It’s always nice when demand and inflation drive up your property values…and your equity in real estate. But when hot markets cool off, it doesn’t necessarily mean your equity growth has to slow down too.
In this episode, we look at strategies to increase property values even when the market is flat of declining. And it’s a lot more than just prettying your properties!
So listen in and discover strategies you can use to make equity in real estate happen to you!
Discussing unique and creative strategies to force equity in your properties:
- Your “I make equity happen in my sleep” show host, Robert Helms
- His “I make spreadsheets happen in my sleep” co-host, Russell Gray
Broadcasting since 1997 with over 300 episodes on iTunes!
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Robert Helms: Welcome to the Real Estate Guys Radio Program. Sometimes you don’t want to sit around and wait for equity to happen – you want to make it happen. Today we’re going to talk about strategies to force equity. I’m your host Robert Helms, and with me is financial strategist, co-host, Rusell Gray.
Russell Gray: Hey, Robert.
Creating Value, Forcing Equity
Robert Helms: It is a wonderful topic we have here today, and that is that you can create equity out of thin air, practically. That is, you can force equity to happen. But, before we talk about that, let’s talk about the different ways that investors find and create equity.
Russell Gray: Well, way back in the day, in our book, “Equity Happens,” we actually covered this topic, and we talked about the different types of equity. We gave it terms so that you could begin to think about strategically: When I’m approaching a property, what am I going to do to create value?
And so a lot of it’s been about cash flow lately, because cash flow controls mortgages – mortgages control property, and then over time, we say equity will happen. One of the ways equity happens is through amortized equity. That’s when the tenant is paying you, and you’re using the money the tenant pays you to pay down the mortgage, and a little bit of that payment every month goes to paying off the mortgage and giving you a slice of equity by reducing your debt. Of course, that assumes that the property price stays even.
Robert Helms: Well, don’t even assume that. I would just say as far as the loan part goes, it’s principle and interest. When you make a payment every month, part of the principle amount of your loan is principle (if it’s amortized, and not interest only). And that principle pay down is essentially you gaining back that much ownership on your property.
So as hopefully your tenant makes that payment instead of you, then you gain back more and more of the equity in the property. Now, separate from that is what is happening to the value of the property. So if we just sit back and say, “Well, my house has gone up in value. My apartment building has gone up in value, because all the apartment buildings in the area have.” That’s more what we call market equity, where the market giveth and the market taketh away. You’re not doing anything for that equity, but a lot of us live in say, single family homes, where we bought it at a price, and today it’s worth a lot more. That is – congratulations – market equity.
Passive Equity’s Different Forms
Russell Gray: In the book, we refer to it as “passive equity,” and that’s because you’re really not doing anything. It comes in two forms, and I want to kind of address that word, “value,” because we’ve been talking about this a lot lately, when we think about denominating our wealth in dollars.
As dollars go down in value, anything denominated in dollars goes up in dollars. And so, it’s easy to go, “Oh, my house went up in value, because it went up in dollars.” But that might not necessarily be true, because if the dollar is falling, it means that the things you could buy with that extra money also went up in value, and so relatively speaking we use the example of cars. If I could sell a house for 10 cars in any given marketplace, and 20 years later the house is worth more, and the cars are worth more, but I can still sell the house for 10 cars, then I could still only sleep say 3 people in a three bedroom house, then the value really hasn’t changed in terms of utility, not to be too confusing.
For the course of this discussion, we’re talking about a property going up in value in terms of dollars, so it’s worth more dollars. Whether those dollars are worth more in the real world? I don’t know.
But then you take a look at the concept of dollars in terms of equity growth, and it comes from two sources. It comes from inflation, which is dollars being worth less, meaning things that are real like real estate and gold and oil and things like that going up in value – and then there’s also the supply and demand in-balance; when you have more people bidding for a property than actually have properties available, or you have an increase in the purchasing capacity, meaning lower interest rates, better incomes, the ability for people to get better loans or easier qualifying.
So there’s a lot of things from a purchasing power standpoint that can drive properties up. In all cases, though, all of those things are out of your control. So, if you pick a good market where you’ve got a good supply-demand in-balance, if you pick a time when maybe interest rates are declining, then maybe you could catch a wave. It doesn’t really matter; you know, you can be strategic about it, but most of those things are out of your control and largely speculative, but if you get it right, equity happens to you, and you really didn’t have to do much for it, except own the property.
Understanding Appreciation Versus Inflation
Robert Helms: Right, so sometimes that increase is inflation, and sometimes that increase is appreciation. And a lot of folks call one the same as the other; they use those terms interchangeably, and they’re not quite.
