It is good to know the fundamental principles of real estate investing especially for new investors to determine whether they are making a good or bad decision on all their future investment plans. The most common mistake while investing in property is that people buy with their emotions. They buy in the wrong place for all the wrong reasons.
They buy property based on:
- Opinion of people who have no knowledge of investing
- In a place, they were born
- They love to buy in places they like to holiday
- Buy in a place where they may like to retire
Does this sound familiar to you?
Although local knowledge is an important factor when buying real estate, this should not limit your options and restrict you to areas that you are familiar with.
You must never buy a property based on emotional reasons! If you wish to succeed with investing in property, you need to make logical decisions based on sound principles of real estate investing.
You can use different strategies in real estate to grow your portfolio. These include investing in rental apartments, single family homes, industrial property, retail real estate, office space, hospitality or overseas properties. You can also gain expertise in lease options, investing in off plan property or buying at foreclosure sale. But these can never replace the fundamental principles of real estate investing.
There can be various strategies but the principles of real estate investing are eternal.
There are many experienced investors who become overconfident and violate these principles—they invariably suffer grave consequences. So please take time to study the following fundamental principles of real estate investing with care.
‘Buy and Hold’ will Make You Rich
Always remember that you buy property for capital appreciation. Real estate first and foremost is a capital business. Rent and cash flow are important to help you own the property for long term.
“Don’t wait to buy real estate, buy real estate and wait.”
~Will Rogers (1935)
Investing means owning real estate for long term. Flipping properties and lease options strategies are used to generate cash to fund your long-term investments and should not be confused with the long-term goal of creating wealth through capital appreciation.
Real Estate is not a get-rich-quick scheme; capital appreciation happens over a period. You must have patience, perseverance and persistence. For this, you have to understand the compounding power of real estate investing.
How many times investors have sold their property for peanuts only to realize a few years later that they would have made a fortune had they had the patience and wisdom to hold it a bit longer.
Please remember the times you have cursed your ancestors for selling a piece of real estate that would have changed your financial future and of the generations to come.
If you can help, never ever sell your property: this is one fundamental principle of real estate investing you should never forget.
‘Cash Flow’ Funds Your Real Estate Business and Gives You Peace of Mind
When I started out in real estate, there were no books or real estate investment seminars. My mentor was a rustic real estate agent who gave me one great piece advice that has stuck in my mind for the past three decades. His advice was very straightforward: “Only buy Cows that give milk.” This one advice has kept me out of trouble in down turns in the property cycle and made me a successful investor.
It is cash flow that funds your lifestyle and gives you peace of mind. The happiest times of my life have been those when I was flush with money to pay my bills, take holidays and meet all my financial commitments. My worst nightmares came when I was low on cash flow to meet my mortgage requirements even when I owned millions of dollars’ worth of real estate in my portfolio.
The main reasons why people get into trouble, have foreclosure sales and become bankrupt are that they fail to understand and monitor their cash flow.
You should subscribe to Warren Buffet’s philosophy of investing for cash flow: whether you buy real estate or stocks … buy only for cash flow. Capital gain will happen over a period with any good investment and cash flow, in the meantime, will help you fund your life style and keep you and your banks happy.
Never buy ‘negatively geared’ properties. A negatively geared property is a property wherein rent received from the tenant does not cover expenses related to the property such as mortgage payments, maintenance charges, rates, insurance, property management costs etc. There is no fun in buying properties that you will need to fund from your pocket monthly. There are many property gurus who will teach you to buy ‘negatively geared’ properties to avail tax refunds. This is plain and simple stupid—keep away from such gurus.
How many properties can you buy if you have to keep supporting them from your hard earned money? What will happen if the interest rates go up, you lose your job or fall ill? Will you be able to continue supporting these properties? Always buy ‘positively geared’ properties that put cash into your pocket after paying all the expenses including mortgage payments.
Buy land only if you have adequate cash flow from other sources. Otherwise, stay away from land investments as they have little or no cash flow. Most people who got into trouble during the crash of 2008 – 2009 were investors with large land holdings or with negatively geared properties in their portfolios. When the market went down, they could not sell their properties even at a discount, resulting in mortgagee sales and bankruptcies. Stick with rental property investments that are cash cows and you will never go wrong.
Remember the good old saying, “Buy cows that give milk.” This is the secret mantra to success in real estate and will keep you out of trouble when things go wrong.
