New Rules for Successful Investing
1. Location, Location, Location
    This sounds like an old rule; but it has a whole new meaning.  For retail properties is means a high traffic, good visibility, easy access location.  Industrial Properties need linkages to rail and other transportation and affordable utilities and access to suitable employees.  Residential, especially 2nd homes, need really easy international access.  Some type of attraction must be available, such as beaches, mountains, golf courses, etc.
    The location must also be considered from an environmental aspect.  Beach properties need to take in consideration the possible rise of sea level and the availability of insurance.  Agricultural properties need to factor possible changes in temperature and moisture.  Any property that requires irrigation, should anticipate huge spikes in the cost of water.  A 1 degree increase in the average annual temperature can change the suitabilility of land for a type of crop.
    Political risk is also becoming more and more a consideration.  How likely is a huge political swing to occur?  What will be the implications of such a swing?  How satisfied is the general population with the status quo?  What are the rules for ownership and how likely are they to change?  These are all important questions for the new investor.  No one is immune to the consequences of fanatical forces.
    There will, for quite a while, be a lot of properties chasing not too many currency units.  Only the “necessary” properties will have good markets.
 

2. Credit is still important; but should carry less weight in making decisions

It is still extremely important to check out tenants and developers and contractors well before doing business with them  Investors often select properties based on the rating of the tenant.  This is a big factor in determining the cap rate at which the property sells.  The weight given to this factor needs to be reduced.  We have seen that even banks and automobile companies can go broke.
Often leases to franchises are guaranteed by the franchisor.  Retail companies frequently have excellent credit and reputations; but if Santa Claus doesn’t come or if he doesn’t bring enough revenue even the best retailers may go into receivership.  Receivership (Bankruptcy) gives a tenant the right to continue paying rent (not rent in arrears) and stay in the property or just walk away from the lease.
Lease terms are as critical as the tenant’s credit.  A big company can go dark and continue paying the rent.  They may or may not continue maintaining the building and the parking lot and landscaping.  Often the tenant chooses the new tenant on a sub-lease and may put someone in the property that does not complement the current tenant-mix.  The loss of a really good anchor can affect the income of all of the other tenants.  In free standing build to suit facilities, always use “market rent” to determine the value rather than contract rent.  Most of these leases contain “weasel clauses”, that allow the tenant to move out with no repercussion.  If the contract rent is higher than market rent, the landlord can be upside down.
 

3. High equity positions
The conventional wisdom in real estate has always been to use leverage and buy as much property as possible with as little money as possible.  In the past USA property has always increased in value and time can heal our mistakes.  No more.  Inflation and increasing property values (in relation to other things) may be a thing of the past.

It seems as much money as the governments need to print to cover the deficits and the stimulus packages, there should be inflation.  Unfortunately this is only part of the equation.  Inflation happens when too much money chases too few goods (assets).  It is possible that the surplus of assets on the market will be temporary.  One would think the too much money would be permanent.  Not so. The too much money thing may not even exist.

The amount of money in circulation is measured by M1, M2 and M3.  An economics class is not necessary to understand these classes.  The main thing to understand is that money supply includes money owed.  This money counts for more because it is counted twice.  The bank considers the note as an asset.  The borrower has the money.  When banks don’t make loans or when people default on loans, money supply shrinks.  Money supply also shrinks as stocks and bonds lose value.

The slower and smaller the economy, the less chance there is of obtaining a suitable rent for a property.  The high equity owner remains flexible enough to reduce rent or sit on a vacant property when there is a high equity position.

4. Don’t believe everything you think
Just because we have studied markets and real estate and finance and investing doesn’t mean we know anything; because we are in a brave new world.  The lawyers talk about “the prudent man”.  Economists assume that markets (and the people who comprise them) will always act in their own self interest.  All of this is junk.  Markets are subject to mass hysteria.  The prudent man does not know any more than you or I.  The new rule, at least in the near future is chaos.
Fractal geometrists tell us even chaos is predictable.  I am not a fractal geometrist. Are you?  What those of us who lack either that skill or crystal balls, we need to be prepared for anything.  The old models show predictable rental income over years and a “reversion” that is usually higher than the purchase price.  Now we need to be more conservative.  We need to factor vacancy and credit losses into single tenant net leased properties.  The reversion should, even best case, be the same as the purchase price.  Perhaps we should be willing to accept lower yields, at least in the short term.
Real estate is still the most permanent asset there is.  But the old adage, “they ain’t making any more of it” has been negated with condominiums, fractionals and Dubai.
This does not matter now; but a professor from NY University once said Real Estate operates on a 14 year cycle.  Real estate investors have a 9 year memory.  We can learn from our friends in South America.  They have dealt with rising and falling prices over the years.  They know how to prosper in any environment.
 

