As any real estate investor knows, properties may generate passive income, but owning them is far from passive.
Because even if you have great property managers and you never see your tenants, you still have important decisions to make about markets, debt and equity.
And while most real estate investors focus on doing deals and managing cash flow (both VERY important activities), the smartest ones also pay attention to asset allocation models.
Yes, it’s true. Asset allocation modeling isn’t just for Wall Street financial planners and paper asset advisors.
Balancing on their chairs in the studio to build on this critical topic:
- Your massively popular host, Robert Helms
- His unbalanced co-host, Russell Gray
All businesses have jargon. So to make sure we’re all in the same page, let’s clarify some terms:
Critical Mass – that’s how much equity you need to invest for cash flow to generate enough spendable cash flow to support yourself in the manner to which you’re accustomed…or would really like to be accustomed!
Asset Allocation – In traditional financial planning, you’d have a pie chart divided into slices for stocks, bonds, cash, precious metals and maybe one or two other things like annuities, fine art, etc. We’ll talk about what that looks like for real estate investors in a moment.
Re-balancing – this is simply adjusting your asset allocations (how much of each component) to bring the ratios into alignment with your predetermined plan or model (which of course presupposes you have a plan or model!).
Make sense so far?
Most people’s investing lives can be divided into two broad categories: Accumulation and Consumption (sometimes called Annuity, not to be confused with insurance products of the same name).
Accumulation is just what it sounds like. You’re accumulating wealth on your quest to reach Critical Mass.
At Critical Mass, you have enough wealth (equity) to deploy for enough Passive Income (money you don’t have to work for) to achieve escape velocity from the gravitational pull of the daily grind. Or as our good friend Robert Kiyosaki would call it, Getting Out of the Rat Race.
Obviously, the FASTER you can build wealth, the sooner you can get to Critical Mass so you can achieve escape velocity.
In our temporarily out-of-print book, Equity Happens, we spend quite a bit of time talking about equity growth strategies and the important role of leverage.
Now that equity is happening again (did you have any doubt?), we thought it was time to revisit some of the important themes inside the topic of getting to critical mass.
First, you have to be on the OWNERSHIP side of the equation. That is, you don’t want to be the lender. You want to be the owner (or part owner). This is called EQUITY. That’s why they call stocks “equities”. In real estate, it’s called being the landlord.
Next, it’s important to pick the RIGHT MARKETS. The old adage about the 3 most important things in real estate being Location, Location and Location is true. Because it’s all about Supply & Demand.
When you pick properties in popular areas (demand), where there is some limiting factor in supply, you have a chance of getting APPRECIATION. That’s people bidding up the value of the property FASTER than the pace of simple inflation.
Of course, what’s “popular” depends a lot on the property type. If you’re depending on rental income to pay for the property, mansions in Beverly Hills might be low in supply and high in demand among Hollywood elite, but no one’s renting them from you. And if they did, the rent probably wouldn’t provide enough cash flow to make the use of leverage appealing.
So “popular” might be affordable houses or apartments in B class neighborhoods in areas with a strong, geographically-linked, regional economy. Or it might be resort properties in a popular area with limited supply and lots of people paying top dollar for overnight stays.
One way to re-balance your real estate during your Accumulation Phase is to REPOSITION EQUITY into hotter markets. You can use a cash out re-finance (those are coming back!) to move equity out of a property you want to keep; or you can sell the property and use a 1031 Tax Deferred Exchange to transfer the equity without paying tax on any gains.
Now, if you were in the Consumption or Annuity Phase, you might move your equity from a highly appreciated, low cash flow market to a market and product types that cash flow like crazy (but maybe don’t appreciate as well). So the idea of re-balancing applies within each phase or in transition from one phase to the other.
Does your brain hurt now? Sorry. Let’s just do a couple of more concepts and then you can get a snack.
LEVERAGE (i.e., debt) can be one of our best friends…especially during the Accumulation Phase. Debt allows you to control MORE property with LESS purchase equity (down payment).
Of course, the down side of leverage is you’ll get less cash flow. But that can be okay, as long as you have enough (with a safety margin) to make the mortgage payments (and you don’t need any cash flow to live on).
And at today’s stupid low interest rates, it’s hard to make the argument that the best use of cash or equity is to reduce mortgage debt. But that’s a different discussion.
The main benefit of leverage is that it MAGNIFIES GROWTH.
For example, if you own a $100,000 property for cash and a year later its value increases 10%, your wealth (equity) has grown by $10,000.
If you paid CASH, then your return on your $100,000 invested is 10%. Super.
Now, if you put only 10% down ($10,000) and got a 90% loan, then you grew $10,000 on $10,000 invested, which is a 100% gain. WOW!
Of course, a paid for property will have more positive cash flow than a 90% leveraged property. That’s the trade-off. Maybe for you something in between is “optimal”. That’s where BALANCING comes in. YOU have to do the math and decide what’s the optimal balance for your situation.
Lastly (at least for this blog)…
You don’t have to wait to build equity. That is, you might be able to proactively do something to the property or its operation to FORCE equity rather than wait for the market to appreciate.
So, in the previous example, if you put $10,000 down on on a $100,000 property, then fix it up, you might not have to wait a year for the value to increase. Because you forced it to happen sooner!
Then you can decide if you want to leave the equity there, or reposition it for more property or higher yield (investing extracted equity for higher interest than the cost of the loan).
See? Real estate asset allocation, rebalancing and equity optimization can be FUN!
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