Doing The Numbers Isn’t The Be All End All To Real Estate Investing

Posted @ 12:06 am - Filed under Real Estate Investing, Builders, Buying Income Property

If you don’t know how to properly analyze income property, meaning before and after tax cash flow, you could find yourself walking in a minefield without a grid map. Numbers are crucial. Chris Lengquist published a piece Wednesday, that underlined that truism. He mentioned it in passing, almost as an afterthought, as he linked his readers to a site showing how much money they’re losing by watching TV. Chris knows his numbers inside and out. He’s a pro. He published a post yesterday talking about a young guy he defined as a property collector. The guy invested, but apparently had no real plan. His posts inspired me to address what else goes into investment real estate, in addition to crunching numbers.

Countless times I’ve selected properties for clients producing inferior numbers to others in the pool for consideration. The following is a list of some of the reasons why.

Location — This seems obvious given the most well known of all real estate cliches. However, if the investor is going for capital growth, Captain Obvious says, “Appreciation is clearly paramount.” That said, in most regions, the areas yielding the highest cash flows (everything else equal except location) will generally not be in the most desired areas. Don’t get me wrong — they don’t have to be bad areas, just where folks who can’t buy want to live, and can afford.

Tenant Quality — If there’s a lesson one of my all-time favorite clients learned early, it was the correlation between headaches and the quality of renters she was approving. Even though it goes against the grain of much of our modern culture, character matters.
Decent credit, being employed, and not showing up to meet the landlord for the first time looking like a drug dealer are all positive indicators, but great managers develop a sixth sense with folks. They’ll pick out the solid citizen 95% of the time. My Grandma would’ve been the best screener ever! Getting bad character past her was like getting a pork chop past a hound dog.

Age — In some areas, San Diego is a good example, a property’s age doesn’t bother folks as it does in other regions. With the exception of recently developed areas here, a young home is 20 years old. There are places though, where age is a huge deal — but usually to the locals, not outsiders. This is true to a large extent in Boise. My So Cal investors will by a rental there built in ‘82 without batting an eye. A local would not even consider doing that. When, down the road, the older property is sold for a nice profit, the investor will get the same grin on his/her face as the seller of a much younger property. At least that’s my experience.

Potential Maintenance Cost — Do your tenants have their own refrigerators, or are they yours? Does your fourplex have one giant water heater, (You pay for hot water.) or one for each unit? (Tenants pay for it.) Is there one gas and/or electric meter, or one for each unit? (Same result as water heater.) Is the parking/driveway asphalt or concrete? Big difference over the long haul — especially when you’re in an area that really heats up in summer.

Tenant Demand — Surprisingly, this is a factor often overlooked by investors, especially new ones. Let’s use San Diego as an illustration again. My daughter lives nearby, and attends the local university. The duplex she rents is walking distance from a trolley stop. It takes her directly to school and back. Do ya think that’s a big deal to other students? Or folks who can take the same trolley to two huge regional shopping centers? Or to their jobs? Of course, it’ll be different factors in different areas. Remember, real estate is nothing if it’s not local in nature. Her duplex is also two minutes from a freeway on-ramp. And at almost 23 (next week) she feels safe when arriving home after dark — no small thing for women. She can also afford the rent while enjoying all these neighborhood perks. It’s no surprise rentals in that neighborhood rent mostly by simple word of mouth.

Vacancy Rate — Again, we’re getting into Duh Theory. Knowing the vacancy rate is considered normal at around 5%.
There have been many cycles in San Diego when the vacancy rate for the county was a virtual concept. You rented your vacancy by putting a 3 X 5 card on the tree in front on Friday, and after your first cup of Saturday morning coffee, you drove over to gather the 13 applications from the impatient folks loitering in their cars. In Boise the rate is now around 2-3%. The point is to know what you’re dealing with so you can plan for potentially longer rent-up periods in areas with higher rates. It’s not rocket science, but thinking you’re gonna rent your vacancy in a week, when the vacancy rate is 16% isn’t realistic. (He said, remaining solidly in Duh Territory.) This doesn’t necessarily mean you shouldn’t buy the property, it just means you should plan for longer periods of zero income every now and then.

In Boise, it wasn’t too long ago when we were facing double digit vacancy rates. But we still bought like crazy because our research and analysis told us rates were about to plummet and rents were about to go up, up and away. Vacancy rates alone shouldn’t sway you to buy or not — low or high. You should have an idea though, what the tea leaves are saying about the future in the region.

Functional Obsolescence — This is something most folks don’t even have on their radar. When a woman walks into a place she’s considering buying or renting, and the kitchen reminds her of an I Love Lucy episode, her next step is usually back towards the door. Those old kitchen designs (He says, slaughtering the very concept of ‘design’.) require a couple to really be in love in order to be in there at the same time. Outdated plumbing, using galvanized pipes usually isn’t a big hit either. Or how ’bout one of my favorites, no A/C? Or wall heaters? Here’s a test. If Grandma had central heating, so should your rentals, ok?

Quality of Construction — This, it turns out, is a subject more apt to generate disagreement among investors. Some will buy less than the highest quality buildings, while others won’t compromise an inch. I’m of the first camp — it doesn’t have to be perfect. Still, we’re not gonna buy something that looks like the local high school woodshop class built it as an extra credit project either. There’s a difference between cutting corners aesthetically, and taking shortcuts in the actual construction of the building. On my last Boise trip I saw some construction that on its best day would be called shoddy. We walked away shaking our heads.

Numbers are crucially important, but of little or no value when you’ve not paid attention to the whole picture. Accurate, conservative numbers are worthless when the property is a poorly maintained, badly constructed, I Love Lucy special, located on the wrong side of the tracks with tenants better suited to act as extras in the local production of The Grapes of Wrath.

Collecting properties vs acquiring a Purposefully Planned portfolio of excellent investments will find you in dire straights sooner or later. In this kinda market it’s more likely to be sooner. Much of my time this year has been spent helping new clients deal with the consequences of their ‘collections‘ acquired during the last few years. This usually ends up being at least a little painful, as they see their investments really take off — just not the way they planned it.

Everything went wrong — “But the numbers crunched BawldGuy, really.”

Kaboom!!

Property Collectors — good one Chris.

Like I said, doing the numbers isn’t the be all end all to real estate investing.

This entry was posted on Friday, July 20th, 2007 at 12:06 am and is filed under Real Estate Investing, Builders, Buying Income Property. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.