Protecting your interests in a group investment (Part 1)

Note: This post is part of a series of posts on the fundamentals of partnership agreements and investing as part of a group. See the introduction of the series here.

What is a Partnership Agreement and why is it so important?

In my earlier post about the pluses and minuses of incorporation I wrote a little about how different forms of business are taxed. While corporations and partnerships may be handled very differently in terms of liability and taxation, they are essentially the same when it comes to establishing the terms of the business. While the government very clearly gives you guidelines for how to pay your taxes, there are no such guidelines for the rules that establish the business. The government stays out of that completely until there is a dispute of some sort and the owners take each other to court.

So when two partners get into a dispute and are taken to court (say one of them "borrowed" money from the company) the court will ask that the owners provide evidence that supports their claims. If the owners had nothing more than a verbal agreement on how the business should be run, both are essentially put to the mercy of the judge.

So your partnership agreement (or the charter of your corporation) exists to protect you against any future problems within the ownership. But the greatest advantage that the partnership agreement provides is that it often can prevent problems from occurring. As the old saying goes, an ounce of prevention is worth a pound of cure.

So what are some very basic things you need to know about partnership agreements?

They clearly defined the terms of the partnership, explaining who owns what and who is allowed to do what. You need to try to cover every possible situation before it arises.

They are not recorded with the government. If you go to court a judge will not see your agreement until you provide it for him, so it is extremely important that every partner (or share holder or a private corporation) has their own signed and dated copy of the agreement. If possible, it can help to get your agreement notarized when it is signed, simply to strengthen the credibility of the document.

Every single partner (or share holder) has to sign one in order to be bound by it. If the document changes in any way, say you add a new investor or changes some of the responsibilities, then every single partner must sign and date a new copy of the agreement.

Every page must be signed and dated (so that new pages cannot be inserted or altered on various copies.
So now you know what a partnership agreement is and how it is used. You also know the important facts about keeping a safe and updated copy. With this knowledge in hand you are ready to begin looking at crafting a partnership agreement for your hypothetical Subway franchise.

Introduction - The basics of entering a group investment
Part 1 - What a partnership agreement is, and what you need to know about it
Part 2 - What is my interest and how do I determine it?
Part 3 - Figuring out the managment

Protecting your interests in a group investment

If you are even a moderately successful investor, at some point in your life you will be approached to pool your resources with a group of people to fund a large investment. This investment could be a restaurant, an apartment complex, a software start up or just about any other idea people can come up with to make money. Some people will just walk away from these opportunities because more people introduces more uncertainty. Others will jump on board immediately. The wise ones will carefully review the investment and, if they think it is sound, they will cautiously enter the partnership.

I'm going to assume right now that someone is starting a hypothetical business (let's pretend they are launching a Subway franchise) and a few people are getting together to invest in it. You've done your research and you think that the investment would be a sound one. But, because you are a wise and canny investor, you insist on carefully working out all of the terms and crafting a legal document before handing over any money.

This document is commonly referred to as a Partnership Agreement. It is used to clearly dictate how the money is to be used, who controls what, who owns what, and what rules the partnership agrees to act under. If you invest in a group this is probably the most important document you will ever sign.

I'm going to write a series about Partnership Agreements, how they legally work, what you need to know before you sign one and finally I'll break one down to talk about the most important parts that protect you as an investor.

This is an on-going series, I'm about halfway done with discussing what I had orginially mapped out. After a couple days break to deal with some lighter issues (like humor), I'll be ready to publish the final three articles.

Introduction - The basics of entering a group investment
Part 1 - What a partnership agreement is, and what you need to know about it
Part 2 - What is my interest and how do I determine it?
Part 3 - Figuring out the managment

Why you make money in real estate (Part 2)

Back in Part One I wrote about what money was. My conclusion there was that money was the way we measure value. The amount of money we are willing to spend displays how valuable something is to us.

So how does that pertain to real estate? If you want to make money in real estate, you need to figure out a way to provide value to someone. Our customers tend to come from two places, tenants and buyers, so everything you do should be adding value to one of those two groups.

Let's take a hypothetical example of John Doe who just bought a book that taught him how to buy a home for No Money Down. He gets a 100% mortgage and let's assume that his mortgage payments are about $1500 a month. He sets his rent to $1600 a month (because he's heard about the importance of cash flow). Now what are the odds that he's going to rent? If his potential tenant could pay $1600 a month in rent, why wouldn't they just go out and buy their own home for $1500 a month like he did? John Doe has failed to add value.

