Archives for October 2012

A Lesson From Sandy: Underestimating Soft Costs

Being prepared

With hurricane Sandy about to deluge the Northeast, I think about how many investors undervalue their insurance when they are purchasing any piece of investment property…especially those investors that are just flipping houses. Too often property investors will consider the expenses that only add to the value of a property. I call these the hard costs of the investment. For example, renovations to a kitchen or bath or performing extensive landscaping on the property are things that will have a direct relationship to your overall costs, since they will actually be seen by the eyes of a potential buyer (or tenant).

Soft costs

But it’s also just as important to consider the soft costs of investment property acquisition when crunching all your numbers. These represent the costs not normally associated with “what’s up on the screen,” or rather, what the potential buyer (or tenant) will not see. Hurricane Sandy reminds us that an expense such as proper insurance should not be overlooked when estimating overall expenses. For property investors, underestimating the cost for insurance is simply foolish.

You should be considering getting full replacement cost for property in case of something catastrophic. Say, a hurricane like Sandy for example. If your asset is wiped out because of a flood or fire you do not want to be woefully underinsured. Thinking that you’re only going to hold the asset for a very short period of time in the case of flipping, or that your tenants don’t care what kind of insurance you carry is terribly shortsighted.

Obtain full replacement value coverage

Make sure when you purchase any investment property that you have it properly insured – and that means obtaining full replacement value coverage. It’s extremely important to spend the extra $100 or $200 to make sure that you cover yourself in case of catastrophe. I know it’s not easy to add more expenses when you think you can cut corners since prospective buyers are not going to see this particular expense. But in the light of this current hurricane bearing down on the Northeast, it’s foolish to shortchange and not fully protect yourself financially in the event of a real catastrophe to your investment property. Better to be prepared and be safe than sorry. Always protect your assets and add an inflated figure for insurance to your list of expenses that you’ll have to satisfy on a monthly basis.

Savings through deductibles

Of course you’ll want to shop around for insurance carriers to find the best deal, but again, make sure that you’re looking to get full replacement value for the property. Your investment property is too valuable to risk taking such a huge loss (the difference between full replacement value and market value in insurance parlance) in case of catastrophe. If you’re going to save on insurance the best way to do it is through obtaining a higher premium deductible amount on the house. So instead of a $500 deductible, consider going with a thousand dollars or more for each claim’s deductible amount. This will at least help defray the added cost of getting full replacement value insurance on the property.

photos courtesy of clubfrontier.org, news.cnet.com, ibtimes.com, genins.com, thectrealtyblog.com

The New REIT-Offs

The wave of the future

Real estate investors should be aware that many non-traditional commercial property holding companies are utilizing recent IRS rulings, and are taking advantage of raising cash through conversion of their holdings into Real Estate Investment Trusts (REITs). By doing so, these companies not only take full advantage of capital market leverage, but they also save on taxes as well. REITs are not subject to federal income tax, because they must distribute at least 90 percent of their taxable earnings to shareholders as dividends. With these devlopments, there is now much greater choice afforded real estate investors among the list of REIT vehicles available for investment.

The non-traditional REIT conversion trend

REIT conversions are being created across a number of industries. Chief among them include prisons, data centers, cell towers and outdoor advertising billboards. This increase in REITs affords much more diversity for the property investor to consider, much more than traditional REITs that invest mostly in retail shopping centers and office buildings, for example. Of course, real estate investors win when they are provided with an ever-increasing array of investment vehicles to invest in.

REITs are required to invest at least 75 percent of their assets in real estate, and need to earn at least 75 percent of their gross income from rents, or from interest on mortgages. They sell shares of stock in their companies to raise equity for further development purchases, since most of their earnings are required to be given back to shareholders in the form of dividends.

Federal tax exemption

Companies that specialize in non-traditional commercial real estate have been jumping on the bandwagon this year, converting to REIT status, then being publicly traded, in order to take advantage of the federal tax exemption. It also provides these firms with the ability for greater growth by accessing more capital quickly. In addition, by taking advantage of this federal tax loophole, these newly converted REITs garner a major bump in valuation overall, simply because of the cost savings of no federal taxes.

With existing bank money market rates hovering in the three quarters of one percent range, property investors are constantly looking for much greater returns in a stable environment. With REIT returns running in the three and a half percent range this year on average, they are increasingly becoming an investment vehicle of choice for many real estate investors.

Close to an all-time high

It’s interesting to note that REITs now rank third amongst purchasers of real estate in the United States over the first half of this year, with acquisitions of $12.2 billion, according to research compiled by Real Capital Analytics Inc. This data shows that REITs rank just behind private buyers (at $40 billion) and institutional investors (at about $30 billion). In addition, REITs in the United States should come close to an all-time high for raising capital by the end of this year. Right now, they are running about 22 percent higher from last year, having raised over $41 billion through the first three quarters of the year.

