Should we give back the security deposit?

I know, I know, the title is a bit evil-sounding. but I needed to get your attention somehow, right? We are dealing with the question of refunding the security deposit, but not in the way you are thinking.

As I wrote in my last post, one of our tenants is moving out earlier than we expected. Their first year ends on June 1st, but they intend to stay until the end of June. This creates a conundrum for us on how to deal with a security deposit.

Section § 55-248.15:1 of Virginia law states that interest has to be paid on a security deposit " an annual rate equal to one percentage point below the Federal Reserve Board discount rate as of January 1 of each year." Doing some research, we discover that the discount rate (referred to as the "primary rate") was 6.25% on January 1st, 2007. On January 1st, 2006 the discount rate was 5.25%.

So that means that we have to pay 4.25% interest on their deposit for 7 months, and 5.25% interest on their deposit for 6 months. So where's the dilemma, you ask?

Virginia law happens to give us an "out" for the interest problem. " interest shall be due and payable unless the security deposit has been held by the landlord for a period exceeding 13 months after the effective date of the rental agreement...". The dilemma presents itself. If we refund their security deposit before July 1st, then we do not have to pay any interest on it. However, since they intend to stay to the end of June, this essentially means refunding the deposit before they move out.

We accepted a security deposit of $800, and doing some quick math we see that if we ended up paying interest, we'd owe them about $841.35 (depending on the day we pay them back). So the difference between our two options is just over $40 (about a month's worth of interest from our savings account).

In this situation, we've decided that holding on to the deposit until we've had a chance to check out the property is worth $40. Even though we have no expectations of finding something wrong (they've offered to steam clean the carpets for us, free-of-charge), it's the safer choice.

Even though $40 doesn't sound like much, good businessmen know that very dollar is important to us (which is why we track them all so closely). We're not stingy, and know that the money spent on air-conditioning repairs will pay itself back through happy tenants and better maintained equipment. But every dollar we spend should have a purpose, and every purpose should be carefully considered. Since this is the first time we've had to deal with this issue, it makes sense to discuss it in depth. In the future, we have precedence to build on.

When a tenant leaves...

One of my most-read posts is Breaking a Lease. So I thought it would be appropriate to mention today that one of our tenants just decided to break theirs. As with every situation, the details vary, so before we talk about how we're going to resolve the issue, let's go through the specifics. first let's discuss the contractual obligations.

1) Their original lease ends on June 1st. So they haven't even yet began the second lease.

2) They agreed verbally to a new lease, but haven't signed one yet. In April they agreed to a 1 year extension at a minor (less than 3%) rent increase. We sent them a copy of the lease to sign and return, but they hadn't done that as of yet.

3) They want to move out at the end of June. They are moving into their new place at the end of June/beginning of July.

Let's start by discussing the implications of the situation. First, we have no written contract, but there is a verbal one. The tenants agreed verbally to stay in the place another year, and as the law in Virginia states, "Rental Agreements" can be oral. Or, better put by a pamphlet provided by Arizona State University, "A verbal contract is just as binding as a written one, but its terms may be more difficult to prove."

So by that philosophy of thought, we have an oral binding agreement to lease to them for another year. So we look at the Early Termination clause within our lease:

EARLY TERMINATION. Tenant may choose to terminate the Agreement before the natural expiration of the Agreement. To exercise this option, Tenant must submit his intentions, in writing, to Landlord at least thirty (30) days before termination and must pay a penalty equal to a single monthly installment in addition to their final month’s rent. In paying this penalty, the Agreement will be terminated and the Landlord will not hold the Tenant accountable for any of the monthly installments remaining in the term of this Agreement.
The termination clause clearly states that the tenants are responsible for notifying us at least 30 days before they leave (which means that they earliest they can terminate would be June 30th), and that in addition they have to provide 1 month's penalty.

So what do we do?

There are a couple of options here. The first is that we could simply agree with them to nullify the oral agreement, and they could complete their lease on June 1st and we could look for new tenants. But this isn't good for either party. They have nowhere to stay until their new place opens up, and we are on very short notice to find someone new.

Secondly we could just enforce the new oral lease. They would be responsible for giving us a month's penalty in addition to paying for June. Personally I think our early termination clause is fair (only a single month's worth of penalty and 30 days notice), and it's the simplest answer. Of course, if they dispute it then we have to defend an oral contract.

Lastly we can compromise on an agreement that both parties are willing to sign.

The agreement that Biff came up with was that they pay for June, and then pay for July when they leave. In return we begin advertising the property immediately and try to gain a tenant. If we secure a tenant before July ends, we will refund them a pro-rated portion of their penalty. For example, if we have a new tenant move in in mid-July, then our current family will receive back 50% of their penalty.

The benefit of this agreement is that both parties are satisfied and will leave happy. We only lose income if we can't find a tenant in the next two months), and they retain a fair chance at keeping a majority of their penalty.

(As we speak the rental sign has been placed in the front yard of the property and Biff has placed an internet ad on the website that has been the most successful for us thus far. We'll work hard to return a majority of that penalty back to our former tenants.)

As far as I can see, Biff and I are left with only one downside. It's widely acknowledged that summer is the best time to locate tenants (due to people moving while children are not in school, college graduates moving, etc.). And while I don't have any statistics that prove that assumption, I do believe it. So this agreement pushes our "locate new tenants" time to late and later in the summer.

However, by both parties compromising on their terms to find a middle ground, we've actually created the oft-mentioned, rarely achieved win/win deal.