So how can we, as real estate investors, add value for our customers? There are a variety of methods, some common and others not so. Let's look at some of the commoner methods that a investor can add value for his customers.

Fix the home up. Buying a fixer-upper and then fixing it is possibly the most obvious method of adding value to a home.

Offer life beyond their means. This is something that every investor does, but rarely thinks about the mechanics behind it. Imagine that John Doe instead sets his rent at $1200 a month. He'll have to either eat a negative cash flow for a while or put more money down at closing, but he has immediately added value. Tenants can now afford to live in a nicer house than they could afford to buy. For example Jane might only be able to allocate $1300 a month to housing, but wants to live in the nice school district for her children. John Doe is allowing her to enjoy a home that she couldn't afford.

Offer hassle-free living. This strategy mostly deals with transient populations who won't sit down long enough to making purchasing a home reasonable. Military bases, college towns, downtown city areas are all places where large numbers of people move, stay for a few short years, and then leave. Very few of them can afford the hassle of buying a house, and even fewer would be profitable in the transaction given the short amount of time involved. You add value by giving them an alternative to purchasing a home.

In these areas you can sometimes start making money immediately. Biff and I bought out first house with only 10% down, yet we were making a $25 a month profit when our first tenant moved in (after all regular monthly costs including insurance, HOA dues and PMI). The reason we were able to do this is because our tenant was a military contractor and wasn't expecting to be in the area for more than 2 years, hardly enough time to buy (we also bought the house at reasonable discount).

Buy properties at a discount. The value added when you buy properties at a discount is the difference between your purchase price and the price that others are willing to pay for the home. You add this value through your knowledge and expertise. With so many investors out there it is very difficult to spot these sorts of bargains, so your value is hard earned.

What are some less common methods that real estate investors use?

Offer to buy out distressed buyers. Find people in difficult situations and offer to buy them out, though at a discount. The value added here is the difference between what you paid for the house and what the market value is. You add this value through time, you are offering money quicker than more traditional methods.

Rezone a property. Some investors have the knowledge and expertise to get areas rezoned or re-lotted. For example an investor might buy a house on a large plot of land and then subdivide it and sell the lots. Since most buyers wouldn't be able to do that on their own (they lack either knowledge or the time to get the knowledge), you've added value through your expertise.

Make the property a landmark. It's also possible to increase value by adding a bit of celebrity to the property. If you buy a very old home, for example, you may be able to petition to have it recognized as a historical landmark. If you really wanted to be a little creative, you could also try tracking down a property that housed some celebrity before they had made it (Eminem's home on eBay leaps to mind) . This could add value to both buyers AND tenants.

An important note to close on is that every method of increasing value requires either money (to fix a house or make a larger down payment) or legwork and expertise (to find bargains or get a property recognized as a landmark). There is no free money in real estate; to get it requires either cash or hard work, and usually both. But if you are willing to get your hands a little dirty and be a little imaginative, then you'll often be surprised how many different ways you can add some value to your customers.

Why you make money in real estate

What is money and why is it so important to us?

A metric is a unit that we use to measure. For example, if you wanted to know how far Miami is from New York, you would probably give an answer in miles, because a mile is a metric used to judge distance. In the same vein, a pound is a metric used to judge weight, and an hour is a metric used to judge time.

Money is civilization's metric used to judge value. We can measure how much you care about something simply by measuring how much money you would pay for it. This is why we use terms like "worth" and "value" in connection with money.

"But," you might protest, "the distance between New York and Miami doesn't change, yet the price of my latte is different every month." And, of course, you'd be wrong. The distance between Miami and New York is actually changing as the shape of the earth changes according to our rotation. But, in the end, that's all irrelevant. If an earthquake broke Florida away from the mainland and moved it 50 miles south, the distance between New York and Miami could still be measured in miles, it would just be about 50 miles greater.

Measurements can easily adjust to things that change, and few things change as quickly as our own minds. What's very important to us today might be nearly worthless tomorrow (bell bottoms, anyone?). But we still use money to measure how much something is worth to us. We show how much we care with our wallets. The stories these numbers tell aren't always politically correct.

For example recently oil troubles have driven up the price of gas. Americans, however, have shown how much they value transportation by continuing to pay higher and higher prices. We care much more about our ability to drive than, say, the victims of hurricane Katrina. Exxon earned almost $10 billion in profits in 3 months, which is more than 20 times as much as Americans gave to Katrina victims. Both of these articles were written in the fall of 2005.