Appreciation is when there is more demand for something, and its relative value does go up. When everything goes up, well, that’s inflation. Now of course, we have to layer that with the fact that we may be sitting in a time when we have a strong or a weak currency – whatever our current currency is. In many parts of the world, real estate is denominated in a currency other than the local currency, which even makes it more confusing.
For instance, a lot of, say, Caribbean countries value their property in US dollars, even though they don’t use that currency in their country, and so that makes it even more confusing. Our job is today to make it less confusing, and to talk about ways that we can create value.
Robert Helms: So when we talk about forcing equity, we’re not talking about inflation. So one of the ways you can create equity – and probably my favorite equity – is found equity, otherwise known as free equity. This is when you find a property that has more value than the seller can recognize in it. And sometimes that’s just about their use and your use, sometimes it’s because you have inside knowledge of a marketplace – but there’s a reason why the property is “worth more” than what you’re paying for.
Russell Gray: Yeah, distress often plays a major factor in that. You know, you’ve got someone who can’t afford to make the payment. They’ve got to get out of the property to save their credit score or to facilitate something else going on in their life; maybe they’ve got a job change and they need to move quickly.
Or maybe you’ve got somebody, for example, we did a deal once where a guy had accumulated I think 10 or 11 different properties, and he needed to do a 1031 exchange, where he needed all 10 or 11 of those properties to sell at exactly the same time. He was willing to give a big discount to a buyer that could take down all of the properties in one transaction.
So, the properties individually were worth more, but to him, it was worth it to sell them for less. And so, for us, when we came in and bought that property, we made about a million dollars on that collective collection of properties, because he needed to move quickly, and we were able to get the deal done. And that’s found equity; that was just sitting there for the claiming.
Phased Equity in New Developments
Robert Helms: Now another interesting type of equity which you could even include in the forced equity discussion except it’s a little bit outside of your control is what we call phased equity, and that’s when you buy in a new development, and the prices go up.
In any new development, you typically see prices increase. Say there’s 100 houses that are sold in 5 phases of 20 houses each, you’re going to pay more in the 5th phase than you would in the first, and that’s kind of independent of what’s happening in the real estate market at the time. That’s just kind of a builder or developer’s model, and part of the thinking is the person who buys the first house out of 100, arguably takes more risk on the project than the person who buys the 100th house out of 100, and so sometimes phased equity, if you buy early, is another way you can create equity.
Russell Gray: Yeah, it’s forced to the developer, because to a degree, he’s controlling the rollout, and again it’s not unusual for a developer to sell the first few properties of the development at cost or even maybe a little bit below just as traction – just to get some proof of concept. And then as the offering begins to take acceptance to the marketplace, they can begin to work the pricing up. But from your perspective, you really don’t have control over that, because it’s up to the developer, so we don’t really put that in the category of forced equity. In our nomenclature, forced equity is something you have direct control over.
Robert Helms: Which is what we’re going to spend most of the show talking about. And quickly, the last kind of equity that we cover in the book is what we call purchase equity. That’s your initial equity. If you bought a property with 20% down, the part that down is the equity stake you have to start with.
What we’re all concerned in is equity growth: Cash flow while we hold the property, perhaps, and equity growth over time. So, now that everyone’s caught up, let’s talk about forcing the equity; using the force. This is a way that you can not sit on your hands and wait for the market to give it to you, but rather this is a way for you to take the reigns and create value. There’s three broad categories that we like to use.
1) New Development: A Fresh Slate
Rusell Gray: So the first one is new development; this is something that you know, you see all the time, and this is what developers do. They go take a piece of dirt and they improve it somehow. The most obvious visual improvement that you see is a complete structure. But there’s a lot of other things that you can do to a piece of dirt to improve it, that may or may not result in something you can see.
Robert Helms: And we’re going to talk about several examples under each of these categories.
2) Redevelopment: The Fixer-Upper
Russell Gray: The next one is redevelopment, and this is your quintessential fixer-upper. Right? You find a house that is in bad condition, and you redevelop it. In other words, you fix it up; you make it look better.
This can be done with a single family home, it can be done with a commercial building, it could be done with a mall; it can be done with all different kinds of properties. The key is, you’re going to go in and make that property better, but it was already there to start with.
Robert Helms: Yep, that’s the distinction between those, and last but not least –
3) Conversion: Changing the Use
Russell Gray: – is conversion. So, conversion is really just changing the use of the property. You know, you see this could be a zoning change. A common one, especially before the crash, was condo conversion. Somebody would buy an apartment building and then they would change the zoning, convert it to condominiums, and then sell each individual apartment as a stand alone unit – as a condominium. And people were forcing a lot of equity in real estate and deals doing that.
