategic investors fared much better. While many of them admit to being surprised by the rapid market decline, given what was happening in much of the Canadian economy, few were caught completely off guard. Most of them were able to take a deep breath and face the rising seas of bad economic news head on. Their properties were well positioned for the long term and, because they weren't selling in a depressed market, they could focus on bringing in steady revenue.
For a better look at how to make that happen in your own portfolio, keep reading!
Strength: From the Ground Up
Anyone who's ever looked at building codes knows that regulations are typically based on local conditions. If you are building in a hurricane, tornado or earthquake zone, the applicable code sets out specific rules. As I see it, the same principle applies to building a portfolio. You may launch that portfolio in clear skies, but you plan for the day when that portfolio has to weather an economic storm.
When I make comments like this in front of new investors, I tend to get a lot of nods. No one gets into this business to lose money—and who doesn't want a strong portfolio? But many aren't prepared to do the work it takes to build that strong foundation, especially when the economic skies and forecasts are all sunny. That's why it takes them by surprise when I then ask these investors to tell me what the 10 fundamentals of real estate investing (recapped below) really have in common.
At this point in the discussion, a lot of non-strategic investors are keen to talk profitability and long-term financial security. So they think my question is all about fishing for an obvious answer such as:
- The fundamentals are all about putting your money to work.
- Real estate investors use fundamentals to put passive income to work to generate long-term capital appreciation.
- Strategic investors use the fundamentals to mitigate risk. They know that it's easier to lose than make money and they are strategic in how they move forward.
- These fundamentals are the crux of a proven investment system.
After processing answers like that, I'm usually left wondering if anyone was listening! What I really want these newcomers to say is that the fundamentals help them buy the right property. How's that for simplicity?
Buying the Right Property
There's an old adage that says hindsight is 20/20. In fact many pundits and commentators use 20/20 hindsight to make themselves look good. Sadly, many investors, both real estate and stock, use 20/20 hindsight to beat up themselves (and others) emotionally. I should've bought more! I should've sold earlier! I wish I hadn't sold then! These three statements of regret can be poisonous. Investors must understand that they will never time the market perfectly. It's normal to wish you had done more/less/nothing at some point of the cycle, so recognize that fact and keep moving.
If I had waited for everything to be perfect, I would never have bought my first property and definitely not my one-hundred-and-seventy-first. That said, ignorance is not bliss and ignorance in business will cost you money. Ignorance leads to risky choices, risky choices lead to speculation and speculation leads to massive loss of wealth when the cycle inevitably turns against you.
In the real estate investment business, portfolio strength begins with the first property, or door. To a strategic investor, that means buying the right property the first time—and then buying another right property after that. And it's not like you're working alone, since the 10 fundamentals provide the information you need to find properties that fit your investment system.
To see how all of this works, let's look at an example. Say you want to buy a revenue property to hold for five years. Sophisticated investors know this property must cover all of its own expenses, including the mortgage and any other money borrowed to buy the property. After that, the property must yield extra cash every month over and above the operations. We call this positive cash flow. To find a property that fits this part of their system, these investors can use tools like REIN's Goldmine Score Card to make sure they are looking in a geographic area that supports their business plan: to make money. Once they find an area that has the right economic fundamentals to attract people who will want to rent places to live, these same investors can study specific properties using additional tools like the REIN Property Analyzer Form and Property Due Diligence Checklist. With this approach, they can dismiss properties that don't even remotely have a chance of weathering market storms. Each step they skip in the pre-purchase work is the equivalent of throwing life jackets overboard, leaving them dangerously exposed when the waves begin to rock the boat. Strategic investors know that it's their business to fall in love with numbers, not a piece of real estate.
A Word about Cash Flow: Rationalizations Make You Broke
Let's be honest: newcomers to this industry often discount the ability to find positive cash flow properties in their target market. They hear about the importance of cash flow, but don't have the patience to wait for the property that will produce it. That's a huge problem the strategic investor doesn't have.
