Thursday, March 26, 2009

Rich Dad's Real Estate Era is Back!!

Long time back I had read the book called "Rich Dad, Poor Dad" by Robert Kiyosaki. Its a very interesting book with great conceptualization about:
  • Personal Finance: How one should manage his own money.
  • Real Estate Investment.
  • Clear definition about what Asset & whats a Liability.
  • Why one needs to own a Business or become an Investor.
Even though I liked his ideas I could never find the kind of Real Estate deals he talked about, in real life. But it seems the time has come that such deals will soon be available.

Check out this article: http://www.thestreet.com/story/10477259/1/buy-rental-properties-with-uncle-sams-cash.html

Our government is unleashing an ocean of cheap financing in the hope of stimulating the economy and preventing further deflation of assets, especially real estate. Although most of this government largesse is going to directly benefit large financial institutions, private-equity shops and hedge funds, there are a couple of ways that smaller investors can directly benefit from it and get their fair share.

Fannie Mae(FNM Quote - Cramer on FNM - Stock Picks), Freddie Mac(FRE Quote - Cramer on FRE - Stock Picks) and the U.S. Department of Housing and Urban Development are offering generous financing terms for the purchase of apartment buildings priced at or above $1.5 million.

In addition, the agencies will now buy the mortgage paper of investor-owned individual rental properties such as condos or single-family homes being used as rental properties, up to 10 properties per individual owner.

The irony of all of this cheap and easy financing for investors in rental properties is that the government is basically trying to replicate exactly the cheap and easy financing that caused the real estate bubble of a few years ago and the current crash.

What is different today is that the spread between the rate of financing and multiple of earnings on rental properties (or capitalization rate) has never been more favorable to investors. (A cap rate for an apartment property is calculated by dividing the current net operating income of the property by the purchase price.)

This is probably a once-in-a-lifetime opportunity for investors to generate current cash flow of 15% to 25% per year by locking in extremely favorable financing from the government to buy rental properties at a time when there are not enough investors willing to step up and buy these properties because of concerns about the economy and falling real estate values.

To understand why rental properties are such a good buy today, let's start by looking at how they traded historically. In supply-constrained markets such as Los Angeles, apartments have generally sold at cap rates -- the inverse of a price-to-earnings multiple -- of between 3% and 8% of the purchase price in good neighborhoods during the past several decades.

A couple of years ago, cap rates were mostly around 3% to 4% of the purchase price, which is the equivalent of a 25 to 33 multiple of earnings, even though interest rates were higher than today. People were very optimistic about rents and real estate values a couple of years ago.

Today, people are very pessimistic about both rents and values. Cap rates are generally closer to 8% today in good neighborhoods, which is the equivalent of a 12.5 multiple of earnings. These numbers not only include operating expenses but also capital replacement reserves for these properties.

Also, because Los Angeles has some form of rent control in most areas, the current rents at these rental properties are substantially below market rents on average. Many properties have average in-place rents that are 30% to 40% below current market rents. What this means is that even if market rents decline somewhat because of a weak economy, average rents at these properties and income should continue to rise because the spread between current and market is larger than the potential decline in market rents.

At today's interest rates, an investor who is an experienced real estate operator meeting certain net worth and liquidity tests can borrow about 75% of the purchase price of these apartments from Fannie or Freddie or HUD at around 5% fixed for seven years.

Ten years is typically the maximum loan term, but the seven-year loan is better because of the current slope of the yield curve and programs offered by Fannie. If you're not an experienced real estate operator or don't have sufficient net worth or liquidity to meet the requirements, you can still take advantage of this attractive financing by investing as a limited partner with an experienced real estate operator.

Experienced real estate operators can be identified in your local market or other markets in which you want to invest through licensed real estate brokers at any of the major national firms such as CB Richard Ellis(FNM Quote - Cramer on FNM - Stock Picks), Cushman or Grubb and Ellis.

At those loan terms, the initial cash flow to the investor would be 17%, and for the reasons explained above, that cash flow is very likely to increase over time. Further, the loans from Fannie, Freddie and HUD are typically non-recourse, meaning that the investor is not personally liable to repay the loans. The lender will look only to the property as collateral for repayment unless there are so called "bad acts" such as fraud or a bankruptcy filing by the owner.