Robert Helms: Absolutely. Today we’re talking about things you can do to a property to increase its worth, and that is forcing equity in our vernacular. You’re turning the property into something different, or you’re creating it out of nothing, or you’re making a change that has it worth more.
Further on New Developments: Ground-Up Construction, Or Even Just The Ground
So, let’s start at the beginning with what we called new development. So, the obvious thing is ground-up construction. You take a piece of dirt, and you turn it into a building that sells for more.
But, before we even get there, there’s a really interesting part of new development that can be quite lucrative, and that is land development.
There’s a lot of folks that we know, that’s what they do. A good friend of ours, he doesn’t ever want to touch anything above the ground. His whole mindset is hey, I’m a land developer. Give me raw dirt; I’ll do what it takes to make sure that that becomes entitled, utility worthy land. And so now, a builder can come in and develop the rest. So he fancies himself “The Guy Below the Dirt,” and he’s happy to create lots, and tracks, and places for developers to go build from the ground up.
Russell Gray: Yeah, when I was a young man, my wife and I used to go up to the Sierra Nevada mountains, and we’d always look around at properties, and there was a lot of just empty land up there. And then every once in a while you’d see somebody that says, “build-able lot.”
Well, what is that? That’s somebody that took a piece of raw dirt, maybe that trees on it, and it didn’t have any utilities, it didn’t have any zoning, and they took and they did exactly what you’re talking about; they went through the process of getting the zoning approved, and getting the utilities plotted in, and laid in – in some cases, all the way up to the building pad, and sometimes you’d see that. You say, “Hey, this is a build-able lot with pad.”
So there are different levels that you can do, but there’s a big difference between simply raw dirt, and something that has actually begun to be ready for a developer – a builder – to actually come build on.
And the reason you might want to consider land development is because your take out purchaser is not a home owner, but it could be a builder, or a developer, or a business, and depending on how big the plot is, and the level of work you do, you can create equity in real estate without having to deal with any of the hassle or the detail work, or the risk of the takeout, because you don’t have to deal with the architecture or any of all the things that can go wrong, and the liabilities that come with giving a new buyer like a 10 year builder warranty. That all falls on the developer or the construction company, not on you.
Robert Helms: And in more rural areas, sometimes there’s not much you physically do to the property. It might just be about zoning and plotting utilities – not even putting them in. As you get to more in-fill and more CBD (central business district) areas, then sometimes your land developers take it all the way to curbs and gutters and streets, and everything but the construction of the unit – the building – whatever that looks like.
And so when we talk about improvements to a property, we’re talking about all of those things – the physical improvements, you see a house on the lot, but also the curbs, the gutters, the streets – everything that had to go into the property to get it ready. So before we get to building anything, there’s the land development side, and the reason it can be lucrative is the value drives in any piece of property from the time it’s raw land til it’s a finished building, and a big chunk of that increase is going to the second step.
We also should talk about something called “entitlements,” and that’s kind of the catch all for any legal requirements the property has to build what you want to build. If it’s raw land, and it’s not zoned, or it’s zoned in some vague zoning criteria, you can come in and petition to change that, and get different entitlements. I’m entitled to build so many units per acre; I’m entitled to build a building of such height and such densities. Just think of those kinds of things when you hear someone say, “entitlements.” It’s changing the permissions associated with development.
And some folks are really good at that part. If you can just figure out some of that, then there’s equity to be forced there. So that’s the ground up part.
The major way we think about new development is when the developer comes by and builds something. And sometimes the developer does go from raw land to a finished product. But a lot of times, a builder would come, say a home builder, and they’d buy 60 lots that have already been readied by a land developer. Now their job is to add materials and labor in such a way that the finished product is worth more than the sum of the costs.
Who’s Your Take Out Buyer?
Russell Gray: Yeah, the secret to success in all of this is knowing who your take out buyer is. What you’re doing is you’re preparing the property for the target market. And you have to do an assessment in your local market as far as what that market needs. And again, if you are preparing a lot to be developed, then you maybe don’t have to be as precise with that, but if you’re going to actually going to build a finished building, then you are going to have to be really precise, right?
You could build an apartment building, you could build a shopping center, you could build an office building, you could build a medical building, you could build a storage facility, you could build all kinds of different things that could go on there, depending on what it is that that particular community needs.
And so, when you begin to figure that out, then you assemble the proper team, and of course the complexity of the team you need when you’re going to actually build something is a lot different than the complexity when you’re just going to entitle a property, or bring in utilities.
Robert Helms: Now before we leave new development, another way of looking at that is what we call master planning. A lot of times a land developer will come in and create more than just a lot or some entitlements, but they’ll actually go through and create a master plan development.