The system's number one job is to help you find the right property and to protect you from rationalizing your way into the wrong property. As humans, we can find many ways to justify just about anything in our lives. In fact, we are incredibly talented at making something we want to happen seem more attractive than it really is. This propensity becomes especially dangerous when we're investing.
That's why it is quite frustrating when you hear beginning investors (and some veterans) change their investing rules because they are finding it more difficult to find properties that fit the system. Instead of hearing them proclaim that the system works when it prevents them from jumping into properties that aren't seaworthy on calm seas let alone stormy waters, these investors are throwing life jackets overboard. Why would you assume a property will make money every month when you can conduct the pre-property purchase due diligence to calculate cash flow and make sure it happens?
Sophisticated investors take a more prudent approach, with most of us even building in extra emergency budget expenses when calculating potential cash flow. Call me cautious but I want at least one life jacket for everyone on board and life boats to take us to safety, just in case.
A Strategic Approach to Market Value
Market values are another area where non-strategic investors confuse reality with what they think they can justify. Strategically speaking, the actual price of the property only matters as a part of the cash flow equation. A million-dollar property in one region might create less cash flow than a $300,000 property in another. So if you ask me what a property is worth, I will tell you it's worth what the market will pay for it. Nothing less. But certainly nothing more. (While I love what market appreciation does for my business, I don't bank on it because it is not income. It is the dessert that comes at the end of the meal—right after you've eaten all of the things that actually keep you alive.)
When I tell people that my portfolio follows three principles—cash flow is king, appreciation is a bonus and every property deal must be a win-win for me, my partners and the people we're dealing with—some investors become quite confused. In their minds, these principles seem to defy conventional wisdom. My response is that long-term positive cash flow doesn't make for an exciting TV show: that's why the flip shows are so entertaining for viewers. Where the sophisticated investor looks for market intelligence and a how-to plan to follow, the emotional investor lets fear and greed cloud his judgment.
That's why I am so careful to temper enthusiasm for this business with talk of hard work. Real estate investment is not difficult. But success in this business is about future wealth and that requires that we build a sturdy, storm-proof portfolio. That takes hard work, but since it's the kind of hard work that my family's and my financial freedom depend on, I'd say it's well worth the effort.
If market newcomers are serious about making money in real estate investment, I challenge them to support their enthusiasm with education about what it takes to buy one “right” property after another. Following a system that already works definitely reduces the amount of hard work it takes to be successful.
Use Information to Reduce Risk
When I bought my first investment property, I was acting with a friend and roommate. The next couple of houses I bought were all homes I lived in and there was never a shortage of quality advice about how that process worked. Connie and I did some first-hand research into the neighbourhoods where we might want to live. We also chose to surround ourselves with people who knew more than we did in real estate and were lucky to have a patient and knowledgeable realtor on our side.
While our real estate resources were more limited in the 1990s, we did our homework as best we could. Then, as now, quality advice helps manage the stress of buying and closing on a property. But let me be clear about what this means for real estate investors, especially if you are new to the business. First and foremost, I believe that sound investment advice, given by someone who is actually experienced and doesn't profit if you buy a property, is available; just be careful of pretenders. With that in mind, experience has taught me to take advice only from someone who meets the following three criteria:
Each of these criteria helps new investors deal with their fear of making mistakes. Like everything in life, you can rest assured we all make mistakes. Your job is to mitigate the downside of the mistakes, learn from them and, most importantly, not repeat them.
Warning: Lemons Will Suck You Dry
Yes, there have been times when I walked away from a property and later realized, with the benefit of 20/20 hindsight, that it would have been a good addition to my portfolio. But if the analysis at the time said no, so did I. There have also been a very small number of properties I bought that I should have rejected.
In both instances, the main reason I might have changed my mind about these properties is that the rules of the game changed after the analysis was complete and a decision made. City governments sometimes do change their collective minds, leading to situations in which long-promised infrastructure projects are suddenly either back on track or cancelled, and anticipated zoning changes either are or are not approved. These actions literally change the fundamentals and so make research that was done earlier irrelevant. Similarly, there have been times when major employers take actions, good or bad, affecting local employment numbers after I've walked away from a property or closed a deal. My analysis simply isn't privy to all the many different variables that can come in to play.