Conversion risk versus reward

All this flurry of REIT conversions for existing, non-traditional commercial real estate companies does not come without costs and risks, of course. The conversion process is quite time consuming and expensive, utilizing a great deal of a company’s resources and capital in the short run. Also, once converted, REITs are subject to the vagaries of any new changes in U.S. tax laws that could adversely affect them down the road. But for now, this wave of conversion activity remains strong. And the great upshot is that real estate investors are offered a much greater choice of REIT vehicles in which to invest.

photos courtesy of debtamerica.com, aaii.com, bestmutualfund.org, myplaniq.com

A Survivalist’s Mentality

Why invest in real estate?

I’ve been taking some basic refresher survival techniques courses lately in preparation for doing winter hiking. Just in case I get lost in the woods, I ‘d like to feel a bit more prepared for emergencies… The local classes I’ve been attending are offered by some honest-to-God survivalists. So not only do I get good, solid practical strategies for making fire, purifying water and making a shelter, to name just a few topics, but I also get a good dose of honest-to-God survivalist philosophy.

Interestingly, this philosophy is the polar opposite of any basic property investing strategy.

Taking extremism in stride…

I wrote last week (“They Sky Is Falling, The Sky Is Falling”) that recent publicity surrounding world-renowned economist Marc Faber’s dire doomsday predictions about the imminent collapse of worldwide economies was a tad extremist.

However, Faber certainly has an advocate in my survival training instructor…His philosophy gushes forth in every class – as he loves to point out corporate and governmental conspiracy theories, the concept that all humans are evil, and his belief that only a handful of people control the world. He actually mentioned a “Mad Max” apocalyptic vision of the world – and only weeks away!

It’s the Great Pumpkin

Naturally, all I could think about was poor Linus waiting patiently in the pumpkin patch, knowing, without any doubt, he’ll eventually get to see the Great Pumpkin. If he can only stay awake. But his true believer mentality will see him through…

I am always struck by the extreme paranoia that seems to pervade survivalist thinking. A thinking I might add, that de facto belittles the notion of building a nest egg of properties based on a slow, deliberate investing strategy, predicated on large degrees of leverage. A paranoia that in turn destroys the idea that investing by its very nature is about saving up for a rainy day. To the true survivalist, that rainy day is literally tomorrow. And you damned well better be prepared for it. Or die.

Planning for that rainy day

But if you’re like me, and you don’t subscribe to theories that drug companies support the proliferation of disease to bolster their profits, that governments enslave their citizenry to maintain their docileness, and that humans are inherently stupid, uneducated and lazy, then man oh man, is it ever a good idea for you to invest in real estate. Property investing is certainly for you!

So do survivalists scare me? No, not really. By and large they are preparing for the fight to come to them. They just believe beyond any doubt that a fight, some fight, is going to come to their neck of the woods when Armegeddon hits.

Obviously, property investors don’t believe Armeggedon will hit. Otherwise, why bother planning for anything longer than tomorrow? We, like Lucy, understand the underlying folly in patiently waiting in the pumpkin patch for something really big to happen. Rather, we desire to concentrate our efforts to invest in real estate, in many different and deliberate ways. Though we will never, ever be able to convince our brethren survivalist believers to the contrary.

photos courtesy of survival.kanakuk.com, edition.cnn.com, blog.competitivefutures.com, en.wikipedia.org, facebook.com

The Sky Is Falling! The Sky Is Falling!

What the doomsayers are espousing…

In my article posted here on September 12^th, “The FED and you,” I concluded that the end result of all the money printing the FED has been doing of late will create a scenario where the next generation will have to pay the piper. And real estate investors today will end up having their heirs pay for this loose money policy.

There are others who are more doom and gloom than I in their predictions, however. One noted economist, Marc Faber, has recently said that “U.S. monetary policy will destroy the world.” He is referring to the most recent stimulus plan by the FED – also known as “QE3” or “QE Forever.” In an article posted last week in MoneyMorning.com that recapped Faber’s dire warnings (Faber warns everything will collapse. (n.d.) Retrieved from moneymorning.com/ob/Faber-warns-everything-will-collapse/), the case was made by Faber and other renowned economists that the dominos were in place for a worldwide collapse to occur. Besides the FED’s current policy of printing money to keep markets stable in the short term, the other key dominos included the major protagonists in the European financial crisis, including Greece, Italy, and now, Spain.

The article went on to describe how Chris Martenson, a global economic forecaster who’s recognized as an expert on the dangers of quick economic growth, had a theory that the world’s economies would collapse in short order. He was quoted as saying: “we found an identical pattern that guarantees they’re going to fail…This pattern is nearly the same as any pyramid scheme.”