Now I've gotten a little off topic here and my goal is not to rant about good or evil. In fact it makes a lot of sense to me that the average American would care more about transportation (by which he gets to his job and thus provides for his family) than the misfortunes of people he has never met that live thousands of miles away. In fact I believe that the amount that private Americans gave in the aftermath of the disaster was quite commendable (how it was managed is another story).

But the important thing is that money is our way of representing value. Your job pays you because the work you do provides value to them. You pay interest on your mortgage because of the value the bank gives you by letting you spend money you don't yet have. The lesson is clear, if you want to earn money you must provide value to someone.

I know this went down as a vague and philosophical post about the concept of money, but I feel it's important to properly label money before we can go about the business of discussing how to generate it. Tomorrow I'd like to reflect on the various ways investors can add value to a property and make money from it.

Breaking down a lease

Own some land and going to rent it out? Before you hand over the keys, make sure your tenants sign a lease. No matter how good a tenant looks, things can always go wrong.

"But how do I make a lease?", you ask. "This is why real estate is so much more complicated than stocks and why I'll never get into it. I'm not a lawyer you know!"

Not so fast my friend. While legal forms, such as a lease, can be intimidating, in the end they're just a list of things you agree to do and a list of things your tenant agrees to do. Usually that's wrapped up in a bunch of legal-ese, but it doesn't have to be. You can very easily make your own lease, or even get one from the web (google the phrase "residential lease" and you'll get tons of templates to use).

Now even if you pull a template off of the web, you need to review it carefully to make sure it covers everything that's important to you. Let's look at the anatomy of a lease and specifically cover the areas that are absolutely necessary to have included in your lease.

A lease consists of 4 basic parts. The first part dictates the specifics of the lease, the rent and dates and so on. The second part explains your rules for living in your house. The third part deals with how you and the tenant will interact, and the last part just deals with the document itself. Sometimes these parts are a bit jumbled up, but they are usually grouped together.

So the first part of the lease deals with the specifics. This is the part of the lease that you have to change every time you get a new tenant. In this part you have to explain:

  • The length of the lease (also referred to as the Term)
  • When the lease begins, when does it end?
  • The rent owed. Most leases will give a total of the amount owed over the life of the lease, and then specify how it's to be paid (i.e. $X on the first of each month)
  • Any money that is due up front, i.e. a security deposit or first and last month's rent. You should clearly state how and when they can get their deposit back (such as "after all deductions for damage have been taken out, the balance will be returned to the Tenant within 45 days of the end of the lease").
I want to take a quick second here to talk about security deposits. Virginia actually has an entire section of law just about how security deposits are to be handled. Every state is different, but I believe most states have similar laws in place, though the specifics may vary. In Virginia, for example, the maximum amount you can ask for a security deposit is equal to two months rent. And if a landlord holds a security deposit for more than 13 months, they have to pay interest on it when they return it. Please take a look through your state laws, or just try to find a FAQ that can answer those types of questions in your state.

Now that we've dealt with the specifics of when the lease takes place and how much the other person owes, it's time to talk about the most important part, protecting your assets. The next section of the lease should dictate the rules that you want to set down for your property, and while those rules can vary from investor to investor, a few rules should be in every lease.

  • How many people can live in the house? This should be filled out before the lease is signed. How do you differentiate between a tenant and a guest? Trust me, you don't want the Cletus's moving in and then having their extended family move in with them.
  • Subletting rules. Subletting is when a tenant decides to rent their lease to someone else. This can often happen in college towns when students will sublet their apartments over the summer. Do you allow it? Do you require approval before it's allowed?
  • Can the tenants alter the house? Put up some new paint? Replace ceiling fans? Unless you chose a tenant because you want them to improve the property, it's probably best to prohibit alterations to the house.
  • How are utilities to be treated? Will you cover them and wrap them into the rent? OR is the tenant supposed to take care of them (including setting them up)?
  • What about pets? Allowed? Not allowed? Are hamsters ok, but a fish tank forbidden?
In addition to this you need to think through all the other rules as well. If there is a yard, who's responsibility is it to keep it clean? If there's a Home Owners Association, they need to be made aware of the rules. Any rules you can think of for how you want your property treated should be covered here.