-In case you were curious, our tenants decided to move out because they, as military, were offered on-base housing more than a year earlier than expected. In addition they just found out that they are pregnant and will be needing some more space. They've been outstanding tenants for us, and we wish them the best with both their new home and the new addition to their family.

Can we make a deal?

A short while ago, I wrote a post that got a lot more response than I was expecting (what I was expecting was.... well.... none, really). The post analyzed a deal that I found on craigslist and while it was obviously a bad deal from the start, the real point of the post was to walk through a bunch of basic steps that you should go through whenever evaluating a property.

Today we'll look at a condo for sale in Silver Spring, Maryland. We'll run this property through the ringers and try to understand what we can before even contacting the agent.

219000 900 sq ft 2 bed 1 Bath Condo with W/D in unit! Conveient Location!

Great location!900 sq ft 2 bed 1 bath condo.. Close to Metro and major highways. Bus stop at entrance. Closing help available. Seller will provide $500 credit for new dishwasher. Washer/Dryer in Unit!!! Not many units have this. Marble floors in Living room. Hardwood floors in bedrooms. Tenant needs to be notified prior to showing. Low Condo fee $369(compared to other units in bldg)includes all utilities.
As I mentioned last time, one of the first things I like to do when researching a property is look at it in Google Maps. As we can see here, the property is only a mile or so away from 495, which is The Beltway around Washington DC. The proximity is definitely a draw, though I wouldn't want to live that close.

In addition we're only about 8 miles away from downtown DC, which can be another significant plus. However the nearest metro station is about 2.5 miles away. Short, but not short enough to walk. So far the property looks to be in a relatively decent location, infrastructure-wise.

Let's start looking at some numbers. The seller is asking for $219,000 for this house. I'll assume for the moment that we intend to place 10% down on any property that we are going to invest in (since 100% financing rarely leads to an positive cashflow). So we need to finance $197,100 on this property.

Comparing a few mortgage rates, it looks like one of the better 30 year rates we could get for a non-owner-occupied loan would probably be around 6.25%. Using a mortgage calculator, we can see that we'd be paying about $1,213.58 a month in principle and interest.

To that we can add what we know as a fact, the condo fees, currently set at $369 a month. Giving us a running total so far of $1,582.58 to float this property.

On top of that we'll throw in a low estimate of about $50 a month to insure the property. You may be paying less on your personal home, but bear in mind that not only is this an investment property, but you also need an umbrella policy to help cover any liability issues you could have. So our running total is up to $1,632.58 to float the property.

We also have to worry about property taxes. With a little detective work (some playing around with Google Maps and then googling "Condo Piney Branch rd Maryland" I discover that the actual address of our condo is 8830 Piney Branch Road. I then go to the Montgomery County government's website (the county that the condo is located in) where I can look up our property taxes.

Using this website I can see the owners of all of the units, what their units were appraised for by the county (usually lower than sale prices), whether or not it's a primary residence, and finally how much their property taxes were. Since all of this information is part of the public record, looking this data up is not illegal nor unethical.

Taking a random sample of records, I can see that, on average, units in the building were assessed by the government for around $100,000 to $110,000. We haven't even looked at comps yet, but this is ringing the alarm bells. In my experience the government typically undershoots their assessments by 20-30%. To see an asking price that is at least double the governments assessment probably means that these sellers are looking to make some serious cash on the sale.

Looking back through past tax assessments we can see that Montgomery County reassesses for tax purposes every year. So that rules out the possibility of an old and out-dated assessment.

Ignoring that for the moment, I can see that the average property tax for a unit in this building ran about $700 a year. Which comes to around $58 a month. Which brings our running total to $1,690.58. Or around $1,700.

So those are our carrying costs. Looking at our friend rent-o-meter, we see that the median rent in our area was about $1,300. So even if your unit was a lot nicer than most units, you probably couldn't rely on getting more than $1400-$1500 a month for the place. In fact, the exact same unit in the building is currently being offered by another owner for $1375 a month. So we're looking at carrying around $200-$400 a month in costs.

Taking a quick look around the web at some other properties for sale in the same building, we find a 3-bedroom unit with more than 50% more square footage on sale for $229,000 (unit 212, which assessed in 2006 for $108,000), another 3-bed with the same footage also for $229,000 (unit 201), a 1-bed with 825 square feet for $189,000, another 3-bed for $249,900 (who is probably unaware of his $20,000 asking premium over his neighbors), and a smaller 3-bed asking for an astronomical $253,900 (with only 1300 square feet, this seller's Realtor is napping on the job to let them ask that price).

So bottom line. Is this a good investment? Well, there's a lot of work left to be done before making that determination. If I were investing in this area, I'd already have my model of the school systems and other amenities in place, so that could give me a more accurate picture. But on the surface, I might not bother to pursue this one further.

One of the flashing red lights is the number of units from the building currently on sale. Another is the fact that there is direct competition for renting the same unit-type within the same building. As I've written before, often the only difference between your condo and someone else's is the view. Add to that that you are considering a significantly negative cashflow until rental prices climb at least 25% and we're probably looking at a no deal.

Not that that is surprising. The MLS, Realtors and newspaper ads seem to be a fairly weak place to find good cashflow deals. More often these deals can be better found by word-of-mouth. But again, the point of these posts is more to discuss the tools you have at your disposal, than to actually find a deal to invest in (to be honest, I'm not even bothering to "research" in the area I buy in, so even if I found a great bargain, I wouldn't be taking it. Real estate is local, and buying out of your target area is a quick recipe for disaster).