Somewhat less than reassuring, right?

I do not subscribe to this Chicken Little philosophy of a oncoming train wreck that will be create a quick, devastating worldwide economic collapse. It makes for good, sensationalist copy – but hardly sound economic theory. I think the head of the International Monetary Fund, Christine Lagarde, would agree.

While governments in Europe and the U.S. have helped create these economic conditions through a combination of volatile spending with little austerity measures in place, governments also have the ability to right their own country’s economic fortunes (albeit with extremely unpopular political overtones). This righting takes time, certainly won’t occur overnight, and historically runs in cycles of five to seven years. What is new here though, is the interconnectedness between countries. That is at the heart of the aforementioned economists’ doomsday theory.

I still don’t buy it. Will the twenty-five percent unemployment rate in Spain bring the U.S. economy to a grinding halt? Possibly – but doubtful. There are too many other countries, investors, banks and extreme oversight in place to prevent a domino effect from occurring. Meaning: is it all a possibility? Yes. Is it a probable scenario? I think not.

Making sense of it all…

So what does it all mean for real estate investors here in the U.S.? I think doomsday scenarios are quite frankly, irresponsible. They can create a sense of economic panic that can affect markets worldwide…not just in real estate. While it is OK to advise about the possibility of a horrendous economic collapse, saying one is imminent is ludicrous.

That said, we are coming through an economic upheaval not seen since the Great Depression. But the downturn cycle that began in 2007 has already begun changing over the last year. And I think it will continue, slowly, but steadily. If you get into property investing, you do so knowing the inherent risks: it’s illiquid, and in a down market, hard to get your money out quickly. But if you’re in for the longer term, the ups and downs tend to even out. Historical data has proven this – and will keep the doomsday prophets at bay.

While the residential real estate market continues to slowly rebound, average national rents have done quite well – and continue to rise at about a six percent annual clip. It’s possible that short-term financial upheavals overseas may create a ripple effect of tighter credit here in the U.S., but nevertheless, renters are still going to rent. As the rental market remains strong, combined with low interest rates on existing mortgages, it makes for an excellent time for real estate investors to be building a portfolio of rental property.

photos courtesy of blogmosaic.knowledgemosaic.com, silverbearcafe.com, infiniteunknown.net, article.wn.com, davidicke.com, chicagolandrealestateforum.com

The Story of Jackie – Ohhhhhh!!!

A cautionary tale when investing in rental property…

I was attending a get-together dinner recently for members of my curling club, as curling season begins in earnest this month. Jackie, one of our esteemed board members (and the most ebullient curler in our group) was recounting her rather unfortunate recent tale of woe. It involved a small, but rather intense kitchen grease fire that she accidentally started in her apartment. Of all the possible worst-outcome scenarios, she has to consider herself lucky – she, nor anyone else in her building, were harmed.

Her apartment was not so lucky.

To her credit, she had the foresight to have a kitchen fire extinguisher on hand in case of emergency, and coupled with her staying calm under pressure, she was quickly able to extinguish the flames caused by the fire. (Note to landlords: provide fire extinguishers for all your tenants….you know – an ounce of prevention and all…) Unfortunately, smoke damage to her unit was extensive, and while the local fire department did not have to put any fire out, the local building inspector pronounced her unit uninhabitable, forcing her to seek temporary lodging.

Several key issues arise from this accident…

Since she as the tenant was responsible for damage to her unit, what exactly is she responsible for? Does the landlord have to make the necessary repairs (utilizing a specialized fire-damage contractor, for example). What time frame must the repairs be done? Doe the landlord have to allow her back into his building after the repairs are made?

To make matters even more complicated, Jackie mentioned this little addendum to her tale of woe: the landlord was set to close on the sale of the building in a few days. So, what happens to that sale? Can it go forward as planned? What liability, if any, does the current owner have to the buyer, since they are under contract?

A bit of a pickle, right?

Let’s start with the basics – that is, Jackie’s rights and responsibilities as a tenant. She apparently did not have a lease, and was on a month to month tenancy arrangement with the landlord. Very common…but alas, very unfortunate for her and her landlord. So when investing in rental property, know that without a lease, the landlord has no requirement to reinstate a tenant in his building after repairs are completed to the unit. In this case, Jackie most probably will have to look for another living arrangement.

Liability issues

Next – what is the extent of Jackie’s liability in this case? She started the fire, so landlord negligence is not applicable here. Most leases have traditional damage clauses in them. For example, a standard Blumberg lease calls for the tenant to make all repairs at their own expense when a fire is started due to their negligence or act.

