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 17:  John Maynard Keynes, the English economist, wrote “The market can stay irrational longer than you can stay solvent.”  Emily had to recognize that current interest rates are irrationally low, and have been for most of a decade. If they continue (and nobody knows whether they will or not . . . but some people have called this period “the new normal”), it’s quite possible that the building she is now considering will appreciate beyond her reach.

If NOI increased: As an example, if the NOI increased 5% a year for five years it would grow to nearly $128,000.  Applying a 1.20 DCR at a 4% interest rate would bring the maximum loan to about $1,800,000. Now add an appropriate down payment ($770,000) and the projected value would be a touch over $2,500,000. In this low rate environment, there is no reasonable way Emily could grow her current down payment 25% (to $770,000) in five years. The building that she could buy now would be unaffordable then.

If she bought today: However, if mortgage rates remain at a hypothetical 4% and Emily bought today, in five years her $620,000 down payment would grow by $500,000 to a total equity of $1,120,000. In what other investment would it be possible for her to do that in just five years? So even though prices are stupid high, if interest rates stay low a purchase today might look brilliant over the next several years.

Emily’s Conclusion.  This was the type of decision Don Corleone hated:  either choice could end very wrong. 

She sat down to tea and a small bowl of chilled clotted cream with blueberries and began to think the matter through. It was easy to forecast a directional shift in interest rates. The 50 year average rate of the 10-year T-note was 6.57%. (That’s for the T-notes only – it is not the 50 year average for mortgage rates.) When rates were less than that, they could be expected to eventually rise. Alternatively, when the 10-year rate was above 6.57%, she realized that the rates would one day almost certainly decline. So the direction of rates didn’t seem too difficult to anticipate: it was simply a matter of reversion to the mean. And so far it’s always happened, sooner or later.

The problem was “when”. She knew of no robust way to predict when rates would change direction. Given what’s happened in the last ten years, if Emily waited for rates to go up, it might be a long, long wait.

Lengthy “dead money” waits between investments are disastrous to a portfolio. Emily liked to visualize that by imagining that if an investor had the time to double her money four times before retirement – say she could double her money every ten years, and she had 40 years before retirement – she could turn $250,000 into $4,000,000.

But if anything happened to reduce the four doublings to, say, three doublings the effect on her ending balance would be catastrophic. If she only had time to double the initial $250,000 three times over an investment career (instead of four) the final value of her portfolio would be

$2,000,000. That’s half of what it could have been!

So Emily understood too well that it would never do to keep dead money. She worked hard to keep her money invested.

She started eating her clotted cream more slowly as she worked through this. Emily disregarded inflation. Inflation adjusted returns mean that today’s $5 may grow to $15 in twenty years . . . but it will still only by one hamburger. She was looking for after-inflation returns, and real estate could provide that.

Basically, it occurred to Emily that there were two ways (maybe more, but she could only think of two) to increase the value of some (but certainly not all) income properties. There was “natural” appreciation, generated during the back half of an interest rate cycle when rates declined. This form of appreciation affects the entire market. It’s not likely that any single individual could change an area’s cap rates by herself, no matter how much she tried. You know what they say about boats and rising tides.

Then there was “forced” appreciation. This is where the owner does something that increases the net income generated by the property. It doesn’t change the cap rate, but it does enlarge the lump sum being capitalized. That can be a wonderful boon. One way to do this is to change the density of a specific property. Greater density usually means a higher Net Operating Income, and therefore greater value.

There were different ways to increase density, Emily thought.  After all, each of the property investments she’d made so far was successful because she changed the use of the improvements towards higher density.

The SFR (the one she recently sold to Shortsy Cake) was successful because Emily repurposed improvements originally meant for a family of maybe 5 or 6 into a commercial day care business serving 18 children and their caretakers. Shortsy’s lease payments were much greater than the rent a family would have reasonably paid for an old house on a busy street.

Her next investment, the fourplex with the large one bedroom units, was remodeled into a fourplex with three bedroom units. Three bedroom units rented for much more than the one bedrooms, even if they had smaller bedrooms.

Emily refinanced the fourplex two years or so after the remodel was completed and the units were fully leased up. She knew the refi lender would want evidence that the building could generate a certain NOI, and the best way to do that was through two consecutive years of tax returns. Interestingly, the original leasing didn’t take long. Remodeled three-bedroom units were so rare and desirable that she had a choice of good quality tenants eager to pay top rent. She got significant cash-out from the subsequent refi, which she banked with the gain from the commercial SFR. The proceeds from the sale plus the refi money gave her enough money for a down payment on a six or eight unit building.

But the problem came back to the trend in interest rates. Emily realized that stupid-low interest rates could not last forever, and she knew the Rule: rates go up, values come down. She had no desire to buy an eight unit building only to see its value implode – yes, Emily had a bit of the drama-queen in her — when rates inevitably climb.

Thing is, if she could buy a property at today’s lower rates, densify it (every time
you make up a new word, a kitten purrs
) to a higher value and then do a cash-out refinance – even if rates were moderately higher – sometime in the reasonably near future, Emily could probably continue building wealth, even through the “dead money” period she saw coming.

How could property be repurposed, beyond turning a SFR into a commercial property, which she’d done, or one-bedroom units into 3-bedroom units, which she’d also done?

Neither of those two examples enlarged the building’s footprint: they just repurposed it. Ok, so Emily thought maybe she could add square footage. Would it be all that hard? She already had a loan officer she loved working with and who could sometimes work miracles, if miracles could be worked. And she had a general contractor, Hiram Abiff, the banks accepted. Hiram once told her that he’d already built a couple of houses from the ground up.

Adding living area is what developers do, and it had a long history. She remembered that site at the edge of town, the one that used to have a large furniture store on it, with its own parking lot. A couple of years after the store closed someone bought the lot and built a high-rise condo project on it: 18 floors, 5 condos per floor. You can bet that putting 90 high-rise condominiums on a lot formerly occupied by a furniture-in-a-box retailer did something to the density factor! Emily knew she lacked both the tract record and the money to do anything as grand as that, but maybe she could find a property somewhere that she could do something with.

She started driving different routes as she went through her daily errands, driving through neighborhoods she’d never been, but found nothing. Later, she began driving further out to the suburbs looking for anything she could work with, but still nothing struck her. Then, as she was driving the side streets home one Saturday afternoon, she stopped at a new listing. An “Open House” was going on. She parked down the street – the closest spot she could find – and walked back to where all the people were.

There was nothing special about the listing, and Emily wasn’t interested in the property. It was just your usual “two on a lot”, but it made Emily’s light bulb blink. “Why not buy an old SFR on a big lot R-2 lot! Get Hiram to build a second house in back! Give the lot greater density!”

Shazam!

 

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 (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 Info@KlariseYahya.com.