ASSET MANAGEMENT: A SERIES OF DECISIONS

Investment real estate management is the cost of monitoring an investment. There are two types of management:

Property Management

Property management is the every day activity required to operate, maintain and keep a real estate investment producing revenue at its optimum level. Property management is exclusive to real estate.

Asset Management

Asset management is the process of monitoring an investment's financial performance (i.e. yield) and a series of decisions (decision points) made to improve and/or stabilize financial performance. The series of decisions you make (whether implicitly or explicitly) during the entire holding period of your real estate investment (the real estate investment life cycle) will affect your yield and accumulation of wealth. Making the right decisions at every decision point will maximize your yield and future wealth (future net worth).

Many of the points discussed here will be covered in my future Courses. They are also available through Consultation.

Alternatives That May Not Be So Obvious

When looking to invest in real estate, the investor must not only decide what property to purchase, he also needs to decide how to purchase it [i.e. installment sale (terms), all cash, what kind of exchange, etc.]. After acquisition, the investor must also decide when and how to sell and what to do with the sale proceeds.

In addition to buying and selling, investors face many other decision points that may not be so obvious, some of which include the following:

  • Whether to renegotiate lease and at what price
  • Whether to buyout tenant and at what price
  • Whether to allow the tenant to buy you out and at what price
  • Whether to convert property to another use
  • Whether to improve property
  • Whether to refinance
  • Whether to have a partial sale
  • Whether to change method of management
  • Whether to restructure ownership
  • Whether to lease or purchase
  • Whether to sale-leaseback or sale and lease something else
  • Whether to build to suit or sell the land

As you might suspect, your typical property management company is usually not qualified to make these types of decisions. And even if they were, they often lack impartiality. If you sell, they lose your business.

Making More Money Through Better Decisions

If investors are not aware of all the decision points facing them, they are unable to consider all of their options. When investors overlook an option they usually implicitly (without questioning) decide to hold and do nothing, the default decision. And even if they were aware, they sometimes do not possess the analytical abilities necessary to make the right decision.

Astute investors regularly evaluate their investments and pursue all their options at each decision point. These investors explicitly (clearly and specifically) make their decisions (to hold, sell, renovate, refinance, etc.). It is in the investor's best interest to consider all his options. Making the right decisions at all decision points during all phases of the real estate investment life cycle will maximize yield and therefore future wealth, the primary goal for most investors.

Objective and subjective forms of investment real estate analysis are often employed before these vital decisions can be made. The yield-conscious investor uses investment analysis based on objective methods rather than "gut feeling" or "guessing" to make his decisions. Investment analysis provides the investor with a sound basis for making critical real estate investment choices.

Most real estae investment decisions involve forecasted cash flows. Because forecasted cash flows from operations form the primary basis for determining investment value of income property, they are often incorporated into this investment analysis. Forecasted cash flows are produced from assumptions and market data obtained from comparable properties such as rents, vacancies and expenses. It is crucial that the assumptions made be reasonable and the market data be accurate in order to produce realistic and reasonably certain forecasted cash flows. The decisions you make based on conclusions reached from investment analysis and your success in investing in real estate depend on it. Using conclusions reached from investment analysis based on badly-estimated future cash flows will likely result in the wrong decision. Given that, a large part of investment real estate risk is attributable to the investor's failure in estimating future cash flows.

The sophisticated investor understands that good decisions require accurate market data and reasonable assumptions. Basing investment real estate analysis upon inaccurate market data and unreasonable assumptions and therefore very uncertain forecasted cash flows increases investment risk and reduces your chances of achieving your financial goals. Accurate market data and reasonable assumptions are dependent upon thorough research and due diligence.

As necessary as objective investment analysis is for the accumulation of wealth, investors also use various forms of subjective analysis to help them make the right decisions. This decision-making process can sometimes resemble more of an art form than a science. One thing is reasonably certain, the success an investor realizes from investing in real estate largely depends upon competent asset management, which is often accomplished with the advice of a qualified Consultant.

