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Tools of the Financial Trade: Real Estate Investment for Building Wealth

This is the second in a series of articles about Real Estate Investing as a Financial Tool.  Read the series from the beginning or click on the links below to learn more about each of the strategies presented.

Real Estate Investment is a versatile financial tool and can be used to help achieve any or all of these investment objectives:

  • Wealth Building
  • Portfolio Diversification
  • Tax Advantages
  • Appreciation Potential
  • Cash Flow Creation
  • Community Support
This post will explore how real estate investment can be used as a strategy to effectively Build Wealth for your overall portfolio and/or financial goals. 

Wealth Building

Real estate investments can help you to acquire assets capable of growing equity and increasing investment capital.  This strategy can be applied quickly or slowly over time, depending on the project, goals, individual capabilities and appetite for risk.

Fast Track

‘Flippers’ use real estate as stepping stones to amass lump sums of equity in a relatively short period of time.  Most often, they purchase a property at well-below market price (often foreclosures or fixers), then turn around and sell as quickly as possible for a profit.

This can be a great way to build significant capital in a relatively short period of time (less than a year).  However, it can come with some significant drawbacks, notably the time, expertise and labor required to prepare the property for resale, higher taxes on short-term gains, and of course the ever-present profit-eroding ‘Unexpected’.  This includes repairs, property expenses, debt and carrying costs, market changes, purchase/sales costs, selling period, etc. that weren’t adequately planned for or anticipated.

It’s easy to get excited when calculating all the potential profits on a transaction but many people forget to also prepare a potential ‘worst-case scenario’ or a contingency plan for the unexpected or underestimated costs that are bound to come up.

Since profits from this method are usually only realized when the property sells, having to hold it even just a few months longer than anticipated can quickly erode returns, especially if financing is involved.

Similarly, many people purchase new construction homes with little or no money down with the intent to sell in a year or two as phases are added, the neighborhood stabilizes and values appreciate.  In the 2008 housing market crash, many buyers purchased without proper due diligence and adequate investment capital.  When financing froze and home sales literally came to a screeching halt, people found that they were unable to sell, unsuited to being an impromptu landlord or unable to afford the monthly costs of owning a rental home, in some cases even with a tenant in place.  Timing is a critical factor, especially when banking on future profits to make up for interim negative cash flow.

Building wealth rapidly is an exciting prospect but be sure to do your homework up front.  Inexperienced and/or under-capitalized investors can quickly find themselves in over their heads and/or with a very expensive learning experience!

Project-by-Project

Slower-paced wealth building usually involves a slightly longer time frame, often 3-5 years or so.  This strategy is typically used with development and construction or ‘value-add’ projects, where an investor will purchase, lease or option a project property and take specific, calculated steps to improve or add to its overall value over a certain length of time with the intent to then re-sell and realize profits.

Land development can range from working with the local city to establish zoning, permitting, platting, subdividing, etc. to putting in the infrastructure (roads, curbing, utilities, etc.) for future construction and actually building on the land.  Each step of the development process can add value to the property, with  investment capital and costs recouped through sales or refinancing.  Many developers look for ways to control the risks involved in the development and construction process, such as lining up a lease or buyer for the property before building or prearranging for higher-cost construction financing to convert automatically to a lower-rate permanent loan after a set period.

Development and construction projects can be quite lucrative but can also carry significant risk to initial investment capital and hefty up-front costs.

Value-add project improvements can include capital or cosmetic repairs like upgrading units, replacing a roof, repainting, resurfacing parking lots, as well as strategic asset management action like leasing vacant space to increase net income, restructuring or extending leases, putting more efficient management systems in place,  fractionalizing ownership, refinancing with a different/better loan product, etc.

Funds to pay for capital improvements are either calculated into the purchase price up front and/or paid for by  existing cash flow from the property.  Strategic actions usually will need a stabilization period for the property to show consistent performance at new income or expense levels.

