I bought my first property when I was 27. The loan to value for the mortgage was 98%. The property was a three-flat building in Chicago where we lived in one unit and needed the rent from the other two units to cover the mortgage. Our contribution to the mortgage was equivalent to the rent that could be charged for the unit we lived in.
At the time, I saw this as a low-risk investment. I went from renting to owning with little money down and no more out of pocket expense than I had as a renter.
The truth was, at one level, that buying that building was a huge risk. With only 2% down, I could have lost the entire down payment and closing costs, albeit a small total amount of capital, if the property value went down just slightly and I couldn’t keep renters in the apartment paying at least what they were paying when I bought the building.
Losing renters would mean having to cover the difference from personal cash flow… which at 27 with student loans and credit card debt was tight. Building repairs and maintenance wasn’t in my cashflow projections when I bought. The entire thing could have fallen apart.
Fortunately, it didn’t.
The renters that came with the building moved out when their leases were up. They were replaced with renters paying higher rents. The real estate market was strong at the time which made it possible to take out a home equity line of credit within a few months of closing that allowed me to make some improvements… with the higher rental income covering the payment on the new loan.
That 2% down payment turned into 75% of the purchase price by the time I sold the building two-and-a-half years later.
High-risk, high reward.
Again, however, I didn’t perceive the risk as high at the time… because I was young and had time to recover from any setbacks. My primary goal was affordable personal housing. My secondary goal was the investment.
A friend of my son’s recently bought his first house. He’s all of 26. When speaking with him about his purchase, he seemed slightly nervous. He eventually said… “I’m young and can afford the risk at this age”. He put 5% down. Based on my calculations, the monthly payment is likely a stretch for him. Maybe he eats ramen noodles for a year.
Or if he really needed to, he could rent out his extra bedroom to help cover the mortgage. At his age, he can absorb the risks in different ways… and he’s already looking to diversify as soon as he can by buying another house and renting out the one he just bought.
Diversification is a great risk mitigator so I admire his plan. Diversification is my main mantra when speaking with real estate investors.
Over the years, I’ve spoken with real estate investors who told me they were diversified… and lost everything. Most of these investors owned highly leveraged properties all in the same local market. One guy owned a dozen houses in Boston that were cash flowing nicely… until he lost a couple renters in an economic downturn.
The cash flow from the other houses weren’t enough to cover the payments on the ones that lost renters. It created a domino effect where he eventually handed over all the properties to the banks.
In his case, leverage was his enemy along with not having enough excess cash flow or cash on hand to carry him through a local economic downturn. Had he even been slightly diversified with houses in more than one city, he may have come out okay from his Boston market downturn.
That example is from the late 1990’s and in a specific market. In 2008, few people were left unscathed no matter how diversified they were if they were highly leveraged.
Pre-global real estate crash, I spoke to many people bragging that they ‘controlled’ millions of dollars’ worth of condos. They could do this because they had put down $5,000 deposits on a handful of pre-construction properties. For $25,000, one guy had contracts on $2 million worth of property—5 condos priced at $400,000 each.
The goal of these real estate ‘investors’ was to flip the condos for more than the contract price before the first payment was due to the developer. That was a huge risk if you didn’t have the funds to back up the play. It’s similar to buying an open call contract for a stock. That’s where you buy the right to buy a stock at a fixed price with the hope of the price going up. That’s not investing, but rather speculation.
Most brokerage firms won’t let you trade call contracts without proving to them you’re a sophisticated investor, i.e. you know what you’re doing and understand the risk, which in the case of an open call contract is the risk of losing 100% of your ‘investment’… the price you paid for the call. However, anyone who could sign their name could buy pre-construction condo if they had $5,000.
The investor’s $25,000 was at risk when he signed the purchase contracts for these condos. He either had to sell the units for more money than the contract or he had to come up with the first progress payment when the time came… for all 5 units. Otherwise, he’d lose the $25,000.
That level of risk became too much even for developers. More and more developers started restricting resale ability in their contracts to keep people from buying for the sole purpose of flipping their contracts to other ‘investors’.
Again, leverage was the enemy… as was the lack of diversification (this particular guy had all five of his units in one building).
During the 2008/2009 global real estate crash, some markets dropped as much as 70% while others as little as 25%. The people and markets that did well during this time were those with low leverage. Markets with low leverage like Panama did well because owners with no mortgage weren’t forced to sell their properties when they couldn’t keep up with the payments… because they had no payments.
Ireland and Spain saw some of the biggest drops because of high leverage in the marketplace. Irish banks were giving 110% loans in 2006 and 2007. People were buying with the expectation of continued market appreciation, but they had no skin in the game. They walked away from those mortgages during the crash leaving a lot of properties with the banks who had to unload them over time, which depressed some markets for years.
One relatively easy risk mitigation rule most people don’t follow is don’t invest more than you can afford to lose. Recent news articles have referenced Mark Cuban’s investments on Shark Tank. He’s invested something like $20 to $25 million in more than 85 companies on Shark Tank. To date, he has apparently not broken even on a cash basis (although the total value of the companies still operating have him well into the black).
$25 million is less than one-half a percent of his total net worth so he’s not missing the cash and can afford to wait for profit payouts from these companies. The equivalent for someone who has $1 million of investable funds is $5,000. You are not going to have an easy time trying to invest $5,000 in 85 companies so you have to play by more restricted rules for investing.
My general rule of thumb is no more than 5% of my investable portfolio for real estate into any single property. However, it’s a hard rule to follow unless you’re a multi-millionaire… or you’re using high levels of leverage. Nevertheless, it’s something to keep in the back of your mind as you look for real estate investments. And when you do break the rule, look for other risk mitigating factors.
One lower risk property investment you can make is in something already built that has a rental track record with a renter in place already. That’s what I bought when I was 27. The leverage risk was high, but the rental risk was low. In the end, the market risk went my way making the overall investment hugely profitable.
Would I make the same investment today that I did back when I was 27? Probably not… not with 98% leverage… well, maybe if the down payment was only $5,000 like it was back then and the rent paid the mortgage. However, I wouldn’t create a portfolio of properties with that structure for myself today.
The time to take bigger risks is when you’re young like my son’s friend… or when the investment represents a small percentage of your portfolio and offers huge upside, like Mark Cuban’s Shark Tank investments.
If you don’t have time to recover from a bad property purchase and the investment amount represents a large portion of your portfolio, you need to take more time to assess the opportunity to make sure it fits your overall investment goals.
Stay diversified,
Lief Simon
Editor, Offshore Living Letter