That can add additional nuances such as architectural control, a homeowner’s association, common area amenities, and that can be a way for you to get properties ready to increase value for everyone involved.
One of the first projects I was ever involved on the sales side was we had listed 5 lots inside a development of 27 lots, so the master developer took an old elementary school, turned it into 27 luxury home lots, and they only allowed builders to buy 5 lots at the most. Their mindset was, “We don’t want every house to look the same; to drive the most value; we want to get different developers.”
Some developers just bought a single property, sometimes an owner bought a property, but there were three different builders that each bought 5 lots, and some builders bought 3 or 4 lots, and so it took on an interesting kind of dynamic, and each of these builders had different products, different floorplans, different styles.
A master developer can come in and say, “No, architecturally this entire area is going to look a certain way, a certain feel; limitations to how many stories certain lot corridors and view corridors.” There’s a lot that a master planner can do, and that really creates equity for everybody.
Russell Gray: You know, it’s interesting, Robert, that you bring that up, because you and I of course didn’t know each other back then.
Robert Helms: Back in the day.
Russell Gray: But I actually attended that elementary school in the 6th grade, and then one day I went back to that and there was a big development there.
Robert Helms: Yeah, sorry.
Russell Gray: And I was shocked, and then when I met you I found out you were the guys that actually had listed the properties there, so that was just a funny interlinking of our pasts way before we got to know each other.
Robert Helms: Well it brings up another interesting thing, which is, as cities go through population changes. This was a city that grew very, very quickly in an area that was growing fast, and they were building new schools. Then it got to kind of this level of stagnation, and all of a sudden they said, well we don’t need as many schools, and so that’s a big part of urban development and planning.
So it’s beyond the scope of today’s show, but the idea’s the same; as we make changes to real estate, it changes and affects the value.
Russell Gray: Right, that’s really the lesson, and this is how you see opportunity. A lot of times, especially, here we are, and we did a prediction show, and you think, “Oh my gosh, you know, there’s so many things changing. The world is changing; it’s changing so fast, it’s scary.”
Well, it’s only scary if you’re not adaptable and you’re not entrepreneurial. If you’re adaptable and you’re entrepreneurial, all the change creates these pockets of opportunity.
In this particular case, the demographics of this area was changing. When my parents bought into that neighborhood, they bought a brand new house that had been built on an apricot orchard. So, the developer came in and bought the orchard. They got the whole thing, planned it. It was a little community (of I don’t know how many homes it was), and they bought that home. And I ended up going to that school which had been there for a while.
We were an in-fill project; there was already all kinds of houses built in that area, but there was this little orchard that was still available. The developer bought it, built the houses, forced equity for himself, and then my parents ended up buying the home.
Well, the school that I attended was in that same general vicinity, and as you said, Robert, as we all kind of aged out, and the people who bought those properties, many of those people still live in those houses to this day. They bought the house and they’re still in those houses today. And that’s a whole different thing about passive equity that happened to them. I know that neighborhood well, right? My parents bought that house for $46,000 and it’s worth $3 million today.
Robert Helms: Wow.
Russell Gray: And it’s the same darn house except 40 years older. There’s a whole lesson there. But the point is, is that when you are paying attention to a neighborhood and you’re paying attention to the changes, and you see these little pieces of properties that are available, even something as what you’d think as permanent as a school, could actually become available, if you’re paying attention. And then you do pay attention, and then you just kind of wait; you stalk your opportunity. When the opportunity comes up, you’re ready to move, because you already thought it through.
Redevelopment: Remodeling, Additions, Rebuilding
Robert Helms: So new development is certainly interesting when it comes to forcing equity in real estate. For most listeners, you’re probably not going to go buy 60 acres and develop a housing track. So, let’s talk about re-development. Something already exists, and we’re going to do something to it to change the value.
Russell Gray: Yeah, so as we mentioned earlier, re-development – I mean, that’s the thing that everybody thinks about. That seems to be the easiest. You know, everything’s already entitled, all the utilities are there, I’m just going to go buy the property, and I’m going to fix it up. I’m going to somehow improve it.
I could be doing an addition, I could be doing a remodel, I could be doing a complete tear down on a basic foundation, and then build something much bigger.
I remember one of the projects you guys had, and we were in an area of town where back in the day, before it had become largely populated, they built these little tiny houses on these great big lots. So you’d have a 1,200 square foot house on an acre lot, right? And that was very, very common in California back in the day when there was land forever like it’s been in Texas, and then they’d you know just have modest little houses.
Today the average size of the house is up, and the average size of the house is down. And so, you would come in and you’d say, “Ok, things are already zoned for a single family residence, but instead of a 1,200 square foot residence, we’re going to build a 3,500 square foot residence. And you could do that.