Investors using this wealth-building model either become, joint-venture with or hire a project manager who is responsible for executing the improvement plan for adding value to the property.  Expertise is obviously an important factor and depending on the scope of the improvements, may involve a great deal of coordination with sub-contractors or other professionals.  Timing can still be a major factor in realizing profits with this wealth-building method, especially if there are heavy up-front costs or if the building is completely vacant.

A detailed cost analysis is essential for any development or improvement project, along with a healthy cushion or reserve fund for the ‘Unexpected’.

Long-Term Outlook

One of the biggest criticisms of real estate is that the investment capital or equity cannot be as easily converted to cash as liquidating a stocks and bonds account.  However, building wealth patiently over time with real estate is how many business and family dynasties were created.

‘Buy and Hold’ is a term often used with much longer investment time frames, often 10 years or more.  Long-term wealth-building can been used strategically in an investment portfolio to achieve various long and short-term objectives depending on what is purchased and how it is structured.

Land-banking is the practice of buying an empty lot or raw piece of land with the anticipation that it will become more valuable over time.  Ever hear of the phrase, ‘Dirt Cheap’?  Unimproved land is less expensive to purchase and costs less to own than property that has a building already on it.  Land-bankers strategically purchase in areas that they consider to be or will eventually be ‘in the path of progress’ as towns and cities grow and develop new communities.  This can happen quickly, take years or may never happen at all if development is slow, takes a different path than anticipated or if environmental or other challenges arise that make development difficult or cost-prohibitive.

Investment Real Estate can be any residential or commercial property purchased for growth and/or profit potential.  Many people buy a second home or break-even rental property in anticipation that eventually over time, it will appreciate in value as most real estate has done historically overall.  This is often referred to as an ‘Appreciation Play’.

Income property is purchased with the expectation that it can generate enough income through rents or leases to ideally provide a source of income for the investor or to at least cover its own expenses for property tax, insurance, ongoing maintenance, repairs and other expenses associated with ownership.  Even property free and clear of any financing will have operating and administrative costs that need to be planned and prepared for.

One of the truly powerful wealth-building abilities of real estate is the ability to leverage your initial investment and increase its earning and growth potential exponentially.

If part of the purchase price is financed there will be loan payments to account for but if those costs are also covered by income generated by the property, the tenants ultimately pay down your loan, thereby increasing your equity and building your wealth in the process.

Obviously, financing adds another variable and additional risk to the equation.  Operating costs and loan payments are due regardless of vacancy or other interruptions in income.  Highly leveraged properties and under-capitalized, inexperienced owners can be a dangerous combination.  Investors need to carefully examine the past and projected performance of the property as well as their ability to manage the asset.  Again, a reserve fund is a wise way to help manage property cash flows and avoid being prematurely forced to sell.

Leverage is simply another tool and can be used as responsibly or irresponsibly as the investor wielding it.

Bottom line:  Build wealth at a pace with which you feel comfortable and can afford.  Expect the Unexpected. Partner with discretion, integrity and experience.  Any investment or project is only as good as the people involved.

This is the second in a series of articles about Real Estate Investing as a Financial Tool.  Read the series from the beginning or click on the links below to learn more about each of the strategies presented.

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Money & Kids: Kids DO Listen When Parents Talk about Money But What Are They Hearing?

If you’re a parent, at some point you’ve probably wondered if your kids ever listen when you speak.  Then you hear some of the same words and phrases being parroted back (often some we don’t necessarily want repeated!) and you know that those ears are wide open and taking it ALL in!

Parenting groups encourage us to talk about not doing drugs, not smoking, staying safe, etc. because the mantras we hear over and over again as kids tend to stick with us throughout our lives.  The same is true when it comes to money and finances.