4 lies that the Gurus will tell you

As I've ranted before, many Guru's are evil people simply interested in parting fools from their money. Most of these charlatans operate in the real estate investing world, but you can find them all over, from internet "work from home" gigs to day-trading seminars. John T. Reed has put together a great list that you should use to help detect whether or not a guy is offering you a empty dream or some solid education.

But the bottom line remains - Always ask yourself, if these gurus can teach you, a novice, to make millions in real estate, why are they teaching instead of making millions upon millions themselves? If it's because they are good-hearted and want to help people, then why are they charging $5,000-$30,000 for their classes?

They are taking advantage of the old-adage "when everyone is digging for gold, sell shovels". But in their case they are trying to convince people to that there's gold in the area first, and then selling them an over-priced "special gold-finding shovel, but stay quiet because it's a secret the miners don't want you to know about!"

Despite all of this, there are still plenty of people out there that fall for their schemes every year. Here's 4 of the common lies that they tell, why they tell it, and why those lies work, and what the real truth behind them is.

Lie #1 - At a job, you work hard to make your boss rich!

Why they tell it - These gurus aren't selling you a TV, they are trying to sell you a lifestyle. In order to pitch you on a new lifestyle, they need to make you resent/regret your current one.

Why it works - Let's face it, most people buck against authority. When you are a teen you rebel against your parents/teachers, and when you are an adult you tend to be at least slightly rebellious against your boss. Most people harbor some resentment for their boss, for reason ranging from their last raise (or lack of one) to some decision the boss made that you didn't approve of.

The truth - You aren't working to make someone else rich. You are working because you agreed to do a job for someone for a certain fee. When a plumber fixes the pipes in a house, he doesn't care what the house sells for afterwards. And if it sells for a large sum of money, does he resent the owner for not giving him a share of that? No, he was paid a set rate to accomplish a task and that's what he did.

If you are unhappy with your rate (i.e. your salary), then look for a job elsewhere. If that's not possible, blame your skill set, not your boss. Harboring resentment for other people due to their successes is petty and pointless.

Lie #2 - Financial security is a myth

Financial Security is a false concept that developed in American society based on the idea that security comes from the perceived reliability of a regular or planned paycheck. Many people, believing in the commitment of their corporations to their well-being, have found themselves downsized, layed-off, outsourced, transferred, or, in some cases, even fired. The immediate reality becomes harshly apparent and sadly disappointing.
Why they tell it - Scare tactics go back a long time. Our current conception of hell as a place of torture and flames comes from the Middle Ages when such vivid descriptions (which led to Dante's Inferno) were used into scaring the populace into embracing their religious beliefs.

Why it works - People worry. Most of the time, you don't need help figuring out what to worry about. By playing on a basic insecurity (can I support my family?) they hit you where you are vulnerable.

The truth - Yes, people get laid off all the time. People also get hired all the time. Your well-being is in your hands, not that of your employers. And the way you take care of yourself is to save money and invest for the long-term (whether that money is earned from a job or self-employment is irrelevant).

Ask any of your friends who are self-employed. Even when you own the company, you still have risks. Clients cancelling orders, deals falling through and unexpected business costs (a new roof, anyone?) can all hurt your bottom line and give you lean months. You can't get fired when you are self-employed, but when you have a boss you aren't responsible for paying all of the business bills.

Lie #3 - Mutual Funds are a Suckers Game

Why they tell it - Most of these gurus are selling an investment strategy to you (real estate, day-trading, etc.) They need to convince you that other investment strategies are horrible ideas, so that you will embrace their ideas.

Why it works - Compounding is a powerful tool. But the sad truth is that it often takes a long time to really get going, and we as humans have a strong need to see results right now! While a 10% return is great, someone who only has $5,000 invested probably doesn't feel like $45 a month is amazing.

The truth - While you should avoid high-fee mutual funds, in general stocks are the best low-maintenance investment you can make. I'm a firm believer in the power of real estate, but at least half of my net-worth is on the stock market right now. There are up-years and down-years, but historically the returns of a S&P500 index fund have been phenomenal. Anyone who tells you that major stocks are a bad place to invest a significant portion of your portfolio is simply trying to sell you something.

Lie #4 - You have to fail to succeed

Why they tell it - This lie is told to cover their asses. When their students fail to make money using their techniques, they can always point the finger back at you and say "Failing is the first step, now apply what you learned and go make some money!"

Why it works - Failure as a lesson is something that everyone has drilled into their heads as a child. It's a lie that parents tell their children to make them feel better when they don't succeed at something.

The truth - Experience is the real teacher, whether that experience was good or bad. People who don't learn from their success in life tend to not learn much from their failures either. We don't have to fail in order to learn, we simply have to try. And while minor failures along the way are only to be expected, major failures are simply the result of bad education, bad decisions, and a lack of foresight.

If you fail at real estate investing, it simply shows you how extremely un-prepared for investing you are. Such failure should lead you to your local community college to take some business classes, real estate classes or basic finance courses. Screwing up a $300,000 house does not qualify you for going out and buying 3 more houses.

How much time does real estate investing take?

