By Stefan Aarnio
Real Estate is one of the only industries I can think of where investors/operators can be absolute morons and still win.
Every day I see scores of smart broke people who can barely make a living in jobs and businesses that they spent 5-15 years of educating themselves for. It makes no sense to see these people commit such large portions of their lives just be broke and barely scraping by. The saddest part is that most of these people are highly intelligent, “A” students, who never really learned about money.
On the flip side, as a full time Real Estate Investor, I often see investors in the market who are total morons that can still make obscene profits or break even on bad deals that they completely screwed up.
But why is this the case?
Why do so many smart, educated, “A” students with high priced educations struggle to make a living while total morons can win big profits?
The answer to the question, I believe, has to do more with the industry and “profit centres” then it does with business acumen, skills or experience.
For example, I know of an investor in my market who decided to buy a commercial condo for $80,000. He planned to rezone it to residential by adding a kitchen sink (It already had a bedroom and full bath and was missing a kitchen sink). After adding a sink, he calculated that he would be able to sell the condo for $160,000+.
When my friend applied to the City for rezoning, they made my investor-friend gut the apartment, bring it up to code, fix the broken roof trusses of the condo building, and then he had to refinish the entire condo. He also had to add soundproofing, fireproofing, update the ducts and venting and increase the standards of just about everything in the condo.
The process took 24 months because he was inexperienced with renovations management and the “rezoning/development” process.
After 24 months of financial bleeding, my friend still has an opportunity to break even or make a small profit because during his renovation period another developer decided to build brand new condos next door priced at $300,000 to $500,000.
This new information can increase the exit price of my friend’s condo and may help him turn a profit. There is no other industry I can think of where an entrepreneur can fail on every single part of a business and still turn a profit or break even. The market virtually bails it self out every time, over time… the question is, how long do you have to wait until you get bailed out?
Now back to the real question… Why is that a moron in real estate can beat a genius in another industry?
The answer, I believe, is that Real Estate has 6 natural profit centres. In other words, a real estate deal naturally makes money in 6 ways while most businesses make money in one way.
Take a lemonade stand for example: a lemonade stand only makes money when it sells a glass of lemonade. This
business has one profit centre, it can only earn money in one way.
Consider a car dealership, it has multiple profit centres. It can make money when a car is bought, sold, financed, provide warranties, sell rustproofing, after sales service, oil changes, air filters, tires, periodic check ups, spare parts, collision repair, painting/repainting etc.
The amount of profit centres at a car dealership can draw revenue from is at least over 10. This is why car companies can grow so large, there are so many profit centres and this makes for a good business.
I would rather own a car dealership with 10+ profit centres than have 1 profit centre at a lemonade stand.
The fact of the matter is, many “smart” people only have 1 profit centre: They trade time for money. If they want more money, they can trade more time, there are no options.
If these “smart” people cannot find a buyer for their time (aka employer), then their revenues and profits go to zero. To me, this is an EXTREMELY risky strategy. I find it scary that most people think that this is “security”. One profit centre is NOT a sound financial strategy.
On the other side of the coin, the car dealership we looked at above has at least 10 ways to make money. If a customer comes into the dealership, they can sell them 10 or more products and services. If a car is sold, there are residual sales for the company and the dealership makes even more cash.
When you look at the amount of profit centres that a car dealership has, it’s no wonder that the industrial revolution was driven by the manufacturing of automobiles.
But why can morons win in Real Estate? There are 6 major profit centres in Real Estate and the best part is, and many are passive and easy to manage. Geniuses with university degrees and jobs make profit in one way, morons with real estate make money in 6 ways.
The 6 profit centres of real estate are:
1) Cash flow: Cash flow is the most important profit centre in real estate. On a buy and hold, “if it doesn’t cash flow, don’t buy it”. Cash flow drives the entire business of real estate and is often the reason why people want to enter the game of real estate. Although cash flow is always alluring and exciting, it is not the biggest money maker on most deals.
2) Instant Equity: Instant equity is extremely important to me when I buy real estate. I always want to make profit as soon as I purchase. Everyone loves to get a deal and I want to make profits on DAY 1. Investors who buy on the retail market off MLS can get pressured by realtors to buy at market prices. You either have to have a very good realtor on your team to negotiate a good deal or buy privately to get a good amount of equity in a purchase.
3) Leverage – One of the main reasons why I choose to invest in real estate is the leverage. For every dollar you put in to real estate, the bank will dollar match (usually between 3-5x of what you put in). Leverage allows your returns to explode and jump to obscene levels because you are investing with BANK MONEY and not your own. In real estate $60,000 will buy you $300,000 of property. In stocks, $60,000 will get you $60,000 of stock. Banks will not lend on their own stock. I find it extremely disturbing to consider that the banks will lend you money for real estate ALL DAY LONG, but will not give you a loan to purchase their own stock.
4) Appreciation: Appreciation is a wonderful “bonus” that professional real estate investors look for in a deal. Many novices don’t understand appreciation and think that all countries and cities appreciate together in sync. However, in reality, real estate is broken down into markets and sub markets. What I look for in deals are undervalued sub markets that are appreciating. I am an advocate of fundamentals and like to stack the odds in my favour.
What controls appreciation? Supply and demand mostly control appreciation. However, physical condition of the actual property can be manipulated to force appreciation. One of my favorite strategies is purchase run down or non functional properties for a discount and force them to apprecaite by fixing the properties problems.
Economy is a huge driver of apprecation and again, economies are broken down into markets and sub markets. You always have to ask yourself, how is the money moving into or out of this market?
When economies are booming, people usually move into town. When economies are threatened, people are usually start moving out.
High interest rates can make properties less affordable and keep money out of the market. This can stop the liquidity of properties and make them very hard to actualize apprecation.
5) Depreciation: Depreciation is an accounting technique that amortizes the property over 25 years, or the life of the building. An accountant can create paper losses and shelter revenues from taxes by creating paper losses.
RECAPTURE: However, there is always a downside, recapture is when the government wants all of their tax savings back when you decide to sell the building. If you are going to depreciate your buildings, consider the cost and benefit of this technique.
WHY I FAVOUR DEPRECIATING? A dollar today is worth more than a dollar 10 years from now. Money is always becoming less valuable every day. Get your money out of your real estate as fast as possible to get it moving as fast as possible!
6) Principal Pay Down: I always grin when I look at my principal pay down on my mortgages. I used to be scared of having high balance mortgages on my properties because I could only see the liability of the debt. Now when I see a high balance mortgage I think “this property makes a lot of principal pay down”.
If you have a $1,000,000 mortgage, in 30 years, that mortgage will be paid off and you will have made $1,000,000. This is a beautiful passive profit centre.
What’s even better about principal pay down is that this equity can be taken out TAX FREE through a debt refinance.
The next time you consider a real estate deal, ask yourself, how will I make money on the six profit centres of real estate? If everything goes wrong, how am I protected from loss? Does this deal align with my goals?
It’s always easier to be on the outside of the market wishing you were in than to be on the inside wishing you were out.
Thanks for reading,
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