THE THREE MARKETS

The wise real estate investor periodically evaluates the three markets (property, capital and space) related to real estate to determine how they will influence their investment decisions. The three markets are related to each other and should be evaluated together as well as individually to determine how they will impact their present or future real estate investment. The astute investor recognizes the fluctuations in the space and capital markets and the effect they have on real estate values (property market) and decides accordingly.

The Chico real estate (property) market, like all others, is cyclical. At any point in time, interest rates (capital market), rental rates (space market) and market values (property market) are either declining or rising. The three markets are seldom at a standstill.

THE CAPITAL MARKET

In 1981 interest rates were at 18%. Rates under 8.5% are relatively attractive. Financing is not permanent while the purchase price is. A less than ideal loan can be refinanced after purchase. A great purchase price will more than justify a less than ideal TEMPORARY loan. Let's assume you wish to buy a duplex that you thought was a money-maker at $315,000 with 30% down [cash and/or non-cash property ($94,500)] and a $220,500 loan. Also assume a 6.75% fixed rate loan was the very best available to non-owner occupied buyers with the best income and fico score but you could only qualify for 8%. First year interest on the 8% (6.75%) $220,500 loan is $17,640 ($14,884). Since interest on rental property is deductable for income tax purposes and, assuming you are in the 35% combined Federal and State income tax bracket, paying $2,756 extra in interest really only costs you $1,791 [$2,756 - (35%)($2,756) = $1,791] because deducting $2,756 saves you $965 (cash) in income tax. It would be extremely foolish to pass on a great real estate investment because of $1,791. The same would probably be true if 9% was the best you could find. Yes, timing is critical when buying and selling real estate, but because of tax benefits (i.e. cash and noncash depreciation deductions), appreciation, cash-flow and debt relief, more money is made while you hold it.

THE CHICO SPACE MARKET

In the 27 years I have been active in Chico real estate I have never seen a really bad Chico rental market because Chico's population grows every year and the Chico economy is stable.

THE CHICO PROPERTY MARKET

Except for refinancing (loan-to-value ratio), the fair market value of your real estate only matters at the time you sell because it changes while you hold it. If you are selling to buy replacement property, a depressed buyer's-market is just as good of a time to sell as in a hot seller's-market. In other words, if you wait for your property to go up in value, you will pay more for your replacement property.

Chico has experienced only two seller-markets in the last 27 years. One lasted two years around 1990 and the other ran from 1998 to 2005. An Enterprise Record article dated 4/21/06 stated, "Annual home price increases in California peaked in June 2004 at 23.2 percent, and that rate has gradually declined ever since." There are record breaking numbers of foreclosures that have resulted in Chico property values dropping dramatically creating great opportunities for buyers.

Some experts say Chico property values have bottomed out because the federal government will step in to stabilize things while others think they may drop more. Even if they drop a little more, and again they may not, those who pay today's depressed fair market value will still make huge profits when they sell in a hot sellers-market.

The big question for buyers is, when will property values bottom out? The big question for sellers is, when will property values begin to rise? It is not a matter of whether property values will bottom out and rise, it is just a question of when. Most of those who wait for the perfect time to buy usually wait until it is too late or, out of frustration or life circumstances, do not buy at all leaving the profits to the more wise and courageous buyers.

Even though there are many things to consider, one of the most important principles to understand and follow for the purpose of making money in real estate is to buy in a depressed buyers-market and to sell in a hot sellers-market. Although one would think that the time to buy is when prices are down and the time to sell is when prices are up, few actually practice this philosophy.

Why does nearly everyone during a hot-sellers-market (demand up/supply down) want to buy a certain type of property but few owners want to sell? And why, in a depressed buyers-market (supply up/demand down) will few buyers even take the time to talk about buying but sellers are plentiful? Answer: most buy and sell at the wrong time. When opportunity knocks, some people open the door while MOST do nothing!