I do enjoy swimming through the blogosphere from time to time like an amoebic creature coasting to the soft ambient sounds in flOw... One of the blogs that I enjoy reading is called The Simple Dollar, and he had a curious post written the other day. It was about some search phrases that people had typed into "the Google oracle" which had led them to his blog. One caught my eye in particular:

How can i build passive income?
Passive income (money that comes in with little or no maintenance effort from yourself) requires extensive capital up front in the form of money, intellectual property, or effort. Sources of passive income include fully-managed properties, web sites, and so on. So how can you build it? You need to invest something of your own into it, whether it be money or ideas or work. Buy a managed property. Start a blog. Write a book. Record some music. Then sell what you’ve got. Over the long haul, money will trickle into your coffers once you’ve put forth that initial capital.
This brings up a familiar phrase to all who have either invested, or thought about investing, in real estate. "Passive Income". How passive is real estate income really? To answer that question, I went back through my e-mails, my records and recollections to try to understand how time-intensive my investing has been. The answer probably will not surprise you, but it's still straight from the horse's mouth.

Real estate investing can really be broken up into 5 phases. Each phase has it's own unique demand on your skills and your time. Not every investor comes across every phase, but your entire real estate experience will probably fall into one of these phases at any time.
  1. Analyzing, purchasing and/or selling property
  2. Property renovation
  3. Finding and preparing for new tenants
  4. Tenant care
  5. Taxes
Now Biff and I don't have experience in all of these areas, but I thought I'd expand upon the areas that we do know about and give you a general idea of the time commitment.

Phase 1: Analyzing, purchasing and/or selling property - 25-100+ hours

Figures that we start with the least definable category. This category could vastly differ from investor to investor, so let's break it down into parts.

Analyzing property is very different for every investor. Your investment strategy could be as simply as noticing that the house next door is going up for sale and making an offer (yes, that counts as investing too). Other investor could scrutinize the MLS every day looking for new deals. Everyone is different and everyone will spend different amounts of time looking for good opportunities.

Purchasing property can also vary from investor to investor, but there are some concrete steps that you have to go through. You need to line up a lender and you need to find insurance. Biff and I always compare at least three lenders, and expect to put in about 20-30 hours on the phones looking at our options. That's partially because we also compare the costs of larger 90% loans to 80/10s or 80/15s. Once we've locked in our lender, it usually takes about 10 hours between the two of us to get out paperwork lined up and submitted(about 5 hours each). Insurance took us about 10 hours of phone work to make our initial comparisons, but now we stick with the same provider (so we spend less than an hour getting it set up for new properties). You also need to deal with the offer paperwork, and negotiating the deal, which can take anywhere from 5 to 15 hours. Finally you have to close on the house, which usually takes about 3 hours, and do a final walk through which can take another 1 hour.

Also, the first time you buy an investment home, there is more overhead to consider. You need to write up a lease, set up bank accounts, figure out how to run a credit report. All in all, that overhead can add another 15 hours to your budget. But once it's taken care of, usually you can just reuse that work in the future (you may adjust your lease, but it's unlikely that you'll re-write it).

Selling properties is something that Biff and I haven't yet experienced, so I don't want to comment on it too much. But your time cost will vary greatly if you decide to sell the property yourself rather than use an agent.

Phase 2: Property Renovation - At least 20 hours a month

This is an area that Biff and I have never experienced, so again I don't want to get too deeply involved. But as one of my co-workers is currently renovating a house in London I thought I'd make a couple of observations.

There are two ways of renovating a home. If you are renovating it yourself, expect it to soak up at least 40-50 hours a week of your time. It's a long hard process that will be quite draining. If you don't make it your full-time occupation, you'll probably find your renovations dragging on for months. However, as you see on TV, many professional investors are well-trained and equipped to deal with renovation and do almost all the work themselves. It is their full-time job.

If you instead opt to pay other people to do the work, still expect to spend at least 20 hours a month working on the home. Though the contractors are doing the labor, you will be working on the budget, handling any crises that occur and making every decision (from the type of tile you want to the location of the walls).

Renovating homes is a very time consuming process, and certainly belongs more in the realm of full-time investing than "passive" investing.

Phase 3: Finding and preparing for new tenants - 15-35 hours a month

If you intend to manage your property (for the love of all that is good in this world, please don't use a property management firm), then you are going to have to find tenants for your properties. When ever you buy a new property or lose a current tenant, your search for a new one will include:
  • Advertising the opening
  • Dealing with phone calls and e-mail inquiries
  • Showing the property
  • Reading applications
  • Running credit reports
All in all, so far in our experiences, Biff and I have typically spent about 3 weeks or so per opening, and each time we've invested about 15-20 hours advertising and choosing a tenant. Unfortunately we haven't figured out how to trim this time down yet, because what works this time, might not a year from now. While a specific website gave us 95% of our applicants for our first opening, the same website didn't get us any attention when we advertised our second opening (instead we found that a sign planted in the yard generated a lot of calls). Every time you have to figure out what is working and focus your attention on it.

*Note that we don't spend 15-20 hours every month on our tenant search, we just spend approximately that much time when we have an opening. And since the same tenant can stay renew their lease multiple times, these 25 hours spent in one month could end up amortizing over years.

In addition you need to clean up the house between tenants. This usually includes painting, windexing, vacuuming and scrubbing most every surface in the house. Biff and I usually make a day out of this, for a time cost between the two of us of about 20 hours. The time, of course, varies depending on how large the unit is (a studio apartment or a single fmaily home?) and the amount of work needed to be done.

One semi-creative solution is to find a workforce of friends and/or kids who can help you paint and clean. Just offer them an age-appropriate combination of pizza, beer and soda as their reward.