In the next section we talk about the relationship between you and your tenant, and what happens if things go wrong. Hopefully nothing bad will happen (the worst Biff and I have put up with is our first tenant hanging animal heads on the walls), but if something goes south you will be extremely glad you wrote this part of the lease. Things to cover in here include:
  • The property is in good condition before the tenants move in. This is important to state and have the tenant sign, in case they wreck the place they can't tell the judge "it was like that when I got here". This, by the way, should be accompanied by an inspection form that you fill out when you let the tenant into the property for the first time.
  • Your access rights. As the owner of the property you have the right to inspect your investment. The tenant should do anything to bar you from areas of the property (such as changing locks).
  • What if someone gets hurt on your property? You need to have a clause in there saying you are not liable (called "indemnification"). Of course if someone is injured due to your negligence (you never got around to fixing those old stairs until the collapsed) the judge will throw this clause out, but if someone trips and falls down the stairs by their own stupidity, this will assist your defense.
  • If the rent is late, what next? Do you impose a late charge?
  • What if either you or the tenant want to break the lease (maybe you have a buyer who is very interested)? How is that situation to be handled?
  • Let's say the lease ends and the tenants moves out, what happens to thing the tenant leaves behind? Include a clause that explains that you have the right to treat such things as "abandoned" and can dispose of them as you wish (even in auction).
  • When the lease is over, then what? Does it continue on in a month-to-month fashion? You definitely need a clause that states you expect the property to be in as good of shape as when the lease began (excluding wear and tear, of course).
A few more things to note in this section. I also have a clause in my lease that says the tenants must leave notice to us if they will be away from more than 7 days, so Biff can keep an eye on the property. As for early termination, if you believe the military will make a reasonable portion of your tenants you should be aware of a federal law that allows soldiers to break a lease penalty-free if they are being shipped out or reassigned. They have to provide you with a copy of the written orders to do so.

Finally the last section of the lease is simply the rules about how the lease itself should be treated. Weird, huh? Yet every lease should mention:
  • The fact that this is a binding document. You might get away without having it, but it certainly can't hurt and helps diffuse any possible "ignorance" defenses.
  • That the lease cannot be modified by either party without all parties signing the new amendment.
  • Severability. This is a fancy legal word that means if some part of this lease is invalid for some reason (like a judge throwing out you no-liability clause) the rest of the document is still considered valid, instead of the entire document just getting thrown out.
Congratulations. You've just written a lease. Now at the bottom make sure you have room for both you and the tenants to sign and date the document. With this document in hand, you are ready to protect both your property and yourself.

Why the real estate business is due for a collapse

I don't have anything against realtors and, were I planning to stay in the country for more than 6 months, I would be working towards getting my license. But I still think the industry is headed for a major shakedown, and let me explain why.

Loss of their information monopoly. It used to be that the only resource for real estate information was through a real estate agent. However as more and more listings appear online and more and more websites appear to centralize this data, it becomes a lot easier for buyers to locate homes on their own. While real estate agents used to be the only people who knew enough about the recent comparable sales to evaluate a property, new tools like Zillow make it easy for anyone to access that information. And while most people will only make a few real estate transactions in their lifetime (thus they rationalize the need for an "expert"), columnists and blogs (like this one) are demystifying the purchasing process, and showing how it's no more difficult to buy a home than a car (and you don't have agents help you find cars).

In addition on the selling side, marketing has constantly gotten better and cheaper through the advent of the internet. With on-line postings getting such a wide audience, the need for a specialist to do this for you has shrunk considerably.

The flood of inexperienced agents over saturating the market. The one thing that real estate agents had going for them was the moniker of "expert on buying and selling homes". However with insane numbers of people becoming agents, this is rapidly losing it's credibility. In Miami there is one realtor for every 17 people! The result is that many buyers and sellers get stuck with terrible "experts". When Biff and I bought our first property we were saddled with a terrible agent. Not only did our agent do a terrible job at locating properties we'd be interested in (we ended up finding the house on our own) but she made some really stupid mistakes, like trying to use white-out to alter a typo in a legal document! Biff made her go make a fresh print of the document. And she still got her cut of the purchase.

Ethical considerations. Most real estate agents will go crazy at this one. They swear up and down that they are acting strictly in the best interests of their clients, especially the buyer's agents who get more money if their client spends more. But no one believes them because evidence to the contrary comes out all the time.

