Chapter Six
Riding the Cycle to Long-Term Sustainable Wealth
I love listening to people talk about what they would buy—if only they could. That's probably why I smile every time I hear that BNL classic, If I Had a Million Dollars. People who are serious about creating wealth take note: real estate is a viable route to long-term sustainable wealth.
Riding a bicycle is one way to increase your physical fitness and improve your chances of living a long and healthy life. Of course, jumping on a bike for the first time in years and sprinting at an Olympic pace can have exactly the opposite effect, making you unwell to the point at which you require resuscitation. That is why slow and steady progress over a few years—giving you time to build up to Olympic sprint levels—is so critical.
The same rule can be applied to riding the real estate cycle. Building your portfolio slowly and steadily, rather than pushing for explosive growth all at once, can lead to your achieving the equivalent of an Olympic level financial goal. Building it fast and furiously, however, can lead to catastrophic financial and emotional issues.
Finding the right portfolio growth speed is one of the foundational pieces to long-term sustainable wealth creation. For some who have a strong financial background, that pace may be quite quick. For others, just getting started on the journey of taking control of their financial future demands a pace that is a little slower and more methodical. The chosen pace is only right or wrong to the extent that it meets the individual investor's goals, strategies and abilities. Indeed, portfolio growth happens quite organically once an investor allows his system to guide his decisions. I am not suggesting that portfolios can (or should!) expand quickly. I am saying that strategic investors who allow themselves to be guided by a proven system that tells them what to do—and when to do it—will find it relatively easy to turn their attention to the specifics of what must be done.
Beware of the Black Swans
Before I explore the specifics of portfolio growth, let's revisit an important point about the reality of the real estate cycle. As stated earlier in this book, systems and up-to-date market data are essential components of the risk-mitigation tools that strategic investors use when building a portfolio. But even with the best systems, one cannot ignore the Black Swans that show up announced. Made popular by Nassim Nicholas Taleb in his book, The Black Swan: The Impact of the Highly Improbable, this rare bird is a metaphor for unforeseen events that affect a plan. He describes these events as:
an event with the following three attributes.
First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility.
Second, it carries an extreme impact.
Third, in spite of its outlier status, after the fact it is often inappropriately rationalized with the benefit of hindsight.
Examples of recent Black Swans include civil unrest in the Middle East, the spread of bird flu, major droughts, the World Trade Center attack of September 11, 2001 and banking fraud driven by the recession. Knowing they exist and can show up at any time is a strong argument in favour of a strategic investor's goal of mitigating risk by building a portfolio slowly and methodically for greater stability.
Strategic investors also remember that Black Swans do not affect every region the same way. When SARS hit Ontario, it stopped much of that province's economy in its tracks, but other regions of North America were largely unaffected. The same thing occurred in 2008. While the global recession hit Europe and the United States extremely hard, its impact was fairly short-lived and not as deep in Canada.
From: Secrets of the Canadian Real Estate Cycle: An Investor's Guide, author with Kieran Trass, Greg Head and Christine Ruptash.
When the 2008 crisis hit, many strategic Canadian real estate investors could see the impending market shift from boom to slump and responded by modifying their tactics. They became more proactive in portfolio management, which is one of the key tactics sophisticated investors employ during an economic downturn.
Less-strategic investors reacted emotionally. Because they were ill-prepared, either emotionally or mentally, for an economic slowdown, some divested their portfolios at great speed and at exactly the wrong moment in the cycle. They improperly extrapolated problems occurring in other regions of the world all the way down to the property they held in locations such as Thunder Bay. They made decisions based on fear, not fact. Strategic investors acted differently. Understanding that regional real estate markets move in cycles that are largely independent of global swings, they shifted their tactics to match market conditions. The other group misinterpreted signals about the shifting market, effectively losing their investor mentality when they panicked. Many members of this non-strategic cohort experienced great financial loss and emotional distress because they made their moves at exactly the wrong time in the cycle. Instead of acting strategically, they followed the crowd.
Some savvy investors downsized by getting rid of speculative or underperforming properties. Others looked for ways to strengthen their marketing to attract and keep quality tenants, at the same time reviewing their operations, looking for possible savings.
