A theory on the history of schools

In my last post I discussed why I believe that the school system is doing nothing to elevate the poor. Essentially I argued that the school system teaches people a great deal of non-essential skills at the expense of true life-skills.

No matter how brilliant Emily Bronte is, the fact is that I will rarely (if ever) benefit from my knowledge of Wuthering Heights. In fact, it nearly damaged me since I, an extremely avid reader, hated that book with a passion and have since regarded all "classics" with a wary eye. In the same note, while it's nice to know how molecules combine, my knowledge of chemistry probably isn't going to have much application in my life. Meanwhile crucial life-skills, such as budgeting, stocks, mortgages and the cost of interest, were either ignored or just lightly mentioned.

Now I'm not against teaching chemistry to our children, for some it ignites an interest that will lead them to a great career. But teaching such things at the expense of critical skills seems counter productive to me.

So how did our educational system come to be this way? I have a general theory, though I warn you that it's largely uncorroborated. Perhaps some people can correct or confirm certain elements of this story.

Let's go back first to a time before schools. During that age long past humanity consisted of mostly farmers and hunters. Children were raised and passed on skills from their elders. If you were a farmer, you learned to farm from your father or some other mentor figure. There were no schools, no tuition, no professional teachers. There are also no rich and no poor. Some may have more than others, but there is no effective way to translate a rich harvest into captial. You will simply eat well that season.

Fast forward a few hundred years and you will begin to see people coalescing into communities, and beginning to specialize. As this happens education continues, mostly the same. If your father is a blacksmith, you will most likely become a blacksmith. The only way to escape such a fate is to apprentice yourself to a man of another profession. However, as civilization develops, so does the concept of wealth. Some men are more successful than others and begin to build their riches.

Step forward again. Civilization is bustling. Classism exists. Those who succeed become very wealthy, those who do not become poor. Science and literacy exist, but are known by few. This is the time from which education pulls it's roots. A wealthy merchant hires a wise man to teach his son reading, writing and philosophy. He doesn't need the man to teach his son about business, he can do that on his own. He knows the fundamentals of business and wealth, and he will pass them on to his child. The teacher is hired to teach that which the wealthy merchant can not. Things like Geometry, Literature, and Physics are the subjects at hand.

Let's stop for a second and see what we've just witnessed. The formation of professional education. A teacher was hired (perhaps for the first time ever, making him the first professional teacher), but not to instill basic life lessons. Those lessons would be passed down from father to son, in the same manner as generations before had. Instead the teacher was brought in to teach "higher" lessons. The father had no need of those lessons to achieve his wealth, yet he wanted them taught to the son.

Step forward in time yet again and we will see the first schools established (in the times of the Greeks and Persians). These schools don't teach their students to be good businessmen, or how to build wealth. Their trades will be taught to them either by their fathers, or through an apprenticeship. Instead these students are taught more classic lessons. History, advanced mathematics, literacy, philosophy. These lessons are useful to their students, but they are still expected to learn their trade skills and the life lessons outside of the educational system.

Fast forward to today. College have replace apprenticeships as the prefered method to acquire tradeskills. High schools (and below) continue to teach many of the same subjects as the early schools. But only a small percentage of student will ever benefit from any individual lesson taught. Few who study chemistry will end up in a profession that utilizes that knowledge. Few who study Shakespeare find need of that knowledge later in life. But students are still expected to learn their life lessons elsewhere, under a different instructor.

These life lessons, not your geometry lessons, are what lead you to wealth and financial comfort. Schools may open your mind, and these days college may lead you to a larger income. But the lessons that differentiate the rich from the poor are simply not taught in our educational system.

I am a huge fan of education, and my degree has provided me with a fulfilling and comfortable career. While the education system may not lead you to wealth, I argue that wealth is a hundred times more difficult to achieve without education, especially in today's world. But understand that a good "education" can only take you so far. If you want to build wealth and financial stability, you need to learn the life-lessons that parents are expected to hand down.

• Save
• Live below your means
• Control your risks
• Make wise investments

Within each is a thousand lessons covering mortgages, compounding interest, the stock market and every other subject. The good news is that tools like the internet have made it possible to share information in ways not even dreamt about as few as 30 years ago. If my parents wanted to invest in a municipal bond arbitrage when they were my age, they would have been out of luck. I, however, can simply look it on on a site like Wikipedia.

As far as wealth is concerned, you are ultimately responsible for your own education.

