Disclaimer: Nothing is this article is meant to constitute financial advice of any kind, and is the opinion of the author only. Seek professional advice before making any financial decision.
Building a Solid Foundation in Real Estate (2010).
With a large number of well known property investors in NZ going bankrupt, this may be a good time to take a look at your own property portfolio or investment strategies. Many of these investors were also promoters and charged thousands of dollars (at times tens of thousands) to mentor the unwary or naive beginning investor, and often charged for their investing seminars and related materials.
If they were so successful and could teach others how to invest and some even tell investors which way the market was going to go (up or down and by how much!) by using various indicators, why have most of these so called experts gone bankrupt themselves - or very close to it? A few of them in my opinion were always out for themselves, in other words deliberately sold or promoted dodgy investments, or had strategies which were just never going to work. Even though a few of us warned other investors about several of these so called and self professed property gurus, they still had a lot of followers that went along with everything they said, as if they were some sort of Messiah or similar. They could do no wrong in their eyes and believed every word they said. Surely you would think with the amount they charged for their mentoring services, seminars, subscriptions, blogs and other products and materials, they would have huge sums of money to invest with and invest it wisely, i.e. with low risk strategies. You would think they would still be very well off today.
I believe it's because none of them had built a solid foundation to begin with. When you build a home, the most important part and the part that takes the longest to build, is the foundation. In property investing, one of the attributes that goes into building a good solid foundation is buying rental properties that the average family will want to rent, e.g. a 2, 3 or 4brm home, in a reasonable location and in tidy order.
Other not so obvious building blocks for your solid foundation include putting down a 20% deposit on each property you buy (as opposed to borrowing against equity gained on any other properties owned), having sufficient cash flow to cover all your expenses with each property, preferably a 20 year or less P & I loan (25year loan possibly if the cash flow is tight, but never 30 years), and buying below market value by knowing your market well. Following this you will build equity each year in your property portfolio (that is with a static or rising market - on a market where property prices drop over the year, it will depend on how much you pay off principal compared to the drop in property prices whether you build any equity or not).
If you use the interest only approach as so many investors still do, and the method usually taught by the promoters mentioned above amongst others, you are only building equity when the property market is rising. You lose equity when the property prices are going down. Out of all the hundreds and hundreds of investors that I’ve met, less than a handful has used the ‘interest only’ strategy well. Each of these investors have either sufficient cash flow from elsewhere (other property strategies or a business etc), a low debt to equity ratio, or they specialise in commercial type multi-unit properties often worth in the millions of dollars to purchase. For the average investor using I/O, I do not know of anyone trying to build a good solid property portfolio (apart from these few people) that I would say has a good, rock solid foundation. There may be a few people out there, but I have never met them!
This is what I would class as a solid foundation in which to build from:
1) Using P & I loans –
(i) never borrow more than 80% of the purchase price (not the property value) when buying
(ii) take out a loan of 25 years and preferably less
(iii) buy the next investment property only when another 20% is saved (not from refinancing existing properties)
(iv) cash flow to cover all the outgoings - including rates and insurance.
By doing this, I believe by the time you have 8 – 10 properties, you will have a good sound foundation on which to build from. I would not borrow against any increased equity at any stage to buy further rental properties - even if they have doubled in value, or your borrowing is below 50% on any of the properties.
2) Using Interest only loans –
(i) never borrow more than 70% of the purchase price (not the property value) when buying
(ii) purchasing the next property only when another 30% is saved (not from refinancing existing rentals as mentioned above)
(iii) cash flow to cover all the outgoings - including rates and insurance.
I would also add that until you get to a level where your portfolio (using I/O) reaches 20 - 25 rental properties, a debt level of 60% or less (by paying off more debt when you are able to) and a positive cash flow after all expenses of a minimum of $5,000 per month, you haven’t got a good foundation. Anything less than this using I/O is in my opinion a time bomb waiting to go off, and any unforeseen circumstances that come along could wipe out everything you’ve worked for. It’s just way too risky, and not worth gambling everything on.
