Ask Marco – Pre-Construction Risks, Evaluating Cash-Flow and Rates of Return | PREI 041
After returning from a two-week vacation in Thailand, I’m back to work answering listener questions. On today’s episode I talk about some miscellaneous stats and cover some listener questions including:
- What do the successful 2% do that the other 98% don’t?
- Do you deal with “active” real estate investments?
- How should I evaluate a property’s cash-flow and rates of return?
- Are there more risks with pre-construction properties?
Enjoy the show!
If you missed last week’s episode, be sure to listen to Leveraging Your Cash, Equity and Time – Keith Weinhold.
Enjoy the show!
– – – – – – –
Download your FREE copy of: The Ultimate Guide to Passive Real Estate Investing.
Get your FREE coffee mug by leaving us a Rating and Review on iTunes. Here’s how.
See all our available Turnkey Rental Properties.
Please give us a RATING & REVIEW (Thank you!)
Real estate investing tips, advice, news & articles.
Ask Marco – Pre-Construction Risks, Evaluating Cash-Flow and Rates of Return
Today, I’m actually going to be your guest too. You have me on both ends. Today I want to talk about some listener questions that we’ve been getting. I appreciate you sending in your questions from week to week. We do try and cover them live with you on the phone or via email, but once in a while, I’ll post some of those out and cover them here on the podcast episodes.
First, I just want to let you know that I just got back from Thailand. In fact, I’m running on coffee at this point. I don’t think I’ve slept in the last 48 hours because it’s about 22 hours of travel. Yesterday, I couldn’t sleep at all because of the time change. I’m effectively running on about 48 hours here of sleep deprivation. But the trip to Thailand was absolutely amazing. It’s a beautiful country. The hospitality is amazing. We were able to eat some great food, ride and feed elephants, go kayaking in the caves, snorkel, go on some river raft rides. The people there are just unbelievably friendly and patient and courteous. It’s a different culture, but it is something that is worth experiencing if you haven’t been there.
What was amazing, and I’m always looking at these different cities and markets in a different light. I always look at it from an economic perspective. I look at the businesses and I try to think about what the opportunities are there and what the restrictions are. This is true for any economy, not just Thailand. We had several tours and I asked our tour guide what the average annual income is of a person in Thailand. The range is pretty diverse. His comments were that the average Thai person makes 120,000 Thai Baht. To translate that into US dollars, 120,000 actually works out to be $3500 per year, not per month, $3500 US per year. That’s according to our tour guide. I did a Google search on the same thing and I wanted to find out how much they make according to some analysis or reports online. What I was able to find was about half of that.
It’s amazing that these people really just live day-to-day, hand to mouth. They make just enough to survive to pay for their accommodation and food. They really don’t have disposable money to spend on things like nice cars or jewelry or trips. They are just hand to mouth, but they’re very happy. I won’t say they’re all happy, but they are satisfied.
I talked to and met a lot of Thai people, many of which didn’t speak much if any English. Everybody was just very courteous. We had a great time. We were there for two weeks. I apologize that I never had a podcast episode out last week. Obviously, that’s the reason why. In fact, I purposely chose not to bring my laptop with me. I did bring my iPhone just to keep up on some email, which I checked late at night or first thing in the morning. For the most part, I was disconnected and unplugged from the world for most of the day. But I stayed in touch with our investment counselors and our team, just to make sure things we’re running smoothly.
The poverty in Thailand is pretty noticeable, especially as you get out of the major cities like Bangkok, Chiang Mai and Phuket. The further out you go from the city core, the less tourism there is and the more poverty and disarray if you will that you see. But there’s still a lot of money being put into those economies for infrastructure. There’s a lot of light and heavy rail transit being built right now, which apparently is supposed to help with the congestion.
Here’s an interesting fact, I didn’t know this, but apparently Bangkok has the world’s third worst traffic congestion. I found that to be amazing coming from Southern California. I thought it was bad here, even though I don’t really drive in the rush hour traffic. When you look at the traffic in Bangkok, it is absolute gridlock. It’s unbelievable how fast you go nowhere. There are people who have to get on the road at [5:30] in the morning just to be able to get to work for 8 AM. It’s just crazy.