In the Detroit suburb of Commerce Township, seller Courtney Tursi is offering a two-year lease on a BMW X3 SUV to the agent who finds a buyer for her contemporary, two-level, four-bedroom, 3.5-bath lakeside home at the end of a private street....... "I said, 'You know what, Courtney, this will get more people to look at the house,'" Waquad says.
If agents were truly looking out for their clients interests, incentives for buying agents (like larger commissions or a BMW lease) wouldn't increase the chance of selling a property. But research shows time and time again that these incentive do work. (In the above example the house in question recieved more inquiries, though not more visits)

In the book Freakanomics, Stephen Levitt ran some numbers to see if real estate agents sold their homes the same way they sold other peoples. According to his research, realtors hold their own homes for 10 days longer than average and sell for 3% more than average (not to mention they keep their 3% commission). His explanation was simple, holding out longer for the bigger price is typically only worth a couple of hundred extra bucks for the realtor (and therefore not worth the delay), even though it could result in tens of thousands of dollars for the seller.

Real estate agents are rapidly on their way to becoming the next used-car salesmen. No one likes them, everyone distrusts them, and no one wants their kid to grow up and become one. An industry based on information brokering can only last for so long when the public doesn't trust them.

Now all of this doesn't mean that I think real estate agents are going away. But I think that their roles will be changing and their fee structures will be going down like the Titanic. Right now that's near impossible given the sheer number of agents who milked the boom dry. But the next couple of years, with the sales going way down, will hopefully wean most of the weak agents off the market. And then the industry can move towards the future.

How to Read a Credit Report

I posted this on last Friday, but through some quirk it somehow ended up buried in my history instead of being at the top of the blog. Here's a short intro blurb, click on "more" if you want to read the whole thing.

While there are many things you can look for, one tool that EVERY landlord should use in the credit report. But first you need to know how to read one. Even if you intend to ever be a landlord, this is probably good information to know so you can read your own credit report.

First of all, to legally obtain someone's credit report you need
written permission to do so. At the end of the application that I put together a separate page that gives our company permission to run a credit check. If this page isn't signed, the application is discarded. Note that some companies can get around this "written permission" law including credit card companies.

The first thing you need to do is obtain the credit report. You can find any number of sites that offer this service to you by googling the phrase "tenant screening", but here's a few to get you started...

Read the rest of the article here...

Dealing with other people

The other day I was flipping through a couple of online articles when I came across an interesting piece that discussed Moral Hazards. A moral hazard is an economist's term for a situation where a person who has to make a decision doesn't have to bear the weight of the consequences. In the author's example, he didn't mind parking in a bad part of town because if something happened to his car the insurance company would be the one who wrote the check. In other words "It's not my problem".

How does that pertain to Real Estate? Well in any business you have to deal with people and you can't always trust those people to do what's best by your company. One of your goals should be to remove as many moral hazards from these people as possible, because very moral hazard is an opportunity for someone to make a decision that
you'll end up paying for. Let's identify some of the people who may be facing moral hazards:

Property Managers: This is the Big Mama of all moral hazards. A property management (PM) group literally takes over most of your decisions without the incentive to protect your interests. Amongst the moral hazards faced by this group:

  • Unnecessary repairs - you are paying for them, not the company.
  • Shoddy repairs - the PM group makes no money from the sale of property, just the leasing. They only need to keep the property in working order. Long term problems that affect resale aren't of concern to them.
  • Choosing contractors - the PM group often will select contractor to do the work that you are paying for. When dealing with PM groups, contractors will often include a "kickback" in their estimate (if the PM group chooses them, they'll overcharge you and give some of it to the PM group)
  • Choosing tenants - as long as the tenants are paying rent, the PM group gets their cut. It doesn't matter if the tenants are destructive, you'll pay those costs.
Many real estate investors, including the highly regarded John T. Reed, have concluded that PM groups are far to dangerous to work with. Instead they recommend either managing the properties yourself or hiring an individual as an employee to do it. Others, such as Rich Dad, Poor Dad guru, Robert Kiyosaki, claim they have better things to do than "fix toilets all day". Deal with PM groups at your own risk.

How can you remove a PM groups moral hazards? The obvious method is simply to not use one. But if you are things can get difficult. Most likely the PM group will be a larger company than you and so you will be dealing with them on their terms. They will draft the agreements and binding documentation that you will have to sign, which leaves you precious little room to protect yourself or remove their incentives.

One thought I had, back when I wanted to invest in my alma mater's college town, was to develop a relationship with some professors who taught property management, and to suggest a program where their students manage the properties for some real-life experience. We changed our business plan before I really worked that idea out, but it might have worked (I can find some obvious kinks in the idea though). Likewise if you want your property to be managed, you'll need to think outside the box or work with a brand new management company who's willing to bend to get your business.