Does the education system produce poor people?

People love to talk about how the rich stay rich and the poor stay poor, and usually the conversation tends to stray in the direction of "tax loopholes" and "the poor being exploited". I'd like to take a second and break into one of my favorite rants on what I think the cause is behind the widening gap between the wealthy and not-so.

I think the cause of that gap is the fault of our educational system.

First I need to convince you that wealth isn't the result of a high salary, but rather it's the result how how you handle your salary. The Millionaire Next Door uses the example of the doctor who earns well into the 6-digits, but is deep in debt due to the vacation home and the boat, contrasted with the white-collar Joe who lives below his means and has saved and invested aggressively. Who is wealthier? The doctor who owns lots of nice things, but has to work every day to make his next payment? Or white collar Joe who has a very large investment pool that will help him stay comfortable for the rest of his life? How many pro-athletes earned millions of dollars, but blew it all on big houses and bling, only to be left with nearly nothing by the time they hit age 50?

So why is this the education system's fault?

As Americans we love to point to our school system as a very fine one. We provide free education to all children up to a high school level. Our children who graduate end up getting some nice jobs in a variety of fields. These children are obvious successes, right?

When I went to high school I was required to take classes in American history, physics, trigonometry, chemistry and literature. All in all I was required to take 28 classes. Not one of those classes was on finance. When I graduated I knew how to calculate the speed of a falling baseball at give point of time, but I didn't know how to amortize a home loan.

The skills I learned in school have helped me tremendously throughout my life. The experiences I had with raw science and literature have definitely shaped me, and in a positive way. The foundations I built have helped me to find a relatively high paying job. But that doesn't necessarily make me any richer.

The problem with the education system is that we teach a lot of fantastic skills, but we don't teach people fundamental life skills. Children are taught skills that can help them earn more money, but rarely are they taught how to handle that money. The reason is that we expect those "life lessons" to be taught by our parents and our peers. We don't need the state to teach you how to manage your money or how to build successful relationships, because that the parent's job.

Where that breaks down is when you find a child with poor role-models. What do you expect a father who blows all of his money on lottery tickets and booze to teach his children about fiscal responsibility? Why are we surprised when the daughter of a beaten and divorced single mom constantly gets into bad relationships? Look at who they learned from. And can we really blame the parents when they themselves never learned any better?

The reason the poor stay poor is because their parents teach them all the wrong financial lessons. A child from this situation will probably never learn about the very basic 401ks or mutual funds, and he will learn to spend what they have instead of saving for tomorrow. Thus the poor begat poor.

The rich will do the very opposite. A child of upper-class parents will be more likely to learn about saving money, paying mortgages and preparing for retirement. When he gets his first real job, his parents will probably tell him to put money into a 401k, and teach him about it. They'll ask him about how much he is saving. They'll encourage him to save up for a house. Even if the child is irresponsible and spends money recklessly, these lessons will be taught. Thus the rich begat the rich.

So is this really the fault of the educational system? It depends on your view of the role of the government. If you feel that the government is the great equalizer, then you should be furious and up in arms wanting change in the system. You should be writing your representatives and demanding that they make basic financial literacy courses mandatory in every high school in America. Every student should be learning about what a 25.99% interest rate on your credit card really means even if your minimum payment is only $100 a month.

So why doesn't the system change? Because the rich realize that the current system gives their children an advantage in the world. And what parents doesn't want their children to have every advantage they can find? And the poor, who should care about this, don't realize it's happening.

Next I want to examine my theory of how the education system came to be this way (which is a largely unproven theory, maybe some of you can help me back it up or prove it wrong).

Property Managers - a new look

In the past I think I've made my views on property management companies pretty clear. I don't like them. I think that they destroy your profits and can often turn a good property into a dump. But to clarify, I'm speaking about companies who manage multiple properties, not individuals that you hire.

The Landlord Blog has a great post about how she is looking for a new property manager. Instead of finding an advertised company, she advertises in the local paper for an enterprising individual. This is the perfect way to have a property managed if you are unwilling/unable to manage the place yourself. By looking outside of professionals, you get the benefit of dealing with someone more likely to remain honest.

John T. Reed agrees. In his review of Rich Dad, Poor Dad he says (italics are mine):

Kiyosaki [author of Rich Dad, Poor Dad] says, “A great property manager is key to success in real estate.” He’s nuts. Experienced property owners do not hire independent 5%-of-the-gross property-management companies. When syndication was big, those companies owned income properties all over the U.S. They tried to use local companies for everything they needed, but they found they could not get good service out of local property-management companies so they all started their own in-house property-management companies. [...]

