If you are a real estate entrepreneur or investor, you questioned what the role of U.S. politics – specifically the presidency – has on the market and on your investments. Since President Trump made his millions in real estate development, one could assume that he wouldn’t make a decision that would adversely impact his investments.
However, if we have learned anything about the political climate is that it is difficult to know what will happen next. While the country is polarized on a variety of issues, we as entrepreneurs and investors have a duty to do what we do best: buy real estate and provide homes for people. I am not a politician and I don’t want to guess what will hit the news wire in the next hour about something that will not directly impact my life. I am a real estate entrepreneur. And from a real estate perspective, Trump should not any negative effect on what we do as real estate entrepreneurs.
We cannot make investment decisions based on who is president, what they are tweeting in social media or what the talking heads on TV are saying from either side. Rather, there are three fundamental rules that we as investors must follow in order to not only take advantage of the current market cycle but also prosper when the market turns.
Here they are:
1) Buy for Cashflow, Never for Appreciation
When we think of real estate, we consider that the values increase over time as a matter of course. According to the U.S. Bureau of Labor Statistics, prices for housing were 52.05% higher in 2018 versus 2000. So, a house valued at $100,000 in 2000 would cost $152,050.77 in 2018 for an equivalent purchase. This is called natural appreciation and is simply the rise in an investment property’s future value over time. This means that you have almost no control over the appreciation.
On the other hand, forced appreciation involves making improvements to a property, increasing revenue and decreasing expenses which drives Net Operating Income – and increases the overall property valuation. If you purchase a multifamily deal for $2MM and drive improvements, reduce some unneeded expenses, and offer new amenities to tenants that they pay for, that property may be worth $4MM because you made improvements, reduced costs and increased income. In this case, you are actively taking part in increasing the property’s present value as well as investor returns.
Many investors have bought for natural appreciation. Often times, nonprofessional investors believe this is the only type of appreciation because this is the one they are most familiar with.
I personally never buy expecting natural appreciation to kick in. I always buy for cashflow. The reason why I do this is because if the property is well maintained and there are plenty of renters in the market, it won’t matter what the market is doing. If you run the property well, make improvements and it is positioned as a nice place to live, the property will perform – even when the market turns.
2) Don’t Use Too Much Leverage
One of the great benefits to buying real estate in the United States is that we can use leverage to multiply our money to take down a deal. For example, if you decided to invest $200,000 in Ford stock, you would only control $200,000 of that stock. However, if you wanted to invest that same $200,000 as a down payment in a building, and you were able to get an 80% LTV (Loan to Value), you would now control a $1,000,000 asset. This is the power of leverage.
But this can also lead to problems if not done right. The less money you put down on a deal, the more leveraged you are. This means your mortgage payment will be high. In a hot market, over-leveraging is very tempting, and some banks will even do it. But if market turns, values drop, and the income falls along with it, you will have to cover that note.
My partners and I never have less than 20% of equity in a deal and we are usually between 25%-30%. There are lenders that will do the 0% down, but you must avoid it. This will prevent you from getting burned in the event of a downturn.
3) Don’t Get Forced into Selling Before Plan
One of the primary reasons people are forced to sell or turn their properties over to the bank is because they bought for natural appreciation or they simply over-leveraged.
Something typical in commercial and multifamily real estate is that there is a balloon payment on the loan. This can become a problem if a big balloon payment is due in the middle of a market downturn and you do not have the reserves to pay. The best thing to do in this case is to plan years in advance (or even before you buy) what the exit strategy will be, such as a refi, pay off or a planned sale.
By applying these three rules, you can build a strong portfolio of real estate while providing investors with healthy returns. The rules will serve you well, regardless of what Trump tweets or does in the White House.
Let me know what you think. Do you use these rules? Leave your responses in the comments.