Tenants - Unlike PM groups, these are often an unavoidable group in real estate investing. They'll be on your property 24/7 making every day decisions on how to treat your things. They are, in fact, paying for the right to do this. A few of the moral hazards posed by tenants are:
  • Causing damage - tenants will often take small risks (like drinking red wine on a white carpet) that can lead to damage, since it's not their problem.
  • Maintenance - tenants (unless they are very long term) will tend to care less about the day-to-day maintenance of the property. They will let things go unreported unless it is interfering with their daily lives.
  • Following housing rules - breaking the rules of a Home Owners Association (parking in the wrong spots, leaving clutter in the yard) is less of a problem because the HOA isn't going to go after them, they'll go after you.
So how do you deal with these moral hazards? Some of them (clutter in the yard) can be dealt with in a very strict leases combined with semi-frequent drive-bys. Others (minor damages) can be dissuaded through a security deposit. Maintenance issues can be dealt with by instituting a semi-annual walkthrough. The goal of which wouldn't be to find problems the tenants are causing (you're not spying on them) but to just check the general health of the house (hot water heater works, AC works, roof isn't leaking). Too many landlords let their tenants report their problems to them.

Another way to deal with these problems is to beef up your tenant selection criteria. If they have to be faced with moral hazards, wouldn't you prefer that they be the best possible people to make those decisions?

Contractors - Contractors are yet another group that get to make decisions affecting the health of the house without you. With that comes the temptation to cut corners and other things that you might end up paying for. Amongst those hazards:
  • Overly expensive materials - sometimes contractors will push you to use certain materials that will allow them to charge you more
  • Shoddy materials - other times contractors will use sub-standard materials on a job to cut their costs
  • Delays - an hour worked today earns them as much as an hour worked next week. But if you are between tenants, every day costs you money.
The best way to deal with contractors is simply to do your research. While you may not be qualified to remodel a bathroom (which is why you brought in the plumber), you certain can go on-line and research the different types of stone flooring possibilities. If possible, it's often nice to acquire the materials yourself, which allows you to avoid the contractor's markup. If you are on a project that is time sensitive (you can't rent out the place until the job is done) offer incentive to the contractor if they are able to meet certain criteria. And never-ever pay in full for a contracting job until you've seen the finished product and you are satisfied.

As we've seen there are two ways to deal with another person's moral hazards. Either take the decision out of their hands or add incentives. But before you run off feeling high and righteous about how all these people are capable of screwing you over, remember that you too face moral hazards every day. A possibly the worst hazard you will face:
  • Delaying repairs - you might be getting a great deal by waiting until next Thursday for the AC repairman to come out, but your tenants living without AC in 100 degree weather might not appreciate it.
So there you have it. Running a real estate business is very simple as far as businesses go, which is why it can be so easy and fun to explore the complexities of it.

Doubters Inc. (or: Should you Incorporate?)

When I read Rich Dad, Poor Dad I was very interested in his section talking about incorporation. He talked about how rich people created companies and then exploited taxes laws that individuals could not. He referred to buying his car through his company and taking trips to Hawaii, essentially tax-deductible. As it turns out, he was being a little loose with his application of tax laws. From John T. Reed's website (a real estate investor who critiques gurus):

"Both corporations and sole proprietors pay expenses before they pay taxes. Sole proprietors pay taxes only on the net income of their businesses, which means after expenses."
A lot of buzz has been made about LLC's, which stands for Limited Liability Company, and how they can do great things for your business. Most talks on the subject concern either taxes or liability concerns. Let's take a look at the implications of creating an LLC.

It turns out that when creating a business (such as real estate) there are two ways to deal with taxes. You can be taxed as an individual or you can be taxed as a corporation (taxation as a corporation can be somewhat complex). One of the advantages of LLC's is that you can actually choose either of those tax structures.

If you choose to be taxed through your person, that's considered under law as being taxed as a sole proprietor (if you are alone in your venture) or as a general partnership (if there are multiple owners/investors). Both forms treat the business's finances as extensions of your own. Each year you take your profits (mostly rental income) and add it to your personal income. Then you subtract all of your expenses and other deductible items such as your mortgage interest and the depreciation you want to claim. For most investors this will actually drop you below your original taxable income (thus the tax advantage of real estate). This is also called pass-through taxation. If you do claim a profit, even after depreciation, then it will be taxed at your personal tax rate (probably 25-35%).

