If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.
Continued from Part 15: The postcards were mailed. People started driving slowly past, some of them stopping on the street to examine the property more closely. Every week or so there were calls to inspect the interior, which Emily finessed by stating “It’s a day care center. They don’t want strangers upsetting the children. Let’s make the inspection for Saturday, when it’s empty.” A few low offers dribbled in. Every time it happened, and even sometimes when it didn’t, Emily reported to Shortsy, “Another offer came in, an owner-user this time. Maybe we’ll have a bidding war.”
It didn’t take long before Shortsy reached “bargaining”. She asked to meet and talk about buying the property. Emily suggested the Starbucks where they had those Double Chocolate Chunk Brownies. She thought Shortsy might need some sugar before the meeting was over. And she once again reflected on how fortunate Shortsy was to have her as a thoughtful friend.
Shortsy agreed on Emily’s price and terms. Emily arrived at the sales figure by taking the value of the appraisal she’d ordered, rounding up to the next $50,000 and then adding 10% for contingencies. Anything close to that number would give Emily enough to retire the existing loan and have money over for another building, maybe six or seven units this time.
Like a lot of people, Shortsy didn’t really pay much attention to the price. Her main interest was the monthly payments. When she saw that she could own her property for not much more than her current lease payments, she grabbed Emily’s pen.
It was hard to get a firm estimate of how long the loan would take to approve and fund, so Emily was flexible about the length of the escrow. She and Shortsy agreed to let the escrow continue until the lender could close the loan. She was, however, adamant about Shortsy cooperating in a 1031 exchange. That permitted Emily to defer the taxes that would normally be due on the sale of her commercial SFR to Shortsy.
The chief advantage to Emily would be that she could use the money that would have otherwise gone to taxes to buy a bigger property (the “upleg”). If, for example, Emily deferred $100,000 of taxes, she could use those funds as the down payment to buy a (example) $300,000 pricier upleg.
If Emily couldn’t find a suitable upleg, then the only penalty was that she’d have to pay the taxes on the profit from her sale to Shortsy. So to Emily, a 1031 exchange was full of upside and had little downside. In her mind, if the trade happened, she’d have successfully deferred the taxes. If it did not happen, she’d only have to pay the taxes she would have had to pay, anyway.
Shortsy was introduced to Emily’s loan broker and the loan process started. A little less than two months later, Shortsy’s SBA loan was recorded and she was a property owner.
Emily was not idle during that period. She spent a lot of her free time reflecting on her financial progress, and where she wanted to be. It’s a process investors should probably do once in a while. Her hope was to develop an investment “system”.
She’d just finished the book by Scott Adams (the “Dilbert” cartoonist), How to Fail at Almost Everything and Still Win Big (available on Amazon). The first 30 pages are variations of “Why you should never trust a cartoonist for advice”, but after that she thought it got pretty good.
One of his important recommendations is to not rely on luck. Luck may or may not happen. And while you’re waiting for it, you are learning to accept failure: “Shucks. Another day with no luck. Guess I have to accept failure.” Adams recommends developing a system. A system is a plan that others have used to get to where you want to be and has a success rate of 50% or better. That excludes lotteries.
In her case, a 50% success rate would be the path taken by half or more of the big property owners. A “big property owner” was, to Emily, anybody who owned 10 units or more, but excluded anybody who inherited their buildings. That exclusion seemed reasonable to her.
Once she learned how others did it, she promised herself that she would follow their path. If she kept to the system long enough she had a reasonable expectation of success: 10 mortgage-free units.
Assuming this responsibility for herself was stressful. Emily got anxiety attacks more often then she admitted to her friends. Sometimes they were almost debilitating. This was partially because she had a multi-tasking personality: she could do several things at once, if she had a mind to. It also meant that when anxiety attacks came, they came in clusters. Since she could do several things at the same time, she got serial anxieties. She could beat one down, but as soon as she did some other one would pop up. If she beat the second one, another one would peek out of its hole somewhere else. Her multi-tasking personality meant that whenever she got anxieties, she often wound up playing whack-a-mole until she fell asleep.
Banana Pudding, who had that handful of rent-a-bedroom SFRs, was just the opposite. Banana had a focused personality. She’d get anxieties too, but since she could only do one thing at a time she got only one anxiety at a time, and it never really bothered her as much. She’d push it back down its hole, shovel some dirt on top and then stand there on the little mound until the creature died.