Phase 4: Tenant Care - About 5-8 hours a month*

This is why real estate is considered "passive income". Note that the time commitment above is entirely based on Biff and I's experience and your mileage may vary.

On an average month I typically spend a couple of hours on the Internet, making sure that rent was deposited and the mortgage was paid on time, and updating our books. Biff, on average, will spend a couple of hours fielding calls from tenants and answering questions. Note that this is an average. Some months may pass where he gets no calls, and others come where he spends several hours getting a repairman to come and fix the air-conditioning.

*Still, at any time a major crisis could occur and we'd probably be on the phones all day trying to fix it. That hasn't happened yet and most likely won't happen often. But eventually it's likely that we will have to deal with a significant problem.

Phase 5: Taxes - About 30 hours a year

I'll admit, your taxes might be a lot easier than mine. Since I do taxes for both myself, my wife and Biff (our real estate gains and losses have to be split between the two of us), my taxes can often take a very long time. If I owned the properties just by myself, then I would likely be able to finish them far more quickly, probably in just 5 hours or so.

Also note that my taxes get done relatively quickly for one reason. My books. I keep very precise books all year long, detailing every business expense, when it occurred, how it was paid for, and even logging all my mileage. When tax time comes around it's a simple matter of opening my spread sheet and totaling the columns. If you don't keep very careful track of your records, you may find taxes taking you a ridiculous amount of time.

So there you have it. Real estate requires constant availability (if something goes wrong, you have to be prepared to respond), but it doesn't always require a great deal of attention. However, if you are after some truly passive income, I strongly suggest investing in stocks. That requires nearly no time investment at all (other than getting a basic education of how to invest), and is truly passive.

Real estate, as I've said before, is a business and requires the time and commitment of all small businesses (though on a slightly smaller scale). If being a business owner excites you, as does keeping corporate books, then this is probably the right type of vehicle to put your money in.

Buy High, Sell Low

Here's a simple fact the most investors probably know but it bears repeating once in a while. To a cashflow investor, high interest rates offer a buying advantage and lower interest rates offer a selling advantage.

This bit of old wisdom, of course, based on the assumption that people tend to pay the same amount for housing, regardless of external factors. If I can afford $2,000 a month for housing, then I can afford $2,000 a month whether that means $1,000 in interest or $500 in interest. Bear in mind this quick example:

John can afford to pay $2,000 a month on his mortgage (any more would be squeezing it a bit tight). If interest rates are at 5% on a 30-year fixed, then he can afford a home worth about $400,000 (assuming a 10% downpayment). If interest rates climb to 8%, he can barely afford a $300,000 home (assuming again a 10% downpayment).

Why does this matter? Because John is your competition. He's the guy out there placing bids on homes and driving the market. What he can do affect what you can do. When interest rates drop, he can afford higher prices and drive the market up.

I haven't seen any empirical evidence that proves that interest rates doesn't impact the percentage of salary the people spend on housing, but the theory in general makes sense. And there isn't any argument that when interest rates climb, it stresses the real estate market because the average person's ability to afford houses falls.

So why are high interest rates so good for you? Because as a buy-and-hold investor, you're not always concerned about the next year or two, but in the next 15. If you buy when interest rates are high you'll probably pay a lower price than you would otherwise (because it will be harder for people to bid the price up). Then, when prices fall again, you can pay to re-finance and the house then becomes tremendously more profitable.

In comparison, low interest rates are the best time to buy, because then people can afford to drive the price of your home up. With lower interest rates they can afford bigger mortgages.

Still, this isn't a very active strategy, since interest rates move at a relatively slow pace and no one can truly predict where they are headed. But it's something to ponder.

A Recap

If this is your first time to my site, here's a quick guide to some of my more interesting articles:

The Danger of Overextending Yourself: If you are getting into real estate investing, you have to read this. You must invest slowly and prepare for the occasional setback.

What Make a Bad Investment: An article that walks step-by-step through a preliminary evaluation of a property, simply by using the ad for the property and Google.

Should I Invest in a Condo? A look at why condos don't make good investments for real estate investors.

Breaking Down a Lease: A look at what a lease is made of, and what you should make sure you include in yours.

Anatomy of a Credit Report: What a credit report looks like and how to read one. You should ALWAYS run a credit report on your prospective tenants.

How Real Estate Investments Make Money: A simple look at how to add value to a property so that you can sell (or rent) at a profit.

Doubter's Inc.: When investing, should you form a corporation? What are the advantages and disadvantages?

And finally, my favorite, The Littlest Millionaire: How you can use your real estate investments to teach your children about money and start them on the path to their own fortunes.

Home Values: Part 4

Originally we discussed the difference between price and value. Again I emphasize that typical tools such as "comps" (comparisons of one home to similar homes that have sold in the area) are indicators of price, not value.

Then we discussed the first two major indicators I use to help understand the value of a home. These indicators, population growth and the growth of available housing, are helpful in understanding the demand of an area.

Last time I wrote about the third major factor in understanding a local economy and it's ability to sustain housing prices, income. Since housing is a necessity, like milk or gas, it tends to climb with cost of living and inflation, which (over the long-term) correspond closely with salaries.

The a commenter called me out on not understanding an area which I made assumptions about, but I've never visited. Again, remember that real estate is local, and only the locals can really understand the market. Which brings us to our final bit, dealing with a specific house.