If you choose to be taxed as a corporation, then the business's finances are kept completely separate from your own. You file taxes separately for yourself and for your business. If your company is producing a profit, even after all the deductions you claim, you can benefit from a slightly more generous tax scale. The first $50,000 in profit generated by your company is taxed at only 15%. But there's a catch. Any time you try to transfer money to yourself from the corporation, you have to report that money as income on your personal tax return the following year. This is often called double-taxation.

For example, Jack is in the 25% tax bracket, and his company cleared $10,000 this year. If he files as a sole-proprietor then he will have to pay $2,500 in taxes and he walks away with $7,500 which is his money to do with as he wishes. He can go on a vacation or re-invest the money in his company.

If Jack files as a corporation then his company only owes $1,500 in taxes. So his company saves $1,000. If Jack intends to use that money to expand his business this is a good deal. However, if Jack wants to withdraw the profit to go on vacation, then he must report the money ($8,500) on his personal tax return the following year, and he'll pay taxes (25% = $2,125) on those gains. So he ends up paying a total of $3,625 in taxes.

As I mentioned above, one of the advantages of LLC's is that you can choose how your business is taxed (other forms of incorporation such as a C-Corp must be taxed as a corporation). If you are like most investors, however, you will probably stick to the rules of the sole-proprietorship. This is the default method of taxation when you own rental property, so forming an LLC doesn't offer any advantages there.

The second main reason that people form LLC's is to deal with liability issues. Under federal laws all assets outside of an LLC are safe if the LLC is sued. In other words, let's assume that you form an LLC and buy 2 houses. Let's say that you order a tremendous amount of work to be done on those homes, but never pay a dime. when the companies who did the work sue for pay, the worst that could happen is that you lose the 2 homes. Those companies could not come after your personal assets (your own home, your 401k, your college fund, etc.)

However, as with most things, there are loopholes. If you are sued under a tort (a lawsuit resulting from negligence), then not only can they sue your LLC for damages, but they can also sue you for your personal negligence. Now when McDonald's gets sued for pouring scalding coffee on a customer, it's shareholders can't be sued because they are passive investors. However the manager of that particular branch could be sued (as well as people further up the chain of command) because they are directly involved in the activity that caused the negligence to occur. If you do not take part in the daily management of your real estate (which is probably a bad idea to begin with) then forming an LLC could protect you. But since most investors will also manage their homes, an LLC would offer little protection from negligence, which is easily the most costly form of liability.

Secondly, if you do get sued you will most likely head to small-claims court. Most landlords choose to represent themselves as opposed to paying for lawyer. If you incorporate you most likely will not be allowed to represent yourself in court, instead you'll be forced to hire legal council. You could win your lawsuit and still lose a tremendous sum of money in legal fees. This is a matter of state law, not federal, so check out the laws where you are buying.

Finally, a last point to consider is that lenders are more wary of LLC's than individuals, and for good reason. As a result lending restrictions for LLC's are far stricter. If I buy a house to live in, the bank will give me a good rate because they feel relatively comfortable that I will do everything to protect where I live. If I buy my house as an investment property (you will be asked this question when applying for mortgages), but sign personally for it, they will give me a slightly worse rate because they know that since I don't live there I won't work as hard to save the house when things go bad.

But if I try to get a mortgage though an LLC, alarm bells go off in the bank. Not only is an LLC far more likely to default than an individual, but if you DO foreclose they can't come after you. Biff and I inquired about getting loans through LLC's while trying to secure a loan for House #1. The best rate we were quoted was a 70% loan at 16% interest. The loan we ended up with, we signed personally for it, was a 90% loan at 5.25% interest (in a 7-year ARM). If we had tried to borrow money through an LLC we would have had to put down three times as much cash and paid three times as much interest.

One way around this is to sign for the loan personally, but put the title in the name of the LLC. Unfortunately this is even more disastrous than signing as an LLC. If you do get sued and end up losing the house, the bank will still come after you, personally, to pay off the balance of your mortgage.

So why would you even consider an LLC? Most people I've spoken with or read about who look seriously into it choose instead to remain a sole-proprietorship or a general partnership. To deal with liability, these investors simply purchase a large umbrella insurance policy. This policy costs very little, but is far better protection for a real estate investor than an LLC ever could be.

What's attractive about real estate?