Do the Math
Real estate investing has nothing to do with emotions. It is only numbers that matter. When you buy a house to live in, there are emotions involved: you must have the comfort level, practicality and pride of ownership. Your house reflects your personality and provides security and warmth to your family.
Real estate investing is all about getting your numbers right. It is about yields on purchase price or market value and capitalization rates. You should understand terms such as Market Value, Cash on Cash Return, Internal Rate of Return and Deposit Re-cycling Time. I have explained these terms at the end of the book (Refer Appendix 2). They may sound difficult at first, but are relatively easier to understand once you start applying them.
You must take into account mortgage financing costs, out goings or cash deductions to work out pre-tax cash flows. And finally, you have to take into account the depreciation and other tax refunds to work out the after-tax cash flow.
It is not humanly possible for anyone to work out these figures manually when you are comparing, let us say, five prospective properties to buy one. Fortunately, we have real estate investing software and investment property calculators to help us in getting all the figures we need to make an invest decision.
If you concentrate on the numbers, it will be easier for you to keep your emotions out when buying an investment property.
To do the math is very important but you should temper the mathematical outcome with subjective analysis and human judgment with regard to quality of construction, location, quality of the tenant and lease terms. You should never get carried away by numbers alone but subject them to your common-sense judgment.
Location Location Location
If the location of your property is right you will never have problems in finding tenants. There is no point in buying a property that shows a great rate of return on paper but has high vacancy rates. Many investors fall prey to not considering the vacancy factor and get carried away in purchasing properties that show high yields.
The property you buy should be in the right demographic area where employment and population are on the rise. Once you have found the right geographic area focus further on neighborhoods that are close to places of employment, shopping centers, schools and transportation centers.
If the location is right, you will have capital growth because of demand.
People often question me, “If the location is so great, then the price of the property will increase because of a high demand and will pull down the rate of return, which will inevitably have an adverse impact on the cash flow from the property, won’t it? Although there is some merit in this argument, astute investors will find ways and means to add value and increase cash flow by making improvements to the property.
Always Buy from a Motivated Seller
You make money in real estate when you buy. Even if you master the best skills, it is virtually impossible to sell a property above market value until and unless you find a stupid buyer, which is rare. To make instant money in real estate, you should buy below the market value, which can only be done through buying a property from a motivated seller. If a person is not motivated to sell then you will never be able to negotiate a great bargain price.
It is not unethical to buy property below its actual value. Selling at a low price becomes desirable when people wish to dispose of their property because of various reasons, which could be due to some urgent financial need. Property is an excellent investment but, at times, difficult to liquidate. You solve the vendor’s problem by coming to their aid with immediate cash. If cash problems are not solved, banks can take over the property and they may lose everything. While investing in real estate, you should understand the vendor’s problems and try and solve them in a way that it can work to the parties’ advantage.
You can accumulate great wealth quickly by simply learning the art of finding motivated sellers and purchasing below market value. Supposing you buy a million-dollar property for $900,000 – which is 10% below market value – if you are able to achieve that then you have created an instant wealth of $100,000.
Use Other People’s Money (OPM) to Fund Your Real Estate
No one has ever become rich by using their personal money. Sooner than later, individuals and companies run out of money to fund their growth. You must learn how to use Other People’s Money or OPM to grow your net worth.
The business of banks is to use other people’s money to make profits. They borrow from you and loan it to businesses at a higher interest rate to make money. You should think like a bank and borrow at reasonable cost of finance to fund your real estate business for much higher profits.
Real estate provides you with a great opportunity to use financial leverage to grow your wealth. Banks and other financial institutions love to finance real estate. The only way you can accelerate your growth is by using OPM and using financial leverage sensibly.
Make Use of the Property Cycle
“Be fearful when others are greedy and be greedy only when others are fearful.”
Property Cycle, unlike stock prices, is very slow moving and comparatively easier to understand.
The easiest option for you is to buy real estate at the bottom of the cycle—but in real life, things are not so simple else everyone would be rich. The bottom of the property market is difficult to predict.
“Buy when everyone else is selling and hold until everyone else is buying.
This is not merely a catchy slogan. It’s the very essence of successful investment.”
~ J. Paul Getty (1976)
If you will wait for the property cycle to bottom out (which is hard to predict,) then you will be able to buy properties only once in seven to ten years and you will miss out on all the other opportunities that happen in other parts of the property cycle.