Contrary to what the less-strategic masses were doing, some sophisticated investors analyzed market fundamentals that favoured rental markets and expanded their holdings by buying the investment properties others were selling at a deep discount. (Market prices rise as a recovery takes root, but decline in a slump.)
Those who opted to vacate the market as soon as possible were obviously guided (or misguided) by an emotional (fearful) response. But what about sophisticated investors who chose to take remarkably different actions? Some consolidated their portfolios or changed their management practices. Others took advantage of falling market values and expanded their portfolios by buying more revenue properties in regions where the economic fundamentals had barely shifted in response to global concerns. Still others did a bit of both. Were any of these strategic investors shrewder than others?
As an industry insider, I can tell you there is no one right answer when it comes to dealing with market shifts and Black Swans. Indeed, I was intrigued to see how individual investors took the same information and employed different tactics to help them survive the economic turbulence that started in 2008. As a group, strategic investors understand that there is no benefit to jumping in and out of this business (or any business, for that matter). Since their goals are long-term and their profits are created over long-term cycles, they analyze market shifts without sacrificing their goals—or the systems they have put in place to achieve those goals. Talk about being intentional and strategic! These investors allowed their systems to level out some of the potentially negative implications that could otherwise result from the inevitable ups and downs of the market. More than anything, their tactics epitomize a commitment to long-term sustainable wealth.
The Beauty of Leverage
Financial leverage, a.k.a. borrowed money, makes the real estate wheel go around. But it's terribly shortsighted to think that leverage is all about money. Sophisticated investors know that money is only one element you can leverage. Yes, you need money to close deals. And money—regardless of whether it's from cash flow, partners or mortgages—definitely attracts more money.
But leverage, in its purest sense, is really about knowledge. It's about who you have surrounded yourself with, their knowledge base and what you bring to the relationship that they can leverage. Knowledge, information and contacts are the other three elements a strategic investor leverages, and none of these can be used effectively unless you surround yourself with other legitimate investors.
- Knowledge: A working knowledge of the strategies and tactics used to create wealth in real estate can be shared and leveraged by working with other legitimate investors, including money partners. This mitigates risk by helping investors avoid financial pitfalls.
- Information: Strategic investors leverage the information of others to gather unbiased and unemotional information on economics, regions, neighbourhoods and properties. Working with trusted sources is the quickest and most effective way to access quality information. Tim Hortons and Walmart don't open stores without doing extensive market research and neither should you. The good news is you don't have to do it all yourself.
- Contacts: Building a trusted team (see Chapter 4) lessens your portfolio risk while saving you time and energy. Strategic investors leverage other investors' contacts while sharing their own, thus strengthening their team and building future contacts.
Financial Leverage
Whether they're buying property for business or personal use, most investors will find themselves talking to a lender about a mortgage. In the simplest terms, the borrower leverages a certain amount of his own capital in return for a loan (private or institutional) on a real property purchase. That is why building solid relationships within the financing community is an important step for investors.
The power of financial leverage is best explained by example. To keep it simple, let's say an investor puts up $200,000 of her own money to buy an investment property. If that property increases in value by 5 per cent ($210,000), the return on investment (ROI) would be 5 per cent. If that same investor leverages the purchase price by using just $40,000 of her own money and borrows $160,000 from the bank, that 5 per cent ROI now escalates to 25 per cent, because the tenant pays the cost of interest. This is in stark contrast to stock market returns. There, a 5 per cent increase in most cases tallies 5 per cent, period.
This example does not dismiss the reality that borrowed money must be paid back. On the contrary, a sound investment system ensures that the rent collected from the property will pay for itself, including the mortgage payment.
Given the potential to leverage borrowed money, the sophisticated real estate investor quickly learns to view his lender as his best partner. He also understand that not all lenders are institutions, and not all institutions are the same or have the same policies. Each bank has its own set of rules and each of these rules can change at a moment's notice. Non-bank institutional lenders such as MCAP are mostly governed by whatever rules the Canada Mortgage and Housing Corporation (CMHC) is operating under, even if the loan does not meet the threshold for insurance.
Credit unions, on the other hand, are not covered under the Bank Act and therefore are able to be more flexible. Good credit unions are becoming more important players in the strategic investors' world. Although most conventional real estate purchases involve institutional lenders, there is a variety of circumstances where private loans make sense. Indeed, while successful investors build their portfolios by sharing risk and ownership with joint venture equity partners, others use private lenders to kick-start a purchase or to bridge a short-term financing gap while still keeping full ownership of the property. Although the interest rate may seem high, it is often still less expensive than giving up 50 per cent of the property's equity appreciation and cash flow to a joint-venture partner.
