[Editor's Note: This is a guest post from David Phelps, D.D.S., who has freed himself from the “slavery” of his dental practice not once but twice by investing in real estate. He now teaches seminars on real estate investing. He subtitles this post Creating Sustainable Income Through Strategic Real Estate Investment In The New Economy. We have no financial relationship.]
I began building my investment portfolio in residential real estate in 1980 while a first year student at Baylor College of Dentistry. During my undergraduate studies, I spent what leisure time I had reading books about the stock market and real estate investment (ok, I admit it, I was a bit on the nerdy side). I could not understand how I, as an individual investor, could exert any control over stock market investments whereas real estate seemed to be the ideal investment for me.
I convinced my father, an ophthalmologist in Colorado, to be my first joint venture partner, a topic I will discuss later in this article. I provided the management component and Dad was the passive capital investor. Fast forward four years later when we sold our property and split a net profit of approximately $50,000. This was far more than I earned waiting tables at night and on weekends and the management of this property consumed very little time at all (we bought the right house in the right neighborhood – one of the keys to successful residential real estate investment).
After graduation, I began the private practice of dentistry and simultaneously continued to acquire and build my real estate portfolio, later adding note receivables secured by real estate, a mobile home park, and a commercial building. Fifteen years into practice, I had enough replacement income via my real estate investments to replace my labor-produced dental income…..and then, unfortunately, my marriage failed. Six years later, my only child, a daughter, age 12, had to undergo a life-saving liver transplant. Life had thrown me a few unplanned curve balls.
Fortunately, my real estate investments provided me the financial foundation to allow me to leave private practice and eventually sell the practice in order to spend the time that I needed and wanted with my daughter. I am happy to report that Jenna is 21 years old and doing well today.
Real Estate Investing Gave Me Freedom
My own life is no longer scheduled by appointment. I work, but I work when I want to work (on real estate investments) and choose what I do and with whom I do it. This is my definition of “freedom.” As a side note, I make far more profit and real equity in real estate investing today than I did in just over twenty years of running a top 5% producing dental practice.
The traditional paradigms of investment and financial planning, that is, earning and saving one’s way to retirement, followed by putting one’s full faith and future in the hands of Wall Street (stock market or municipal bonds) are no longer valid….if they ever were.
Like it or not, we live in uncharted waters today, with political and economic dynamics that have to date never been experienced. Wall Street has not proven to be a good steward of our money. The outright manipulation and high speed trading functions of these markets is reason enough not to be the place for the prudent individual retail investor to place his hard earned capital.
Historically, more wealth has been created via real estate than any other investment class. The majority of business owners who are financially free have a significant portion of their assets invested in real estate. Last year, Warren Buffet stated, “If it were practical to load up on single-family homes, I would.” Today, Warren Buffet is systematically buying up real estate brokerages throughout the nation, providing him access to all of the single-family properties that he desires.
[Editorial Note: I disagree with the simplification that investing in stocks and bonds is the equivalent of putting one's future in the hands of Wall Street.]
Issues with Other Methods of Real Estate Investing
Why not commercial or multi-family, REITS (real estate investment trusts), PPM’s (private placement equity funds), limited partnerships, or TIC’s (tenant-in common) vehicles? Each of these investment classes allow for ease of investment for the passive investor who wishes to diversify into real estate, but not without some serious downside risk.
The problem with each of these asset classes is that the investor loses control over his investment. Capital is pooled with other investors and a management entity (which generally takes a handsome fee on the front end plus management fees during the holding period) does all of the management work. In an ideal world, the investor receives the anticipated return on investment as well as a return of his initial capital invested.
Unfortunately, the loss of investment control simply to be passive often results in a loss of investment capital. The internet is abundant with lawsuits from unhappy investors who believe that they were misled with false or misleading representations, or the management entity invested in inappropriate investments, or mismanaged the assets and so on.
Myths of Single Family Real Estate Investment
Then what are the options for the individual investor, particularly White Coat Investors, who are busy and focused on running and maintaining a viable professional practice, yet don’t want to lose control over their investments by handing them over to Wall Street or pooling their investment capital with syndications?
Let’s deal with some of the myths of single-family real estate investment before discussing the benefits and how best to be an efficient and prudent passive investor.
Common objections or barriers for the novice single-family real estate investor are:
1) Inefficient market….it’s not easy! (the stock market being an “efficient”market).
2) Limited access to opportunities (where and how does one find ‘good deals?”).