Real estate agents will often tell you that they bring an expertise and knowledge into property that isn't matched. But the real estate profession is based more on selling feelings than numbers. Just for kicks, the next time you are buying a house and the agent mentions something like "this is a wonderful school district", ask him/her to quantify the value of the school district. For example, would this house be worth 22% less if it were in an adjacent district? Can they show numbers to prove it?

The impact of schools on a property's value is not necessarily tied into the actual quality of the school system either. Using our lovable grade system, it's easy to realize that a C+ school system that is surrounded by F-rated school systems has a much greater impact on the value of a property than an A+ school system surrounded by A's.

As a value investor (or a wannabe one) these are questions that we need to ask. After all, we don't plan on raising our kids in that property, so the only value a good school district has for us is in a premium to the sale price.

Let's say that you are interested in a house. This house is average in just about every way for the county, except that it's in the best school district in the county. The other schools in the area are relatively bad. The seller is asking for $120,000 for the home, where you've judged most homes to be valued at about $100,000.

The question becomes, is the good school district worth a 20% premium of what you think is a fair value price for the county? Let's do some more basic math.

Let's say that the average house in the county is currently asking about $110,000 (so we have, in our opinion, an over-valued market). We compare home sales in the good school district with equivalent homes sold in the not good school district (this could be over quite a period of time, it doesn't have to be in just the past few months. In fact the longer the set of data the better). Through our research we discover that the average home in the good school district has sold for about 30% more than a similar one in a worse district.

So when we throw that onto our county average, we discover that a house in that area is, by our calculations, valued at around $130,000. So even though the county itself is generally over-valued, and this house is costing more than the average home in the county, we have evidence that suggests that this home would be a good value.

Besides schools, here are some other factors that you should consider taking into account when calculating the value of a property:

  • Amount of land. Obviously more land is worth more, but how much? In a very crowded area, having twice as much land as your neighbors could make your property worth more than twice as much. But in a sparsely populated county, having 50% more land than your neighbor might only be worth a 15% premium (especially considering zoning regulations).
  • Proximity to major landmarks. Is your townhouse within walking distance of a subway station? The local high school? What about shopping or a major park? In more rural areas where you have to drive to get anywhere, this might not as significant a feature.
  • Condition of home. The obvious base case is a home that is in move-in condition. Obviously if a house needs a lot of work, the house has a lower value. Making these adjustments is best left to professionals, which is why I strongly recommend that you leave fix-n-flips to investors who've worked as carpenters, plumbers or builders of some capacity. Relying on a contractor to help you assess the value of a home is a risky proposition unless he's related to you (Biff and I prefer to stay with move-in ready homes and only adjust based on the home inspection).
  • Rental conditions in the area. What's rent like in the area right now? For a fix-n-flip this might not matter much, but for someone who buys and holds, this matters. Remember, a property that is a fantastic value for someone to buy and live in, isn't necessarily a great value for an investor.
The end goal for a value investor is that he wants to create a formula that he can input variables into and get out a single number.

To extend our earlier example, assume that the investor has done his homework. Using the first two posts he establishes what he believes to be a average home value for a county ($100,000). He finds a home within this county that he is interested in, and the asking price is $120,000.

Crunching the numbers he discovers that (all other factors being the same):
  • a home in the best school district is worth about 10% more than an average home
  • a home within 5 blocks of the subway is worth about 25% more than an average home
  • a home with about 10% less land than it's neighbors is worth about 5% less
  • the home needs a new roof, which will cost about $15,000
We assume, of course, that our fictional home is in the best school district, within 5 blocks of the subway and is on a slightly (about 10%) smaller lot than it's neighbors. Our value investor then plugs these factors into his fictional formula and sees that, according to his calculations, the home is worth about:
$100,000 (average home)
+ $10,000 (school premium)
+ $25,000 (subway premium)
- $5,000 (land premium)
- $15,000 (condition premium)
= $115,000
So what has our investor discovered? He's discovered that his formula is telling him that $120,000 is too much to pay for that house right now. Does that mean that he can't buy it? Of course not, maybe he has a hunch that he wants to play (maybe he thinks that building regulations in that area are about to tighten up considerably, which would increase the value of the property). Does this mean that if he buys the property he's going to lose money? Of course not, ask the people who bought eBay stock at 200, before it soared past 300. Just because an item is over-valued doesn't mean that it'll revert to the mean immediately.

You even have to consider the possibility that his valuation forumla is wrong or simply inadequate.

All he's really learned is that his impartial and unemotional evaluation of the house has told him that the property is over-priced (remember, he created this formula based on what factors he thought would impact homes in his area). He can take that advice or throw it away as he likes. But that's just one more crucial tool in his bag of tricks that lets him make more informed desicions than the typical home buyer.

Obviously this is a very simple formula, one that almost anyone could construct with Google and access to sale histories (if you don't have MLS access, you could even use a tool like Zillow). The more experienced the investor, the more complex his formula might become. For example, a person living in Fairfax might know since Fairfax is a home for many government-related officials, every time there's a shift in power in DC, new appointees come in and old appointees stay as higher paid lobbyists, boosting the income.

So a clever investor might feel that the results of the 2008 election will greatly increase the number of highly paid lobbyists in DC. If he then ran his numbers and Fairfax was under-valued when considering the salary boost that he anticipates, he would see the area as a great place to buy over the next year or so.

Another clever investor in Iowa might find out that an Ethanol plant will be built in his town itn he next year or so. Doing research on similar towns, he finds that such contruction has often boosted that town's median salaries by 20-30%. This might be worth putting into his formula, to see where he thinks the values of homes are going in his area.