Robert Helms: Well, and there’s rules around that. I remember a couple of the architects in the area, they were specialists at that, because in a couple of the towns we worked in, you could not change the footprint of the front of the house. The offsets had to remain the same. And so, they would come in, and they would take everything down except the little front corner of the house, and as long as that stayed, even though you completely created this mammoth, different house, it didn’t count as ground-up construction.
Russell Gray: Yeah, those are the little things you have to pay attention to. And if you’re working with an experienced architect in that particular area, that really knows the local ordinances, you can do that. Because sometimes you just have to leave one stick of wood up. If you leave one stick of wood upright, it’s considered a remodel and not a new build. It’s crazy the way these laws work, and it’s different in every jurisdiction, so you just have to be aware of that.
Robert Helms: So a big part of rehab is the folks that come in and are trying to heal America one house at a time. They find a dilapidated house – give you an example of the folks who bought houses 40 years and haven’t done anything – those could be prime candidates for someone to come in, buy that house with all its deferred you know, maintenance and all the work, and all the outdated fixtures – fix that up, and sell it for a profit.
So, we see all kinds of television shows on flipping this house and that house; we just met a couple of hosts of shows like that this week, and that’s still a very vibrant part of real estate.
Now, we would say that buying a house to flip could make a great opportunity for somebody, but it’s probably not real estate investing. It’s more of a business, a business of buying something, adding value to it, and selling it for more.
It’s forcing equity, but that’s different than being a real estate investor. But understand this: the idea of buying a house that needs a lot of work, and doing the work, doesn’t mean you have to sell the house. That’s a way to force equity – to keep a house. If you force equity into a house, and then keep it as a rental, you’re now the beneficiary of that upside.
Russell Gray: Yeah, we call that flip and hold. The strategy is that you’re going to flip if you will, or rehab the property – but you’re going to flip the financing. And then that way you hold the property and you just flip out the financing and you take your equity off the table to the extent that the mortgage company will allow you to do that, and then use the income on the property to service the debt, and then hold onto it for the long haul so that you can have passive equity and amortized equity, and all the things we enjoy about buy and hold real estate.
Robert Helms: One of the strategies of that today – and this has been this way for a long time – is that when you buy an asset that is in really rough shape, many lenders aren’t going to like that collateral. So there are lenders who will make those types of loan, whether it’s a bridge lender, or a hard money lender, construction or permanent financing – come and get you a loan to buy this lousy property.
You’re going to add value to it, actual materials, labor, paint, carpet – all that. And now, another lender – or it could even be the same lender – will come in and give you a new loan once that property has been completed. You’re probably going to get a better rate, a higher loan to value, it’s going to be an easier loan to live with.
Russell Gray: This is actually something that’s a very active strategy in the current market conditions. You’ve got lots and lots of people who want to put their money to work. They’re in search of yield.
I want to make a distinction about flipping, because a lot of times the word flipping is not considered to be legitimate investing, and I don’t mean investing like the difference between passive investing, where we’re talking about where you just put your money to work and let somebody else do it, versus active investing, where I’m out there working, finding houses, fixing up like a turn-key operator would, forcing the equity as an active business.
The term flipping that people look at sometimes in a negative way, is people that buy a property and don’t do anything to it, and then just try to mark it up and flip it to somebody else.
Robert Helms: The hot potato property.
Russell Gray: Yeah, you haven’t added any value. Again, we’re not opposed to that, but, we do hang out with some people that are negative about that type of activity, because you haven’t added any value to it.
I could make the argument on the other side, hey, if you’re smart enough to find a found equity deal and get control of it under the fair market price, and you can give it somebody where there’s still some meat on the bone – nothing wrong with that.
Robert Helms: You just described what wholesalers do. They look for opportunity. They rarely touch the property in any way. Do they add value? Only a ton of value, because I as the person who might buy one of those, am too busy to foster the relationships, beat the bushes, find the deals – and they have a pipeline of deals. They can be great.
So we’re not trying to pass judgment on real estate today. We’re happy to do that at cocktail conversations at a seminar or something. But the idea today is what are ways that we can do something as investors, grab the reigns, and create an increase in price or value.
Russell Gray: Well the rehab thing right now is a big opportunity, and again, there’s lots of private capital that is looking to fund those forced equity deals, and give you short term use of their money for a high interest rate, which is a good rate of return on their money – but in terms of your cost, it’s really small, because you’re only going to hold the money for a short period of time. So, the short of that is you have a lot of working capital that’s available to help you do these kinds of deals in this particular market.