Why would an individual choose to invest in real estate instead of something else like stocks or bonds, or start some other sort of company like a gas station? Here's a quick list of some of the things that characterize long-term real estate investing (flipping is a different beast all together). If some of these appeal to you then maybe real estate is right up your alley.

Real estate investing is:

  • Entrepreneurial - With stocks and bonds you just choose, buy and then watch things happen beyond your control. With real estate you are essentially creating a company that you can impact the success of. You have to deal with things like revenues, expenses, interviews (for tenants), contractors, accounting and the like. Being a land lord is being a businessman, which can appeal to a lot of people.
  • Income Generating - Land lording produces an income stream in the form of rental payments in addition to the appreciation of the house. This can be very attractive to people who are investing with goal of using some gains each year to cover running costs (like putting kids through college). With stocks or bonds you have to constantly be selling to meet those costs.
  • Off Hours - Unlike trying to open a retail store, most of the business transacted in real estate occurs outside of regular work hours. Since tenants, for the most part, tend to work the same hours you do, showing properties or dealing with problems tends to occur more often after five than during the day. If you work a regular job, this makes real estate investing a feasible business.
  • Not Correlated to Stocks and Bonds - Obviously, in the end all things are related (especially to the interest rates). But for the most part real estate is pretty separate from the stock market. Houses can go up in price when the market is booming and they can go up in price when the market is flat (and they can go down during both periods as well). So real estate is an attractive diversification strategy for many. Though I have yet to meet a successful land lord who didn't have a nice stock portfolio.
  • Long Term - In general real estate is a solid long term investment. When you get into real estate you typically stay in it for a while. For some people that's a major negative, but for others that's a very attractive characteristic. The money I have in real estate right now will be in real estate for some time, out of my reach. Even if I wanted it desperately it'd be weeks or months before I could get anything into my checking account. It's safe from any emotional decisions I could make (like letting my fiance talk me into spending some of it on our wedding).
Most (if not all) of those points should speak very strongly to you if you are considering real estate as an investment. For me personally, I tend to feel the strongest about the facts that real estate is entrepreneurial (I've learned an amazing amount about taxes and accounting since this began) and long-term.

High Stakes Poker

I've recently gotten myself into on-line poker through Poker Stars. I blame it on my brother. I've been hosting a $20 poker night every week for almost a year now, but until my brother moved in with me that was it. Watching my brother play poker on my laptop almost every evening in various cash games and tourneys... It was too tempting.

And I started thinking about how poker is like real estate investing (my analogy could probably extend to all investing, but I'll pretend it doesn't so I can feel more original). If you've ever seen Rounders you'll remember that Mike Mc'D and his gang talk about the grind. Poker is a job to them, and they've learned that you don't earn a living from the huge pots, you earn it by winning lots and lots of little pots every day.

Every investment move you make is a gamble. Even US Treasury bonds could go defunct if the Democrats rose up and overthrew the government. Obviously that's a very slight risk, which is why you receive a very small reward (5.07% on a 30-year). Whereas that hot stock you heard about in the cafe could go up 300% in two weeks, but it's more likely to crash.

Poker is the same way. Professional players know that you don't earn a living by taking $100 to a $10/$20 table. You earn a living by taking $100 to a $0.25/$0.50 table and slowly building. If you don't know what you are doing you won't lose too much, but you shouldn't be playing in cash games anyways. If you DO know what you are doing, then the reward for each hand is small, but you don't have the risk of 2-3 bad hands completely wiping you out. (Or, in no-limit games the chance of those hands wiping you out is much much smaller).

In real estate it's the same. Some people gamble big, using all their available cash to buy multiple houses for zero-down and trying to flip them. A very small percentage of them escape unscathed, much less with a profit. The smart investors know that in semi-Efficient Market (like real estate) it's best to make small bets (by putting fair amounts of money down and keeping a reasonable cash reserve) and nurture them into good cash cows.

Unfortunately another similarity between poker and real estate is that the media loves to fawn over, and glorify, the 0.01% of people who gamble big and win big, conveniently ignoring the hordes who made similar bets and lost and ignoring the fact that those "winners" would be unable to replicate their success even under threat of death (it was all just luck).

If you get into real estate investing, get into the grind. Magic profits don't appear overnight and sing happy songs 'till you fall asleep, but the success rate is immeasurably higher. You WILL cash out, just not tomorrow.

And if you happen to be playing on Poker Stars, you may just run into me on the $.10/$.25 no-limit Hold'em tables. I'll be the guy not losing big.