As a cardinal rule, real estate investors must learn to analyze the profit potential in any deal. How will you make money and not lose it in 2015? Here are some principles to remember and apply to any deal or strategy.

INVESTING IN REAL ESTATE IS A BUSINESS, LARGE OR SMALL

You must approach your investment as a business venture. Put on your entrepreneurs hat and calculate the risk. Business owners go into business to make a profit, or should go into business to make a profit.

The big question you must ask is can I make any money in this deal? Its easy to be an optimist, since we all know that money grows on trees. However, thats the lazy mans way out. In reality, we all know what lazy men accomplishvery littlesince they dont want to work. Your job is to poke at the potential. looking for hidden opportunities to create value and minimize the pitfalls that will drain profitability. This requires effort, rolling up your sleeves to deal with the dirt of details .

PROTECT YOUR PROFIT MARGINS FROM THE GET-GO

1) Acquire the property for the price that builds in profitabilitythat means negotiating terms or price. It also means doing your due diligence on the property, factoring in pre-development costs and property defects, before you go to closing. You make your money going into the deal, up front. at the price that protects your margins of profitability. For new construction, add to this pre-development phase the cost per square foot that will meet permit and code approvals. For income or commercial properties, create a lease pro-forma that reflects current rents for the asset class being improved or built. For existing structures, properly estimate your repairs.

2) Calculate the cost of improvement. Whether youre dealing in repairs or new construction, do you have a Plan A, Plan B, Plan C to control those costs when the unexpected steals your margins? The unexpected happensa lot! Thieves masquerade as unaccounted for cost overruns, contractors who take off with sizeable draws and no work to show for it, material theft, time and weather delays, failed inspections that are red tagged, and the list goes on.

3) Anticipate holding costs and exit strategy costs. Beyond debt service, taxes, insurance, sales commissions & fees, the stabilization period of lease up for commercial and income properties can be added to this post-improvement/post-construction list. Using a spreadsheet or pro-forma can paint likely scenarios an investor should expect, prior to realizing a cash out or paid return on investment (ROI). Project two or three periods and the cost consequences that affect the projects bottom line. Dont skimp. Build a best and worse case scenario to properly evaluate the projects potential.

REAL ESTATE IS NOT A LIQUID INVESTMENT

Since real estate is an illiquid investment, an investor has to think long term. Even if the term is a two week period for repairs, the investment strategy requires planning, execution and adding value to realize a profit or gain.

If youre a first time investor, or just considering real estate as an investment vehicle for your portfolio or retirement plans, realize that youre shifting away from dependence on a financial advisor who will generally steer you towards liquid investments, like stocks & bonds, precious metals, mutual funds and other liquid instruments that trade in efficient markets. Those you can buy and sell in a moments notice. Real estate is not liquid, or quickly traded, unless you invest in a REIT fund. Youre in it for the long haul and should plan accordingly.

The period of time, or hold time. is a part of the strategy to gain value, forced or market appreciation and tax benefits that can positively add to the bottom line. Planning the timeline should be a part of your preliminary analysis, comparing the Present Value (PV) of your dollars or sweat equity invested in the project to the Future Value (FV) or return you can anticipate when you cash out (in the form of equity) upon the propertys sale, a debt interest yield, 1031 tax deferred savings exchange or other form of income derived from the property throughout the hold period.

ANALYZING A DEAL FOR PROFITABILITY USING METRICS

Now come the basic tools of the trade. Theres a broad spectrum of software and online tools available to help you analyze property and project values, but Ill boil it down to a few concepts to help you identify value and risk.

RESIDENTIAL FLIP METRIC WHOLESALE/70% ARV

Whether you want to lend capital to close a deal, to fund repairs or finance the mortgage loan or want to earn equity as a partner, you must buy/acquire the property at a wholesale price. That means below the current retail market value. Since youre dealing at the wholesale level, just like any business person does, your aim is to treat the whole strategy as a business deal that youll markup to profit from the gain.

Hard money lenders (private lenders or groups that lend w/o conforming to FHA guidelines required of conventional lenders, such as banks) will readily finance real estate deals that follow a formula that protects their capital invested in residential properties. The national formula (most common in metro markets) is to pick up a 1-4 unit property @ 65% to 70% of the retail price of a fully repaired and/or updated property, based on similar properties that have recently sold (usually within 90 days). Those similar, recently sold properties are called comps. short for comparables. The caveat is that all repair or rehab costs must be factored into the wholesale price. In short, this formula is known as 70% ARV (After Repaired Value),  or whatever percentage the lender requires for the loan.