If nothing else, simply trying to build a valuation formula can often teach you so much about an area, even if you tend to disregard the results of your calculations. More investors have been burned from having too little information, than from having too much. Give it a shot and see what you learn.

What other variables in a home are worth quantifying? (Yes, this is my shameless attempt to see who is reading these posts and actually thinking about them)

The next indicator of property value

We started by talking about the difference between price and value. Then we began our discussion about how one can go about determining value for real estate. Last time we spoke about how population can affect value, and how comparing population growth to new home building is a good tool to help figure out the demand in the area.

You've probably seen a supply and demand curve before. Just in case, here is one again:

Basic economics teaches us that demand drives up price. For example, if you have 100 collectible bobble heads and 600 people are willing to pay $10 for them, then your price is too low. Ideally you'd want to find a price for the bobble heads that exactly 100 people would be willing to pay, so you could maximize your profit.

Houses are the same way, there are fewer houses than there are people. If we theoretically assume that there are two potential buyers for every one house, then the goal is to drive up the price until exactly half of the buyers are priced out. Now this is very rough math, because homes are not a standard commodity, and each home is different and therefore valued differently. But the general concept is the same, by raising the price, you remove potential buyers until there is a smaller pool of buyers left for your home. Simple supply and demand.

Unfortunately, things are never really that simple. This model can work when looking at items that people pay cash for, like bobble heads or TVs. But when it comes to houses the question isn't what people are willing to pay, but often what the banks will allow them to pay.

Homes don't sell unless people can afford to pay for them. So when housing prices soar, they can only be met by one of three factors:

1) A lot of new money enters the market.

This happens a lot in big cities. In London, where I reside now, people are getting priced out of the market because a lot of European millionaires have been purchasing homes here.

2) Loans become easier to obtain in larger amounts.
When prices go up, people need to be able to afford the higher prices. A neighborhood that supports middle income families is unlikely to start selling homes to multi-millionaires. If banks lend out more money, then new middle income families can afford to pay more for those houses.

3) Salaries grow
The only other way that people can afford to pay higher prices for housing is if those people are now earning more money. Then again they can qualify for larger mortgages.

The second method is obviously unsustainable. As banks are figuring out now, you can't just keep lending people more money. There is a limit as to how much a family can repay. As shown by the higher foreclosure rates throughout the country, these extreme mortgages simply don't work once they've passed a certain point.

The first method is also unsustainable to a certain point. Even the wealthiest people need access to labor provided by the less wealthy. Even Orange County and Manhattan have McDonald's, janitors and cab drivers. If rich people keep moving into an area and riving the less fortunate out, a point could be reached where it's no longer feasible for the less wealthy to provide the services to the wealthy. At that point the community begins to lose value due to the lack of basic services.

Fortunately that rarely occurs because new money tends to boost the local economy, bringing us to the third point, rising salaries. This is the only independently sustainable method that supports rising housing costs. When people are earning more, they can afford to make higher payments, and thus (excluding interest rate climbs) can afford to pay more for a house.

So a key factor in figuring out the value of homes in an area is trying to discover what people can afford to pay for them. So starting with Fairfax, we are looking at one of the highest grossing counties in the nation. The median household income is $88,100. Now as a general rule, I believe that a healthy mortgage for a family is approximately 3 times the family's income. Recently that number has averaged out nationally to be far higher than that, which is part of the reason that foreclosures are climbing so rapidly. That's just for the mortgages, so when you factor in previous equity and down payment, I believe that a sustainable price for an average home is about 4 times the median household income.

So right now I'd expect an average Fairfax home to be fairly valued at around $350,000. Note that an "average" home could be a farmer house, a McMansion, a town home or even a condo, depending on the market you are researching. In this case, Fairfax, we're talking about a single family detached home, as most of the county is white collar commuters to Washington DC.

In Orange County the median household income is $61,899. So I would expect an average house in that county to be worth somewhere in the neighborhood of about $250,000. Now you may gasp at this number, because we all know Orange County due to it's high-income areas, but there are other parts that are not quite as nice. Compare the village of Anaheim Hills with it's median income of over $120,000 to the less prosperous village of Laguna Woods with a median income of closer to $30,000.

Which brings in a nice point. The narrower you can restrict you focus, the better you judgment will be. For example, I'd value a typical home in Laguna Woods at being somewhere in the neighborhood of $120,000, but it's easy to see a typical home in Anaheim Hills reaching $500,000.

Now can you find a home in Laguna Woods right now for $120,000? I honestly don't know since I've never been there, but I suspect not. The thing to remember is that we're trying to separate price from value here. When eBay stock reached heights of $400, that didn't mean it was time to plow in and buy more eBay. So this indicator tells us that if you see homes in Laguna Woods asking for $300,000 they are probably still on the high side of price.

Now this information comes, as all information does, with caveats. for example if you are buying in Florida or Phoenix, it's possible that median incomes are being driven down by retirees. Retirees who saved properly (or have nice pensions and lots of equity) can usually afford far more than 20-year-olds on the same income. The rules simply aren't the same.

Secondly, just because a home in Fairfax is priced at $500,00 doesn't means it's a poor value. Nor does seeing a house listed in Orange County for $100,000 mean you should place an offer immediately. What we've simply done is given ourselves a baseline for the area, and learned what we're expect the majority of people to be able to pay. When it comes to a specific property, that's where things get a lot more complicated.