The problem with property-management companies is that they neglect properties and use expensive suppliers and subcontractors. I estimate that approximately 90% to 95% of property managers take kickbacks from those expensive suppliers. When I was a property manager I reported a number of bribe attempts to my boss. Both my predecessor and my successor at the job took kickbacks. (A subcontractor showed me a canceled check cashed by my predecessor and my successor was fired for taking kickbacks.) My secretary had worked for a major property-management company before working for me. She said every property manager in her old company took kickbacks.

If you ask the typical successful investor if he ever used a property manager, he will shudder at the memory, admit that he did once, and somberly swear, “Never again.”

Anesia at The Landlord Blog is, in essence if not fact, finding independant contractors to manage her properties. She is creating her own in-house management team. This provides a large number of specific benefits.

• Reliance upon her - Unlike a Property Management Group, her managers probably only manage the properties she assigns them. If she is displeased with their performance, she can replace them. Compare that to a company who likely manages properties for dozens of investors. If you break contract with them they still have plenty of other streams of revenue to fall back on.
• Lack of a network - Because these individuals are likely to only be managing her properties, they most likely don't have a network of contractors that they frequently use. As a result, they're less likely to take kickbacks or order unnessecary work.
• Work on her terms - If you go to a major Property Management Firm and bring your own contract with you, you'll be laughed out of the door. These firms have their own contracts they you have to sign, not the other way around. But when Anesia hires these individuals she can draw up the contracts that they'll work under. Obviously both side need to come to agreement, but that gives you a lot more leverage than the standard PM boilerplate.

Obviously the down side of such an arrangement is that she'll have to be much more active in helping these people manage her properties, in addition to the extra workload of hiring new personnel when one of her managers is fired/quits. But that additional work is worth the risk reduction of having more control over how your properties are handled.

If you choose a professional Property Management Group because you were too lazy to manage your properties, I seriously suggest that you consider other forms of investment (try an S&P 500 index fund. Good returns with minimal effort). But if you want your properties to be managed to free up some time for other activites (like finding new properties), I strongly urge you to review Anesia's methodology and try it for yourself. It'll be far more profitable in the long run.

And if you are in the Phoenix area and are looking for a way into real estate, I suggest you apply to her for the job. Not only can you earn money towards that first down-payment, but you will learn a tremendous amount about real estate and will have regular access to an experienced investor.

Properties in the UK

I'm currently engaged to be married in December. Shortly after, my new spouse and I intend to move to London. Now this is possible due to my partnership, my partner will continue to manage the properties and I will continue to do all of the accounting and tax work. One of the absolute joys of having a responsible partner.

But on the other hand, I'm beginning to realize that with all of the information out there for real estate investors, nearly 100% of it seems to be aimed at Americans. I have yet to come across a decent number of sites dealing with property, landlording and investing in countries such as England.

Specifically I've been looking for websites or blogs that discuss the properties laws of England, what would a first-time home buyer do in England (what are mortgages like over there?! What are their rates?), what is the market like, and what are the general laws pertaining to landlording? Is the 6% sales commission the standard for them too? All of this information is easily at hand for an American. Just go to any number of sites, from bankrate.com to yahoo.com (not to mention all the fine blogs out there) and you'll find plenty of articles dealing with every aspect of home buying and investing. But I still can't find the UK versions of these websites.

So here's my question to you, kind readers. Am I looking in all of the wrong places? Does this information on real estate in the UK exist and I just can't find it? Or is there an enormous hole that could potentially be a lucrative niche to fill?

When a resident breaks a lease...

I came across an article on apartment ratings that discussed some of the complexities of breaking a lease from the tenant's point of view. At the end of the article is a very long list of comments from people who felt they've been "wronged" by their landlords and deserve to get out of their lease. I'm not here to discuss who is right and who is wrong, since I don't know much about individual situations, but I thought I'd look at some other their comments and talk about them from the landlord's point of view.

I live in Kenosha, WI and rented a condo on Dec. 12, 2005. My lease was extended until May 2007 and I can no longer afford this condo. This situation is so messed up and the story is so long I can't even get into it. How can I break the lease early and still get my deposit back?

