Keystone Development Advisors, LLC: February 2007

Real Estate Investment in 2007 and Beyond
By David H. Farmer

The real estate market is DEAD! Or is it? I like the analogy of a pendulum swinging from boom to bust and back to boom again. What makes the real estate market swing from boom to bust and back again is demand. Let’s be honest, consumers or end-users drive the real estate market just like they drive any market. When a product is scarce or demand outstrips supply, the price goes up. When a product is widely available or demand is slack, the price goes down.For those pundits and experts that claim the market is fine “we just need some time to sell the inventory”, you are wrong. For those “investors” that have been burned, due to slack demand, after the recent run-up in prices that claim the market is dead, you are wrong too. To the pundits and experts I say end-users prices need to fall to build demand. The excess product inventory in the market (pick your product, it does not matter) is so extreme time itself will not cure the problem. Prices need to fall. To “investors” I say desirable product at the right price is selling.In Southwest Florida where I live and spend over half of my time you can see both sides of this issue. Two production homebuilders that I work with regularly are looking for land to keep up with demand for their product. These homebuilders have price points that reflect what most of us can afford to pay in rent, namely in the $150’s to the $250’s. Many other builders, mostly nationally known, are cutting prices and “dumping” massive amounts of inventory in an effort to reduce the pain of interest carry costs. These homebuilders have price points that reflect the crazy “irrational exuberance” of 2003-2005, namely in the $300’s to the $500’s that most people cannot afford to rent on a modest income. What is really sad is the nationals are cutting prices, but they are still above the $300’s mark which is out of most peoples reach. I had one national builder exclaim “I don’t even know how you can build a house for less than $250 thousand!” Boy, are they in trouble.Another group that is in trouble is “mom and pop” investors who got caught buying or holding real estate when the music stopped. These folks do not have the same deep pockets that the national builders have. They cannot afford to cut their asking price to 60% of what they paid. So, in the case of homes and condos they try to rent them accepting a loss for what they hope will be a short period of time, maybe a few months, hopefully not years. The problem here is the sheer number of small investors that are holding property in this fashion. It will be hard for a builder to charge more for a particular product when a buyer can find many similar examples on the market for less than the (future) cost to build new. Prices will stagnate and the market will view the area as a poor place to invest money for the future.Now that you are convinced all real estate is currently and for the foreseeable future a poor investment, let me tell you a little secret; land and homes at price points that “normal” people can afford are selling and selling well. Places that did not experience the surge in “appreciation” like Naples, Florida did are selling new homes priced $250 thousand and under with little apparent lag from pre surge levels (circa 2004). In general terms, if you buy a quality home for less than $250 thousand you will probably experience the traditional 3-6% annual appreciation of past years, maybe more. If you can sell homes for less than $250 thousand, you will probably do very well indeed.Here are the five essentials to professional real estate investing:1. Location, Location, Location. This mantra is tried and true but it has a cousin some investors forget about, namely Quality, Quality, Quality. You can have a great location in terms of proximity but a poor location in terms of quality. Sometimes quality can be mitigated by installing buffers for noise and site problems. Other times a low quality site is just that, low quality and that will come back to haunt you in terms of sales velocity. Your competitor’s sales will occur much faster if you are both in the same location but you have a quality issue and he does not.2. Price, Price, Price. One of my favorite questions is “How much for how much?”. Sellers that are not serious will tell you to make an offer. Motivated sellers will tell you the bottom line and stick to it. Regardless of price what matters most is value. Brokers have tried to sell me land that was only $5,000 per acre. Sounds good so far right? The key to value is how much of that land will be needed to produce a given amount of product. For example, if I need 10 acres to meet zoning codes to build one house, then each “unit” will have a land cost of $50,000. In some areas that is a great deal. In most areas that is a terrible deal. I try not to get too excited about a deal until I know the answer to “how much for how much”. There is an old saying in real estate “you make money buying land not selling it”. In other words if you pay too much on the front end it will be hard to make it up when it comes time to sell. Knowing what something is worth is part art and part calculation.The issue of price cuts both ways. When you go to sell the property it is most helpful if you can show the buyer why the property is worth what you are asking. At a very minimum you need to be able to explain how you arrived at the asking price. One method I use to sell property is to show the buyer how they are going to make money. You see, I am a specialist. I know my limits and I do not want to be the guy that does everything from A-Z. This also means that I do not necessarily get the highest sale price. So what. I want people to buy from me again and helping them make money will bring them back again and again. A friend of mine was telling me “I just cannot give this property away”. I immediately said, “Excuse me, give?” I will take anything you are giving away. He then qualified his statement saying he wanted X million dollars. I asked him where he got his number and he told me “that is what they were paying last year”. While he at least had a basis for his price, last year’s numbers do not mean a hill of beans, especially in a soft market. I tried showing him that is price was inconsistent with the neighborhood but he said he would hold out for his price. He is still holding.3. Investigate, Investigate, Investigate. A word that should be synonymous with investment is investigate. As Ben Franklin said “an ounce of prevention is worth a pound of cure”. The internet can be a great source of preliminary information about a particular site or region. I use a site that offers access to USGS maps and aerial photos. The great thing about USGS maps is they show general topographic information and can indicate if an area is inundated with water for part of the year. The maps are only a guide but this preliminary legwork is a great first step in deciding if a property is worthy of spending on the traditional studies and surveys. In a typical property investigation, known in the business as due diligence, costs range from a few thousand dollars to hundreds of thousands. A general rule of thumb for a due diligence budget is about 2% of the purchase price.4. Variety, Variety, Variety. As the saying goes variety is the spice of life. This is also an often overlooked key to successful investing. I call it the Neapolitan approach – a little chocolate, a little strawberry and a little vanilla. Make sure you have a variety of products and locations to suit more than one budget and lifestyle preference. This may include multiple lot sizes, single and multi-story units and units for families and singles. Commercial developments can also benefit from this approach. Also, incorporation/integration of commercial and residential, sometimes referred to as mixed-use, goes a long way toward satisfying the Neapolitan approach.5. Taxes, Taxes, Taxes. Anytime you are talking about making money taxes need to be considered before the investment is made. There are many ways to structure deals, there are only a few ways to do it right in terms of taxes. Structured correctly, a long-term capital gain can be accomplished at favorable rates as compared to regular income rates. Expert tax advice from a trusted personal tax consultant is advisable.Professional investors should focus on land or developments that will produce products affordable to the masses. While this attitude is socially responsible, I am advocating this position out of pure investment responsibility.There are many facets to real estate investment and development. Think of the preceding information as general guidance and not the complete picture. Start small and try to learn from other’s mistakes. Another good piece of advice is to partner with an experienced person or group that is reputable and has a track record in purchasing, permitting, marketing and ultimately selling the property at a profit.

All articles, text, graphics, the selection and arrangement are Copyright 2006-2007 by Keystone Companies, LLC. ALL RIGHTS RESERVED. Any use of materials on this blog, including reproduction, modification, distribution or republication, without the prior written consent of David H. Farmer or Keystone Companies, LLC is strictly prohibited.

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