Increasing the Rent as a Means to Increase Value
Robert Helms: Absolutely. We’re talking about forcing equity in real estate, when the investor does something to change the value of the property. So many people just wait for the market to give them equity, and that maybe works out, but here are some things you can do to create it.
We’re talking about this category of re-development, or second development chances, or rehabbing property, and so forth. And we talked about buying a property, increasing the value, something as simple as carpets and paint all the way to ripping it up and changing the walls and adding and all that stuff as a way to sell a property, or as a way to keep that property in your portfolio.
Another way is buying a property, increasing the rents, therefore increasing the value. This is what Ken McElroy does.
Russell Gray: Yeah, this is corporate raiders, people who take over companies, you know like Bain Capital with Mitt Romney back in the day, these were guys who would buy companies they felt were underperforming – undermanaged. They would improve the management, improve the profitability, and then flip the company by selling it. So it’s the same thing.
So basically what you’re saying is you’ve got maybe a lazy landlord, you’ve got a management company that isn’t paying attention or a landlord that is not paying attention, and then you can go in there and begin to improve the actual operations of the property.
So an operational expert could come in and run a property, and this typically pans out better in a multi-family, where you’ve got more units, but you could do it on a single family home, too, because if you’ve got somebody who’s not paying attention, they could be renting a property for way less than it’s worth in the market, just because they are too lazy to evict the person, or they have a personal relationship and they don’t want to increase the rent, or whatever, and you get your hands on the property and you can bring it up to market.
Considering Comparative Market Values, And Other Factors
Robert Helms: Well I think the reason that you make the distinction is based on the way appraisers value property. Most single family houses, regardless if they are rental properties or not, are valued by the comparative market approach, what are other properties similar selling – not the rent so much, whereas apartments tend to be the income approach of that evaluation, and it’s more about “What is the income?”.
So if I increase the income on a property, let’s say I have a way to do that through management that doesn’t affect the physicality at all; I just rent it differently, and raise the rent. Did I raise the value of the property? Absolutely I did, because an income property is based on the value of the rents that it generates. So that’s the concept, and you can do both. Ken McElroy typically improves not only the physicality of the property in some way, but also the operations.
Russell Gray: Yeah and so it goes two parts; it’s just like any business. You know, you improve the physicality or the desirability. You add a washer, dryer, covered parking, some amenity, and then you’re able to charge more, so you raise the revenue.
The other part of it, by being a great operator, is you operate more efficiently. Maybe you keep tighter control on your expenses, you know, payroll, or you use more efficient purchasing on supplies, and carpets, and things like that – things that maybe don’t make any difference on profitability but drive more profit to the bottom line. When we talk about a property being valued by income, it’s not rents; it’s net operating income.
When you calculate a capitalization rate or a cap rate on a property, you divide the net operating income, which is revenue (the incoming rents), less expenses (everything going out), and you get a number – net operating income. You annualize that number by multiplying it by 12, if you did the calculation on a monthly basis, and you divide it into the purchase price. And that gives you your cap rate. And when cap rates are coming down, that means that the purchase price is going up relative to the amount of income. It can be a dangerous time to buy. There’s a couple of ways that you can improve the situation.
One way is if you can re-finance later down the road at a lower interest rate – right now, that’s a dangerous game to play, because interest rates are super low, and they’re not trending down. They’re trending sideways and up.
So you can’t count necessarily on being able to re-finance to create more bottom line. But you could do things like property tax abatement, or challenging the evaluation – sometimes that can make a difference.
There’s things that you can do in operating a property to drive more profit to the bottom line, and that’s the key. So if you’re going to buy a property that is at a small cap rate, meaning that you’re paying a lot for the available income, and you can’t count on re-financing, make sure you have a plan in the operations to either raise the revenue, or decrease other expenses besides your interest expense.
Conversion: Beyond Physical Changes – Zoning and Entitlements
Robert Helms: And our last broad category of forced equity is conversion. When you’re changing the use of a property, and Russ, you mentioned this idea of condo conversion that was popular for a while, and it probably will be again – the idea of buying an apartment building. Still, today, many apartment buildings exist that are separately plated. They have separate APN numbers (partial numbers), and they were built that way so they had a versatility of their use.
And whether they were or not, it’s possible for a developer to come along and say, “Ok so it’s a 100 unit apartment building. You know what? These are really nice apartments, class A apartments. We could convert this into a condominium building and sell the individual units, probably at a premium.” What I pay for per door as a buyer of 100 unit A class apartment building, is the lesser than what they would sell for individually in many cases.
So, the reason to consider a conversion is if there’s a higher and better use. In the case of a condo conversion, it’s because, you know what? There’s more buyers than there are apartments. Why did that happen when it happened? Well, think about when that happened, it was 2000, 2002, 2004. At that time, we had better, and lower, and less LTV financing than ever before; all these amazing first time loan programs.