Look at all the buyers who were involved in bidding wars (multiple offers) between 2002 -2005 who bought and now lost much if not all of their down payment. In today's buyers-market most are UNWILLING to make reasonable offers. Investing in real estate is not rocket science, but wisdom and courage is required to make money in real estate.

And then there are those who plan to buy and sell at the right time but then do not because they have unreasonable expectations (prices). Instead they waist large amounts of their time and leave the profits for others. If you can find a seller willing to sell at today's depressed value (consider yourself fortunate) you will earn massive profits when you sell in a hot sellers-market. Buying for less is certainly possible but if you limit your purchase to under today's depressed value you may buy nothing or buy at a less than ideal time (prices). Some sellers must sell but many more refuse to sell at today's value or take their property off the market. This may explain why the median sales price has held strong even with all the foreclosures.

"Those rare sapient souls who recognize when a market is about to bottom out and have the courage to lead the way in buying, followed by selling when the market is at its peak, are the people who amass staggering fortunes from real estate."

Leta McCurry, COMMERCIAL REAL ESTATE

How will you feel when you learn most if not all the properties you had your eye on are SOLD, more buyers are making offers (increased demand) and sellers are either taking their properties off the market (decreased supply) or holding firm or raising their prices (decreased motivation) because they know the real estate market will soon improve?

With sound advice and good judgment, you will decide to buy and sell at a good time.

The Sell or Hold Decision

The investor is faced with the decision to sell or hold when changes take place in any one or more of the three markets: capital, space and property. Investors exercising sound reasoning examine the benefits of continuing to hold their real estate investment by performing incremental analysis rather than relying on "gut feeling." Investors must assess their real estate investment on an ongoing basis to determine the ideal holding period.

The How to Sell or Buy and Corresponding Price Decisions

When a decision is made to sell or buy, the seller or buyer may need to determine an installment sale price that is equivalent to the all cash price. An acceptable all cash price may be clear to the seller, but it is often not clear what an acceptable installment sale price should be. In other words, with what price should the seller counter the installment sale offer in order for that price to be equivalent to the seller's acceptable all cash price? Or to put it another way, at what sales prices would both (all cash and installment sale) result in the same accumulation of wealth at the same future point in time? Through investment analysis investors can objectively answer this question.

The Refinance Decision

An investor is faced with the decision to refinance when changes occur in the capital market. Some investors use a rule of thumb based on the difference between the current market rate available and the existing contract rate to decide whether to refinance. An investor/borrower who uses only this rule of thumb in making his refinance decisions may decide to refinance if the current market rate available is 1.75% or more under their existing contract rate. However, this rule of thumb does not take into consideration the following, very important factors:

  • The borrower's expected holding period and its effect on the benefits of refinancing
  • The reinvestment of equity pulled out from refinancing
  • The upfront refinance costs
  • Time value of money by discounting the future savings from refinancing

Incremental net present value (NPV) analysis is better than using a rule of thumb to decide on whether to refinance.

The Lease Buyout/Renegotiation Decision

An investor is faced with the decision to buy out a tenant or allow the tenant to buy him out or renegotiate a lease when changes occur in the space market (supply and demand of space). A reasonable price to pay to buy out a lease is the present value (PV) of the differences in periodic cash flows under the existing lease and one at current market rates plus cost to release (i.e. tenant improvements, advertising, vacancy, etc.).

The Decision to Improve Property

An investor is faced with the decision to improve income property when he experiences changes in the space market. Rather than selling or continuing to hold a property "as is," several additional options are available to investors such as: rehabilitation, modernization, expansion, and conversion. The issue is how to properly analyze these various options. Like the initial investment decisions, each of these decisions involves comparing forecasted benefits to the estimated cost of the investment. As with the decision to sell or hold, incremental net present value (NPV) or internal rate of return (IRR) analysis is used.

 

 
     
 


David M. Hector
Real Estate Brokerage
DRE # 00796981
Office: (530) 893-5533
Fax: (530) 893-5575

Toll Free: (800) 898-5568
Email: dh@davidhector.com


© 2003-2009 David M. Hector