3) No centralized management (the investor’s nightmare).
4) Lack of liquidity (takes time to liquidate real estate equity)
These very objections to single-family investment are what make this asset class a prime opportunity for those who wish to build wealth in today’s economy. We are experiencing a massive transfer of wealth (redistribution) today with trillion dollar bailouts of the big banks and Wall Street and the concurrent collapse of the housing bubble in 2007-2008.
Those who have access to and an understanding of local markets are taking advantage and acquiring these assets at well-below replacement cost and with cash flow returns well into double digits. Strict credit financing and underwriting regulation has reduced the percentage of available homeowners who can qualify for financing which in turn causes rents (cash flow) to increase.
The inefficiencies in the market, the lack of ability for real estate values to be traded on an exchange, is what allows for the real opportunities for the astute investor. It is because of these inefficiencies that real estate cannot be manipulated by high-speed computer or insider trading and keeps professional or sophisticated traders out of the market.
Finding ‘good deals’ is an art and requires both a local presence or network and the ability to lead generate through various media sources.The passive investor must rely on a co-venture partner who is a ‘boots-on-the-ground’ active investor to gain access to the best opportunities. It’s all about the connection, or “who you know” (see joint ventures below).
Almost everyone knows someone or has direct experience with a landlord/tenant horror story. But it is this very management skill that creates real opportunities for those who know how to either systematize or outsource the management component. Real estate investment is not for the accidental landlord; someone must set up management systems and processes.
The fast track for the ‘passive investor’ for finding the best local opportunities and handling the management issue is through purposely-structured joint ventures with an active co-venture partner. A joint venture is not a partnership. Joint ventures provide for severable interests in real estate that are documented, secured and do not require the future division of interests through litigation (the messy downside to traditional partnerships).
The most successful people in the world are those who learned early that almost any endeavor can be achieved more efficiently by collaborating with others who bring complementary assets, skills or resources to the project or investment. Going solo limits the efficiency and ability to achieve and produce more.
Avoid Banks To Finance Real Estate
Real estate values have always been dependent on the availability of financing. When interest rates are low and banks and mortgage institutions are providing relatively easy credit financing, real estate is more liquid and values increase (the driving force in the housing bubble which peaked in 2006). During times of limited access to credit financing, housing values decrease and real estate is less liquid (the cause of the housing bubble collapse in 2007).
Novice investors consider traditional bank institutions as the main source for investment financing. This limits the investor to the bank’s lending criteria and requires placing all of one’s personal assets at risk (personal liability . Experienced investors have long avoided bank financing for acquisition and holding periods and instead utilize both private lenders and seller financing for leveraged acquisitions.
When one has developed access to private funds, no longer are real estate investments illiquid and leverage financing carries much less risk. Additionally, private funds can be used in both equity and debt financing (the former being the most risk averse form of financing and the subject of a future article).
Additional Real Estate Benefits
Additional benefits of real estate investment include
- Income – there will always be a need for well-located bread and butter single-family houses. The occupants, or tenants, go to work every day to earn income in order to pay rent, the source of income, similar to the dividends paid by some stocks. Income via real estate carries a natural inflation-index component.
- Depreciation – real estate provides tax benefits that no other asset class provides, including depreciation, tax-deferred equity appreciation and tax-free exchanging of capital gains profits.
- Equity – ‘equity capture’ can be created by acquiring distressed assets at discounts to market values and can be ‘forced’ by adding value by way of property renovation. Equity may also increase by natural appreciation or inflation in the economy.
- Amortization – the pay down of debt leverage by tenant income (rent) is another form of equity building.
- Leverage – the ability to control a larger portfolio of equities with relatively nominal percentages of capital investment.
As an aside, my father, my first joint venture partner, continued his own investment into real estate after our first successful project and made a real estate investment a significant portion of his retirement assets. Today, his investments are almost all invested in notes secured by real estate, providing him monthly cash flow without any management issues….the perfect endgame for him. He no longer has a need to build his wealth through equity acquisition.
In future articles, I will discuss how joint ventures are created, various yield returns available for single-family properties, the proper use of leverage, equity versus debt investments, and the use of self-directed IRA’s and real estate investment.
What do you think? Does single family home real estate investing have a place in your portfolio? What percentage of your portfolio would you allocate to it? What have you done to avoid being an accidental landlord and to outsource the tasks you can't or don't want to do? Comment below!