So folks that were tenants, who couldn’t buy because they couldn’t save up 20% down payment, all of the sudden became buyers, and we needed inventory. And there was nowhere to build in a lot of these places. So, smart developers figured out how to convert.
We saw how that worked out when we took too much existing apartment inventory and turned it into condominiums. But it’s only one example – lots of other ways that we can create value through a change of use.
In addition to taking an existing property and changing it, sometimes all we convert is the entitlements that we talked about earlier, say the zoning. A simple zoning change can have a marked difference in the value of a property.
Russell Gray: Yeah, we’ve talked about this before, but when we very first started working together, we were looking for an office. You guys were working out of a mobile home, because it was available and convenient – and you used that as a home office, if you will, away from your regular brick and mortar office with the brand that you were affiliated with at the time.
Then, later on you bought a commercial building, but prior to that, when we were out looking for a property, we found a home. And this was one of these ranch homes that had been part of a farming family and they owned acres and acres and acres out in a part that was once rural, that had now become very developed.
And so, this little stand-alone house that had been there since forever was there, but it was right on a main street, and it really should have been a commercial property. But we looked at it and we said, “Man, let’s go buy that property, and convert it.” And we went down to the city planning commission. We talked with them. “You guys, would you be willing to do this?”
I remember taking the pictures, and going and saying, “Hey, I really think this thing should be zoned commercial.” And they said that they would consider it. It would be a $5,000 fee to get it done. And we went back to the people who were selling the property, and said, “Hey, we’d like to make an offer on the property.” And they wanted a lot for it, right? I think they wanted 1.2 million at a time when the house on it was probably only worth about $5- or $600,000.
Robert Helms: As a house.
Russell Gray: As a house.
Robert Helms: They recognized there was better use for it than just being a house.
Russell Gray: So, we ended up doing a lot of the homework, and we said, we want to put a contingency in the contract that says we will go through with the deal if we can get the zoning thing approved.
And we were willing to spend the $5,000 to do that, as long as we had an out on the contract. Well, they ended up not taking our offer, but a funny thing happened. They took the idea and today there’s a medical office building on that very same property.
Robert Helms: In many, many cities across our country and lots of countries, you’ll find this. If you go downtown, and look at a bunch of say, law offices, many times they’re inside of what used to be a single family house. So that’s exactly what we’re talking about – changing the use.
A lot of other great examples – we just looked at a property on one of our field trips that used to be a big, empty box store, and has been converted to indoor sports fields, so people can play soccer, and other sports, inside, which is important when you’re in a market where the weather gets really, really hot or really, really cold. That’s a great use.
Sometimes you’ll go downtown and you’ll see what was once old office being converted to new apartments, because people are moving downtown: lofts.
So there’s a lot of different ways you can change the use of a property, and you get creative. Now it does usually entail having to get that legal entitlement part. You can’t just take what was an industrial building and decide you want to do raves there on the weekends.
In fact, there was a nightclub years ago in northern California that was exactly that. Did you ever go to, “One Step Beyond?”. That was a nightclub in Santa Clara, California that was in this industrial area, where they got the permission at night, when there was plenty of parking. This was a building that was challenged because, as an industrial building, with a few people working there, it didn’t take a lot of parking, but the use was really more for manufacturing and so forth, so there wasn’t very much parking for a building of this size. So these guys said, well we have a solution – write to the city, we will only park cars from 9 o’clock at night til 2 o’clock in the morning, at the opposite time, so the neighboring folks all got together, they got a reciprocal parking agreement, and total change of view. So, you have to get creative when it comes to changing the use.
Russell Gray: There’s another one, too, that comes up. Sometimes there’s these churches that have occupied industrial buildings. Somehow, some way, there were able to get an exemption; maybe at the time, business was soft, office buildings were available, and they get in.
And it could be that you get your hands on a church that maybe has grown and has moved to another facility, and now this church building that can be rezoned back to commercial, where it’s got a lot more value – if, again, the economic circumstances will support that.
Robert Helms: I saw the Red Hot Chili Peppers play at the Limelight in New York City, which was an old church converted to a nightclub. So, all kinds of ways to convert – we could go on and on about that one.
Keys to Making Forced Equity in Real Estate Work
Let’s instead wrap up the show with some keys to making forced equity work. Because, this is all good stuff, but you’ve got to really, number one, think about the end game. Why is it that you’re either changing the use, or rehabbing? Is that really going to drive enough value?