Over time, I've learned to give myself a pat on the back every time I walk away from a property that would have weakened my portfolio because that's exactly what a sophisticated investor is supposed to do. And don't talk to me about making lemonade from lemons! While that might be an interesting analogy, I have learned to appreciate avoiding lemons. It makes real estate much more boring—and much more profitable.
Value Facts, Not Conjecture
Be aware of low unemployment rates, which are great for housing demand, but not so great if you are trying to get a contractor to do renovations in a timely manner. In fact, there have been times, in booming markets, where I just had to walk away from properties that would have been a great deal based solely on the fact that I would not be able to renovate or repair them fast enough to get them back on the rental market in a reasonable period of time. Budget also becomes a concern in booming markets as contractors working in regions with labour shortages have to charge premium contracting rates. You can mitigate these risks if you have developed a long-term relationship with a renovation expert. The higher costs and longer turnaround times won't disappear, but having these relationships can make your work a priority.
I must caution the reader that while this all sounds easy on paper, it's much more difficult to do in real life. Canadian investors who were bullish on expanding their portfolios through the first three quarters of 2008 were probably not wrong in terms of how they assessed the fundamentals. The problems, if and when they arose, were often related to the properties they were buying, not the economy in which they were buying. Until September 2008, it was easy to get caught up in the market euphoria, making cash flow a secondary consideration. That was a big mistake.
That is why education is the most valuable commodity a real estate investor can get before he or she buys property. Much of what you will need to know can be learned by surrounding yourself with successful real estate investors who are open to helping new investors get into the business. To summarize that thought: you must surround yourself with people who are achieving more. Most of the mistakes investors might make (like overestimating cash flow or underestimating the complications of tenant relations) are mistakes others have already made. The people you choose to listen to do not have to have made these mistakes themselves. But they know others who have made them. They know how to fix the mistake and will definitely understand that education is the best way to avoid problems in the first place.
Working with successful real estate investors should also help to protect your business from the vagaries of the hot tip. Investing based on inside information or hot tips will often be the opposite of what market fundamentals are saying. Even when tips prove to be right, the sophisticated investor will want to base investment decisions on his or her own examination of the data. The fact that a property may yield cash flow (and even rapidly appreciate) if a particular development goes ahead (like a new transportation route or construction of a major source of employment) is little consolation to an investor who buys based on a hot tip that doesn't come true. You might as well go to Vegas, put your money on red and wait for the wheel to spin. That's no way to invest, that's just pure speculation. A strategic investor would wait until the projects start, then buy from the speculators who want to get out with their quick buck. Because the investor's decision is based on the fundamentals, she gets the benefit of lower risk—with long-term profits.
In sum, the sophisticated investor may keep an eye on properties affected by a hot tip. But they're unlikely to buy until the development proceeds. Veteran investors sometimes joke that they make their money as settlers, not as pioneers.
Beware of the Big Talker
Do take note of the fact that my advisor criteria stipulate that you get advice from experienced and successful real estate investors. The ugly truth about the world of real estate investing is that not every investor makes money buying, holding and selling real estate. Some advisors make money solely by giving advice, advice that is often packaged alongside strategies to market specific properties. Let me be clear: if an insider's advice is based on me buying property from him or her, I'm out.
By the same token, my business depends on my reputation as a real estate investment researcher and analyst as well as being an active investor. In other words, I eat my own cooking.
It's worth adding a note about the negative big talker: these individuals like to give advice about why you should not invest in real estate. Their advice is laden with stories about their own problems, or with anecdotes about problems others have had. Again, real estate investing is not something everyone can do well. But if you wouldn't take cooking lessons from someone who boils the potato pot dry, why would you take advice from a landlord who cannot keep his rental suites full or his ledger in the black?