Let’s look at that income thing for a moment. How does that level of income and poverty compare to us here in the western world? Here’s a quote from the Social Security board that should uproot your financial paradigm. It goes like this, “At the age of 65, 75% of all Americans are dependent on relatives, family and charity. 23% are still working and only 2% are financially independent.” This is a stunning figure. This is just stunning to hear. For many, that means you have to be in school for over a decade, you spend years paying off your student loans and then you end up possibly in a career that isn’t completely satisfying to you and you still have a 98% chance of financial failure. The question is, what is that successful 2% doing that the other 98% are not? The most financially successful individuals have created forms of residual income. Meaning, that they get paid whether they go to work or not, whether they’re physically working or not. The rest had to keep working to earn an income.
It’s that 2% that figured out that residual income, monthly regular cashflow is the way to break out of that rat race, if you will, and become financially independent. Because if you don’t have regular income coming in, whether you’re working or not, then you are effectively tied to a system where you have to produce, each and every month, in the form of time in order to get paid. That’s it. The good news is it’s duplicatable. Real estate is the vehicle to help you do it. In fact, real estate is the best vehicle to help you achieve those financial goals.
I like a quote from Mark Victor Hanson, who’s the coauthor of The One Minute Millionaire. He says, “Don’t wait until everything is just right. It never will be perfect. There will always be challenges, obstacles and less than perfect conditions. So what? Get started now. With each step you take, you will grow stronger and stronger, more and more skilled, more and more self-confident and more and more successful.”
Think about that. Regardless of where you are, whether you’re just getting started or you’ve already built a partial portfolio, you just got to keep going, learn from your past, get over the obstacles and challenges ahead of you and just keep going. That’s been a hard thing for me to do, but it’s doable. I tend to be a bit of a perfectionist and needed to break out of those chains.
Let’s cover a few of the listener questions that were submitted here over the last few weeks. The first one is from a gentleman named Therry. I believe I’m pronouncing that correctly. Therry says, “Hello. I would like to know if you also deal with active real estate investments. Thanks.” Short answer is no. Let’s differentiate what an active and a passive real estate investment is. If you haven’t listened to one of the early foundational podcast episodes, I believe it was the first or second one, you can go back to listen to that and get more detail on this.
Essentially, an active real estate investment is one where you are actively involved, meaning that you are the one rolling up your sleeves and in some cases, getting your hands dirty. You’re out looking for that needle in the haystack or that distressed property or the property from a distressed seller that you can pick up at a discount. In either case, you’re buying a property at a deep enough discount where you can put in the required capital to make that property either rent ready or fully refurbished, as turnkey as you want to make it, put it into service, in other words, put a tenant in place and then self-manage it or have someone manage it for you. It means that you are actively involved in some or all of that process of finding the property and getting it operational and maybe even managing it.
On the flip side of that, you have what I refer to as passive real estate investing. That means that it is more or less done for you or at the very least, done with you, as is the case with our company. In that situation, you are buying a performing asset. Meaning, that the property likely has a tenant in place, paying rent every month, it’s professionally managed. All you’re really doing is buying and financing it. Then the rest is just a monthly minimal management of keeping track of the income and expenses on that property and maybe communicating with your property manager every month or every three months. There’s not a lot to be done.
The product that we sell, the product that we have on our website is all a turnkey product, meaning that it is more or less done for you. You’re just picking the market, picking the properties and building your portfolio as opposed to looking for distressed properties that need to be refurbished and you need to bring in the crews and the people and the capital and all that good stuff and put in the time. Anyway, that’s a long answer to a short question, but I just wanted to help differentiate between the active and the passive real estate investing and investments.
The next question is from Sandesh. He says, “Hi, Marco. A quick question about depreciation on tax returns. I know you guys are not CPAs, but I’m sure you must have done it so many times. If a property is older than 27.5 years when I bought it and if I bought it rehabbed, can I still claim the depreciation on the building, not the land? Does the counter get reset somewhere during the process or is this something that is applicable to properties newer than 27 years only and just once during the life of the building?”
Although that sounds like a confusing question, and I’m not sure where the question is in there. Sandesh, I think you have this confused in your mind a little bit. Let me clarify for you and the listeners. First of all, the 27.5 years that you’re referring to is referring to the depreciation life cycle of that property. A residential property that is a one to four unit property will have a depreciation life cycle of 27.5 years. What that means is the IRS will allow you to depreciate the building, the improvements, not the land, but the improvements over that 27.5 years. It has nothing to do with the age of the property, nor does it have to do with when you buy it. That clock starts ticking the day you take possession of that property. It doesn’t matter as to whether it’s new construction, whether it’s five years old or 50 years old, you and everyone else will get that 27.5 year depreciation on any property you purchase starting from the year that you buy it and for 27.5 years thereafter.
