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John Schaub will speak for Bay Area Wealth Builders in San Francisco on July 17th & 18th, 2010.

This review originally appeared in Real Estate Investor’s Monthly.

Book Review: Building Wealth One House at a Time

I like John. He is charismatic and personable and could probably get elected governor of Florida if he was of a mind. When evaluating his book, however, I and others need to be careful not to be influenced by his personality.

I also think he generally knows what he's talking about in real estate and is a straight shooter. He has been successful over a long period of time. I recommend his books and seminars.

Having said that, I generally think this book is a little bit off the best approach. So the book is a useful takeoff point for discussing my differences with much real estate investment thinking.

Action oriented

John is action oriented and against analysis paralysis. Me, too. I have written about that problem at my Web site and in my newsletter and books. My How to Get Started book has a step-by-step schedule with deadlines and some rather stern admonitions to get going and actually get your name on a deed.

However, I also have a need to understand things. The sort of readers who subscribe to my newsletter share that with me. So I am more analytical than John. On page viii of his book, he puts down Ph.D.s who don't do deals because of too much analysis. I think he meant MBAs, like me, who are far more prevalent in real estate that Ph.D.s.

Maybe too simple

John has a lot of action-oriented rules, but many strike me as too simplistic and perhaps a matter of taste or John's personal experience. I am also a product of my MBA training. When I was in grad school, we spent all day every day in the same amphitheater with the same 85 sectionmates.

The verbal combat was gladiatorial. If there was any flaw in your logic, multiple sectionmates would shred your analysis. Many of John's rules would get that response. "What's the basis of that? Who said so? What about situation A where that rule would be a bad idea?" One of the benefits of the MBA program I went through is you spend the rest of your life thinking rigorously about business decisions—which is a good thing.

Look things up

Another difference between me and most people in real estate is my quasi-engineering training in college and my MBA. I have found that those with advanced degrees in hard subjects like math and science tend to look things up when they are trying to understand something. Most real estate investors do not. Rather, they hear something that is an attractive or believable fact and glom onto it.

For example, on page 1 of Schaub's book, he says, "house prices have increased at an average annual rate of roughly 5 percent for about as long as we can remember." That is virtually the foundation of his whole approach and probably the foundation of the vast majority of investors' approaches. So it's a pretty darned important "fact." I would check it out before I said it.

As it turns out, I just received another book called, "Are you missing the real estate boom?" by David Lereah, the economist for the National Association of Realtors. Yes, I know the NAR is biased. I have written about it. But they are also pretty straight shooters. Lereah has advanced degrees and he looks stuff up.

1.5% a year

He says real (adjusted for inflation) home price gains have averaged just 1.5% annually in the past 35 years. He called the 5.4% annual pace of the 2002-2004 period "unsustainable."

Real appreciation rates matter only to free-and clear homes, but John is an advocate of them. (I am too, but only as a risk reducer.) If owning a free-and-clear home only gets you 1.5% a year over the last 35 years, there had better be lots of cash flow. In fact, I suspect free-and-clear rental house cash flow is around 5% or 6% calculated honestly. 6.5% to 7.5% yield is too low for the hassles and risks of real estate investing. Also, we have extremely high transaction costs which further reduce the yield when you try to convert it to cash.

Inflation

The median home price in 1970 was $20,000. In the 4th quarter of 2004, it was $184,100. That is about a 6.5% annual compound rate over 35 years, not adjusted for inflation. If home prices had just kept pace with inflation, the median price would now be $97,600.

But the figures are misleading. The current average home is a much nicer, bigger building with more amenities than the average 1970 home. For example, it typically has multiple bathrooms, insulation, and central air. It also has had tens of thousands of dollars spent repairing and updating it. Saying it goes up 5% per year encourages invalid comparison to other types of investment like stocks, bonds, and commodities that have far lower transaction costs, no time consumption, and no repairs and upkeep.

Also, you cannot buy "real estate." You can only buy 123 Elm Street or 5460 Valley Boulevard or whatever. With a smaller sample size, you have wider variations in returns.

Leverage

With leverage, which John and I also advocate, inflation does move you ahead in real terms as long as your negative cash flow is not wiping out the inflation appreciation.

East Coast margins

Another phenomenon I have observed and written about is that East Coast investors tend to have lower profit margins and expectations than those on the West Coast. John is arguably the top East Coast real estate guru and he is no exception.