Emily envied people with focused personalities. They seemed to have fewer and more manageable anxiety attacks. As it was, Emily became anxious even before beginning work on her system. What if it didn’t work? What if it worked, but she did it wrong? What if she plugged wrong data into the system, or not enough data? What if she did everything right but it still failed?
The whack-a-moling began early. Emily was already anxious. As a coping mechanism, she forced herself to take the first step, to gather the data.
In her second job, on the weekends when she worked in a property manager’s office, she sometimes had business reasons to contact the company’s clients. Not every time, but more times than not, if there was time to chat Emily found she could get a client to talk about how he got started, and what he would do differently. She asked intelligent questions, and they were answered sincerely. The clients liked that she was curious. Many of them cried themselves to sleep every night, wishing their children or grandchildren would please show a little interest.
It didn’t take long. Three or four weeks into the interviews Emily had talked to more than a dozen clients and recognized that most (not all, but most) of the property owners had started small. Typically, they bought a single family home and woke up one day to find it was worth a lot more than they paid for it. They refinanced the SFR, pulling enough cash out of their equity to buy a small (2 to 4 unit) apartment building in the neighborhood.
That purchase appreciated over time, and was eventually refinanced to harvest enough equity to buy a 5 or 6 or 7 unit building. Eventually the fourplex and the six units were, in turn, refinanced and a 9-12 unit building purchased.
She understood that almost nobody could save enough money for a down payment on an apartment building. They could try, but while they were squirreling away their pennies, properties kept getting more and more expensive and the necessary down payments ratcheted upwards. The goal posts kept receding. Successful investors got the down payment from refinancing a property they already owned. Regress far enough and it almost always reduces to that first SFR they bought years ago with a 5% FHA down payment.
So one part of the secret is to buy a property and to allow that property to buy the next one, and the one after that, ad infinitum. If (as some people do) the refinance money is spent frivolously, like on food or water or chemotherapy, the accumulation of units stops cascading. But if they had the discipline to always reinvest, well, given another refinance or two and suddenly the client was buying 20+ unit buildings. Rinse and repeat enough times and at a certain point the client no longer had to work for others.
She noticed that an important element was to not sell properties. The people she talked to were buyers, not sellers. But Emily had sold her commercial SFR, so did she make a mistake? She didn’t think so. She had a good reason to sell the SFR, or at last she thought she did. It was due to income risk. If, for whatever reason, Shortsy didn’t / couldn’t make the lease payments Emily would have an effective vacancy rate (on that property) of 100%.
A little more thought made her realize that the insight could be generalized. It wasn’t enough to have a portfolio whose combined total net incomes would service their combined mortgages. An example might be a portfolio with seven strong cash flow buildings and three that were money sinks. The seven fat buildings could support the three lean buildings, but the portfolio risk was great. If something reduced the cash flow from even one of the profitable buildings, all her financial assets might be put at risk.
Emily saw buildings as other people saw employees. She realized that every investment she owned had to pay its own way. She would work with a troubled building to increase its profitability, but if the resistance was too great she sold it without remorse. Sometimes you just had to cull the herd. Portfolio risk could be managed by only keeping successful buildings.
Besides portfolio risk, there was liquidity risk. Emily was worried about the marketability (from both the sale and the refinance perspectives) of a SFR with commercial zoning, on a busy street, occupied by a day-care center. She’d refinanced it once, but it was a struggle. An asset whose equity was difficult to harvest contributed little in the system Emily was developing. She’d learned to prefer apartments. Because she had a good reason to violate the Never Sell dictum, she didn’t think it applied to her. That was a part of Emily’s personality: if she had a good reason to do something, she didn’t think the rules against it applied to her. This time she was probably right. Other times, her audience wasn’t as receptive. “But officer, I was speeding because I’m late for work! Whatsa matter with you? Didn’t you see me putting on my mascara when I ran the red light?”
Not being a dumb-bunny, Emily saw the buy-refinance-buy process as the matrix of the investment system she was developing. Everything revolved around that. She reached for her daily journal and began to record the System (she’d begun capitalizing the name) and how, over time, it worked for her in practice.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker & Commercial Loan Broker – BRE: 00957107 MLO: 249261. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can probably help. Find out how much loan the building will support. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].