You may have heard the difference between good debt and bad debt and to a certain point I agree with what others say about this. It is very beneficial to use good debt (debt that somebody else pays you to own) to help you leverage your money while you are in the building stage of your property portfolio. However there comes a time when you will hopefully say to yourself – “this is a level I’m comfortable with, and now rather than buying any more properties, I will focus more on directing any excess savings into paying down debt on my rental properties at a faster rate than what I have been doing.” Paying all of your debt off, therefore being totally debt free is what the ultimate goal (in my opinion) should be.
In my property portfolio, I have 9 existing loans at the moment (out of 40 properties) with loans of less than $65,000 on each, one of them being a mortgage of only $38,000 on a property with a market value of approx $200,000.
Assumptions
If you have the assumption (even now!!) that property prices consistently go up in value over time, that very thought could cost you everything you want to achieve with your real estate investing (more so if you use interest only).
Here are a few other assumptions that have caught people out in the last few years.
1) I’m good at buying properties below market price - therefore I am a good investor
2) I am good investor, therefore I am also a good property trader
3) I am good at business and have made lots of money by running a successful business, therefore I will also be good at real estate investing
4) I am a good property investor, therefore I am also good at speculating with design and builds, buying sections and sub-dividing properties
5) That person is well known and speaks so smoothly and with confidence on stage, I will be able to learn a lot from him/her
6) The person speaking on stage is very enthusiastic about what they are selling. It must be amazing what they are selling, plus so many other people agree with what he’s saying - it has to be genuine
7) I would never buy outside Wellington, Auckland or Christchurch - the smaller towns just don’t have any capital gain{(i)if you rely on any capital gain, to me you are not an investor but more of a speculator, (ii) over the last 50 years or so in NZ, cities with 100,000 or more population have had an average % per annum growth rate within approx 1% compared to the other cities in NZ)}
8) This person has written a book on property investing, I will follow their plan and therefore will also be successful
9) This person knows exactly which locations will go up in value as opposed to other areas, I will therefore follow their advice on where to buy and when to sell
10) I’ve heard that tax liens are the way to go, there is so much money to be made in them, I’m going over to the U.S. to invest for myself
11) These people on this property chat forum have written well over 1,000 posts telling other investors how to do it, they must know what they’re talking about (for every one of these posters on property forums that does know something about investing, another 4 or 5 know very little about it, and spoil it for the new people wanting to learn)
12) Property is the best investment you can ever make, you will never lose money by investing in property
So these are some of the assumptions that people have made about property investing - more so in the last 10 years or so. When you assume anything like what is mentioned above, you stop thinking for yourself. When you stop thinking for yourself and follow others blindly, you are not taking responsibility and you also have an excuse to blame others if things go wrong for you, in other words – it’s not your fault. So take responsibility, don’t follow the crowd, think for yourself, and if something sounds too good to be true - 99% of the time it is.
For me, I’ve had two major threats to my property investment portfolio, and without a good solid foundation when these events happened, either one of them would have wiped me out as well.
The most recent (18 months ago) was a separation with my partner of 16 years which cost me a lot of money and is something I would not want to go through again!
The other threat or event that happened was about 6 years ago. It’s a long story which was written about in my updated book in 2008 (“NZ Real Estate Investors’ Secrets” - available through Good Returns), with me losing approx $1.5 million over the 12 months from the end of 2005 to the end of 2006. It all stemmed from me being in hospital with peritonitis (burst appendix) and coming out of hospital 10 days later on such a high with all the drugs, etc. I bought about 5 million dollars worth of property and cars over the following two months, breaking most of my own investing rules - and it nearly cost me everything. For a long time my cash flow was approx $70,000 a month negative. So going backwards by $70,000 each and every month, selling these properties and cars I had just bought at huge discounts, as well as selling around 20 properties from my existing rental portfolio (I had about 65 properties at the time) was the only way I could save it all. But without the solid foundation that I’d built up over the previous years, I would have been left bankrupt - like a lot of other investors have ended up today.
So in summary, take a look at your own property portfolio, or if you are just beginning - look at various potential threats or dangers and create a plan that is as safe as you can possibly make it. Build a solid foundation, there is no rush. Build it solid enough that it can withstand any potential threats you think could happen one day. A lot of the time we have assumptions, not realising they are just assumptions and are not based on any facts. Read books, talk to other successful people that also invest, but always think for yourself.
Have fun along the way and celebrate your successes, safe investing.
Graeme Fowler