Five Lessons Washington Could Learn From Real Estate Investors

With all the news about the debt ceiling crisis, it’s hard not to think about policy making. And while we think there are some great lessons available for real estate investors, we also think the politicians would benefit from looking at the situation like a real estate investor.

Since we recently interviewed two presidential candidates (watch for those interviews to be released soon!), maybe some policymakers are paying attention to our lowly blog?  Who knows.  But you’re here (which we appreciate), so let’s get on with it.

Lesson #1:  Add New Customers

For a real estate investor, this means acquiring more revenue producing units.  Notice that this isn’t “raising rents”. Raise rents in a weak economy and you LOSE customers, not gain them.  In fact, if you tell tenants you’re thinking about raising rents, new people won’t move in and existing tenants will start looking for someplace else to live.

For Washington, businesses are “customers”.  Like tenants, businesses and the people they employ get up every day and go to work.  Then they send a portion of their earnings to Uncle Sam (in the form of taxes) just like a tenant sends a real estate investor a portion of his earnings in the form of rent.

So if a new tenant will not move in or an existing tenant will move out if rental increases are being hinted at, is it any surprise that businesses aren’t being formed, won’t hire, or move out of the country when higher taxes (or other similar government imposed burdens) are being threatened?  Consider how General Electric and Google have organized themselves (legally) to move their profits off shore, or how Amazon recently canceled contracts with all their California based affiliate marketers.  Did those companies want to invest time and effort to do those things? No.  But they decided is was the lesser of evils.

As a landlord, if you want to attract new tenants, you must provide a safe, affordable place to live. If Washington wants to “create jobs”, the focus needs to be on providing a safe, affordable place to do business.  We look to acquire rental real estate in places that are friendly to business.

Lesson #2: High Overhead Slows Growth

The bigger your real estate portfolio grows, the more people you’ll need to help you manage it.  These include your tax advisor, estate planning attorney, asset protection attorney, insurance broker, mortgage broker, etc.  You’ll also have property managers, maintenance people and a bevy of sub-contractors.

All these people must be supported by your rental income.  But you have to add tenants before you add team members.  If you get it backwards, you go broke, even though you have a “big” business.  “Big” isn’t necessarily profitable.

When you watch the news coming out of Washington, ask yourself if Uncle Sam is growing government in response to a growing number of businesses, or independently of economic growth.  In other words, private sector employment should be growing first and faster.  If not, then expenses will go up and revenues won’t and you’ll be hemorrhaging cash.  And if you think raising rents on your tenants in a soft economy is the answer, go back to Lesson #1.

Lesson #3:  Cash Flow is Not Profit

As a real estate investor, it’s important to make payments on time.  It preserves a strong credit rating, which is a very useful tool for investing.  But if your rents decline and you’re using credit lines to make your payments, it may seem to you and the outside world that you have everything under control.  However, you’re headed for disaster.

At some point, you’ll run out of credit.  And even if your lenders are dumb enough to keep raising your credit limit, all you’re doing is delaying the inevitable because each month more of your available cash flow goes to interest until that’s all there is.  The real problem is that you’re not running a profitable business.

When an investor is faced with this problem (and it happens all the time), he has some choices:

  • Increase revenue.  This can be done by raising rents on the existing tenants (if the economy will permit it – see Lesson #1) or by acquiring new profitable tenants (if you act before you’ve depleted your remaining cash and credit).
  • Decrease expenses. This is hard to do, but it’s going to happen anyway if you don’t fix the problem, so better to be proactive.

When we mentor investors, we encourage them to act like they’re on a space ship in trouble (think Apollo 13).  To survive, you have to make a limited amount of resources last until you can get out of trouble.  This means cutting all non-essentials quickly and deeply.  If you just lost your job, using your “free time” and credit cards to repaint the house, put on a new roof, re-carpet and update the plumbing is probably not the kind of “investment in infrastructure” that will lead to long term prosperity.  Better to go acquire more revenue producing doors.  To survive, you have to keep the main thing the main thing.  And the main thing is to increase revenue (acquire more customers) faster than you increase expenses (hire more employees).

Lesson #4:  Inflation is Not Wealth

In a financial system that is designed to inflate (a topic too big for this article), it’s easy to be deceived into thinking your successful when you’re not.  WARNING: Math Ahead. 😉

For example, if you own a rental property that has 10 units renting for $100 a month in 1960, your gross income is $1000 a month.  So the building might be worth $12,000.  Assume for now it’s paid for, so that’s $12,000 of equity for you.

If in 2010, units in that same building are renting for $1,000 a month, your gross income is now $10,000 a month.  So this property many be worth $1.2 million.  Again, it’s paid for, so it’s all equity.  Are you richer?

Well, think about that.  Let’s assume that you could buy a new car in 1960 for $2000.  So your building is worth 60 cars. ($120,000/$2000 = 60)

What about in 2010?