So, why does this formula act as a metric, you may ask? The lender will look at the repair budget, comps and likelihood that the property purchase price is reasonable and marketable, if he or she has to foreclose and finish or sell the property, if the borrower fails to fulfill the terms of the agreement (usually that means s/he stops making the interest only payments due each month while the repairs are underway or during the life of the loan). Quite often, these balloon loans are made for a 6-12 month period and include the rehab/repair funds, which are escrowed and released in the form of line item draws, reimbursed upon the completion and inspection of the budgeted repair.

As a metric, the 70% ARV formula is a tried and true lending guideline that insures that the lender and investor will both profit from the deal. For the lender, the profit occurs in the form of interest and points on the debt side. For the investor (or partners), the 30% profit margin on the equity side guarantees increased value through the forced appreciation of repairs. The investor will also incur expenses in the form of holding costs (during any balloon or permanent mortgage loan) and sales costs (if the property is flipped or sold on the retail market, rather than held as an investment property leased to tenants).

RESIDENTIAL FLIP OR HOLD METRIC PRICE PER SQUARE FOOT/PSF

A common metric most homeowners are familiar with is Price Per Square Foot (PSF).  Its easy to think in Per Square Foot costs, since most retail home listings orient us to this metric. If an average 3 bedroom/2 bath home measures 1500 SF, its easy to adjust common neighborhood values to Per Square Foot assessments. In one major metro market, an average middle class home may sell for $125 PSF. In that same market, high end or luxury neighborhoods may retail for $350 PSF. Since the values are specific to the market, the PSF metric works for quick analysis.

If you run across a listing that is 30% or more below the neighborhood or zip code average PSF, chances are that the property has issues that will require repairs, often mechanical or structural in nature. Those lipstick on a pig deals are far and few between, now that so many have caught the HGTV flip fever,  enticing wanna-be investors to find cosmetically challenged properties in need of a good make-over. Nonetheless, good deals can appear on the Multiple Listing Service (MLS) for the intrepid willing to tackle problems most newbie or first-time rehabbers/flippers avoid.

MULTIFAMILY RESIDENTIAL HOLD METRIC  GROSS RENT MULTIPLIER (GRM)

Multifamily residential units, namely 2/3/4-plex properties, are commonly held by individual investors for both rental income and long term appreciation. Since these small multifamily properties are classified as residential. as opposed to commercial. by the FHA, government backed residential investment mortgages are obtained by qualified investors at favorable interest rates, just as single family residential mortgages are approved by these same conventional lenders.

Much like multifamily commercial apartments (deemed as five or more units), the metric of valuation is affected by the income derived from rents. Small multifamily properties, be they duplexes, triplexes, quads, 6/8/12/20 unit small apartment complexes have historically been valued by a metric known as the Gross Rent Multiplier (GRM).

The way it works is to derive a value for the income property, so that the GRM metric can be compared to similar properties in the area. The lower the GRM value, the better the opportunity or deal for the investor. The calculation formula follows:

GRM = Purchase Price / Gross Income

Example 1:     GRM = $300,000 / $30,000  (or)  GRM = 10x

Example 2:     GRM = $300,000 / $60,000  (or)  GRM = 5x

Assuming similar comps for both examples (lets call them Property 1 & Property 2), Example 2 (Property 2) is the more attractive deal, due to the higher income derived, reflected in the lower GRM metric, 5x.

COMMERCIAL FLIP OR HOLD METRIC  CAPITALIZATION RATE/CAP RATE

On the commercial side, there are several property valuation or appraisal methods with their own metric calculations. For investors, the capitalization rate metric is the most common. It takes into account a true Rate of Return (ROR), so that high net worth individuals or grouped investors (syndication) can calculate the best yield for their invested funds. Heres how the Cap Rate formula is calculated:

CAP RATE = Net Operating Income (NOI) / Property Price

Example 1:     CAP RATE = $200,000 / $2,000,000  (or)  CAP RATE = 10% ROI

Example 2:     CAP RATE = $200,000 / $4,000,000  (or)  CAP RATE = 5% ROI

Which would you rather have as an investor, a 10% or 5% yield on your investment? I thought so. Since Example 1 produces the better return for the funds invested, the Cap Rate metric shifts from valuations based on market metrics to an income method, easily understood by investors who have many investment vehicles to choose from.

Effective yields make it easy to compare risk and rates of return. Real estate has less volatility associated with its market value, due to the fact that its a hard, tangible asset. This intrinsic value lowers the risk for investors, when compared to a security that is rated, based on a companys performance, history of operation, financial data, etc. (eg. Morningstar index). Investors that control a hard, income producing asset can make changes that affect performance, unlike a security investment thats controlled and managed by an elected board of directors and management team chosen by the board.