Take his 10-10-10 Rule. One of the 10s is his recommendation that you buy the property for 10% below market value. I wrote a two-volume book on the subject of bargain purchases. Its title is How to Buy Real Estate for at Least 20% Below Market Value.

Why 20%?

Why did I pick 20%? Because I interviewed over 166 actual case history investors. They said 20% was the minimum. If you get less of a discount, you cannot buy the property and turn around and immediately sell it for a profit. East Coast guys would say they don't need to sell it that fast. West Coast guys would say if you can't, it's not a profitable deal.

West Coast is right

The West Coast guys are right. The East Coast approach is a combination of almost bargain purchase and speculation of market-wide appreciation. The West Coast guys benefit from market-wide appreciation, but they don't rely on it. They also wonder why anyone would accept a 10% discount when they could get 20%.

Not that it's easy to get 20%, but it's doable. It's just a different habit.

Sources of profit

John's notions on how real estate works are also noteworthy. He seems to think you get your profit from a combination of market-wide appreciation, negotiation of a better-than-average deal, lease options, and smart selection of the best neighborhood. That is probably the consensus view.

Again, the approaches I try to find when I interview successful investors are a couple notches above that in terms of mastering the controllable variables. To me, market-wide appreciation is unpredictable and uncontrollable. So I mostly ignore it. It's there. It's good. But I do not know anything about it, so I am not qualified to write about it. Furthermore, neither is anyone else. It's unknowable.

Negotiation skills

I think negotiation is an important skill in real estate, but I think it's overrated. If you negotiate too hard, you lose deals to other buyers and you get a reputation that scares people. I would characterize negotiation as important, but only marginally, in the grand scheme of real estate investing—more of an urban myth than a viable strategy. I tried it. I was a real estate agent and I took multiple negotiation seminars and read every negotiating book I could find. More bargains stem from low asking price.

Neighborhood

John has a Goldilocks theory of neighborhood selection: not too expensive and not too cheap. Go with the neighborhood where prices are just right.

The investors I have interviewed generally agree that the best deals are at the bottom of the viable economic spectrum. When I say viable, I mean not so far down that you get robbed at gunpoint every time you visit your property and no subcontractors will go there.

The number of financing alternatives is the greatest. The number of qualified buyers is greatest. Most importantly, the sellers and competing buyers there are the least informed. I expect that John's preference for the middle of the spectrum is part of why he accepts a 10% discount rather than 20%.

'If it don't go up, don't buy it.'

Will Rogers once said the formula for stock market success was easy. "If it don't go up, don't buy it." I sometimes refer to that sort of advice as tautological. There is a lot of such advice in investing, like, "The right way to go is to get a good property manager."

John does some of that like, "Some houses rarely drop in price, and those are the ones you want to buy." I am not sure any particular house has such a characteristic. For example, they all drop in price if interest rates go up. With extensive study, you could probably find that some houses had some resistance to certain risks in the real estate market. Although I would more likely believe that of some neighborhoods than individual houses.

Don't tell me to get a good guy or house. Tell me specifically how to do that.

Maddeningly imprecise

The consensus advice, including John's, on how to find the "right" houses is maddeningly imprecise. Reminds me of career guys always talking about the "real Army" when I was in the Army. There was no doubt that the "real Army" was a fabulous organization to work for and we were all going there when we left the current lousy assignment. But no one would ever identify specifically where the "real Army" was. It was just out there somewhere. The civilian equivalents are the "right people" and the "right house" and the "right neighborhood."

Good basic stuff

One of the occupational hazards of studying real estate investment for almost 40 years as I have is that I get more knowledgeable every year. You would think that would be a good thing and it is. But it causes me to be harder to please with regard to knowledge. In other words, I sort of assume that everyone knows what I know. Since few others have been studying it for 40 years, that's probably not true.

John's book has lots of good basic stuff that I agree with. It makes me go "ho hum," but if you are at an earlier stage of learning, it may be great new stuff to you. For example, on page 14, John says buying with high leverage is risky business. I said that in one of my own books—How to Use Leverage to Maximize Your Real Estate Investment Return—so it's arguably a good thing to say. It just seems too obvious to me at this stage.

Reliance on market appreciation

The main difference between John's approach and what I try to write about is he relies more on market-wide appreciation for profits. That is, indeed, the main way money has been made in real estate. It is probably the main way subscribers to this newsletter have made their money.

