I like investing in residential real estate for several reasons:
- The market is dominated by unsophisticated buyers/sellers, who are often driven by external events and emotions;
- The availability of long-term fixed-rate non-recourse finance; and
- Favorable tax treatment.
There are some drawbacks:
- It is extremely expensive to buy and sell => a mistake will cost me 10% (gross), if I am lucky. If borrowing, even conservatively, then I can lose 35-50% of my equity in a year.
- It is lumpy => if you need the money back then it is very difficult to gradually drawdown your investment.
- It is illiquid => if we _really_ need to cash out then we won’t be able to cash out
- Humans are hardwired to over-buy => as soon as I could afford a huge home, I bought one. It took me years to get my capital back. I was very lucky => I purchased with a large margin of safety (no leverage, big site, big building, prime neighborhood).
Taking the above, together, real estate is a useful core holding for money that won’t be needed for 10+ years.
I follow two types of markets:
Markets where growth in prices is driving by “wealth feelings” in the top 0.01% of society => Vail mountainside homes, Boulder view properties. These properties have done well, appreciating to levels where implied yields are -2% to 2%.
I prefer to invest in traditional markets => markets where price growth is backed by a combination of real-economic growth (ability to pay), construction inflation (replacement cost) and discounted cash flow (net yields above my cost of capital).
Both markets are influenced by the availability of credit. Both markets benefit from scarcity and desirability in location selection.
Remember that even a “cash buyer” is influenced by easy credit. Credit conditions influence the value of ALL assets => wealth effects. These wealth effects cut both ways => highly wealthy people can feel “poor” when their balance sheets are shrinking.
When I buy, I create a margin of safety by seeking:
- Land for cheap => is there extra land I could sell off or am I buying in a very desirable location.
- A lot of square footage for cheap => ideally, I’d like to get the land for “free” by paying less than the replacement cost for the building. Even if you never build, it helps to know building costs.
- Distressed seller => life happens, often at inconvenient times.
- Closed credit markets => by ensuring I have the ability to hold through tough times, I can use unallocated capital to buy during down markets.
I’ve been preparing for my next deal by improving my credit worthiness:
- Building up a capital reserve.
- Improving my credit rating – paying credit cards early, taking advantage of a 60-month 0% car loan offer, always paying my mortgage on time => taken together these strategies added 80 points to my credit score from 2012 to 2019.
- Reducing leverage => paying down my mortgage and car loan. Closing out my second mortgage.
We’ve seen significant house price inflation in Boulder => supported by: (a) rising construction costs, (b) local economic growth, (c) inward migration of wealthy coastal buyers, and (d) easy credit terms.
In 2019, I looked at deals to increase investment in Boulder (buying apartments and renovating houses). In the end, we decided to decrease investment in real estate through a sale-and-leaseback of our home.
The leaseback costs me some tax (today) and positions me to borrow long at favorable terms. The option also costs me the future capital appreciation of my home, which won’t be mine any more. We retain exposure to the Boulder market through rental properties we own.
I’ve structured the deal with vendor finance, allowing a gradual drawdown of the proceeds. The net monthly cash flow covers our cost of living through my youngest daughter’s high school graduation. Having our cost of living covered protects my ability to control my schedule => highly valuable to my family in a way that’s difficult to quantify.
This is the cheapest way for me to sell real estate and positions us to buy when conditions swing in our favor.
Raise money before you need it.
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