Real estate runs in cycles. Booms & busts. High & low inventory. Rising & declining rents. My father taught me this principle when he worked in commercial development in the 70s & 80s. Real estate runs in 6-7 year cycles. Not that I cared much about the idea, as a teenager. Nonetheless, the precept was ingrained. Decades later, Ive come to respect the wisdom in that observation. Real estate is a cyclical business.

STATE & NATIONAL ECONOMIC CYCLES

www.recenter.tamu.edu/pdf/1862.pdf

So, we can say our state economy is growing, in a phase of expansion. as economists term. With the MSAs of Midland, Odessa, Longview and Houston-Sugarland-Baytown leading the way, it appears Oil and Energy  command the most industry attention. Its no surprise that Mining & Logging rank first in employment growth (annual 11.29% increase), followed by Transportation, Warehousing, Utilities (8.41%) and Construction (6.18%). Conversely, the industries and sectors that provided the greatest annual contribution to the states employment growth rate include Professional & Business Services (#1),  Trade (#2)  and Educational & Health Services (#3), with Mining & Logging (#8) trailing behind Construction (#7). Perhaps, the Texas economy is far more diversified in 2014, compared to its energy dependence past, think 1982 (oil price crash) and 1986 (S&L crisis).

CAPITAL CYCLES

Compared to other industry sectors, real estate is capital-intensive. A venture capitalist betting on the technology sector can very well generate far more revenue for every dollar invested in a start-up, if contrasted with the number of dollars required to produce attractive returns leasing or selling property per square foot. Therefore, capital markets and their cycles impact whether real estate is in or out of favor, as an investment vehicle.

Liquidity Cycles dictate how much capital is available to invest. The rise and fall of interest rates also determines the cost of capital, impacting the decision to borrow. Traditionally, the Liquidity Cycle & Interest Rate Cycle may be at odds, depending on laws, lending guidelines and competition affecting the marketplace. Higher rates of interest may create liquidity in the market, making funds available for real estate projects. However, the cost of the debt capital creates negative leverage. producing an unprofitable project for the investor or developer.

Real estate, like other commodities, contends with the decisions of Wall Street, the Fed, lenders, economists and analysts, on a macro-level. The fallout years of the housing bubble (2007-09) led to institutional & corporate cash hording, risk-averse lending practices and a general distaste of the sector through 2012, some would argue. No doubt, savvy investors saw opportunity in the foreclosure and short sale residential market, absorbing some of the red ink drying on the REO asset managers books. Early on, hard money loans, savings, retirement funds and private lenders cash beat the hedge funds to those below-market deals. The market corrected, while Dodd-Frank set out to limit easy credit and sub-prime lending standards. In a nutshell, interest rates were favorable during the recession, while debt liquidity was almost non-existent.

Fortunately, the liquidity crisis eased and all that pent-up capital started chasing deals for better yields. given the historically low discount rate set by the Fed. Only time will tell how long the party of todays liquidity & interest rate cycle will continue. No doubt, the combination has led the state out of a recovery phase and into an expansion phase, especially in the booming Texas Triangle metros.

GEOGRAPHIC CYCLES

So, where to invest in Texas in 2015? Thats a good question. It pays to examine population trends around the state.

The Texas A&M Real Estate Center provides plenty of helpful statistical information and news

blog.recenter.tamu.edu/. As pointed out in a previous post, the

Texas Triangle (DFW, Houston & Austin/San Antonio) has witnessed unparalleled economic and

population growth the last several years. Based on a Rental Growth Rate Cycle. rents have risen

to levels that have forced new single and multifamily construction. The demand for housing has

far outpaced the supply in the Triangle.

Weve especially witnessed this phenomenon in the Austin MSA. Apartment rents and occupancy have outpaced that of NYC, over the past six months. According to RentJungle.com (Nov 2014), the average apartment rent in Austin increased 9%, compared to NYCs 6% increase. Those in the business of flipping existing properties and new construction have fared very well, especially in the core, provided they protected their margins. Multifamily was predicted to rise, with so many renters moving into town. Single Family Residences followed the same pattern, noting the low levels of inventory and three years of consistent appreciation increases.

The border cities of McAllen/Brownsville, Laredo and El Paso have not experienced the same

pressure as the Triangle. This is a case of Geographic Cycles shifting back to the major metros.

www.recenter.tamu.edu/pdf/1862.pdf

Does the Geographical Occupancy Cycle suggest Texas border cities are a bad bet for investors?

Housing inventory in these mini-metro/micropolitan cities show quite a gap for the month of

October 2014. McAllen ranks highest at nearly 14 months, while Laredo was below 6 months.