But if the tenant has no renter’s insurance, it is doubtful they will be able to cover all related repair expenses. So in reality, the limit of financial liability for any tenant is the full amount of their security deposit. If there is no lease, then the security deposit is all the landlord can recover. (Though legal action to recover further damages can be sought in the court system, it’s usually quite difficult and pointless for landlords to attempt to recover from most cash-strapped tenants.)

How to best protect yourself

Obviously, you as a landlord need to protect yourself. So the three basic rules to be learned here when investing in rental property are: You must always have a lease. In that lease you must always require the tenant to carry renter’s insurance. And that lease must also require that you be named as a co-insured on the tenant’s policy.

Now, if the tenant has a tenant’s insurance policy, then the tenant’s insurance carrier would be in the first position to pick up the tab for all repairs due to the tenant’s negligence. However, if the tenant has no renter’s insurance, then the landlord’s building insurance policy would come to the forefront, and would pay for the requisite repairs (less the deductible of course). And the landlord could use the tenant’s security deposit to defray the cost of his deductible, for example.

Either way, the tenant is still responsible for their rent up till the time the unit was damaged. If the unit becomes uninhabitable, the tenant cannot be charged rent. Of course, the tenant usually wants to move back in after repairs are completed. So it behooves the tenant to aid the landlord in finding a contractor quickly to make those repairs as soon as possible. In this case, without a lease, it becomes the landlord’s option whether to allow Jackie back in as his tenant again.

If other tenants in the building were affected by the fire as well, the landlord can’t demand the tenant make restitution for the other tenants’ rent roll, or repairs to their units. In that case, the landlord’s insurance policy would cover both the lost rent revenue from other tenants, as well as increased expenses due to the additional repairs from the fire damage. However, any time a claim is made on a landlord’s insurance policy, obtaining subsequent coverage for future buildings may be much harder to get. In addition, premiums may rise on existing policies as a consequence of a claim. That’s why it’s also so important to require your tenants to carry their own insurance, with you named as the co-insured on that policy.

The hard part

When there is an existing contract of sale in effect between the landlord and a buyer for the rental property and then disaster strikes prior to closing – whether through an act of nature, or an act of God… or an act of Jackie…the seller is required to put the building back to the condition it was in when the contract was signed. This does not mean they are required to make everything new. De facto, some repairs require new materials – for example, new sheetrock being installed due to a small amount of fire damage. Or, in the case of a total destruction of a building due to flood, fire, tornado, etc. the buyer is not entitled to a new building.

As such, most real estate contracts cover this rare possibility by allowing the buyer to either accept the seller’s insurance company’s amount for replacement coverage, thereby taking the building damaged, as is, along with the settlement cash, or they can walk away from the deal with their deposit returned to them.

Renegotiating

In the case of a smaller amount of damage, like oh, say… a small kitchen grease fire, then it is common for some amount of renegotiation to occur. The buyer will usually be presented with several scenarios: if they want a quicker closing, they can wait for the seller’s insurance company to present an amount they are willing to offer the seller for the repairs, as mentioned above. The buyer could then accept that amount, take the building as is, then close and make the repairs themselves.

Another alternative is for the seller to make the repairs to the building, in concert with their insurance company. While this is common, it will also take much longer to close, as everyone must wait for not only the insurance company to send an adjuster out, but also a claim amount must be approved with the seller, and then a contractor has to be hired and he must then make all the repairs prior to the closing being set. Yet another option is for the seller and buyer to renegotiate the price of the building immediately, not waiting for the insurance adjuster.

Delays abound

In all cases, it ain’t pretty. And if the buyer had his financing set to go for the original closing date, he might lose it if the closing were to be delayed by more than a month or two. And usually a sales contract would spell out a buyer’s rights in event the seller has to delay a closing. (The norm would be that the buyer unilaterally would then have the right to exit the deal if he chose not to wait.)

The bottom line

So while poor Jackie has to wait for all these issues to sort themselves out, including finding temporary housing, she also wonders if she can be locally “blacklisted” by area landlords for her accident. And the answer is yes, she can. When subsequent landlords ask for her prior landlords contact information to check her references as a tenant, they may disqualify her as a prospective tenant for purely economic reasons: she has unfortunately made herself a higher-risk tenant due to this one accident.

But there will always be landlords who don’t do their homework, and don’t check references when selecting tenants. In a more positive light, some landlords may be more understanding of a prior accident, and not be so rigid, if they can be financially protected. As mentioned above, a solid lease which calls for a tenant to have renter’s insurance, and which names the landlord as co-insured, should be adequate protection for anyone investing in rental property.

photos courtesy of biancoinsurancepittsburgh.com, glogster.com, recipetips.com, floridarealestatelawyerblog.com, intowner.com, startribune.com, home.howstuffworks.com, insurancequotes.com, ehow.com