For example, those who buy a discounted property with a plan to renovate the property and either quickly resell it or refinance it often find the use of private lenders works well. Here, a short-term loan at 12 per cent interest may work better than a less-flexible bank's 4 per cent deal. In fact, many regular institutions do not like making these short-term mortgages and make it difficult to get approval. In cases like that, strategic investors leverage their knowledge, information and contacts to access the funds that fit the specific tactic.
This kind of arrangement at the front-end of a property investment gives the real estate expert several options in terms of a longer-term strategy. For example, a strategic investor may borrow from a private source to give himself time to turn a poorly-managed revenue property into a well-managed site with full suites and quality tenants. An investor could use private capital to launch this investment and then pay back the higher-cost capital (with interest) when the property is performing at its best. Once that occurs, the investment will be attractive to a regular institution that offers much lower interest rates. A real estate investor may also use private cash to turn the property around and then use another partner's cash to buy out the loan, with the second co-venturer entering the deal as part of a longer-term buy-and-hold strategy with the real estate expert. The real estate investor could also buy out the private loan and maintain 100 per cent ownership once the property was operational.
This has some obvious profit advantages upon property disposition. That said, investors who think that leverage is all about your own or private money will miss key opportunities to expand their portfolios.
Financial Partner's Money
While some real estate investors focus on private loans or their own capital to build their portfolios, most do not. Instead, they leverage a co-venturer's ability to borrow capital from traditional financial institutions. The most common of these deals involve a 50:50 partnership in which a joint-venture partner puts up the capital for the down payment. The partners share ownership, with the real estate expert (there's that word again!) doing all of the work associated with finding, managing and eventually selling the property. Profits are shared 50:50 after the initial down payment is returned to the co-venturer.
Again, this strategy says as much about relationships as it does about money. This is why successful real estate investors who build their portfolios using what they call “other people's money” insist that finding joint-venture (JV) capital is easy. By focusing on strong relationships with members of their investment teams, these individuals build their portfolios using the JV money of people they already know. In many cases, these people come from the investor's inner circle of contacts. They are family members, friends or co-workers, or have a direct relationship with the investor's family, friends or co-workers. Long before the first JV deal closes, these individuals already have some kind of a track record with the real estate expert.
To learn more about how sophisticated investors translate their personal and business relationships into real estate co-ventures, take REIN's home study course, JV Secrets, or read my bestselling book (with Russell Westcott), Real Estate Joint Ventures: The Canadian Investor's Guide to Raising Money and Getting Deals Done. Both provide a step-by-step system for finding, utilizing and maximizing joint-venture money. This strategy works by creating strong relationships in which each party (the investor and the partner) profit by leveraging their assets. The investor leverages his knowledge, information and contacts and the financial partner his access to capital.
The joint venture is a powerful investment tool, since satisfied money partners tend to come back for more!
Leveraging Real Estate Expertise
A lot of investors struggle with the notion of what it means to leverage their real estate expertise. Novice investors worry they don't know enough and veterans forget their advanced knowledge of real estate is what separates them from the pack. So what sets real estate experts apart from others? In addition to having real life investment experience, strategic real estate experts define themselves in three key ways:
Turn All Conversations to Real Estate
The real estate expert doesn't want to bore people with the details of what he does. But whether he's investing part-time or full-time, the strategic investor understands the intrinsic value of being able to turn all conversations to real estate—without selling.
Remember what I said above about the value of the investor's relationships and inner circle? Sophisticated real estate investors who are serious about growing their portfolios with the outcome of long-term sustainable wealth are like any other proud business owner: they talk to people about what they do and how they do it. By willingly sharing stories about their experiences, they tell rather than sell the deal. This helps build that inner circle of potential partners and contacts.
The less-strategic investors are often of two camps. Members of one group are too reticent and perhaps even embarrassed that they are real estate investors. Consequently, they choose not to talk to anyone about what they do. Members of the second group are so aggressive that whenever they talk about their investments they become like pushy salesmen and make everyone around them uncomfortable. Neither of these approaches would be successful in any business or profession (unless, of course, they are selling food slicers at the local fair) so it's not surprising they don't work in the investment real estate realm either.