Always be prepared and make sure your tenants understand the lease. As I wrote in an earlier post, a lease is simply a list of rules that both you and the tenant agree to wrapped up in legalese. It doesn't have to be terribly difficult to comprehend. And, as good and ethical landlords, we should also do our best to make sure that the tenant understands the lease. Just handing it to them and asking them to sign is not due diligence. At the very least you should brush over every major point on the lease and explain their obligations.

Remind your tenants that a lease is a legal contract like a car loan or a mortgage. If you fell on hard times and couldn't make your car payments, the bank isn't going to be kind and forgiving. As a human being you can be a bit more compassionate than a corporate machine, but you are still running a business and this contract will be treated as such.

Hello. I live in Tampa Florida and I just bought a condominium [...] I can't afford to pay the rent and the mortage at the same time. I'm disabled and I live on a second floor, can i use that as an excuse to move, since that was one of the reason I bought a first floor condo.

Know your rights. There are a great many laws out there designed to protect tenants, most of these are state-based, which makes them even more difficult to research and understand. But all landlords need to keep up on what tenants are and aren't allowed to do. For example, this tenant appears to have no legal ground to exit a lease under claims of disability. She might be able to convince a judge had she become disabled after signing the lease and was unable to use the premises, but it's unlikely that her current argument would stand in court. That she bought a condo without thinking about the lease she was in is a problem that is hers to deal with.

On the other hand, every state that I know of has a law in place to allow military personnel to break a lease without penalty if they are reassigned. The Virginia law (§ 55-248.21:1) requires that they give at least 30 days written notice.

When it comes to a private owner, they don't have the same legal standing as a company in that they often cannot run a credit check on you or send you to a collection agency for amounts due. If you are one of those people who have had bad rental histories or have aweful credit, they are the best places to check into first.

You ARE a company. If anyone read this and laughed, then I can't blame you. The very act of running a business makes you a company in the government's eyes. You may not have the resources or the legal departments of a major rental corporation, but you are legally allowed to do everything they are. That includes credit checks and turning bad debts over for collection. In fact, if there is anyone out there that isn't running credit checks on tenants, you deserve tenants like these. Credit checks might be intimidating, but they are simple once you learn how to use them.

I live alone and it is difficult just getting around now, so I have to move in with some family. However, I still have 2 months left on my lease, but cannot afford to pay now. Is it a binding law or if the apartment management is willing, can they let you out of the lease?

The lease is as binding as you make it. If someone leaves, nothing will happen to them unless you pursue it. This cuts both ways. If the man above did truly fall ill and needed to move in with relatives, you might allow him to break his lease without penalty out of sheer decency. But if a jackass moves out in the dead of winter without warning, nothing will come of it unless you file a claim against them.

A word of warning, I have heard if said many times that pursuing a deadbeat tenant once they have left your property is a waste of time. I have no personal experience with this subject, but be warned that most deadbeat tenants don't have the cash lying around just waiting to be seized. Trying to extract penalties from them post-tenancy can be a long, difficult and possibly expensive process. Often the best you can do is send a collection agency after them and mar their credit history.

hi... there is a sexual predator moving 2 blocks from us and we have a younger daughter.. he is actually a first degree sexual offender meaning the girl molested was under 13 years of age. I was wondering if this allows us to be able to break our lease if we feel unsafe... which we do.

Learn to talk to your tenants. Not everything has to be a fight. In this example explain to them that registered predators are allowed to live almost where ever they want, and that the other parents in the neighborhood who own their houses have no recourse (they can't force the previous owner to buy the house back just because the predator moved in). And who's to say that a predator wouldn't move into your new neighborhood too? You can only live in fear for so long. Form a neighborhood watch and take this opportunity to sit down with your daughter and explain the dangers of people she doesn't know. Work together with your community to actively prevent bad situations from occuring.

In the lease it says that if you break the lease you have to pay equal to 3 months rent. I can not afford rent let alone 3 months of it at one time. Is there anything I can do?

Don't be a dick. Sure, as landlords we hate broken leases. Broken leases lead to all sorts of expenses for us, from advertising for new tenants to vacancies. But don't go overboard in fixing penalties for breaking a lease because sometimes life happens and your tenant gets a new job in another state. Biff and I ask for 30 days notice and then a 1-month's rent penalty. That gives us (in essence) a 60-day window to find a new tenant form the moment we know about the vacancy. I think that is a very reasonable period of time to find someone to fill the place, and very few people ever need to move on less than 30 days notice.

