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Ignoring transaction costs
When investors brag about their real estate profits, they leave out the transaction costs. You cannot do that. They are enormous in real estate, typically around 10% of the value of the property when you buy and something similar when you sell. In contrast, transaction costs when you buy securities (stocks and bonds) can be as low as zero if you buy direct from the borrower (e.g., the U.S. Treasury) or company (e.g., Apple, Inc.) in question. Since real estate investors typically use leverage (borrowed mortgage money), the amount of the transaction costs can equal or exceed the entire amount of the down payment.
This creates a huge new-car-used-car effect. When you buy a new car and drive it off the lot, it becomes a used car and the resale value drops dramatically. A similar thing happens to your net worth when you buy real estate. If you were to immediately turn around and resale, you would suffer tremendous loss as a result of the buying and selling transaction costs.
The best mutual funds like Vanguard 500 Index Fund emphasize minimizing fees and transaction costs. The need to do that in real estate is far, far greater so ignoring the transaction costs is a far greater mistake than it is in stocks and bonds. The fact that real estate transaction costs are so high means investors need to emphasize avoiding transactions and minimizing transaction costs when transactions themselves cannot be avoided.
Ignoring capital expenditures
When discussing their cash flow, investors ignore capital expenditures like replacing a refrigerator or a roof or a furnace. When you ask why they left that out, they say, “It’s just a one-time expenditure.”
And the relevance of that is what? An expenditure is an expenditure. If it’s a never expenditure, don’t count it. Otherwise, it counts. Plus, when you gain experience, you learn it’s always something. In 2001, you have to replace a fridge in your rental house. In 2002, the driveway is so shot you have to repave it. In 2002, you get the bad news that the 12-year old air-conditioner compressor needs to be replaced. In 2003, the hot water heater goes. But in 2004, no capital expenditures. Hallelujah! Then, in 2005, you need a new roof which costs more than all the prior capital expenditures combined, plus the furnace needs a new combustion chamber. And on it goes.
If you had bought stocks instead of the rental house, an investment that is often compared to rental property, you would not be spending money on refrigerators and such. You buy the stock, period. So don’t say real estate is better than stocks because of higher cash flow when you leave out the biggest expenses.
Your actual cash flow
Here is how to calculate your cash flow truthfully:
1. Enter Line 22 (Income or loss from rental property) from your IRS 1040 Schedule E
2. Add Line 20 (Depreciation) from your IRS 1040 Schedule E
3. Subtract the amount by which you paid your mortgages on the rental property down (from your annual mortgage statement)
4. Subtract the total in column (c) of Line 19 (a through i) of IRS Form 4562 (total of all capital expenditures for the year)
5. The answer is the true amount of cash flow you got from your property that year
Embarrassing, isn’t it?
Now contrast that with how most investors and bogus gurus inaccurately calculate cash flow:
1. Enter rents for the year
2. Subtract property taxes, insurance, and utilities
3. Subtract mortgage payments
This obviously overstates cash flow by leaving out other operating expenses like repairs, vacancy and collection loss, supplies, gardening, snow removal, etc., etc. And it leaves out the capital expenditures discussed above.
Ignoring the value of your time
If you buy stocks or bonds, you should just buy a Vanguard index fund of them and forget about it. That will take none of your time. In contrast, owning rental property takes lots of your time. If you do everything yourself like most small real estate investors, it will take you about 4.6 hours per residential unit per month. Nonresidential varies according to the type of building and lease terms. Nonresidential takes less time per square foot but it takes far more time than owning stock or bond index funds.
Also, buying, renovating, and selling properties takes enormous amounts of additional time. Exactly how much depends on your acquisition strategy and diligence, what renovation projects you do, and whether you sell without a real estate agent.
If you buy a bond index fund, you decide how much risk you want to take and select a bond fund where the Moody’s or S&P ratings of the bonds match that amount of risk. The same is true if you buy a stock index fund although they don’t have the same sort of risk ratings and if you buy a widely diversified one as you should, the only risk is that the majority of the value of the stock market will simultaneously fall and stay down for the rest of your ownership period.
In real estate, investors often ignore the readily available risk-management tools like fixed-rate mortgages, non-recourse mortgages, avoidance of balloon payments, warranty deeds, and so on. Investors and bad gurus are also appallingly cavalier about dramatically increasing risk by using high leverage. They treat failure to use high leverage as a sign of cowardice or lack of manhood. See my free Web article on nothing down.
Investors tend to be good about getting title insurance and hazard and liability insurance, although that may be because the lenders require it. But they are appallingly bad about protecting themselves against the many other risks like lawsuits, a regional or national drop in market values, toxic contamination, rent control, floods, poor workmanship by subcontractors, misbehavior by employees, interest rate increases, down-zoning, and so forth.
The typical conversation I would have with an investor or guru who ignores risk goes like this.
Reed: How are you protecting yourself against a drop in market values?
Investor or guru: That’s part of the deal. You could get killed crossing the street. There’s risk in everything. You can’t worry about stuff like that if you’re going to be a real estate investor. Besides, real estate values always go up over the long run. Downturns are only temporary.
Reed: What about diversifying so your eggs are not all in one market or property type?
Investor or guru: I just buy rental houses here where I know the market.
Reed: Does knowing the market mean you are invulnerable to being hurt by lawsuits, toxics, rent control, and so forth?
Investor or guru: Like I said, you can get killed crossing the street. You can’t worry about stuff like that?
The investor or guru side of this conversation is childlike and mindless. It is ostrich head in the sand. The truth is investors and their bogus gurus do not know anything about risk management, do not want to know anything about it, and do not even want to think about risk because it depresses them.
In fact, you can and must manage each and every risk you face. I recently read a book called All the money in the world about the Forbes 400 richest people in America. One of the things I was struck by was their risk management. For example, Donald Trump got burned a number of years ago to the point where his net worth was minus $900 million for a while. Nowadays, the various Trump buildings you see under construction in Chicago or Las Vegas or wherever are not owned by him. Rather, he just licenses his name to them. He gets a fee for that and a bonus if sales or rentals exceed certain bench marks, but he loses nothing if the projects fail or produce disappointing results. Smart.
Money managers like hedge fund billionaire George Soros typically get 2% of the value of the assets they manage per year plus 20% of any profits they make. Again, no risk of loss for any reason. Sophisticated financial people use all sorts of techniques small real estate investors never even think of like extremely broad diversification, living in states with unlimited homestead bankruptcy exemptions, put options, and selling short to hedge against various risks. (Selling short has nothing to do with the currently fashionable real estate seminar topic of short sales.)
Being too lenient with tenants and employees
Like almost all other beginning real estate investors, I was too lenient with my tenants and employees initially. I wanted to be liked. But I quickly figured out why landlords and bosses are the way they are. A great many real estate investors never figure it out and either flee from the business or get eaten alive by their tenants and/or employees. See my book How to Manage Residential Property for Maximum Cash Flow and Resale Value for details on the proper approach to tenants and employees.