But that will have to wait for another post. Because once again I've run out of the time and the will to continue. Until next time. Cheers.

What is the value of property?

Last post I discussed the difference between price and value. As I wrote, price is what someone will pay for a good right now, but value is a calculation of the goods underlying assets. One example of this might be an old car. You may have a car that is a piece of crap and doesn't run. Try selling that on craigslist and see what sort of offers you get. But if the right buyer comes along, he may look at your piece of crap car that doesn't run, and he may see parts that can be salvaged and sold, and therefore make you an offer on the car.

So how does one discover the value of property? I already mentioned that comps are no good, they are reflections of price, not value. And appraisals are notoriously flexible. Besides, we don't want to base our views on what other people think. If you look for "bargains" using other people's yardsticks, you'll find a crowd with the same yardsticks looking wherever you do.

For a quick disclaimer, value does have something similar to price, in that everyone has their own views. Some value investors, when looking at stocks, may think that the loan/asset ratio is the most important yardstick. Others will swear by earning growth. Some even look at employee turnover as a crucial factor. The indicators that I look at are by no means comprehensive, nor are they guarantees. But they are what I look at.

The most important thing to remember is that real estate is local. National trends and charts are great, but what's happening in Michigan doesn't necessarily have anything to do with what's going on in California. So the first measurement we need to take is of the local economy.

Layman's terms: If the local economy is going in the tank, houses in the area are probably collapsing with them. If the local economy is booming and lots of new money is coming in, houses are probably climbing in price.

One of the first measurements to take of the economy would be the population growth. Housing, of course is a market, and therefore the more people coming into the market the higher the demand is. And demand is good when we intend to be a supplier. So we want to see what the population is doing. Let's compare two locations, Orange County, CA and Fairfax, VA.

We can grab our population number from a variety of locations, including the census website, the wikipedia and even county government websites.

Here we can see that the OC is growing at about 0.5% a year lately, while Fairfax is growing at about 1.5%. But looking at longer trends, Orange county has definitely been growing at a quicker rate. Meanwhile the US has been growing at about just under 1% a year. It seems safe to say that both Fairfax and Orange are growing at faster rates than the US in general (though OC is in a bit of a slump).

The next thing to look at is the building trends in the area. Fairfax's number of people per housing unit has remained relatively steady through the years, from 2.77 in 1980 to 2.70 in 1990 back to 2.71 in 2005. This is a good indicator that the area is not over-built, and probably still has a healthy number of houses.

Orange County's numbers are quite healthy. The population has been rising faster than new housing units are built. In 1990 there were 2.89 people per housing unit. In 2000 there were 2.93 people per housing unit, and in 2005 there were 3.00 people per housing unit. This indicates a healthy growth in population without too much of a boom of building.

An important note here is that with the recent housing boom, looking up numbers from 2005 probably aren't enough. But since I have a life aside from real estate, I'll leave finding the latest numbers up to you.

So far I think e can agree the the population numbers for both Orange County and Fairfax are healthy. Next post we'll look at the next major indicator, salaries (people have to pay for those houses somehow).

Understanding Value

There are two types of investors in the stock market. Speculators (or "emotional investors") and value (or "unemotional") investors.

Now speculative investors are not necessarily bad, and a lot of traders make a lot of money in the speculation market. When you are speculative investor, you are investing based on what you think the crowd is going to do. If you see a stock going up and you think it's hype will last for a while, then a speculative investor sees that as a good time to buy. He doesn't care what he's actually buying, whether its an oil company, a dot-com or a company that sends people out to pick up your dog poo.

The key ability of a speculative investor is his ability to read a market. He must be deep enough within the market (or close enough to the market-movers) to get clear indicators of the immediate future. If he misjudges or mistimes a market swing, his entire strategy can fall apart. His goal is to create a series of short-term successes.

Value investors are of a different breed, of which Warren Buffet is probably the most famous. Value investors do not care about the timing or the swings of the market. Instead their investment method is based on calculating the underlying value of a company. This is done by a variety of methods, including figuring out the value of the equipment and property owned by the company, the company's revenues, and the growth potential.

The key ability of a value investor is figuring out the worth of the underlying asset. When he buys stock, he compares the worth of the company to the worth of the stock. If it's a good match, he buys. He doesn't care if the stock is rising or falling, but simply whether or not it's a good buy right now. He may get hammered in the short term, but does not worry about it because if his calculations are correct then the company will rebound.

How does this work in real estate? Obviously the speculators are easy to spot. These people bought because real estate was climbing, and some have cashed out and some are losing their shorts.

But value is a more difficult proposition. Most of the time when I hear people talk about a properties value, they refer to either assessments or comps (which are comparisons of a property to other similar properties that have sold recently). The problem is that assessments are notoriously all over the chart and have no real meaning. And comps are more of a study of the "price" and not "the value of the underlying asset".

Comps are valuable tools to the speculative investors. But the question is how to figure out the real value of real estate. Something that I will go into more depth on next time.

But before you get your hopes up, remember that every investment strategy is based on predicting the future. Everyone looks at their own indicators and makes their own models. Some are more successful than others, but no one is 100% correct. The goal in investing is finding strategies that you are comfortable with, and that are designed to allow a certain level of failure.

That said, next post I want to go a little into the indicators that I use to try to better determine the value of real estate. It's by no means a comprehensive formula, but helps me loosely figure out what I believe that value of a piece of property is.