An added bonus of making penalties more reasonable is that the probability of the penalty being paid goes up tremendously. Let's face it, if your tenant gets a new job in Paris, he's going one way or another. If you are asking for his first-born son he's more likely to try to dodge the bill. But asking for something practical (like a penalty equal to one month's rent) means you are much more likely to get that money.

For your amusement

I think you'll really enjoy this best-of post that I came across on craigslist.

The kind of Landlord I am

1. Responsible for the weather
My building manager called to say one of the tenants wanted a discount for the days it was hot outside. Why? Because it was also hot inside. Their electricity is fine. They could run both air conditioners and fans and keep a supply of popsicles, just like I did in my apartment. My response: Will you pay extra if the weather is nice?

2. In charge of the animal kingdom
A tenant complained about mice. I sent over an exterminator several times. He stuffed steel wool in holes, baited traps, sprayed outside etc. Eventually he refused to go back because the tenant continued to leave open packages of food on the floor and counters. She insisted I was responsible for the problem. As if I commanded the mice to invade her house.

3. Menace to domesticated animals
One tenant was convinced I was poisoning her and her wooly mammoth dog with carbon monoxide. (What will I think of next?) Fire department went over there. Gas company went over there. City of Evanston sent an inspector. Everyone who tested got the same result. No discernable level. She tried to deduct $200 from her rent to pay for her vet bill. This woman also accused me of running a bicycle chop shop in the basement. And wanted me to compensate her for a parking ticket she got in front of my building.

4. Pet killer
I hired a carpenter to fix something. With the tenant’s permission, the carpenter went into the apartment. Apparently the act of opening the door scared the dog. The dog ran down a set of internal stairs, bumped his head and died six weeks later. This story was condensed to “Landlord killed my dog.” There are several neighbors who will not even say hi to me. One of whom made it his mission to make sure my landscaping is always in 100% compliance with arcane City ordinances.

5. Made of money
Tenant asked to break her lease because the price of her anti-depressants went up. No mention of the car she just purchased. Maybe she thought the hint of mental illness would scare or embarass me. She was three months into a twenty four month lease. 24 month lease she specifically asked for.

6. Heartless
Contrary to popular belief, I do not enjoy evicting single mothers at Christmas time. It takes months to evict and the landlord rarely recoups the back rent or court costs. FYI, I do not think it is more important to make your car payment. Thanks for asking.

Please pay your rent on time and remember, I am not omnipotent or an evil genius. A lease is a business arrangement.
And one more thing, why oh why wait until Sunday at 8pm to call and say your heat has been out since Friday afternoon? You call immediately if the microwave burns your popcorn.

Biff and I haven't had any incidents like the ones mentioned here... but it's only a matter of time.

The value of a home

You've probably heard it said before, "the value of a thing is equal to what ever you can convince a fool to pay for it."

It's never truer than in real estate. When you shop around for a new Xbox360, everyone is pretty much selling it for the same price. That's because the product is the exact same anywhere, so your incentive to shop around increases. In other words, it doesn't matter where you buy your Xbox360, they're all the same when you bring them home, therefore if you can find a lower price somewhere else there no reason for you to pay the higher price.

Real estate is different because no two products are exactly alike, making pricing more of a negotiation than a sale. You can't truly "value" a property, because it's worth is simply what you can convince someone else to pay for it.

There's a great post on The Landlord Blog that discusses the negotiation of a house purchase. Essentially the builder offered a "huge" reduction in price (about $75k), but when the blogger checked it against comparable sales, it was still too expensive. They made what they felt was a fair offer, and it was turned down.

So who was right? The builder or the blogger? The answer is neither. The builder obviously felt that the property could fetch a higher price than the blogger was offering, while the blogger obviously felt that the property was not a good value at that price. Only time can tell, but right now we can say that the blogger was 100% correct to walk away (good poker players know when to fold, and good investors know when to walk away from a bad deal). If the builder can find "a greater fool", then they made the right choice as well.

Brokers are NOT your friends

I came across this story today about how 7 mortgage brokers in Boston were shut down for using illegal and unethical practices:

Regulators have also gathered evidence of other abuses in the industry, including brokers discouraging homebuyers from hiring lawyers to scrutinize mortgage documents and persuading borrowers to sign blank loan applications. As a result, the division has adopted emergency, and permanent, regulations banning fraudulent practices, particularly scams that target poor consumers with limited English skills.