But what are your kids hearing from you as a parent about money?  Quite possibly, you’re repeating some of the same things you may have heard growing up without really thinking about the messages you’re sending or the way your kids will interpret them:

  • We can’t afford it / It’s too expensive
  • Money doesn’t grow on trees
  • Debt is bad
  • Money is the root of all evil
  • Rich people are snobs

Kids are capable of internalizing and processing some pretty complex ideas.  They may not engage in direct discussion or they might take time to mull things over but kids see, hear and listen, and they make sense of their world by processing all the information and cues around them based on their own limited experiences.

As parents, we are in a unique position of influence that shapes the way our kids think about and treat money.  Kids listen to what we say and look at what we do.  If we don’t dialogue with them, though, those verbal and non-verbal cues are open to interpretation and the conclusions that your kids draw may not be the ones you intended.

For example, you might think your kids will see you working long hours every day and, by that example, develop a great work ethic and commitment.  However, they might interpret it as work/money is more important than family and resent that field/job/industry/you/etc.  Discussion is a vital part of communication to ensure that the message intended is indeed the message received.

People need to talk more about money.  Not the ‘How-much-do-you-make?’ kind of talk, but conscious conversation, real talk about money, like how you think and feel about it, what it can and can’t do, how to get and how to make more of it.

Although not the main idea of the blog, I read this great post on New Methods that to me, really underscores the importance of talking to your kids about money on an everyday, spontaneous basis.  The kid asks his dad how he’s able to go fishing in the middle of the day when most of the other people he knows are at work and dad explains that by owning a business, it can keep working even when he isn’t there. Just a 30 second exchange can have a significant impact on an 8 year-old kid, how he thinks about money and how it can help to shape his life (be sure to read about the author at the end of the post!)

The post also made me think about Robert Kiyosaki’s Rich Dad, Poor Dad, which distinguishes between the mindset of an employee vs that of an owner.  The parent in the blog is sending an owner-mentality message about money.  Instead of the typical ‘work hard, get a good job’ message, the advantages of being the boss or owner are communicated.

Does that mean that we all have to be business owners to talk about money to our kids?  Of course not.  Talking about financial alternatives and options just lets our kids know that there are many different ways out there to make a living.  It also doesn’t give a free pass from talking about money to those who are well-off.  In fact, financially successful people who don’t talk to their kids about money and fiscal responsibility often end up with a very short legacy indeed!

The first step is to be aware of your own thinking and what you’re saying about money.  After reading this article, I’m willing to bet you’ll start hearing yourself all the time!  Once you realize how you communicate about money, you can decide if those really are the messages that you want to share.  If not, you can alter the phrases to convey a different kind of message:

  • We’re choosing NOT to spend our funds on X because it isn’t a family priority or goal right now
  • Money can grow on ‘trees’ – referral trees and networking that brings more customers/business/revenue
  • Some debt (like credit cards) can be dangerous but some debt (like a mortgage) can be a helpful tool to build wealth
  • Money is just a tool; the person using it decides how it will be used
  • People of character do good things regardless of the amount of money they have
Start thinking about the messages you WANT your kids to hear from you about money so the words and ideas are readily available when those spontaneous, teachable moments come up.  Otherwise you’ll default back to the same old standard phrases.   
I like to tell the story of a discussion I overheard between my two sons because it really reflects the difference in my own mindset based on my own understanding of money, how I talked to my kids and where I was at in life when each of them was growing (they are 8 years apart):

Older Son:  One day I’d like to manage a nice restaurant like this.  I could do a great job.

Younger Son:  Great!  You can work for me because one day I’m going to own a nice restaurant like this!

‘Make Money’ is not a SMART Goal

‎”It is more important to know where you are going than to get there quickly.” ~ Mabel Newcomer

If you don’t have a clear, defined financial goal how are you going to know if you ever reach it?

‘Make Money’ is not a SMART goal (Specific Measurable Attainable Realistic Timely).  How much money?  In what time frame?  With what amount initially invested?  You need to clearly state exactly what it is you want to accomplish.  Then, you can measure and evaluate, and make adjustments as needed to stay on course.