Housing sales were up 30% higher in Laredo than Brownsville, its nearest border competitor in

recenter.tamu.edu/pdf/2046.pdf

These indicators prove population and economic activity are happening along the border, though inconsistent in their rates of growth. The Rental Growth Rate Cycle in the cities of El Paso and Laredo show impressive jumps over the last six months. El Paso increased 12%, while Laredo jumped 20% on average. Comparable rents are considerably lower than those of the Triangle, but the increases are worth noting when calculating cap rate values for multifamily properties.

As with all cycles, local real estate markets cycle from phases of expansion to oversupply. then

leading to recession and eventual recovery. Choosing a geographical market to park your hard

earned or borrowed dollars (or yen, pesos, etc) requires local knowledge of employment,

population change and shifts in demand for particular property and asset classes.

PROPERTY & ASSET CLASS CYCLES

New housing starts and levels of single family residential inventory consistently tell an

investor whether long term occupancy commitments to a geographical area are rising, falling, or remaining steady. This residential indicator has a direct impact on the cycles of property types that are most likely to succeed. Think 30 year mortgages. If these are in demand in certain

neighborhoods, municipalities and cities, the homeowner is making a hefty financial commitment to a lender, a local governments tax base and local businesses that occupy commercial space. Employment growth usually leads the way in these communities. Eventually, most tenants want to own a residential asset, rather than waste rent dollars forever. The savvy real estate investor pays close attention to these long term population and economic trends affecting the communities targeted for investment.

If new housing starts and low inventory lead a local economy from the recovery phase to the

expansion phase, Property Types or Asset Classes follow, especially Multifamily and

Industrial/Warehouse/Storage. Most investors choose to target residential or commercial

properties, since institutional properties (schools, hospitals, govt, etc) serve the interests of

large developers and institutional investors. Commercial Asset Classes. like Hospitality, Central

Business Districts (CBD), Offices, Retail, Senior Housing, to name a few, create opportunities

for investors to develop or add value to new or existing income properties.

Traditionally, commercial or income properties follow long term occupancy trends and the phases that follow periods of residential expansion. Growth rates may level off where residential properties enter the oversupply and recessionary phases, but the base of occupants and tenants create demand for commercial properties in their communities. As local populations cycle through residential housing phases of occupancy and vacancy, the smart investor calculates directional trends.

Ive witnessed these cycles in the San Marcos & New Braunfels corridor along I-35 over the last ten years. Inevitably, nicer and newer housing developments moved south of San Marcos and north or west of the city of New Braunfels. Apartments followed, along with mini-storage units and warehouse or business parks. Medical offices populated Common Street in New Braunfels & along Wonderworld Drive in San Marcos. Massive retail strip centers like Creekside and the largest Buckys gas station in the state developed at the north side intersection of FM306 & I-35 in New Braunfels. The same occurred along southbound I-35 in San Marcos, leading towards the immensely successful Outlet Malls. Hotels are popping up nearby, anticipating travelers, vacationers and shoppers. Each asset class continues to develop where the local long term occupants dwell and affect property value.

PROPERTIES, PROJECTS & PARTNERS

Where will you choose to invest in Texas in 2015?

The cycles and trends discussed should help you narrow down a strategy in the community you

target. Moving from the macro to micro indicators, here are a couple of thoughts.

1) Choose properties types and locations you feel a personal commitment to developing or

improving. Like any small business, the entrepreneur has to believe in his or her product or

service. When you have heart it shows in the quality and your commitment to doing a job well done. After all, youre creating an asset for an end user, customer, tenant, homeowner. These

individuals have choices. When they choose your asset, theyre placing trust in the value youve

created in your property. Respect that and put the end user first.

2) Partner with your local communitys plan for development. City officials, local bankers,

employers, civic organizations all have a vested interest in making their community a great place to live, work and play. Be a part of that vision. Its far easier to succeed when you make

friends, rather than enemies, as a property investor. One successful project will lead to

another. Its a great strategy to win friends and influence people.

3) Take your team of real estate professionals out for coffee or dinner. They have a wealth of

local and legal knowledge that can often make or break your project. Youve chosen to partner

with them as team members. Value their work and knowledge. Show it in 2015.

4) Persist. The successful investor anticipates problems. Persist through problems. Youre a

problem solver. Thats your job. See each project through to solutions that work, that add value.

When I set out to be a property investor in the South Austin to San Marcos corridor, I learned

these principles along the way. I value these communities and the people that serve them and call them home. Each Property. Project and Partner that I evaluate need to share the same commitment to improving the community, benefitting the bottom line while providing value to the end user.

Happy Holidays. Until 2015!