Strategic investors know the calm and sophisticated approach is best because their inner circles, when combined with the inner circles of their family, friends and co-workers, give them incredible access to potential partners, some interested only in private loans, others in co-venturing on revenue properties.
To find co-venturers within those circles, investors practise doing what it takes to turn all conversations to real estate. They do not shy away from questions about what they do, how they do it and how it benefits their money partners. When conversations take a more businesslike edge, these investors set up meetings to go over the details in a more formal—and professional—environment. As real estate experts they will do what it takes to show others that they know what they're talking about. Again, it's all about telling, not selling.
The bottom line is that strategic investors know they must become the person who attracts working capital. They constantly ask, “If I was approached with this deal in the manner I just approached this prospect, would I lend this individual money to buy revenue property?” The real answer to the question lies in the result: if no cheques come in, then the answer is obvious and changes must be made.
The investor who is serious about building long-term sustainable wealth appreciates that question because she knows it can lead to more fruitful discussions of specific real estate investments. She is okay with the question because she knows she can answer it: her response always comes from her proven system and her commitment to mutually beneficial investments.
The CCI Index
This willingness to turn all conversations to real estate is an extension of the CCI Index discussed in Chapter Five. In sum, an investor with a high CCI IQ knows what he's talking about and is committed to acting ethically and legally. He turns all conversation to real estate because he recognizes that his investments offer mutually-beneficial financial opportunities. The fact that the vast majority of his money partners will always be individuals with whom he already has a relationship is a definite bonus. Who doesn't want to work with people you already know and like?
Portfolio Strength: Marketing and Management
Investors who are serious about growing their portfolios soon recognize that their most important marketing tools all come back to evidence of their investment success. Buying the right properties is critical—but it's closely followed by the need to manage those properties for investment success. This is the meat and potatoes of why JV partners will be attracted to your investments.
Strategic investors recognize that quality investments only perform if they have high-quality marketing and property management. The first focuses on keeping suites full or finding the right buyers for properties that are for sale. Marketing is definitely part of property management. I've noted it separately because non-strategic investors often fail to give marketing its due. They think they're struggling with cash flow and the need to master budget contingencies when their real problem is rooted in the fact that their suites are not rented. That sounds trite, but it's true. It's comparable to not being able to see the forest for the trees!
Quality property management should always include a marketing component. But marketing is never an end in itself. For most investors, marketing is all about getting quality tenants into quality suites—and that emphasis on quality is key. The raw beauty of real estate investing is that properties that produce cash flow enable your clients (tenants) to pay your debt and enhance your long-term financial security. Strategic investors take that very seriously.
Again, a healthy property contributes to a healthy portfolio, which improves your ability to capitalize on future wealth. Ignore property management, or undervalue its contribution to your portfolio's strength, and you play Russian roulette with your future.
Don't let Unqualified Media Noise Influence Your Investment Decisions
Portfolio strength is one of the best ways to bring JV partners into your investment business. Money partners are attracted by proven success. That proven track record can be compromised by misinformation.
The introduction to this chapter alluded to one of the biggest problems new and experienced investors encounter: confusion about what the real estate market cycle is and how it impacts investment portfolios. This confusion is compounded by what I call “unqualified media noise,” which can greatly complicate an investor's ability to establish himself as an expert.
To be clear, professional media can be an excellent source of information about what's happening in local, national and global economies. But with the advent of the internet, many unqualified voices also make themselves heard and bombard investors with a lot of erroneous noise. The end result is that all the sometimes contradictory and misguided information leaves non-investors confused. To avoid a similar fate, strategic investors must develop a filter that focuses on trusted and unbiased sources with strong real estate investment fundamentals and experience. There is no time to listen to theorists who just re-state scraps and tidbits they've heard. A good example of how erroneous information can cloud decisions is embodied by a common assessment of the 2008 recession. Those who say it was the worst since the Great Depression add negative fuel to the information fire. In reality, that recession isn't even the second-worst in Canada; it's the third-worst. When the constant repetition of that mistruth entered the common psyche, it left a majority of Canadian convinced this was the worst recession in Canadian history. Known as an “availability heuristic,” myths such as this feed a very powerful thought process that becomes dangerous in its ability simultaneously to be easy to remember—and wrong! Strategic investors must continually fight to avoid getting caught in similar traps. Those who manage to do that are able to see the market with a clarity that few others share!