And in order to do that, you’ve got to know the comps. You’ve got to know the comps going in. If I’m going to, say, improve a house that is the dilapidated house on the street, I better know the market value at the completed side. And also, what’s the demand for that property?
Russell Gray: Yeah, because one of the things that a lot of rookies do, is they go in and they do what they want to do, and they try to make the property give them what they need. It doesn’t work that way. You have to give the community what it needs, and what it’s willing to accept.
One of the keys to doing that is having the right people on your team. Because you’re not going to be able to know everything. You can start with a hypothesis. You can say, hey, this is what I think. And then you need to ask around.
Like, Robert, I’ve seen you go in and do development. And you think, “I think a retail center would go really good here.” And so, before you start breaking ground and building your retail center, or hiring an architect to design a retail center, what you do is, you go to the leasing community, and you go, “Hey guys, if I were to build this building here, could you lease it?”
And if they say, “Yeah, that’d be great,” well, okay, that’s a point on the curve, right? That gives you an indication – it validates your hunch that this is what the market would need.
Robert Helms: You can take that a step further than that. There are companies that specialize in these kinds of studies, where they will go out and do a market study for you. And I tell you what, that is worth its weight in gold.
A couple of times, we held from pulling the trigger on something we thought was a great idea, because these guys said, “No, it’s overbuilt. There’s too much of that here right now.”
We use to build office condominium, which was a hot product. We went into a couple of markets as the first or second developer to do it, and did really well. And then suddenly there were 15 developers doing it; it got overbuilt. So pretty soon, I said, “Well that was a really good idea two years ago.” So the point is, do your homework on that. Make sure you know what the values are.
Predicting Costs, Setting Up a Timeline
Robert Helms: You also want to make sure if you’re not doing the construction – and I hope you’re not – that you get accurate bids.
Russell Gray: Yes, because controlling your cost is important, right? In anything, if you say, “Hey, this is what it’s worth on the take out.” That is, understanding the market value, as you just talked about, Robert, then the next thing is, “What’s it going to cost to get this thing ready to sell?”
And if you miss on that mark, you can suck up all your gross profit, and then some, and now you’re underwater. So, controlling your cost is really important. So the strategy there is making sure that when you’re getting those bids coming in, you get guaranteed bids, and there’s a whole strategy in that that we don’t have time to get into, but make sure you know what you’re doing.
Robert Helms: The other part of that is not only that you know the cost, but the timeline. If you’re talking about permits, zoning changes – that stuff doesn’t happen overnight. Sometimes it can really languish on. So make sure you know, “What’s the time period?” Not only the time period for getting things done, but what if there are consultants involved? What if there are third party appraisers, and those kinds of folks? Architects? That all takes time to do, and time tends to expand beyond what you allow for it.
Russell Gray: Yeah, and this goes back again to being really aware of what’s going on in the market. We personally had this situation happen where we did our due diligence, and our due diligence said that it should take 6 weeks to get a permit. So we did our homework, and the word on the street was it was going to take about 6 weeks to get this thing done – this zoning change approved.
Well, it ended up that everybody and their brother was doing this particular zoning change at the time, and it ended up, instead of taking 6 weeks, it took 6 months. And when you’re using hard money in particular, which is very expensive on an annualized basis, and you’re trying to get in and out quickly, these time delays can be crushing.
And when you’re holding a property, and you’ve got to deal with security, and you’ve got to deal with insurance and interest carry, and then you are stringing that out with no revenue coming in, because you can’t get done what you’re going to get done until you get all these things in place, it can really eat into your profits.
So really make sure you do your homework on your timelines and all the factors that could affect your timelines when you’re doing your budgeting. And you make sure that you always put in a fudge factor, right? You want to make sure that you don’t let the thing overrun too much.
Robert Helms: And you also just want to be cognizant of your transaction cost. You know, a lot of times folks will find a great vein of property, or an area where they can buy a property that needs work, rehab it, and sell it for a profit. But every time I do that, there’s a pretty substantial transaction cost, right? Commissions, county and city transfer fees, and all that – so always do the math. The math will tell you what to do.
But, there’s a great opportunity out there. What we love about forcing equity is it’s not market dependent. A lot of folks can only make money when the market goes up. You can force equity and make money when the property’s going up in value, generally when the area is flat or stagnant – even when values are trending down, a change of views can be a profitable thing. Just be careful out there.
Hey, next week on the show, it is your chance to submit a question. So if you haven’t done that recently, go to our website, www.realestateguysradio.com and click, “Ask the guys.”
Anything that has to do with real estate, we’ll answer your questions. We’ll answer a bunch of them next week on the program. Coming up in future weeks, a lot of good guests are scheduled, so we’re looking forward to 2016. Until next week, go out and force some equity to happen!
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