Managing for Profit
Once the right property is in his portfolio, the strategic investor strengthens that investment by managing the property for profitability. In simplest terms, managing for profit is all about being proactive in all aspects of the business. From a more strategic viewpoint, keen attention to the profitability of each new property—and making sure it is going to be easily and properly managed—must be part of the decision-making process. Great deals with poor management quickly become bad deals.
Managing for profit requires that investors understand all aspects of their business, from overall property and tenant management to marketing strategies and portfolio-management systems that are designed to help investors deal with everything from paperwork to repairs. Each of these areas represents a profit centre for your business—a profit centre that can lose money if it's not well managed. Each of these areas also links solidly back to quality and up-to-date bookkeeping, since that's what gives you the numbers you need to make good decisions. If you are behind in your bookkeeping, you can never make a proper, non-emotional decision about a property.
The implications of not managing for profit range from the nickel-and-dime frustration of paying higher-than-necessary water bills caused by leaky toilets or dripping taps, to the higher-stakes hassles caused when vacant units throw off cash flow or force a cash infusion. Just because you have hired a property management company doesn't mean you abdicate your responsibility—you must manage the managers.
The Midas Trap
I speak a lot about strategic or sophisticated investors versus beginner investors. It is important to understand one very important fact: sometimes, and it's more often than I'd like to see, veteran investors begin to believe they are infallible and can do no wrong. This approach is not strategic.
What happens is that after a few wins, with very few mistakes or losses, a veteran investor may get a little lax about applying his system, undertaking his analysis and making his property choices. In fact, as strange as this seems, some actually go out and find or create mistakes so they have something to solve. Buoyed by their ability to make several good choices—or by the fact that they enjoyed some plain old-fashioned (and terribly non-strategic) good luck—these investors forget how those choices were made (cautiously and with much supporting data). They start to think their success says more about them than their system. Well, King Midas and his ability to turn everything he touched to gold was a myth—and so is the idea that some investors can buy and sell property with impunity, always making money and never making mistakes.
Motivated by their own Midas complex, which fosters greed and a belief in fast cash, these individuals buy the wrong properties because they think they can make any property profitable. Please don't fall into this trap.
The best way to avoid the Midas mistake is to stick with your system. Just because you are good at buying existing properties and making them yield positive cash flow does not mean that you are automatically going to be great at developing properties or at a different system, such as lease-to-own or flipping for profit.
Breaking the Law
Investors who are determined to capitalize on the peaks and valleys of the market will always be disappointed. But while there's no surefire way to know when a market is nearing the top or bottom of its cycle, the economic storms caused by illegal actions are entirely preventable. They can also derail an otherwise healthy portfolio, and that's why strategic investors will tell you that they always work within the law.
They do not sign any papers that are not accurate, nor do they misrepresent themselves in meetings with other people. While some dishonest mortgage brokers or other shady professionals may tell you it is okay to misrepresent certain facts, you must be aware that any document you sign or declaration you make represents only you. If an error is caught, you are the only one who pays the price. The advisor gets away scot-free, leaving you to twist in the wind. That is why it is easy for them to give bad advice.
According to the law, the rulings always go back to intention. As in: what was the intention of the buyer or seller for this property? If it's easy to prove that you were not going to move into a property and make it your principal residence, it is illegal to sign papers that say you do plan to move in. Signing those papers may help you get a better mortgage or to get it more easily, but it's mortgage fraud, and lawbreakers can and do go to jail for fraud.
You will lose the loan when a lender or mortgage broker learns that you cannot supply the financial evidence they need to approve your mortgage. You will lose your real estate agent's trust when you tie him or her up with a sale you do not (or cannot) close.
And what do you think happens when investors try dishonest strategies more than once? You may think you are learning on the job. Others might think you are taking advantage of their expertise—and wasting their valuable time. To do their jobs well, real estate investors need to have a good working relationship with lenders, mortgage brokers, real estate agents, contractors, lawyers, accountants, property managers, tenants and other investors. The next chapter looks at how one builds a real estate investment team.