The funny thing is that while the target of these brokers were nailed for targeting people way over their heads, thousands of brokers are selling loans to middle class familes that really can't afford them. (Of course "can't afford them" is arguably subjective... which is why these brokers are still in business).

Whenever you are entering into any contract or sale, remember that you have no friends in business. Your mortgage broker isn't really looking for the best deal for you, he's looking for the best deal for himself that he can convince you to take. Your real estate agent isn't trying to get you the best possible price, he's trying to get the easiest commission he can. Remember that the majority of his commissions is set by the general market, not how well he sells your house. An extra $10,000 for you is only worth a couple of hundred to him. All of the moral hazards I wrote about earlier still apply.

Case in point, the shirt house Biff and I bought we purchased with $19,400 equity (10% down). We brought just over $22,000 to the closing table. The second house we went with a less typical broker and purchased with $9,995 equity (5% down) but ended up bringing (after fees and other garbage) about $18,000 to the table. I don't know how that slipped past us, we didn't buy any points, but it did and I regret it each day.

I'm not saying that everyone is out to screw you. I'm saying that there's a fair number of people out to screw you and the only way to tell the difference between them and the good people is to do your own research.

Protecting your interests in a group investment (Part 3)

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 to the series here.

Figuring out the management

Since the point of your partnership agreement is to protect you against inappropriate acts by your partners (such as taking all the money and running off to Aruba), we have to take some time to expressly define how the company is going to be run. You need to define your leadership, set boundaries on your management and make sure that any situation not covered in your plan is brought to the attention of the ownership.

Did you get all of that? If not, don't worry, we'll walk through each of them.

The difference between leadership and management is that leaders figure out the path and goals for the company, while the managers make sure that path is followed and that the goals are reached.

Your leadership is obviously going to consist of your owners, because they make the final decisions. Your managers can also be owners, or you could use a third party (such as an employee or, in real estate, a property management company).

So we defined who our leaders were when we figured out what the ownership interest were. The next step is to determine how decisions amongst the leadership will be made. Most often this is by a majority vote, but that leaves a lot of questions unanswered. Specifically you need to answer the following questions:

• Who can vote?
• How many votes does each owner get?
• Does every owner need to be included in every decision? (For example, if there are 4 owners with 25% each, and three of them decide they want to buy something, does the fourth have to be asked since the majority was already achieved?)
• Who can call a vote?
• How do you bring an issue to a vote?
• What happens if one (or more) of the owners is unavailable at the time of the vote?
• Can an owner designate a representative to cast his votes during times of absence?

That's a lot of questions to deal with, but it sets a very strong foundation for the future operation of the company. Even issues such as a simple majority vote can be negotiated. In our Subway franchise example, I own 55% of the company while Uncle Joe owns 45%. But to preserve the partnership we can reach an agreement that for a vote to pass it must receive at least 60% of the vote. That way, for now, I can't force any decisions on Uncle Joe. But if we accept other investors in the future, I'll still be in a very strong position.

Once we've defined the leadership we have to set boundaries on the management. Whether the business is being managed by an owner or by a third party, strong rules need to exist to allow the manger to deal with simple daily problems, while raising major issues to the leadership.

A simple way to achieve this is to define Ordinary Business Activities. In the Agreement between Biff and I, I defined Ordinary Business Activities as:

"the normal day-to-day business activities of the Partnership and excludes activities involving decisions that could potentially have a substantial current or future impact on the Partnership's assets, debts, income or expenses".

This list should mostly cover everything you think should be accomplished without needing a vote. Looking at our fictional Subway franchise a list of Ordinary Business Activities could include:

• Opening and closing the store
• Making and selling sandwiches and other foodstuffs (restricted to the menu)
  
• Ordering supplies (within certain limits)
• Accepting job applications
• Building maintenance
  

Actions that aren't included within Ordinary Business Activities, and thus would require a vote to execute could include:

• Hiring or firing employees
• Giving raises
• Purchasing equipment
• Menu changes
  

In addition you probably want to define certain exceptions to the OBA rules, where certain events always require a vote, such as entering a contract with an annual cost of over $1,000 (say, with a cleaning and maintenance company).

The last thing you need is to have a manager be hamstrung by overly restrictive rules that make him require a vote on every possible activity. But at the same time you don't want the manager to be making unilateral decisions that significantly impact the future of the company. In other words, you don't want the manager to be allowed to do whatever he likes.