I think where you’re getting confused here is that you think it’s based on the age of the property and it’s not. It’s based on the day of the acquisition or the time of acquisition. The clock just counts down from 27.5 years from there. Every year, you can take one 27.5 as a ratio so divide one by 27.5. That’s the percent that you get to depreciate on the building or the improvement.
Hopefully that was clear. It’s really not anything complicated. Depreciation is an amazing benefit of real estate. It’s a phantom expense. You don’t have to spend a single penny in order to get it. The fact that you own that real estate is all you need. The government, the IRS allows you to depreciate, to deduct that 1/27th of the property’s value, the building’s value. If you have any other questions about that, contact one of our investment counselors and we can help you a little further.
The next question is from Thomas. He says, “Hi. I have a question regarding how to evaluate cashflow related to return and evaluating a property in terms of how profitable it is from the start. As you mentioned in one of your ten rules, you should always buy property with positive return right from the start. What type of cashflow should I judge this on? I usually do three calculations of cashflow: net operating income, before-tax cashflow and after-tax cashflow. Which one of these should I base my return calculations on?” I’m just going to skip ahead. He says, “Love your podcast. Lots of good input.”
Thomas, this is a good question. Different investors sometimes will evaluate their properties differently. Some people like to focus on the cap rate or the capitalization rate. Some people will look at the net operating income, which is basically the income minus the expenses, not including your debt service. You don’t deduct your mortgage to calculate your net operating income. It’s simply your income minus all your expenses. That is your net operating income. Your before-tax cashflow is the next step beyond that, which is your net operating income minus your debt service. Finally, your after-tax cashflow takes that before-tax cashflow and deducts any kind of taxes owed or any kind of tax benefits that are calculated into that. That’s going to differ from person to person because everyone’s personal tax situation will differ.
I think the best place to start is to look at the cash-on-cash return. It’s really one of my favorite starting points. In fact, really my first metric is the rent-to-value ratio, which is the gross monthly rent. Let’s say it’s $1000 a month, divided by the purchase price or the acquisition price of the property, let’s say that’s $100,000, that gives you a 1% rent-to-value ratio. I like to see a minimum of 1%, although I can go down to 0.8% and still be happy with the property. If it’s in the right market, it has the right appreciation potential. Maybe there are some unique characteristics about that property. I like to see a 1% rent-to-value ratio or RV ratio.
The next thing I look at is the cash-on-cash return. That is simply how much net income is, that property producing for you every year and divide that total amount into the amount that you’ve taken out of pocket to acquire it. If the property is generating, let’s say for simple math, $2000 a year net positive income and you had to take out of pocket a grand total of $20,000 to acquire that property. That $2000 divided into the $20,000 is 10%. The cash-on-cash return of that property is 10%. In other words, without factoring in any equity growth or tax benefits from that depreciation, that property is generating a 10% real cash-on-cash return for you every year, which is pretty decent.
You’re going to find that a lot of the properties that you will find out there, if you do look hard and know where to look or if you look at the properties that are offered through us and through our network, that the cash-on-cash returns are almost always in the teens and sometimes in the lower 20% range. Just as a rule of thumb, just bank on about 15% plus or minus as far as the cash-on-cash return. Of course, there are assumptions being made here as far as how much you’re putting down and whatnot.
Cash-on-cash return would be my second place. I always assume there’s positive cashflow. It’s not something that I have to stop and measure. I’m not going to look at a property or consider a property if it doesn’t have positive cashflow from the day you buy it, from day one, from the first month of operation. I want to walk into or acquire a property with positive cashflow. If it has negative cashflow, it’s typically a no go. I’m not going to bother with it.
There are only few rare circumstances where that’s going to be an exception. That is this, if the negative cashflow is very, very small, but I also was able to pick up a property that had enough of a discount to compensate for that negative cashflow and I’m in a market where I know I’m buying below the mean for that market or the mean for that neighborhood, meaning that I am getting a property that has a higher potential of increasing in value than going down. In other words, I’m getting a good deal right from the get go. I don’t find these too often. You’re typically going to find those in some of the more expensive markets, but that’s really not my main focus and that’s not where I want to be looking at in the first place.