Potential money partners without that expertise in real estate may be so confused and caught up in an availability heuristic that they cannot get past it, even when strategic investors try to share real truth.
A strategic investor will also explain to his money partners and potential money partners that the vast majority of headlines are designed to sell media, not to provide unbiased facts and figures. A renter who is thinking about buying a home may listen to news of interest rate increases and decide to keep renting, a fact that might impact the local housing market. An investor may hear the same news and be excited about the fact that higher rates stabilize his target area's rental pool. Similarly, home buyers can fall in love with a property. Conversely, the investor falls in love with numbers—not a great kitchen or bathroom!
Separating E-Facts and E-Fiction
Confusion about what the media noise means is amplified by the current proliferation of misinformation in what some call the “Age of Protest.” Fuelled by access to the internet, which provides a cheap but massive platform to even the most ignorant or biased among us, discussions abound of real estate markets, booms, busts and bubbles.
Fortunately for the real estate investment business, that debate often happens well outside the circles frequented by strategic investors. The strategic investor should stay out of the fray. He knows that his portfolio performance is dependent on the relationships he builds with people who are in his inner circle, where his non-real estate related relationships have already engendered relationships based on mutual respect and trust. The strategic investor becomes the go-to person for people with questions about real estate and when these individuals see how the expert uses facts and fundamentals to address their concerns or queries, they listen more closely to his ideas.
Again, success in real estate is about building portfolio strength based on market fundamentals. It is about the facts, not guesswork.
- I invest based on my own analysis of proven real estate fundamentals.
- This is why I focus on a particular geographic area.
- I follow a system that values the importance of cash flow.
- I know how to put different kinds of investments to work (private loan or co-ownership).
- I focus on certain tactics (rent-to-own, buy-and-hold, fix-and-flip).
- I am committed to win-win property investments.
How to Work with Partners
Finding money partners can be easier than working with them, but the strategic investor uses knowledge to navigate his way around potential landmines. By applying the same level of due diligence to partner evaluations that they'd apply to property searches, sophisticated investors bring new partners into their property investments without compromising long-term financial goals.
For a primer on working with JV partners, check out my book, Real Estate Investing in Canada 2.0. A more advanced discussion of how to put together solid JV deals is detailed in my book (with Russell Westcott), Real Estate Joint Ventures: The Canadian Investor's Guide to Raising Money and Getting Deals Done. The most important point to remember is that you do not need to work with everyone who wants a piece of your investment pie. The people you choose to work with must be qualified to be there—and your system can help you identify them because it troubleshoots potential problems, including many that new investors may not immediately recognize.
The joint ventures secrets book, for example, walks investors through everything, from how to generate JV leads, to the application of the principles of wealth-attraction and how to filter potential money partners to make sure you can work together. The system also covers how to structure JV deals and the essentials of what must be included in a legally binding JV agreement.
The strict application of so much upfront due diligence explains why few strategic investors ever revisit formal JV agreements. When so much attention is paid to how these deals are structured, they rarely unravel.
- Interest rates. Analyze your properties with an interest rate that's 1 per cent higher than today's rate.
- Job growth. Ignore national figures, focus on your target region and how it is being affected. Sustained unemployment is high in some parts of the country. Focus on regions with persistent job growth and jobs created by projects with multi-year timelines. These jobs will stay in place even with shifts in commodity prices and demand. They also attract a majority of workers from outside the region. Investors call these workers “renters.”
- The European factor. Global investors (including Canadians) see the upside of a stable economy but the money they're putting into Canadian real estate, especially in major centres like Toronto and Vancouver, can definitely skew the market. The sophisticated investor avoids overheated markets—and follows job and population growth instead.
- Markets heat. Markets cool. Overheated markets eventually cool down. Seasoned investors watch for the strategic advantages offered by cooling markets (think: motivated vendors and dropping prices). They also watch for the economic fundamentals that will sustain long-term growth. What happens when people lose confidence in the real estate market? They become renters.
- Strategy wins. Knowledge and strategy always trump emotions and guesswork.