These rules and boundaries are extremely important to record and update whether you are participating in management or not. If you are managing an aspect of the company, then this will give certain decisions to you and you alone. If other owners object to your choices, you can easily provide them with the evidence that the decision was yours to make. If you aren't involved in the management of the company, then this is a way of ensuring a level of accountability.

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 (Part 2)

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 to the series here.

What are my interests and how do I determine them?


So in our series here we've been dealing with a fictional Subway franchise start up. I'll freely admit right now that I know very little about terms and conditions relating to Subway franchises so some information I present here may be inaccurate depending on the paperwork you have to sign with Doctors Associates Inc (the owners of the Subway brand). However, in general the concepts here should pertain to most situations, especially companies that are wholly original (not beholden to any super-brand company).

So what are your interests in your new investment? Generally, if you are putting forward money to advance this business, you'll want to be paid back in one of two ways. If you loan the money to the new company you'll form a bond and want to dictate terms of interest and a repayment schedule. However that would make you a creditor, not a partner, so we'll over look that possibility for now.

The second way to be paid back is to own a portion of the company. In essence, you'll be a stock holder in a privately held company (though partnerships do not need an official issuance of certificates). How much of the company should you own? This is often the first, and most difficult, question to answer. The answer can only be found through long negotiation between all interested parties. When negotiating your share of ownership interest, here are a number of concepts that should be considered.

Capital Invested. Who is going to be fronting the money, and how much? In our hypothetical example let's pretend that Uncle Joe is starting the Subway franchise but he's asking you to front 70% of the capital. A good starting place for the ownership discussion would be starting the shares according to the monetary investment, giving us a launching point of owning 70% of the company.

Expertise. Is the company going to be relying on the expertise of any of the partners? Maybe Uncle Joe managed a successful Burger King for 15 years and has the know-how to hire the right people and run the day to day operations. In a real estate partnership maybe one of the investors is a lawyer who knows how to get property re-zoned according to the investment strategy. In both cases, the partners who bring expertise to a company have a stronger negotiating position.

Level of Effort. Are one or more of the partners going to be investing significantly more time into the company than the others? Maybe Uncle Joe intends to manage the Subway full-time, while you sit back and do very little in the day-to-day operations. This work can be compensated in two ways. He can be paid a regular salary, or he can be compensated through greater ownership. Most likely it will be a combination of the two, with him taking a lower-than-average salary to help the company through it's early times, but in return taking a slightly larger ownership interest.

Referring back to our other example, let's say that we intend to get some investment property re-zoned and one of the investors, the real estate lawyer, will be the one to do so. He expects it to take a couple of weeks to fill out and file all the paperwork. The partnership can either reward him for his effort with a larger share of the partnership, or it can offer to pay him for his work (leaving his ownership level the same). Note that if the partnership pays him he will earn money regardless of the success of the investment. Offering him a larger share will link the return on his effort to the success of his filing.

In the end though, determining the ownership shares for the individual investors lays entirely on the shoulders of the individuals. There is no simple formula that can be used, instead it's simply reliant upon the negotiation skills of those included, which is why mergers between companies can take months as professional negotiators debate every fine point.

Obviously the more important the partner is to the success of the business, the larger a share they can command. A good question you can ask yourself repeatedly during this stage is, "What are my odds of success if I found someone else to replace this partner? What would my partner's odds of success be?" Could he find someone else willing to finance the investment? Could you find someone else to replace the knowledge he provides?

In the case of Biff and I, we each brought certain advantages to the table (my accounting and financial skills and his proximity to the properties) and we agreed to split all expenses 50/50. So even though Biff had a slight advantage in our negotiations (it would probably be easier for him to find someone financially gifted, than it would be for me to find someone I trust who lives in an affordable area), he didn't push because he knew that we'd both be profiting from our joint venture. Many small group investments go the same route, splitting costs, workloads and ownership equally. But each situation is unique.

In our hypothetical example, we finally settle on giving Uncle Joe a 45% ownership share based on his 30% capital investment, his expertise in the field and his offer to take a small pay-cut until the business turns a profit for 3 consecutive months. The good news is that once we've reached this point we've already answered a large number of questions including:

1. Who is going to invest in the company?
   
2. How much does each partner contribute?
3. What is the role of each partner in the company?
4. How much of the company does each partner own?

We're now well on our way to collecting more of the information we'll need before we draft our partnership agreement.

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 (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.

[Edit]
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.