From a small northwestern observatory…

Several years ago, I had a client – a family fund, actually – that had a neat, very long term investment strategy. To simplify, imagine that they started with $2 million. They found a “fixer upper” property that could be purchased for $1 million, and then spent the other $1 million on repairs, upgrades, etc. After the fix-up, the property was worth $3 million. They then finance the property, taking out $2 million in cash, and do it again. Do this 100 times, and you have $300 million in property and $100 million in net equity. Neat, eh?

Now, there are three caveats to this precise strategy. First, you need to start with $2 million. Second, you need to think VERY long term. Finally, it’s helpful (but not necessary) to have a market where real estate values are steadily growing. However, these aren’t barriers to entry, and even a more modest investor in a flat market can make this math work.

One of the important benefits in real estate investing is the value of entrepreneurial effort. In the stock market, informational efficiencies and rational expectations generally prevent significant abnormal returns for your effort. While there are noteworthy exceptions, the stock market investor is usually a tape reader (as they used to call them) and a victim of the systemic shifts in the market.

Conversely, the savvy real estate investor enjoys a significant return for his or her effort, and in the case of my client, this entrepreneurial effort can be capitalized into a non-taxed increase in value. The key, however, is finding value-added projects, where the value increase exceeds the cost. All too many real estate investors miss the mark on this, and end up with no net increase in equity, or worse spending more than they receive in value return. The graphic below simplifies the decision rule. Consider investments where the value exceeds the cost, rather than the other way around. As simple as this seems, all too many real estate investors trip up on this simple rule.

Another key element — you make money when you buy real estate, not when you sell. My clients were careful to seek out investments that needed a facelift — ugly properties that could benefit from some significant sweat equity.

So, how and where do you find these diamonds in the rough? I have a few ideas, and in fact discuss many of them in Real Estate Valuation and Strategy. Over the course of the next few blog posts, I’m going to share some ideas that work in the real market, at a variety of value points such that even the most fledgling investor can find some opportunities.

As always, if you have any questions or comments, please reach out! I look forward to hearing from you.

John A. Kilpatrick, Ph.D., MAI — john@greenfieldadvisors.com