Forrest’s Blog

In Part 1 of this series we discussed the nature and objectives of the real estate “Flipper”.  Flippers are really one specific type of short-term investor or business that relies upon the old formula of buy-low, upgrade for maximum return using the least amount of capital, then sell-high.  But what about the short term investor that buys real estate that may be held for one to five years?  What are their risks? What are their investment objectives?

To be sure the short term real estate investor generally will value capital gains over cash flow.  Just look back at the 2003-2004 real estate market here in Las Vegas.  Investors flocked into new subdivisions hoping to get in on the ground floor of each new development.  Many planned to purchase the properties with little of no money down on the hopes of selling six months to two years down the road. 

And why not?

The two story 1900 square foot new home that was offered at $210,000 in the spring of 2003 was advertised over $450,000 by the summer of 2004.  Many of us remember the waiting lists that clients were required to be on for months just to have the opportunity to be offered a contract on one of these homes.  Still, others were placed on lists where the honored buyer was selected by way of a lottery and then waited six months or more for the home to be completed.  Of course, this world came crashing down in the fall of 2004 when several builders reduced tract prices on these homes by $70,000 to over $100,000.  Do you think that some buyers were already upside down on their mortgages as a direct result of this event?  Of course they were! 

Real estate investors are not immune from market risks any more than someone who invests in stocks or bonds.  The vast majority of investors (in the above purchase example) focused solely or predominantly on their prospective capital gains and generally ignored any market risk consequences.  Worse yet, very few of these investors developed much of a plan to create or foster cash flow on these properties. 

So let’s look at a $350,000 investor owned property financed by an 80/20 loan package.  Assuming a first loan amount of $280,000 this investor is looking at a $1500 per month mortgage payment.  The second loan of $70,000 will result in a montly payment probably in excess of $500.  However, keep in mind that if this first loan is an adjustable rate loan, then it was probably set to be refinanced in 3 - 5 years and will go up even further.  Now let’s assume taxes in the range of $250 per month and an association fee of $100 per month.  This investor is staring at a monthly expense of over $2,300 on this investment property.

Rental Cash Flow Capability

The numbers used in the above example are actually typical for several new subdivisions around the Greater Las Vegas area.  This investor should have carefully studied the rental market for these homes!  If they had undertaken a thorough examination of rental rates they would have discovered that homes such as these were only renting for $1100 - $1500 per month on average.  Yes . . . your math is correct!  This investor may be swallowing a $1250 per month negative cash flow on just this one property.  A short term negative cash flow may be fine, but for how long does your investor want to endure this level of negative cash flow?  And this is already assuming that it will be rented.  My critics have and will continue to argue that my perceived need for equity is a result of being too conservative and because I am the product of WWII parents.  I can live with that!

Two Fundamentals

First, never lose sight of the importance of cash flow when investing in real estate for the short term.  Second, please do not underestimate the importance of equity in real estate investments.  Many investors have been encouraged to leverage their every investment dollar in order to maximize their overall returns, capital gains, and net worth.  This may work if, and only if, the market continues to rise without ever dipping or falling.  Remember that leverage works both ways!  If your every dollar is leveraged and the market falls . . . then you can have leveraged losses if you must sell.

Leveraged Losses

I realize that there is a mountain of news press that relates subprime loans, stated income loans, loan fraud, etc. to the current rate of foreclosure activity.   But I believe that it is time to look at the role of the short term investor in the foreclosure market.   Just look at the number of investor owned homes that are on the market in the Greater Las Vegas area.  Wouldn’t it be interesting to survey each of those investors as to their original goals as well as what led them to their ultimate buying decision?  I would assert that the astute short term investor could avoid many pitfalls by keeping focused on the need for cash flow and equity in their investment transactions.  How many buying decisions would have been altered if short term market risk had been factored in to the buying equation?

Part 3 will conclude this series by looking at the long term investor.