But it does not interest me as a writer and no one needs to buy books or newsletters to pursue that approach. A fortune cookie will do: "Confucius say buy real estate. It's going up."

Make money on purpose

I prefer to figure out how to make money on purpose in real estate. Making money on market-wide appreciation is really speculation or gambling. If you cannot control or forecast market-wide appreciation, which is the case, relying on it is a pure gamble.

For one thing, market-wide appreciation is heavily dependent on mortgage interest rates, which are utterly unpredictable. The prosecution rests.

Get both

Furthermore, my approach does not prevent you from benefitting from market-wide appreciation. Rather market-wide appreciation becomes frosting on the deliberate-profit cake.

More and more I think like a builder. Builders do not rely on market-wide appreciation for profit. They benefit from it, but they do not rely on it. They make profit in a flat market by adding value to raw land and a pile of building materials.

I also think like a miner. Adding value is only one way to make a profit in real estate. Finding overlooked value is another and actually a more prevalent way for those who buy existing buildings. Finding overlooked value is what miners do.

My books Fixers and How to Increase the Value of Real Estate cover adding value. My book How to Buy Real Estate for at Least 20% Below Market Value covers finding overlooked value.

It's also analogous to the nature-versus-nurture debate or, as we say in football, coaching versus recruiting.

Real estate investors tend to be more into recruiting and finding than creating. That's fine. Both can be profitable and serve the common good in an "invisible hand" way.

More capital gain

I wrote "interesting" next to an item on page 18 of John's book. He said high-income people might be better off buying more expensive rental homes because that would cause them to have relatively more capital gain and less rental income than if they bought a moderate-priced home.

High-income people cannot deduct rental property losses because their adjusted gross not counting real estate exceeds $150,000. So they get more after-tax income from capital gains than from operating a rental property.

However, I have never bought the notion that high-priced homes appreciate at a higher rate than moderate-priced homes. John does believe that. If it were true, the disparity between the two would grow greater as a percentage year by year. Say that in 2004 the median price of a high home were $400,000 and the median price of a moderate home were $250,000. That means the moderate home is 62.5% of the high one.

Then say the high home appreciates 10% and the moderate, 5%. That gives new prices of $250,000 x 1.05 = $262,500 and $400,000 x 1.10 = $440,000. Now the moderate home is only $262,500 ÷ $440,000 =59.7% of the high. Run those numbers since the beginning of home building and you get something that bears no resemblance to current reality.

Incomes determine

Basically, there is a bell curve of people in terms of all sorts of variables including how much home they can buy and they need a bell curve of homes to buy. Home prices are ultimately tied to incomes. On a number of occasions, I have shown that the lowest priced area in the U.S. appreciated faster than the highest. In some years, it's the other way around. But in general, the whole market appreciates at the same rate.

The only advantage I see to the top end of the market is less management per dollar of value. If you buy $3,000,000 worth of homes in my area, it would be two houses and two tenants. Buy the same dollar amount of homes in South Bend, IN and you have 30 homes and 30 tenants.

I used to feel bad for the Realtors in nearby Camden, NJ when I was an agent. They had to sell about four houses to make the same commission I made on one. Then I moved to California and saw that I would have had to sell about three suburban New Jersey homes to make the commission I would make selling one in California.

Not a straight trade

So I agree with John that high-income people would be less interested in operating rentals than lower income investors—because of tax laws and the higher value of their time. But I disagree with the notion that merely moving up the scale trades rental operating profits for equivalent capital gains.

I think the higher priced homes are simply less profitable overall because of greater negative cash flow. I think the higher-income investor would get both cash flow and capital gain in the lower priced homes—albeit with fewer operating loss deductions. With the higher priced home, he will get the same capital gain percentage-wise, but his overall net profit will be diminished by greater after-tax negative cash flow.

The beaten track

Perhaps the main difference between John's approach and the one that investors I talk to seem to find most successful is the question of whether to stay on, or get off, the beaten track. John largely says to stay on it, as in buying the most popular type of home: the three-bedroom in a nice neighborhood.

The approach that makes more sense to me is to buy off the beaten track—like a one-bedroom house—then move it somewhat toward the beaten track—like modifying the floor plan to produce a second bedroom.

Trying to move it all the way to the most popular category probably violates the "get the fast buck not the last buck" rule.

You can call this the contrarian approach or the leper approach. The basic idea is that properties that are shunned for reasons that are economically correctable contain built-in profits. The investor's role is to find those opportunities and realize those profits by making the required changes.