Your after-tax cashflow again, is going to differ from person to person because of your personal tax situation. The before-tax cashflow is something I do look at. With a fully leveraged property, meaning a property that you’ve acquired with a minimum down payment of 20%, you should see typically, your monthly cashflow anywhere from $200 to as much as $400 per month. That’s net cashflow, meaning after all your expenses. I’m also assuming here that you’re deducting for a vacancy factor, in other words, you want to budget for future vacancies and a maintenance and reserve budget. Once you’ve deducted all those costs, you should be somewhere in the neighborhood of $200 to $400 per month, per door on your property. Often, I’ll see around $250, maybe as much as $300 on a lot of properties that we see and have today. Again, that’s going to vary from market to market, neighborhood to neighborhood and even from price point to price point. Same market, same neighborhood.
A property that’s let’s say, $80,000 will have a different cashflow than a property that’s a $120,000 in a nearby neighborhood. You can see dozens and dozens of examples on our website. If you just go there and click on the orange button that says, Analyze this, you can actually compare property to property. Anyway Thomas, thanks for that question. It’s a good question.
We have a question here from Steve who says, “Hi, Marco. I’m a dedicated listener to your podcast. I appreciate all the great content that you provide on passive real estate investing. My wife and I are ready to purchase our first investment property and are following the steps outlined by you. We have a goal of 20 properties by 2020 and to buy two in 2016. We are looking at A to B+ neighborhoods with roughly 1% rent-to-value ratio. We are willing to sacrifice some cashflow for premium neighborhoods and tenants, though we do have a constraint of all properties showing positive cashflow from the start. My question for you is should we be considering pre-construction listings from your network? My concern is that buying pre-construction seems to be far less passive and carry more risk than buying an existing turnkey property. Since this would be our first investment property purchase, I was thinking it may be best to focus on newly rehabbed single-family residential properties. I’d appreciate it if you would provide some insight on buying pre-construction and specifically, does this seem like a good starting point for a new investor?”
Steve adds a PS here, “We have been educating ourselves over the last year following your first rule and subscribed to many podcasts. We live in San Francisco Bay Area and both work in high tech and don’t have much time for the active side of investing. We are hoping to build a good relationship with a turnkey provider. After research, we’d like to start working with you and your team.”
Steve, thank you very much. I appreciate that. You have some great questions here. I did reply to you via email. Basically, what I had said is this. Based on your email, I can tell you’ve really listened to our podcast. It sounds like you have a clearly defined goal and a criteria to work from. That makes it much easier to identify the right properties and build a portfolio. Well done.
Having said that, new construction can be a good option for you. Some people like it because there should be no near term or deferred maintenance required. However, the give and the take is that new construction often has a lower rent-to-value ratio and a lower rate of return because the construction costs on a price per square foot basis is typically higher than that of most newly renovated properties. Another advantage of many construction projects is that they are often found in the path of progress and typically, in B+ to A- neighborhoods, sometimes even A grade neighborhoods. There’s always a give and take with new construction. You need to ask yourself what’s more important between lower rates of return versus an all new property. Everything else being equal, I might go with a new construction simply because it’s all new and I have a bias towards new construction. The unfortunate thing is, ever since 2007 or so, it has been far more advantageous from a cost perspective to purchase existing inventory that is rent ready or newly refurbished and go with that, because the numbers are more appealing and more attractive and you can get better deals because the new construction is more expensive, the rates of return are lower because that cost is higher. At the end of the day, you will be in good shape with a stabilized property in the right neighborhood and with great property management, regardless of whether you choose new construction or whether you choose a newly refurbished property.
Steve goes on to say the following: “Just to clarify my question on risk associated with pre construction investing, my concerns were about the various things that “could go wrong” or delay the construction. For example, if we were counting on collecting rent six months after purchase and the project gets delayed to one year or longer, is there any compensation to the buyer? Or worse, what happens if the builder runs into issues and close his shop?”
First off, there are no rent guarantees. The fact is that the property cannot be leased until the property is constructed. Until it’s built and the certificate of occupancy is issued, you cannot move a tenant into the property. Therefore, if you don’t have a tenant, you don’t have income. You could be projecting or budgeting that cashflow, but if it’s three months later, it’s three months later. You just have to start your pro forma from that point forward.
If the builder goes out of business, and this has happened in the past, I’ve seen it happen with some of the projects I’ve been involved with in years pass. This goes back many years. It’s not a recent thing. You could not be stuck, but you would be basically stuck with a null and void contract and a deposit that would have to be returned. If your deposit is an escrow, there’s no issue, the title company just sends back the earnest money deposit. What you don’t want to find yourself in is a situation where you’re sending a deposit directly to the builder and the builder’s holding it in their account. God forbid that builder goes out of business. Then you might have a real hard time getting your deposit back.
In terms of a builder going out of business, it’s not a high risk. It is a risk, but it’s not a high risk. However, if let’s say, a builder starts construction and then they go out of business, that could be an issue. That doesn’t happen often. Usually, what happens in that situation is the builder would’ve pulled some sort of builder’s risk insurance out on the project. If you’re the one getting loan, in other words, it’s a pre-construction loan or a construction loan that you are the one personally qualifying for, that lender wants to get repaid. They’re going to insist from the builder that they get builder’s risk insurance to cover all kinds of natural disasters and maybe some other risk factors.
The builder, what you’ll want to see, and this is what we typically see, the builder doesn’t make a profit unless they actually build it out. They may have a small amount of profit that they make on each draw throughout the process. On each draw, they are incentivized to continue building to the next phase until they get to the final phase. Often, their profit is back-loaded. Meaning that they’ll make a little bit of profit along the way, but the bulk of their profit comes out on the last draw from your construction loan. Until they actually get to the point where the project is completed and they issue a certificate of occupancy, they’re not going to get what is essentially the bulk of their profit or the profit period.
You should talk to the builder about that and have your attorney review the documents just to see how the draws are made and what assurances or securities in place for you, whether it’d be insurance or otherwise. I can’t be too specific because it’s going to vary from development to development, builder to builder, construction loan to construction loan. But the general process is about the same, you’ll always want to see an insurance policy built in there. Talk to our investment counselor. I noticed you’ve talked to one of our investment counselors, Steve. He can go to more detail about that, especially with this particular builder that we’re working with in Missouri. We’ve worked with them for about seven years. They’re very dedicated and very reliable.
To some degree, new construction is a personal preference. Like I said, I have a bias for it. I like new construction, but it doesn’t always make sense. However, in some markets, you can buy new construction properties that do make sense. If you like the fact that it has a five or ten year warranty, new home warranty, that everything is in new condition, new shape, you’re not going to have to worry about deferred maintenance, if you feel that’s going to attract a better quality tenant, maybe a higher quality, higher grade, better demographic type of tenant, then maybe lean towards that. There’s certainly nothing wrong with new construction. It’s just as good, if not better in some cases than newly refurbished properties. It’s again, what are your goals? What is your criteria? If that is what your criteria dictates that you should be purchasing, then go for it. However, if you’re comparing new construction to refurbished properties and they both meet your criteria, then again, it’s just a matter what you favor more.
I like new construction. If you’re on the fence and everything else being equal is pushing you in that direction, then I say go for it. We have some great projects in Kansas City right now, in the Stone Bridge I believe it is, development. There are some new construction projects in Memphis and we have on-and-offs on new construction projects in the Texas markets. There are not a lot of them, but they do exist. Talk to our investment counselors and they can give you more details about what we have available and what’s coming down the pipe and how that compares.
Anyway, not a very specific answer to your question, but hopefully, it does answer it to some degree what your question is all about. By the way, I wouldn’t say that one has more active involvement than the other. They’re both going to be just as passive. One doesn’t carry more risk than the other. If you’re comparing a newly constructed property to a newly refurbished property that had an extensive renovation and repair, particularly with a focus on the mechanicals, then you are essentially comparing apples to apples. At that point, you might want to look at what other criteria is on your list to compare and contrast these properties. Could it be tenant type, the maturity of the neighborhood, the management team that is managing the property, etc.? Again, talk to our investment counselors and we can help break those down one by one and help you compare side by side.
Thanks for the question, Steve. I appreciate it. Thanks for being a dedicated listener. That’s it for today. I will be doing another episode of the listener questions here in the near future. If you have a question, just go to PassiveRealEstateInvesting.com, click on the Ask Marco button, send in your question, it goes straight to me. I will review them, I may answer you directly via email. If not, I’ll save that and keep it for an upcoming podcast episode.
Download our free report, The Ultimate Guide to Passive Real Estate Investing. If you haven’t subscribed, remember to do so. We appreciate all that you guys do for us. We’re going to keep delivering the content for you. Anyway, glad to have you as a listener. That’s it for now. Again, thanks for listening. I look forward to seeing you on our next episode. Take care.
– – – – – – –
Download your FREE copy of: The Ultimate Guide to Passive Real Estate Investing.
Get your FREE coffee mug by leaving us a Rating and Review on iTunes. Here’s how.
See all our available Turnkey Rental Properties.
Please give us a RATING & REVIEW (Thank you!)