It gets even better. As a direct owner of rental properties, the cash flow you receive is partially sheltered from income taxes by depreciation. Depending on your personal tax bracket, the 17% pre-tax cash flow yield from the example above could be substantially higher on an after-tax basis.

Lastly, these properties can often be purchased at a large discount to replacement cost, which is the cost to build new apartments or other multifamily housing such as condos. This discount to replacement cost further increases the chance of an increase in the value of the property in the future.

For investors with a higher risk tolerance, there are even better cash flow opportunities in rental properties located in markets like Phoenix. Historically, cap rates in Phoenix have ranged from about 5% to 10%. Cap rates are higher, which means that income multiples are lower, in Phoenix vs. someplace like Los Angeles because the supply of housing is not as constrained, and there is no rent control, so rents are always close to market. At the peak of the real estate market a couple of years ago, cap rates in Phoenix were mostly in the 5%-6% range because of investor optimism.

Today, cap rates are sometimes 11% for similar rental properties. Although there is still some potential that the income at these properties could decline because of economic weakness, a significant amount of that decline has already happened during the past two years.

If you buy at an 11% cap rate, borrow 70% of the purchase price from Fannie, Freddie or HUD at 5.25%, which is available for Phoenix properties, your initial cash flow to the equity is nearly 25%. Even if the cash flow declined by 10% after you buy the property, your cash flow to the equity would still be 21%.

As previously mentioned, these pre-tax cash flow yields will be even higher after adjusting for the tax benefits of direct real estate ownership, and there is also likely to be future appreciation because of lower cap rates in the future and the large discount to replacement cost at which these properties can be purchased today.

If you compare these two opportunities for direct ownership of a multifamily property to owning a public apartment REIT such as Equity Residential(EQR Quote - Cramer on EQR - Stock Picks), owning the REIT shares doesn't look very attractive.

Even at these depressed share prices, EQR's common stock pre-tax yield is only about 10% vs the 17% to 25% yields in these examples. Also, the investor does not receive any additional tax benefit from sheltering income by owning REIT shares.

As a public company, EQR's stock is also subject to many other issues for an investor such as Sarbanes-Oxley, more expensive overhead and management costs, short-sellers driving down the shares via various trading strategies, negative impact from inclusion in the REIT index, and potential misalignment of interests between the managers and the shareholders.

EQR also has a much more complicated and risky capital structure as far as its corporate debt and preferred stock vs. an individual apartment building.

Many investors will not be able to understand all of these risks, as recently happened with General Growth Properties(GGP Quote - Cramer on GGP - Stock Picks), which has seen its share price collapse nearly to zero primarily because of issues relating to its capital structure and unrelated to its properties.

Further, this more complicated capital structure means that the investor is not getting a similar direct benefit from government financing that you can get from buying apartments directly. Yet another risk with REITs that will be difficult for investors to evaluate is the quality of earnings and the assets in the portfolio of a public company. The additional liquidity that you get from having a public security does not compensate you for the much lower yield and other costs and risks involved.

There are obviously other risks of direct ownership, including asset selection, market selection, due diligence and other property-specific issues such as evictions of tenants and bad debts. Finding good-quality apartments buildings for sale and evaluating those investments can be challenging for individuals with no real estate experience.

However, this process is actually easier than trying to understand the balance sheet and portfolio of a national REIT. Investors who want to pursue these investments should start by contacting apartment sales brokers and mortgage finance brokers in their local area.

Alternatively, all of the issues relating to asset selection, underwriting and due diligence can be handled by professional real estate operating and management companies that will typically invest their own capital alongside the limited partner investors so that there is no potential for a misalignment of interests.

If investors want to own rental properties for cash flow and appreciation, this is potentially a great time to do it through direct ownership that takes advantage of attractive government financing.

The spread between apartment cap rates and fixed-rate financing to buy them has never been wider. It is very likely that this spread will narrow either because of higher interest rates or lower cap rates in the future. In either case, this should be a relatively good time to buy if investors want to achieve solid current cash flow returns and upside potential.

No comments: