In today's increasingly unstable real estate economy, it's critical that real estate investors really understand both sides of the balance sheet. Only a few years ago, people were making millions flipping houses. The strategy was simply: buy low; fix up; sell high. You can't do that today. Wise real estate investors understand that continuing with this strategy will lead to bankruptcy. Instead, they're turning to the traditional accounting-math based means of building on their investments: leveraged buying, understanding cash flow and reserves, and paying down debt instead of letting it ride on the chance that the increased equity will pay it off for them.
Cash Vs. Credit: The Concept of Leverage
If you have $100,000 cash to invest and the house you want costs $100,000, should you just buy it outright? Some investors will. But smart real estate investors realize that the $100K, invested well, could bring a 15% return, while a loan for the same $100K will cost you perhaps 7% interest on the debt. That means that by putting all your money into the house, you're giving up $8000 a year or more.
This is leverage in practice: using resources in such a way that returns on investment are magnified. Usually, it's the use of borrowed funds to invest, but this is a chancy practice. If real estate investors leverage cash holdings to invest while paying off a real estate loan, however, they can always count on profiting provided they manage it properly. Though on paper you have a debt, in reality you've gifted yourself with good cash flow, which is more important than owning property outright.
If you leverage real estate and reinvest in more real estate, you could find yourself in a very profitable position. Consider this: with the same $100,000 you had earlier, you put 10% down on ten $100,000 properties. This does two things. First, you magnify your original potential earnings by a factor of ten. Second, you cushion yourself against the potential fall in price of one or more of your properties by diversifying your debt. Real estate investors spread out their cash like this all the time, renting out all ten properties at a break-even or better rental charge. If all properties consistently have renters, your properties pay off their debt and you own outright ten properties, which you can sell or leverage again.
This is how real estate investors build empires.
Cash Flow Vs. Cash Reserves
Remember earlier the statement that good cash flow is more important than owning property outright? That's because good cash flow is the lifeblood of business. Smart real estate investors, however, also manage money so that they have healthy cash reserves.
In both cases, you start with a goal: hold a property X years before selling, or own X properties outright in ten years to subsequently develop into something bigger, or to build up enough property to purchase property elsewhere. Any goal is fine, provided the real estate investor has a clear goal and a clear plan for reaching it.
Assume that your goal right now is to hold a property for five years, making a profit on it while you hold it. You find a renter before you purchase the property. You have $50,000 to spend, so you put $45,000 down and finance the rest, getting a very good mortgage rate and a bill of about $1000 a month, while your renter will be paying you $1350 a month. This gives you a monthly profit over your mortgage of $350, positive cash flow.
Now suppose your renter's business fails and he leaves after only four months. You have an empty property, probably with repairs and renovations to be made before you can rent it out again. Your debt payment of $1000 is outstanding until you get that new renter. Suddenly, your cash flow is gone, most of the last four months' profit is gone, and you are preparing to dip into savings to do the renovations. Smart real estate investors plan for this eventuality, holding a significant amount in reserves. Without this extra cash, your investment runs a good chance of becoming a liability.
Paying Down Debt
Experienced real estate investors know one very important thing about debt: all mortgage interest is a deductible expense, while all profit from rents or proceeds of sales are taxable. This should completely change the way you look at your cash flow and debt options.
A debt, in today's tax reality, is a net asset on the tax books. If you are renting a profitable property in an appreciating part of town, it may be to your advantage to retain debt, not pay it off. If you're having trouble renting a property in a part of town that is rapidly depreciating and you can't sell it, it may be time to pay it off to avoid further interest while you're looking for a buyer. This allows you to cancel mortgage insurance and write off the depreciating amount as a net loss, in the long run.
When a smart real estate investor does the math on both the positive and negative ends of the real estate spectrum, seeming paradoxes like this become clear. Don't be trapped by your cash flow and debt assumptions. Think about everything before making your financial plans.
$600 million worth of property is being managed by Tony Seruga, Yolanda Seruga, Yolanda Bishop and their partners as of May 2006. They specialize in commercial real estate, and are always looking for new projects across the U.S. http://www.maverickrei.com.
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