In real estate, you make money either through Cash Flow, Capital Growth or Equity. These are known as the three corners of the property triangle. You will rarely be able to achieve all three at a particular stage in the property cycle. For instance, when the property prices are regressing, you cannot buy real estate for capital growth but it is an opportune time to buy properties below market value and create instant equity—which is better than waiting for capital growth. At the bottom of the cycle, you will be able to buy properties that give high cash flow as the prices are down and return on investment much better.
The beauty of property cycle is that it is very slow moving; you will get ample warning signs on things to come if you are not blinded by greed and emotions.
If you are to be successful in real estate, you must negotiate everything whether it is the price of the property, rent and lease terms with your tenants, mortgage rates with the banks, property management contracts or repairs, and up-gradation costs with the traders.
Every time you negotiate, you save money and improve your chances of success. For example: by negotiating a 0.2% lower interest rate on a 30-year mortgage loan with your bank, you can save hundreds of thousands of dollars over the lifetime of the loan.
Everything in business is negotiable. If someone tells you otherwise, the person is a fool. Please stay away from him! Real estate negotiation is one skill that you have to master to become successful.
Learn to Walk Away from a Deal
Do not get emotionally attached to a deal. Learn to walk away if the numbers are not correct. The deal of a life time comes along every single day if you are on a constant lookout.
“The single most powerful tool for winning a negotiation is the ability to get up and walk away from the table without a deal.”
Knowledge of Real Estate Investing is the Key to Success
Knowledge of real estate investing is the biggest leverage you can apply to succeed in real estate. Whether you are a newbie or an experienced property investor, you should continuously upgrade your knowledge.
An outstanding investment property is never seen with the eyes but always with the mind. Thousands of people will pass a property and will see no any value in it. It takes an educated mind to understand what is the real value and potential of a property. At times, even vendors do not understand the full potential of their properties. Like everything in life, education is the key.
You have to constantly view deals, visit properties, read books, watch videos, attend seminars and, join property investor’s forums regularly for fresh information; you have to acquire knowledge to an extent that it becomes your second nature. When you reach this stage, you will be able to spot a great real estate investing opportunity when you browse the internet, see an inconsequential advertisement in the newspaper or during your morning walk.
Buildings Depreciate, Land Appreciate
This is an extremely important principle to understand. Land appreciates over a period of time whereas buildings depreciate. The value of a property consists of land and improvements. Land generates very little or no cash flow; it is mostly the improvements or buildings on the property that generate cash flow.
Buy properties that have large land element whilst keeping an eye on cash flow.
Generally speaking, city apartments have higher rentals but little or no land element. Over a period of time, apartment buildings become old and dilapidated—they lose in value. Single family homes, on the other hand, have lesser cash flow due to the land element. The trick is to buy discounted properties from motivated sellers and increase the rental returns through improvements such as adding additional rooms or building an additional home on the vacant land if permitted by the council.
Even as buildings depreciate, the underlying increase in value of land will make you rich.
“Buy on the fringe and wait. Buy land near a growing city! Buy real estate when other people want to sell. Hold what you buy!”
~John Jacob Astor (1848)
Taking action is the key to your success. There is no point in having all the knowledge and not applying towards your success.
It is fear that keeps people away from buying real estate. Knowledge – to some extent – abates this fear. However, no one can reach a state of complete knowledge to overcome fear. You have to act in good faith and intelligence; inaction will keep you tied to poverty. Once you start taking action, your experience and confidence in real estate investing will increase.
Action is always superior to inaction. When I started out, I had no knowledge of real estate investing. My mentor was a very rustic real estate agent. He pushed me hard into buying my first property probably because he wanted to make a commission. The only sensible thing I did was to take the leap of faith and get pushed into buying my first investment property. I have never looked back since. For the first few years, I was a ‘street smart’ real estate investor … I was learning by taking action.
I never learnt anything new at a property seminar that was not in a book. What helped me was the synergy of like-minded people: it helped me overcome my fear of investing. If so many people could do it successfully, so could I. The best way to overcome fear and taking action is to find a mentor and join a group of successful real estate investors.
Take action even if you have limited knowledge about real estate investing. Think big but start small. A few small steps will change the outcome of your life.
Understanding and applying these basic principles is the key to success in real estate investing.