When you want to go somewhere you’ve never been before do you just get in the car, start driving and hope you get there?  Of course not.  You get out a map, look at where you are and where you want to go, and then plan a route that suits you best based on your personal preferences and needs – like taking or avoiding toll roads or highways, visiting certain cities or sites along the way, taking 3 hours to get there versus 6 hours, etc.  If you run into a roadblock or detour or something unexpected comes up then you pull the map back out, make the necessary adjustments and get back on the road.  A plan to meet your financial goals can and should be crafted and maintained in much the same manner.

So what is it that you want your investments to accomplish?  Think both short and long-term.  Do you want to generate income to pay for college tuition?  A wedding?  To replace a spouse’s income so they can stay home with kids or retire early?  To help you retire to a warmer climate or closer to children and grandchildren?

It’s okay to think big; you just have to be prepared to plan and break it down into manageable chunks to make it happen.  You also need to be patient and give the plan time to work.  You can’t make a great chili without letting the spices simmer!  It’s also okay to change your mind and make changes along the way.  You never know what life’s going to throw at you.

One of my biggest pet peeves is that most so-called ‘financial advisors’ don’t seem to actually advise people at all.  They just babble on about risk and safety and then suggest putting money into a company-managed fund (for which they get compensated) and eventually you should ‘make money’, because it’s a ‘balanced’ fund where losers are off-set by winners.

Really?!  I should spend the next 30 years investing my life savings in something I don’t fully understand that might eventually make me some amount of money?  How is that a good plan?  Please don’t tell me that it’s to protect my principal.  If that were the case, it’d be easier and safer to just stick to FDIC-insured CD’s.

Every asset should have a POSITIVE effect:  Generating income, off-setting paper gains/losses, creating tax benefits, preserving or enhancing net worth or otherwise helping me reach my overall personal and financial goals in some way, shape or form.  Personally, I want my assets working as hard as possible!  Every investment should have a specific purpose for being in your portfolio and role to play in working towards your overall goals.  

If you don’t understand why you are invested in a particular product or vehicle, you need to ask questions and do some research.  At the very least you should be able to read and understand your investment account statements.  If your advisor can’t or won’t help, it might be time to find a new advisor.  Remember, no one will care as much about your money as you.

Bottom line, if I’m paying for advice, I want an opinion.  I’m not asking for a guarantee, just an opinion from a knowledgeable professional in that particular field.  I want a summary of information and data used to form that opinion.  I want to know exactly what this particular investment is designed to do for my portfolio and how and when it will help achieve my overall investment goals.

Then I can make an informed decision and make sure I stay on track to accomplish my goal.

The Golden Rule

Maybe you’ve heard of it.  Maybe you’ve experienced it.  Maybe you’re one of the ones teaching the lesson.  Any which way you look at it, the concept is pretty clear:

The Golden Rule of the world of finance ~ Whoever has the Gold makes the Rules.

Money is a pretty complicated thing.   When you don’t have it, your life can be complicated.  When you do have it your life can be complicated.  The big difference in those complications seems to be whether you are following someone else’s rules or making your own.

Right now there are a lot of people at the mercy of rules dictated by institutions and government and others all over the financial industry.  Real estate owners and investors are not the only ones feeling the credit crunch, although they are arguably shouldering the brunt of the on-going mess in both residential and commercial markets.  Barriers such as tightening regulations and newly imposed standards are hurting new purchases.  Lower property values are making it tough to refinance even solid performing properties.  Existing Home Equity Lines of Credit (HELOC’s) are being capped and closed despite perfect payment histories and spotless borrower credit.  They may not tell you this, but even lenders who actually want to renew your investment loans may not be able to because they already have too many of that particular type of loan on their books.

Take a look at the banking and credit card sectors, too.  If you haven’t been monitoring your statements on a regular basis, you really need to pull them out and read carefully.  Your savings rate may have been cut and credit card interest rates could have tripled for no apparent reason.  New monthly and annual fees may now be applied to your accounts and many in-place fees may have jumped up.  Worse, that credit card you haven’t used in a while may have actually been canceled and your account closed at the company’s sole discretion.  Every single one of these situations has happened to me over the past two years.