If a new car in 2010 is $20,000, then your building is still worth 60 cars. ($1,200,000 / $20,000 = 60)

Hmmm….in 2010, the building still houses 10 people and is still worth 60 cars.  So in terms of relative value and utility, it hasn’t changed.  But now you’re a “millionaire”.

If instead, over the years, you re-invested the income and equity (see Bob’s Big Boo Boo in Equity Happens), and you acquired 10 more buildings from 1960 to 2010, now you have a properties which will house 100 people and is worth 600 cars.  NOW you’re richer.  Why?  You have more property.

More property, not more dollars, make you rich. This is very important when dollars are losing value.  For an extreme example, think how many trillionaires there are in Zimbabwe.

So for Washington to measure economic growth in terms of dollars is very confusing.  And you can’t run a business with confusing numbers.  Did the economy grow or didn’t it?  Our we in recovery or aren’t we?

Think about it this way.  If an economy produces 1 million widgets at $100 each, then you have a $100 million economy.  If the price of the widgets increases to $120, you have a $120 million economy.  But did your economy really grow 20%?  The dollars say so, but production and employment say you didn’t.  You’re still only making 1 million widgets.  And your’re still only employing however many people it takes to build 1 million widgets.  So you didn’t grow at all.

Not to belabor the point (but we’re going to anyway), what if the widgets are $120 and you only make 900,000 of them and then lay off a corresponding 10% of your workforce?  Your economy “grew” from $100 million to $108 million (900,000 widgest at $120 each = $108 million).  An 8% increase!  But you produced less and have higher unemployment.  That’s called a jobless recovery or staglflation.

In real estate, if you own 1 property now and in 50 years you own 1 property, you might have a higher dollar denominated cash flow and net worth, but you aren’t any richer if everything else around you also inflated.  You don’t have any more property.

More property means more tenants.  Tenants who work (produce) means more productivity.  More productivity (not inflated dollars) is what makes you (and a country) richer. A wise real estate investor will focus on acquiring more tenants. See Lesson #1.

Lesson #5: Not All Jobs Are Equal

When a real estate investor considers a geographic region as a place to invest, jobs are the single most important factor.  Tenants have a much easier time paying rent when they have jobs.

But not all jobs are created equal.  And the difference is where the money comes from.

So businesses (the source of jobs) can be divided into two categories: Primary and Secondary.

A “Primary” business is one that sells products (derives revenue) from OUTSIDE the region.  That is, a Primary business pulls money in from elsewhere and funnels it into the local economy through their local vendors and employees.

So when a Primary business uses local business for office supplies, printing, temporary help, insurance, maintenance, utilities, sub-contract work, etc., they are effectively distributing the outside money into the local economy through these “Secondary” or support businesses.  Then all those employees further distribute the money as it passes through their hands and into the local economy.

But the key to a region’s prosperity is having a strong base of Primary businesses.  As investors, we avoid markets which don’t have a strong base of Primary businesses. Without Primary businesses, the Secondary businesses can’t thrive.  And each time a Primary business is lost, you lose not only the Primary business’ jobs, but many of the Secondary business’ jobs as well.  It weakens the entire regional economy.

It would be a like a family of brothers all living in the same house.  If one brother has a good job outside the home, he can hire one brother to wash the cars and mow the grass.  He can hire another to cook and clean.  He could rent another brother’s boat for a fun day at the lake.  He is the Primary earner and he can then trade his outside money for various goods and services within the household.  But he is really supporting the whole family, though no one is getting charity.  The prosperity is distributed to each brother according to his contribution.  However, all the brothers would be wise to be nice to the Primary earner.  If he moves out, everyone loses their jobs.

So imagine that one day, the Primary earning brother finds out that one his other brothers took some money out of his wallet without working for it.  He gets mad and decides to move, taking his primary income with him. Now all the remaining brothers are sitting home trying to figure out that to do next.

One brother decides to use his credit card to get an advance and then hires one of his other brother to mow the lawn.  Then that brother uses his “earnings” to hire another brother to cook and clean.  And that other brother uses his “earnings” to rent the boat.  To the outside world, and maybe to the brothers themselves, it looks the same as before.  But now they are simply trading with borrowed money.  How long can that last?

Sooner or later, that credit card has to be paid.  And someone better get a job outside the home and bring in some real money in, or everyone will eventually be broke and homeless.  A higher credit limit might put the problem off a while, but it isn’t a long term solution.  You can’t lose your Primary earners and expect to be prosperous long term.

A country, like a state, like a local region, like a family, better have some Primary earners. And the more, the better.  Without money coming in from the outside, deficits pile up and everyone is just passing borrowed money around and feigning prosperity while a financial time bomb is ticking in the background.  See Lesson #1.

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