5. Appreciation is a bonus, not a given
For my lifetime (I’m 62), there has been an increase in the price of real estate almost every year.  In the years where there was a tiny slide backwards the steady progress resumed to give an overall upward trend.  In the long term, even though it will start from a lower level this trend will probably continue.  The increases may just track inflation though.  Supply is still higher than demand and construction still continues.  Households are being consolidated, reducing demand.

When calculating IRR a “reversion” (sales proceeds) is always added to the last years projected cash flow.  It is quite rare to see a reversion number used that is lower than the purchase price.  That could become the new reality.  Think about an empty freestanding retail store.  Many of these building are expensive types of construction.  The additional costs is factored into the rent.  When the original lease is up, a new tenant may not need a building that is designed to another company’s model.  The building may even have functional or style obsolescence.  The value of the property at that time is land value minus the cost of tearing down the building.

We know that the retail, office and industrial uses are changing rapidly because of the internet and outsourcing.  How can we be sure that the buildings we have will still be useful?  I really don’t think we can.  Cost recovery allowed by the IRS is 39 years.  Perhaps we should consider that a building will actually be worthless at the end of that time and plan accordingly.  If the building is still useful, we get a bonus.  If not, we are prepared.
 

6. Speculation has to take a new form
There used to be a saying among real estate investors, “time will heal your mistakes”.  No more.  Speculators need to have a good knowledge of the path of progress.  This is where profits will come from in the future.  A good source of this knowledge is the comprehensive plans that most cities have.  These plans normally have a year number such as 2010 or something like that.
It is a good idea to see how past plans were implemented.  Some municipalities take these plans seriously and some don’t.  The next place to look is the department of transportation.  Progress follows roads.  Once again it is necessary to see how high the priority is for the roads.  The hardest thing about this strategy is timing.  Usually the property owners know about the coming roads and think the property will be worth more than the reality of the project will bear.

Look for improving neighborhoods.  Gentrification is a great source of profits in property.  There are always property owners in blighted neighborhoods who are ready to sell and escape.  These projects usually require renovation as well as speculation; but the investor makes an entrepreneurial profit as well.  Contractors often use these projects to keep crews busy during slow times.
 

7. Look for the path of progress
We talked about the path of progress in the last article.  It can be identified using the standard methods that everyone uses of neighborhood or urban plans or DOT projections.  The problem here is that everyone knows these tricks.  We need something new.  How do we predict the path of progress?

There used to be an old management system called MBWA (Management by walking around).  I cannot help but think this would be the way to evaluate a neighborhood that in the path of progress.  Walk around a neighborhood talk to the people who live there.  See what they think.  See what the neighbors are doing.  Look for neighborhoods where the neighbors are calling about people who don’t keep their yards well.  Look for neighborhoods where neighbors call the police about suspicious activity.

Don’t move too fast.  The neighborhoods generally continue to go down for awhile before they come up.  Remember, you have to own the property and deal with the problems until the turn around is well under way.  As with technology it is better to be on the cutting edge rather than the bleeding edge.  Identifying neighborhoods and properties on the rise will be the best way to be ahead of the crowd.
 
 

8. You will never lose money on a property you don’t buy
This may sound overly simplistic.  Think about it.  How many times have you said “I could have bought that property for $*****?  The fact is you didn’t buy it.  You did not make the huge profit that would have come in your mind.  You did not have to make the payments for 30 years and deal with the tenants and the maintenance and the upfit.

Up until a year ago almost every property we see would look good in retrospect.  You could have bought a property 15 years ago for $90,000.  Today it is worth $210,000.  Wow, what a missed opportunity.  With compounding the profit was only 5.8% per year.  The opportunity missed was even less spectacular if part of the original price was financed.  It is quite rare to have a significant positive cash flow on a residential property that is purchased with OPM (other people’s money).  A significant negative cash flow is more common.  If the owner’s effort is factored in the negative cash flow is even greater.  Positive cash flows are more common in commercial properties; but the significant appreciation is not.

The new investor still has plenty of opportunities.  They need to be scrutinized more closely.  Frequently a buyer is heard to say.  I bought a property worth $300,000 for $100,000.  The truth is property is worth $100,000; because that is all it would bring on the market.  A real business approach must be applied to investment real estate.  This will be the source of future wealth building.
 
 

This page comes from a series of articles published in a blog titled "Do International Real Estate"  It is reproduced here because a blog appears in reverse order of the way it is written.  The articles will be added to this page as they are posted on the blog.

Last updated 7/27/09