It’s frustrating.  But unfortunately, when you have structured your life around debt and credit provided by others, you often end up paying the price, literally.  Remember the Golden Rule?  They have the gold so they make the rules.

Sure, you can rant and rave about the injustice of it all but basically if you want or need the cash/credit that they offer, you must accept their terms or go elsewhere.  Credit card companies send you those lovely little notices stating that if you don’t want to accept the new rate you are welcome to cancel the account and simply pay off the balance.  They are banking on the fact that most people won’t be in a position to do so.   Why do you think they send applications to college students as soon as they turn 18?  Because spending habits are formed early and hard to break.  Once you dig that hole, it’s hard to get back out.  And the cycle begins…

So what can we do?  Well, we can start by weaning ourselves off of this dependency on credit as a means to support unsustainable and, in most cases, unnecessary lifestyles.  It’s hard and will take some time and changes but has to be done if you don’t want to be a slave to your debt.

  • Take your financial temperature.  The first step is to really look at your financial situation.  Figure out what income you have coming in and what expenses you have going out each month.  Look at everything – credit card purchases, ATM withdrawals and cash purchases, bank statements.  Click here to request a template to help you get organized.  As ugly or upside down as it may be, that’s your current budget.  Make a list of all your loans, balances, rates, etc.  Don’t panic at the totals.  You have to know where you are before you can look at where you’re going.
  • Live within your means.   If your expense dollars outnumber your income dollars, rest assured you aren’t alone.  But unless you are the US Government and can print more money, you’re going to have to slash those expenses and bring them in line with your income.  Be prepared to make big changes.  Maybe you can save $1000/mo by renting instead of owning your home or eliminate a $400/mo payment entirely by buying a used car.  You don’t have to cut out everything, just prioritize and make sure you are spending on what is truly important to you (read more  Live and Spend without the Guilt).  Remember, this is your financial health we’re talking about.  Would you choose to not reset a broken arm because others might think you look ‘different’ in a cast?
  • Reduce credit card balances.  Start with the highest interest rate and pay as much as you can each month while making minimum payments on everything else.  It’ll take some time but you will begin to see that balance go down more and more each month.  Focus on that great feeling and it will motivate you to keep going.  Rinse and repeat for each card with a balance.
  • Transfer balances.  Call every company you owe and find out if they will review your account history and lower interest rates.  Find out if they will accept a lump sum payment for a discount if you pay the balance now.  If and when you have room on a lower rate card, use it to pay off another card and proactively manage your debt to pay less total interest.  Set email alerts when rate specials end so that you can reevaluate as needed.  Saving on interest is like putting CASH back in your pocket.
  • Bring the list; leave the cards.  Temptation is best dealt with by removing it altogether.  Take a list when you shop and ONLY get those items.  Leave your credit cards at home and use cash.  The less accessible your money is, the less likely you are to spend it.  And for goodness sake, go to the local park for recreation and exercise, not the mall!

We all know that money itself can’t buy happiness (on the contrary, money tends to magnify the real issues in most situations).  But, like any other tool at our disposal, having exactly what you need at hand can make a world of difference in accomplishing our goals.  

These people and institutions only have the power that we give them, though.  That WE GIVE THEM.  Our spending habits are letting these people hold us underwater.  Take back control of your life, your spending, your credit and borrowing power.  Choose to pay and play by your own rules.

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Please note that we are NOT attorneys, certified public accountants, certified financial advisors, registered investment advisors or securities brokers. We do NOT provide legal or financial advice, nor do we make any recommendation or endorsement as to any particular investment, advisor or other service or product, or to any material submitted by third parties or linked to this site. Anything and everything posted, reposted, linked to or shared on this weblog is solely for information and discussion purposes.

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